London/Frankfurt: Jean-Claude Trichet's shot against inflation may end up inflicting collateral damage on Europe's most cash-strapped economies.
Primed to raise its benchmark interest rate this week for the first time in almost three years, President Trichet's European Central Bank (ECB) again faces the conundrum that its monetary policy rarely suits all 17 members of the Eurozone, where the kaleidoscope of growth ranges from record expansion to recession paired with a sovereign-debt crisis.
The upshot may be that the normalisation of rates from a record low of 1 per cent will disproportionately hurt Spain, Greece, Portugal and Ireland, while failing to nip inflation threats in Germany.
Such uneven fallout risks exacerbating the two-speed European recovery and dealing further damage to the bonds of so-called peripheral nations. Credit Suisse Group AG is warning investors away from the region's stocks and banks partly because of concern the ECB is making a policy mistake.
Price stability
"As the ECB continues to tighten, it increases the risk that the sovereign-debt crisis comes back," said Gavyn Davies, chairman of London-based hedge fund Fulcrum Asset Management LLP, which oversees about $1.5 billion (Dh5.5 billion) in assets. "It will manifest itself with the troubled economies moving into slower growth rates, and the fiscal arithmetic will worsen again."
Trichet and his 22 fellow policy makers convene in Frankfurt April 7, a month since he surprised investors by signalling an increase in the ECB's key rate by a quarter of a percentage point as inflation accelerated to 2.6 per cent in March, the fastest in more than two years.
In enacting the first rise since July 2008, policy makers would be focusing on their primary goal of price stability rather than secondary mandates to support growth. They'd also be taking the lead over the Federal Reserve in starting to withdraw emergency lending rates.
Belgian Guy Quaden, who retired March 31 as one of the longest-serving ECB council members, said "a cautious increase" won't hurt the region's economic recovery because "both growth and inflation have become again significantly positive."
Even so, the weakness of the periphery and its banks mean "the ECB simply cannot raise rates too aggressively without breaking up the Eurozone," said Simon Maughan, co-head of European equities at MF Global Ltd. in London. A Bloomberg News survey predicts the central bank will lift its main rate to 1.75 per cent by year-end, based on the median estimate of 31 economists.
Record debt burdens
Economies from Ireland to Spain are buckling under record debt burdens and the bursting of property bubbles, even as Germany expanded 3.6 per cent last year, the strongest pace in two decades. In forecasting Eurozone growth of 1.6 per cent this year, the European Commission predicts expansion of 2.4 per cent in Germany, three times the anticipated rate for Spain, where unemployment is 20 per cent, the highest in the region.
The situation is a "precise reverse" of the period before December 2005, when the ECB last began raising rates, said Nick Kounis, head of macro research at ABN Amro Bank NV in Amsterdam. Then Germany was weak, with growth of 0.8 per cent that year, while the Irish and Spanish economies expanded 6 per cent and 3.6 per cent.
"We were in a world where rates were much too accommodative for the periphery and much too tight for the core," Kounis said. "Now, the situation is the same, only the countries are different. It's a problem with their one-size- fits-all policy."
The ECB has set its benchmark at 1 per cent since May 2009. Spain, Portugal, Ireland and Greece, which are responsible for about 17 per cent of Eurozone gross domestic product, would need an average rate of minus 4.6 per cent under the Taylor Rule, according to estimates by Credit Suisse equity strategists including London-based Luca Paolini. Germany, which accounts for almost a third of GDP, requires a rate of 4.5 per cent, they say.
The Taylor Rule, devised by Stanford University economist John B. Taylor, is a measure of where rates should be set given inflation and growth projections.
Paolini and his colleagues recommend investors in continental European stocks stay 5 per cent "underweight" the level suggested by benchmark indexes, in part because the ECB could be making a "policy mistake" if an April increase marks the start of a series of moves. In a March 9 report, they also cut their view of European banks to "benchmark" from "small overweight" and said low leverage and loan-to-deposit rates at Italian banks such as Intesa Sanpaolo SpA should help them outperform Spanish rivals.
Rising rates
"For the Irish, Greek, Spanish and Portuguese banks, rising interest rates are negative," said Carlos Egea, a strategist on Morgan Stanley's peripheral sovereign and bank trading desk in London. "They're positive for the Italians."
Greece, where government debt is set to rise to 156 per cent of GDP by 2014, will face an additional debt-service charge of 1.6 per cent of GDP if market borrowing costs gain 1 per cent on the back of the ECB raising rates, Paolini estimates.
