The ECB's Dangerous Gamble

 |  Includes: EZU, FXE
by: Zhong Jin
The ECB just raised its policy rate to 1.25% from previous 1% on Thursday, right after Portugal asked EU to bail it out. Now the ECB is leading the US, UK and Japan in the cycle of monetary tightening. At the same time, it keeps its emergency liquidity programs to support the troubled banks and indebted PIIGS governments. By raising the policy rate and providing liquidity to market at the same time, the ECB hopes to achieve both goals at once: controlling inflation and keeping troubled countries afloat.
This is of course a noble idea. But the ECB essentially took a dangerous gamble, betting that restructuring economies of troubled countries (PIIGS) will stimulate enough new private investments sooner than popular angers in those countries rock the boat.
Until now, economic activities in the EU had been accelerating for several months. The upward economic trend in private sectors just took a small break in March. Manufacturing PMI in various EU countries showed that growth rates, though generally positive, are slightly lower in March than in February.
Click to enlarge
Yields of government bonds of EU countries are still largely divergent. The ECB’s rate raise will have little impact to narrow the gap. Yields of 10 yr government bonds of Spain, Ireland, and Greece are nearly at twice the levels of a year ago. While the ECB bond purchasing programs and EU emergency funding keep injecting liquidity into banking systems in these countries, much higher borrowing costs remained another large obstacle for economic growth.
Click to enlarge
As the ECB goes further down the path of fighting inflation, the deflationary impact will hit the vulnerable regions first, since profitable and competitive economies can better withstand and absorb the additional cost resulting from the higher interest rate. Economies of PIIGS are going to further slow down in the next few months.
Click to enlarge
The fiscal bail-out is essentially transferring money from EU core economies such as Germany and France to weak PIIGS. Of course German taxpayers do not like to see their money supporting the generous welfare system in other countries. Hence, Germany has requested structural reforms of economic and fiscal policies in other countries. These structural reforms, in plain language, include lower wages, fewer benefits, later retirement, higher taxes, and smaller pensions. None of these provisions would improve a worker’s income in short run.
In other countries such as the US and China, workers are relatively free to move from one region to another to pursue better opportunities. Internal economic migration, though not always a smooth process, is an important mechanism to help balance the regional inequality. Although the EU has already integrated in many ways, except for a small portion of skilled workers, most people in PIIGS do not have the option to move to Germany or Netherlands to look for jobs due to language difficulties and regulatory barriers in labor markets. And at the low end labor market, they are not competitive enough compared to unskilled workers from Eastern European countries.
Although EU emergency funds and the ECB have enough capacity to support the troubled countries for a while, the coming monetary tightening cycle will only hurt the real economy of these countries. For the majority of the populations of indebted countries, it means that they have to endure the economic sacrifice even longer to see the prosperity coming again. Alternative options such as restructuring the existing debts (default) or pursuing their own independent monetary polices (leaving Euro zone), while having their own costs, look more attractive to people in indebted EU countries (Neither is appealing for EUR). The ECB can squeeze speculators’ short positions on EU assets in the financial market. But it has few tools to prevent indebted countries from choosing alternative options. In my opinion, eventually the ECB will lose.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.