Spotty euro area recovery to compliate ECB’s interest rate policy this year

Spotty euro area recovery complicates ECB policy

LONDON — The recession may have officially ended in France and Germany, the heart of Europe’s economy. But broken government finances around the periphery — and a spotty and uncertain economic recovery — could make this a very difficult year for the European Central Bank.

Though the eurozone’s two largest economies have been showing modest growth since the second quarter of 2009, other members of the 16-country eurozone such as Greece, Ireland and Spain continue to be plagued by mounting deficit worries, debt downgrades and even fears about default.

That could complicate ECB President Jean-Claude Trichet’s job in finding one interest rate to suit all parties in the months ahead.

As a result, there’s a huge divergence of opinion in the markets as to when the European Central Bank will start to raise its benchmark interest rate from its current historic low of 1 percent.

Some economists think the bank is underestimating the pace of the recovery in the way many feel it underestimated the scale of the contraction beforehand. Others think that there are too many questions about government finances to clear up before borrowing costs can start to rise again.

With policy set to remain unaltered at the bank’s first meeting of 2010 on Thursday, investors will be particularly interested in hearing Trichet’s outlook on issues that have intensified since the last interest rate meeting in early December, not least the mounting budgetary difficulties in Greece.

For many in the markets, sovereign credit risks will be one of the key topics on the ECB’s plate this year. Since the last meeting, the new Socialist government in Greece was forced into an emergency budget last month after credit rating agencies, such as Standard & Poor’s and Moody’s, downgraded its view on the country’s debt.

That set off market concerns, in the wake of the debt problems afflicting Dubai, that Greece will have to be bailed out by its partners in the European Union to avoid a default that could damage confidence in the shared currency. EU officials have warned Greece no bailout will be forthcoming, but that hasn’t stopped speculation that other countries might have to step in with some form of financial help.

Greece isn’t the only eurozone country whose public finances have been ravaged by the recession — Ireland, Portugal and Spain are also set to introduce tough austerity measures even though economic recovery is by no means entrenched.

“The ECB will find it difficult to raise interest rates this year given issues relating to sovereign solvency and financing for some eurozone economies,” said Neil Mackinnon, global macro strategist at VTB Capital.

Other economists reckon the European Central Bank should not lose sight of its job, which is to set interest rates to achieve inflation of below but close to 2 percent in the medium term across the whole eurozone. That means raising rates if necessary.

In any case, the laggards should benefit over the year from the upturn in their major trading partners and beyond, said Holger Schmieding, European economist at Bank of America Merrill Lynch.

Schmieding dismissed recent suggestions that such countries would look to leave the single currency area especially as many of the more fragile countries have fared better under the euro umbrella than many outside it, such as Iceland. The small island nation suffered a steep and painful devaluation of its national currency, a problem euro members don’t face.

Getting kicked out for breaking EU rules on deficits won’t happen, either, he said.

“As they are part of a tightly knit European political family, the risk that they may get kicked out of the eurozone is virtually zero as well,” he said.

The European Central Bank itself raised the issues of leaving or being expelled from the euro zone, but mostly to emphasize how remote the possibilities are. In a legal note on its website just before Christmas, bank legal counsel Phoebus Athanassiou explained how the recently ratified Lisbon Treaty did add a provision for a country to unilaterally leave the eurozone or to be expelled, but that move down either path is laden with extreme difficulties. Until the Lisbon treaty took effect Jan. 1, EU agreements were silent on how anyone could leave the euro.

Countries that abandon the currency would have to do without substantial development aid aimed at helping lagging regions and improving transport links.

“For the poorer euro members, who are the main beneficiaries of ’structural’ or ‘cohesion’ funds, the cost of leaving would likely be much greater than the fiscal efforts required to end their profligacy,” said Schmieding.

The economic outlook for the eurozone also hinges on what actually happens with the currency. Having spent much of 2009 rising against the dollar, the euro ended the year by declining, as investors fretted about the debt situation.

Further euro exchange rate weakness would likely be welcomed across the eurozone as it would help exports. That would cement the economic recovery in the stronger economies and help the weaker economies emerge from recession.

“If ongoing concerns about economic divergences in the region prompt the currency to depreciate further, exporters across the region could actually benefit from such concerns,” said Ben May, European economist at Capital Economics.

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