Who is Afraid of the Global Rebalancing?

More than the uneventful October ECB meeting, the stream of strong IP numbers in the three largest economies of the area was the real news of last week. As a consequence, we decided to revise up our eurozone GDP forecast for the third quarter. We now see 3Q GDP at 0.4% qoq vs. our previous expectations of 0.2%, strongly up from the prior -0.2% and pretty much in line with an educated guess of the post-crisis eurozone growth potential. No doubt, this is very good news but the risk of a renewed slowdown in the last quarter of the year is very concrete. We changed the quarterly profile of growth, and now expect GDP to slow to 0.2% in the last quarter of the year, and to decelerate again to 0.1% in the first three months of 2010. In our view, it’s too early to change the overall picture which remains one of below-trend GDP growth throughout the forecast horizon.

This week is very light in terms of data releases and events. The German ZEW index for October (Tue 13) should add further, though slowing, momentum to the brighter sentiment picture whereas ECB rhetoric (Tumpel-Gugerell on Tue 13 and Bini Smaghi on Wed 14) should stick to the plot played by Trichet in Venice, welcoming recent improvements but warning on the fragility of the recovery. Slightly more important will be the final estimate of eurozone September inflation (Thu 15) – which we expect confirmed at -0.3% yoy – especially if core prices drift downward to 1.2%.

Preventing the exchange rate from being another drag

As mentioned, the October ECB press conference delivered no relevant news. One of the possible exceptions has been Trichet’s comments on the strength of the euro. Trichet clearly claimed that there is agreement among G20 participants on the need to reduce excessive volatility in FX markets and he very cautiously hinted at some sort of agreement on possible coordinated intervention to counteract a very unwelcome further appreciation of the euro.

The exchange rate issue has been always a very tricky one in the ECB’s history. Nowadays, it has to be considered also in the wider perspective of the ongoing correction in global imbalances. Our view is that global imbalances probably were not among the main causes of the financial apocalypse of the last two years, but likely one of the key factors that aggravated its harsh consequences on the real economy. All of a sudden, after the collapse in global trade last autumn, the US consumer found himself with no savings to use as a buffer to offset the negative wealth effect of housing and equity markets, and large-surplus countries didn’t have any endogenous engine of growth to rely upon amid plunging exports.

The situation is definitely improving: latest figures tell us that the US current account deficit is now lower than 3% of GDP, surpluses of oil-exporting countries are shrinking in the wake of the plunge in oil quotations from the peak of July 2008, and also in China in the first half of 2009 there has been a significant narrowing in the trade surplus. The eurozone shifted from a broadly-balanced current account to a small deficit thanks to a certain resilience in private consumption that has made imports fall less than exports.

What we should expect on the matter going forward remains difficult to detect. However, an article published in the latest Quarterly Report on the Euro Area published by the European Commission (EC) helps in shedding some light. The EC argues that although the euro area played a negligible role in the building up of global imbalances, it may be one of the casualties of the ongoing rebalancing process (http://ec.europa.eu/economy_finance/publications/publication15971_en.pdf).

No surprises, lots will depend on the role China will decide to play. In the EC’s opinion, in a more benign scenario the Chinese economy would take care of absorbing all the projected reduction in the US trade deficit via a significant appreciation of the real effective exchange rate. In this scenario, the euro area will experience a significant narrowing of the trade deficit with China, and a fall in the trade surplus with the US as a consequence of a mild appreciation of the euro. The worst case scenario is one where China could resist absorbing US products or allow only a very modest appreciation of the renminbi. In this case, a significant trade deficit for the eurozone would emerge because of the likely very sizeable appreciation of the euro.

It seems to us that in the current beginning of a very fragile recovery (apart from the nice rebound we are going to see in the third quarter), the ECB is becoming increasingly aware that a stronger euro must be absolutely avoided. A couple of years ago, we developed a model aimed at providing a rule of thumb to determine the dampening effect of currency appreciation on economic activity. Indeed, rather than export we chose the GDP as the endogenous variable of the model because we wanted to allow for spill-over effects of changes in export demand onto domestic variables – mostly investment spending. The dampening effect on GDP of a 1% appreciation in the nominal trade-weighted (TW) euro is about 0.1% in a two-year time: the impact is negligible in the first two quarters, but becomes significant thereafter and the largest single-quarter effect (50% of the total cumulative response) is felt after nine months. This means that the 2% appreciation seen since the beginning of 3Q 2009 may shave off 0.2pp from an already-anemic GDP over the forecast horizon. Further euro strengthening in the remainder of the year will bring down our baseline 0.8% growth forecast for 2010 worryingly closer (or even below) to the 0.3% that the ECB staff is currently envisaging.

This is a new era for lots of aspects of monetary policy. We think that it may also become a new era of ECB’s rhetoric on the exchange rate. It would be paradoxical that one of the few balanced economic areas of the world bears the burden of the global readjustment. What can be certainly said is that, irrespective of how the ECB decides to tackle the exchange rate issue, a strong euro is another solid argument in favor of our view of a refi rate stuck at 1% throughout 2010.