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Analysis
Bank of England setback adds to euro tests

Bank of England setback adds to euro tests

Conditions will be less benign than in 2013 

by David Marsh

Wed 29 Jan 2014

Mark Carney, the Governor of the Bank of England, has made an embarrassing about-turn on 'forward guidance' as a result of an unexpected fall in UK unemployment. It seems likely that interest rates in Britain – the euro area's most important trading partner – will be on the rise by the end of the year. This is likely to be one more factor adding to difficulties for the 18-member euro bloc.

Since August, the Bank of England's forward guidance has laid down that interest rates would remain on hold until unemployment falls to 7% – a condition which, as a result of better-than-expected UK economic recovery, may have been achieved in December.

The prospective tightening in the UK, as well as cautious ‘tapering’ of Federal Reserve monetary stimulus and uncertainties in leading emerging market economies, will provide a further test of European policy-makers' resolve to protect the single currency's long-term health.

Political and economic circumstances may make 2014 a lot less benign than 2013 for euro peripheral country debt and equity markets.

Last year the financial markets were far more bullish than justified by economic circumstances. This year, growth is ready to resume in Europe. But, as so often happens, financial markets got in their reward early. Market practitioners may start looking forward to the next crisis.

Just as the euro area was eventually badly hit by the fall-out from the Lehman Brothers bankruptcy in September 2008, turbulence in exposed developing nations, ranging from Argentina and South Africa to Russia and Turkey, will have big repercussions for the euro bloc.

Home-grown problems, too, have not been resolved. President François Hollande of France has announced structural economic reforms akin to the ones that allowed Germany to reinvigorate its economy – in much less difficult external circumstances – 10 years ago, but is a long way from implementing them. Greece has taken painful and praiseworthy steps to adjust, but remains accident-prone.

May elections for the European Parliament are likely to see extremist anti-European parties winning a significant number of seats. The rise of the anti-euro Front National presents a particular problem for Hollande.

Despite a slow recovery over the past 12 months, the euro area remains fragmented. The gulf is between the better performing northern creditor countries, led by Germany, and the badly hit southern and western nations that have restored balance of payments equilibrium thanks mainly to austerity. This has produced record-breaking unemployment in several countries. Germany, meanwhile, has registered several years of record current account surpluses. According to the Bundesbank, the country has accumulated net foreign assets of €1.2tn, double the amount in 2008 before the financial crisis – money owed by foreign debtors that will never completely be repaid.

European central bankers, while broadcasting worries about the slow pace of reforms in Europe, have been dropping hints that the delayed German Constitutional Court decision on the European Central Bank’s (ECB) Outright Monetary Transactions (OMT) bond-buying programme might be negative for markets. The euro authorities had been hoping that, by the time the court announced its decision, financial markets would be sufficiently robust to shrug off any restrictive judgment (such as placing Bundestag-authorised limits on Bundesbank involvement in OMT). This may no longer be the case.

Conditions in Berlin are somewhat fraught. Chancellor Angela Merkel has been sidelined as a result of a skiing accident. Her deputy in the Grand Coalition, resilient and ambitious Social Democrat leader Sigmar Gabriel, has been doing his best to outshine her in recent weeks – leaving doubts about the effectiveness of Germany’s euro policies.

Mario Draghi, the ECB president, has warned that the European crisis is not over and that the ECB has no special plans such as US, UK or Japan-style quantitative easing to buoy the European economy. He has signalled that ECB may fight deflation in Europe by buying packages of bank loans to households and companies. The plan has been discussed for months but has been difficult to bring to fruition.

The ECB claims it should not be seen as the rescuer of last resort for the euro area. If 2014 turns out badly, by the end of the year that is one statement that will command near-universal credibility.

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