Big rouble in little Europe

Published in (Wellington), 3 May 2022

Let’s start with a quiz. Over the past 12 months, which of these currencies performed the worst against the US dollar: the Zimbabwe dollar, the Russian Rouble, or the Euro?

You may notice this is a trick question if you follow the financial markets.

Since the old Zimbabwe Dollar is pegged to the greenback (and no longer Zimbabwe’s official currency), it can no longer move against the US dollar.

That leaves the Rouble and the Euro. After all the sanctions against Russia, the Rouble must have performed worse than the Euro, right?

Good guess, but still wrong.

The Russian Rouble has actually gained 2.5 percent against the US dollar since May 2021. Meanwhile, the Euro is down 12.3 percent over the same period – and heading towards parity.

Since the US is hardly an oasis of economic calm these days, the Euro’s weakness is even more shocking. With consumer price inflation running 8.5 percent in March and an annualised growth rate of -1.4 percent, the US has well and truly entered stagflation territory.

And the Euro has lost value against the Rouble, even as Russia stumbles towards depression and hyperinflation.

How can the extraordinary weakness of the Eurozone’s currency be explained?

Two factors are behind this: Europe’s looming energy crisis, and the European Central Bank’s inability to respond appropriately to rising prices.

The first issue is clear and easy to explain. It is not just that coal, gas, and oil prices have risen due to the war in Ukraine. This affects all countries, not just Europe.

For Europe, the problem is diversifying away from Russian energy imports. Logistics are at the heart of the problem. It is necessary to find new suppliers and design new methods for delivering supplies to Europe. This will not be a quick process. It will also result in more expensive sources of energy than Russian oil, gas, and coal.

A more acute concern is that Russia could cut off its energy supplies before Europe is prepared for it. That Gazprom stopped serving Poland and Bulgaria last week was another sign from Moscow such an export stop might be imminent.

These energy worries have contributed substantially to the Euro’s weakness. However, Europe’s monetary problems go much deeper, and the Ukrainian conflict is merely bringing the situation to a head.

Since 2008/09, the European Central Bank has assumed an increased role within the fabric of European institutions. It is not just a lender of last resort, like other central banks. It also underwrites Europe’s governments, banking system, and the Euro itself.

No-one expressed this more clearly than Mario Draghi when he was president of the bank: “Within our mandate, the European Central Bank is ready to do whatever it takes to preserve the Euro,” he told markets in July 2012. “And believe me, it will be enough.”

Whether the bank has acted within its mandate since then is debatable. At the very least, the bank’s expanded role does not appear to be compatible with its sole focus on price stability.

But the Ukraine war will now test the final part of Draghi’s 2012 statement: can the European Central Bank’s actions preserve the Euro? Or will the bank’s actions cause the long-term collapse of the Euro?

That would be another way to interpret the dismal performance of the Euro in foreign exchange markets. The bank is stuck even more than the Federal Reserve.

The Federal Reserve is experiencing a rerun of the stagflation of the 1970s. While consumer prices are skyrocketing, the US economy is stagnating or entering a recession.

That leaves the Fed with a dilemma, but at least it has a choice. Either it can curb inflation while torpedoing the economy, or it can watch inflation rise while delaying the inevitable economic consequences. This choice is unpalatable, but at least it is a choice.

The European Central Bank, meanwhile, has few options. A substantial increase in interest rates will not only damage the already fragile European economy. It could also push some heavily indebted European governments off a cliff.

The Harmonised Index of Consumer Prices in Europe registered 7.4 percent inflation in March. Meanwhile, the three official European Central Bank interest rates (main refinancing operations, marginal lending facility and the deposit facility) stand at 0.00%, 0.25% and -0.50% respectively. Real interest rates are extremely negative.

Even halving the gap between consumer price inflation and official interest rates would raise government bond yields to a point where Southern European governments would struggle. Note that Italian 10-year bonds have already risen from a level of around 0.5 percent in late 2020 to just under 2.8 percent today. Furthermore, note that Italy has a debt-to-GDP ratio of 150 percent.

Thus, the bank’s options are severely limited. The bank could not take a tough stance on inflation even if it wanted to. Markets know this and now anticipate a structurally weaker Euro in the future.

It would be wrong to blame Putin for the Euro’s plunge in foreign exchange markets. But it was Putin who knocked over the European Central Bank’s house of cards with his war against Ukraine.

Europe will face difficult monetary conditions for years to come. If the bank is unlucky, inflation expectations will solidify, and rapid price increases will become a permanent feature for the Eurozone.

When we run the quiz above again in a few years, what will be the result?

Well, let’s hope Europe will not have to worry about comparisons with Zimbabwe.

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