The Macro View: Cost of euro currency stability – an eyewatering €750bn?

The markets’ brutal reaction to the first Greek rescue package offer, totalling €30bn, left Europe’s leaders with policy choices they were anxious to avoid. But a second, much larger, €110bn bailout package triggered violent opposition in Greece and negative market reactions. Euro declines, mainly against the US dollar, have gathered momentum and share prices have fallen.

A Greek default, even if portrayed as debt restructuring, risks unleashing a serious crisis. Major banks, mainly in France and Germany, have significant exposure to Greece. The ripple effects of default could be devastating, if contagion unleashes a domino effect that overwhelms other countries.

As the dangers of financial meltdown escalated, Europe’s finance ministers and central bankers abruptly reversed their initial, timid approach, mounting a dramatic €750bn rescue plan aimed at stabilising the euro. The new package, which is in addition to the €110bn Greek bailout and is the biggest since the collapse of Lehman Brothers in 2008, involves loan guarantees and balance of payments support to countries facing pressures.

The International Monetary Fund is closely involved in the rescue plans; this signals international support and is aimed at helping ensure that those receiving support will implement austerity measures.

The massive euro rescue package was initially well received, with the euro and share prices recovering. The hope is that the sheer size of the packages will deter speculators and that the money will not have to be used.

But the euro will be threatened if similar crises occur. Even if the eurozone’s core survives, members such as Greece may be forced to leave temporarily and then request to rejoin the club at a lower exchange rate. The problems facing the Eurozone’s periphery are not simply financial. They entail competitiveness losses that are very difficult to regain if the exchange rate cannot be devalued. The packages will buy time – but they will not secure the euro’s survival.

UK General Election
Meanwhile, Europe’s uncertainties worsened following the inconclusive results of the UK General Election. A hung parliament was widely predicted but a coalition government need not preclude effective action to deal with the unsustainable fiscal deficit.

In contrast to Europe, Asia’s main problems are excessively rapid expansion and inflation. China’s GDP growth accelerated to 11.9 percent year-on-year in the first quarter of 2010, the fastest increase in almost three years. Fears over overheating remain a serious concern. China is already acting to restrain lending bubbles and further steps are expected. Official interest rates will be raised in the next few months.

More controversially, to help cool the economy, the Chinese will probably allow a moderate appreciation of the yuan exchange rate, reversing their resolute opposition so far to such a move. But China will move very cautiously. It wants to avoid big inflows of capital, and is reluctant to yield to international pressures.

India raised interest rates for a second month in a row in April, to contain rising inflation. With India’s industrial output recording double-digit growth in the past few months, further tightening is likely.

Other Asian countries, and Australia, are moving in the same direction. Tighter policies would inevitably cause growth to slow next year, but Asia will still continue to lead the global recovery in 2011.

US growth
The US economy, though less dynamic than India and China, continues to grow more strongly than Western Europe. US GDP expanded at an annualised rate of 3.2 percent in the first quarter of 2010, less than the 5.6 percent growth in the fourth quarter of 2009 and slightly weaker than analysts had expected, but nevertheless a very satisfactory pace.

The US labour market is also improving, after very sharp job losses during the recession. The 290,000 new US jobs created in April signalled the biggest increase in four years and was bigger than expected; the early estimate for March new jobs was revised significantly upward. But 66,000 of the April jobs were temporary workers for the 2010 census.

More worryingly, the jobless rate rose to 9.9 percent in April, because previously discouraged workers re-entered the labour force and the new jobs created were still not sufficient. Even so, the fact that the private sector accounts for the vast majority of the new jobs created in April reinforces optimism that the US recovery is likely to strengthen.

While Asian interest rates will go up, Europe and the US will persevere with expansionary monetary policies. Official interest rates will stay exceptionally low, and increases are unlikely until the fourth quarter of 2010 at the earliest.

Though central banks are worried about inflation, quantitative easing will be withdrawn very slowly. Indeed, the fact that the European Central Bank is playing a key role in the euro rescue package, by agreeing for the first time to buy government bonds, will delay any tendency to tighten policy.

The key point is that recovery is still very fragile, mainly in Europe. Growth forecasts for 2011, both globally and in most major economies, have been cut further in recent weeks.

David Kern is chief economist at the British Chambers of Commerce