ECB's options: a cheaper euro or a dead euro

An ultra-loose monetary policy by the European Central Bank (ECB) is required to (a) prevent the euro from collapsing, and (b) devalue the euro to help eurozone countries recover. Hopefully, ECB will act in haste.

The ECB can either devalue the euro by cutting rates to zero percent and pumping in huge sums of money or let the euro die through inaction. The crisis-hit eurozone requires decisive action from the ECB for it to survive, and the central bank is still harping on containing inflation expectations as per its mandate.

Circumstances force the most hardened resistors to change to embrace a new order, and the ECB must follow its counterparts in the US, Japan and UK to be more proactive towards maintaining financial market stability in the eurozone.

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The numbers say it all. Eurozone economic growth is flat and is expected to go into recession, as countries from Greece to Spain to Italy and France show steep falls in growth due to fiscal austerity measures. ECB, in the face of a weakening economy, is still maintaining policy rates at 1 percent while the US, UK and Japan are keeping policy rates at 0 percent, 0.5 percent and 0.1 percent respectively to shore up economic growth in their countries.

It is true that the ECB has expanded its balance-sheet by over 100 percent over the last four years. The ECB balance-sheet stands at around 3 trillion. However, the ECB has to expand its balance-sheet more by buying bonds of the debt-ridden countries of Spain and Italy to help stabilise bond yields that are threatening to cross unsustainable levels. Spain’s 10-year bond yield has crossed the euro era record of 7 percent and at these levels Spain will require a bailout, and the size of the bailout fund of 700 billion will not be enough to bailout Spain whose public debt is over 650 billion.

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Spain’s woes feeding into Italy will make matters worse as Italy’s public debt is around 2 trillion. At some point of time, if the ECB does not act, the euro will collapse as the problems will become too big for anyone to handle and Italy, Spain, Portugal, Ireland, Greece and even France will be forced to go out of the euro. This is an option that no one wants as it will lead to chaos across the globe.

The eurozone desperately requires an undervalued euro. The euro area accounts for over 15 percent of world exports and many economies, including Greece, France, Italy and Spain, have a good flow of tourists contributing significantly to their economies. The euro has fallen over 15 percent against the USD and over 40 percent against the Japanese yen over the last four years, but it still has room to go down further.

An ECB maintaining a monetary policy that is tighter than that of the US and Japan will not help bring down the value of the euro. A weak euro will help exports of the euro area, which in turn will help bring back its economies into positive growth, given their high share of world exports.

The ECB has kept its benchmark policy rates at 1 percent over the last seven months and has infused over 1 trillion through LTRO (Long Term Refinancing Operations) to provide liquidity to eurozone banks. The LTRO is basically a three-year collateralised funding at 1 percent for banks. ECB provided funds through LTRO for banks so that banks can purchase euro nations’ sovereign bonds.

The fact that LTRO did not work with bond yields of countries such as Spain touching fresh highs in June 2012 should force the ECB to look at increasing the size of the LTRO and adopting other policy measures, including direct bond purchases, to stem the sharp rise in the borrowing costs for eurozone countries that are struggling with high debt.

A_rjun Parthasarathy is the Editor of www.investorsareidiots.com, a web site for investors._