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Ambrose Evans-Pritchard: ECB Mulls Negative Rates as Europe's Economic Crisis Deepens
By Ambrose Evans-Pritchard, Dec 6, 2012
The European Central Bank has slashed its eurozone growth forecasts and warned that recession will drag on into the middle of next year, sending the euro plunging below €1.30 to the dollar.
Mario Draghi, the ECB’s president, said the governing council had discussed a cut in overnight deposit rate to below zero for the first time, and was "operationally ready" to do so if needed.
The comment sent the euro into a nosedive, dropping from $1.3075 to $1.2950 in just two hours. "A negative deposit rate is the mother of all sell signals for a currency," said Hans Redeker, currency chief at Morgan Stanley.
"You only do it if your purpose is to drive down the exchange rate to help exports. We know from Japan’s experience that you lose control of monetary policy if you go that route. We don’t think it will happen because the cost is too high, so we expect the euro to rebound."
Mr Draghi struggled to explain why the ECB held its main interest rate at 0.75pc, even though it expects economic contraction of 0.3pc next year, with inflation falling below its 2pc target. He said there had been a "wide discussion", a code term implying that several members pushed for a cut.
"It’s a dereliction of duty. If the outlook is so bad, get ahead of the situation and cut now," said Stephen Pope from the consultants Spotlight.
The euro came under further pressure from the escalating crisis in Italy, where ex-premier Silvio Berlusconi withdrew support from the technocrat government of Mario Monti, vowing to fight further austerity. "The country is on the edge of the abyss: I can’t allow my country to plunge into an endless recessionary spiral," he said.
Mr Berlusconi hinted at a run for office early next year, despite a four-year prison conviction for fraud - still under appeal.
"The situation today is far worse than a year ago when I left the government. We have an extra million unemployed, the debt is rising, firms are closing, property is collapsing, and the car market is destroyed. We can’t keep going on like this," he said.
The rupture with Mr Monti is a stark reminder that Europe’s political crisis continues to fester as the region slides deeper into slump.
The yield on German 10-year Bunds fell to a five-month low of 1.29pc on save-haven flows, while Italy’s yields spiked to 4.55pc. The FTSE MIB index of Italian stock in Milan fell 1.4pc.
Mr Monti survived a senate vote on his fiscal package after Mr Berlusconi’s Liberty Party abstained, but his position is becoming untenable.
Mr Berlusconi has come close to calling for a break-up of EMU, saying repeatedly that Germany should leave the euro, and break the vicious cycle by allowing the Latin bloc to regain competitiveness.
Unlike Spain, Italy has already been through the brunt of its austerity so there are hopes that Italians will start to see some light at the end of the tunnel in mid-2013.
Views are polarized, however. Citigroup expects Italy to contract by 2.1pc this year, a further 1.2pc in 2013, and again by 1.5pc in 2014, with near zero growth in each year up to 2017.
"Italy’s primary budget surplus probably will be close to 3pc of GDP by end-2013, but the debt-to-GDP ratio is likely to go on rising due to the "snowball effect". Debt restructuring - probably through maturity extensions and coupon reductions - will probably be inevitable in 2015, once it becomes clear that austerity alone cannot restore fiscal sustainability," it said.
The International Monetary Fund expects Italy’s public debt to reach 128pc of GDP next year, 4pc of GDP higher than forecast as recently as April.
The IMF’s shifting forecast shows much damage the austerity policies are doing to Italy’s underlying economy, with the "fiscal mulitplier" much higher that originally thought. It is an open debate whether Italy’s is chasing its tail by tightening too hard.
Credit stress in the Club Med region is increasingly spreading to companies. The rating agency Moody’s warned that default risk is rising for any European firm exposed to the EMU periphery - including the UK groups Dixons and Imperial Tobacco, with large sales in Spain. "The North South gap is widening. Crucially, contagion could affect the stable areas if macro conditions worsen."
There have been 129 downgrades in Europe so far this year, against 47 upgrades, with fears that companies will struggle to repay $363bn of junk bonds coming due over the next four years, known as the "refinancing wall".
A separate report by Standard & Poor’s said "underlying economic realities" are catching up with Europe’s companies. "Although the intervention by the ECB appears to have averted the crisis by reducing the risk of a disorderly break-up of the euro, the hard grind of adjustment and austerity remain."
It warned of a coming wave of defaults in steel, refining, shipping, cars, and smaller mining groups, with 200 companies "vulnerable" as debt comes due in 2013 and 2014. Some 49 are likely to default by late next year. "Companies highly exposed to the periphery of the eurozone, will remain under the intense scrutiny of trade counterparties. We see little reason to expect the growing divide between the core and periphery of Europe to close up any time soon," it said.
S&P said Spanish companies now have to pay almost twice as much as German rivals to borrow, with the premium on five-year at a post-EMU high of 250 basis points.
Some Spanish firms are trying to diversify out of their home country as fast as possible or even reinvent themselves as non-Spanish groups. Inaer Aviation has switched its headquarters to London in the hope of obtaining cheaper credit. The technology group Abengoa is pushing 99pc of its investment over the next three years into ventures outside Spain.
The risk is that this exodus will create a self-fulfillng process, leaving Spain starved of investment and even less able to claw its way out of the EMU crisis.
Jean-Michel Six, S&P’s Europe economist, said EMU has degenerated into a "customs union", since the interbank market has been shut since 2011 in what amounts to a regime of "capital controls" within monetary union.
"There are two eurozones, a northern one and a southern one," he said.