Good morning and welcome to today’s foreign exchange market commentary on Wednesday, the 19th of December.
Since the present economic crisis broke out in Europe in 2008, the continent has been threatened by two crises. A sudden speculative attack on some of the most indebted countries’ bonds that could immediately endanger the single currency’s future was the biggest threat. ECB President Mario Draghi’s public pledge to stop a sovereign default diminished that danger in the short run. The other looming danger, of no growth or negative growth, has started to get serious. ECB’s latest macroeconomic forecast outlines the danger clearly: eurozone will contract this year and may grow by 0.3 percent in 2013.
Europe has consistently overestimated its growth targets because European policymakers always underestimate fiscal multipliers. This worrisome trend however could get worse. It is plausible that slow growth is driving up debt levels. It is also possible that the debt overhang is itself curbing growth. Few people are willing to acknowledge it since it amounts to seeking debt forgiveness. But soon it will be realised that the problem is not limited to Greece only.
The problem of debt overhang has been around for ages. Any country facing such a situation is unwilling to undertake painful structural reforms because it gets nothing in return. Growth, driven by private investments, slows down because investors realise additional taxes will be spent in servicing existing debt.
A country’s repayment capacity may eventually fall if the disincentive is large enough. This gives rise to debt-capacity Laffer Curve. If the debt volume crosses a certain threshold, the flow of payments that creditors get start to diminish. Hence, creditors are more secured if debtor countries are short of the inflexion point.
Many Latin American countries faced similar situations in the 1980s. But skeptics may argue Europe is not LatAm since borrowing costs are much lower than what Mexico or Argentina had to pay then. But for many European countries, the debt-GDP ratio is even higher. For example, France’s debt-GDP stands at 90 percent while it stands above 100 percent for five other members.
Many in Europe are coming around the fact that Greece would need further debt forgiveness down the line. But very few seem to believe that Portugal, Ireland, Spain and Italy, and much less France, may need debt reduction as well. But then not so long ago, not too many believed the euro could face the danger of blowing up either.
CURRENCY RATES OVERVIEW
GBP/EURO – 1.2284
GBP/US$ – 1.6268
GBP/CHF – 1.4841
GBP/CAN$ – 1.6032
GBP/AUS$ – 1.5450
GBP/ZAR – 13.7672
GBP/JPY – 137.24
GBP/HKD – 12.6061
GBP/NZD – 1.9354
GBP/SEK – 10.7231
EUR: The single currency extended gains against the US dollar for a seventh session on Tuesday as investors grew optimistic of a budget deal before the end of the year. Risk sentiments got a boost after House Speaker John Boehner held a news conference to say they are working on “Plan B” that would include higher tax rates for Americans making more than $1 million a year. Euro got further support after ratings agency S&P raised Greece to B-minus from SD – selective default with a stable outlook and the EUR/USD pair changed hands at around 1.3224. We have the German business confidence data due today and a higher reading is likely to lift the euro further.
USD: The US dollar retreated yesterday as demand for safer assets dropped following speculations that the continuing deadlock over spending cuts and tax hikes could be resolved soon. The ICE dollar index, a barometer of the greenback’s strength against a basket of six currencies, fell to 79.348 from 79.556 on Monday. President Obama softened his stance on Monday, offering to start tax rate hikes at $400,000 in income for individuals against the $250,000 suggested earlier, and agreed to cut entitlements and social security benefits. The revised plan is expected to raise $1.2 trillion in taxes in the next decade. Cable also gained against the greenback with the GBP/USD pair trading around the 1.6270 level, its highest since September. Markets will stay focused on the minutes from this month’s Monetary Policy Committee meeting which some expect to deviate from the recent unanimous decisions on interest rates.
Have a great day!
