ECB: Between A Rock and A Hard Place

A year ago, the European Central Bank‘s concern was simple: economic recovery. The year 2009 proved to be relatively good, as the euro zone was able to finally climb out of recession and post some optimistic economic data here and there. All good, right? Not exactly. As the euro zone starts to recover, the ECB now faces the challenge of uneven growth among the member states.

Setting a monetary policy that takes into account the needs of each euro zone member is certainly not an easy task. While Germany and France were able to post growth of 0.7% and 0.3% respectively during the third quarter of 2009, nations like Greece and Spain remained in the recession pool and continued to anguish in debt hell. During this period, Greece and Spain’s economies shrank by 1.7% and 0.3%! Note, however, that the ECB’s primary objective, as defined in the Maastricht Treaty a couple of decades back, is maintaining price stability (a. k. a. inflation) and not ensuring growth!

Greece’s problems do not end with their shrinking economy. Since the beginning of the recession, the country has built itself a mountain of debt amounting to about $500 billion! From the looks of it, their government’s massive spending in their effort to lift the country from the recession did not work at all.

Moreover, given the Greece’s deteriorating fiscal condition, Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings have all downgraded their ratings on the country’s sovereign debt. These credit downgrades have led to the ECB deciding that they will no longer accept Greek notes as collateral by the end of 2010 and that the country will have to get their funds from a different source other than the ECB. With a credit downgrade, of course, Greece’s government will therefore need to pay more interest for them to borrow. If only they could pay off their debt with some home-cooked paninis – ha!

As much as the ECB wants to help Greece, they simply cannot give any single country a “special treatment” since their policies should be applicable to all of the euro zone member states. I guess my buddies over in Greece won’t be saying WHOPPPA for some time!

Meanwhile, my comprades over in Spain face a similar problem. Like Greece, Spain is also being plagued by their mounting sovereign debt position. As a result, the country’s sovereign credit rating was lowered from AAA to AA+ by S&P as well. Although Spain can still use their sovereign notes as collateral for borrowing funds from the ECB, the rating downgrades to Spain’s notes will add more premiums on Spanish debt.

You see, having a centralized economic policy for the entire euro zone has its cons. While further monetary easing measures may be apt to help Greece’s and Spain’s economies, the ECB simply cannot because it needs to consider the financial condition of the entire euro zone. Germany and France, which both seem to be doing great, take about 40% of the euro zone’s total output. Given this, ECB’s policies usually tend to be in their favor, leaving the relatively smaller countries on the sideline.

These series of problems have scared the willies out of some European investors, as it appears that confidence is slowly going down the drain. Later today, the German ZEW economic sentiment index will be released. The survey is expected to show a reading of 49.8, which would mark its fourth monthly decline. After hitting highs in September, confidence has leveled off and has been slowly decreasing. It seems to me that investors feel that things aren’t as rosy as they could be in the largest economy in the euro zone. And once confidence wanes, this could have a snowball effect, which leaves the euro zone in a big fat mess… well, a bigger one than the one it’s in now!

Oh my, the euro zone has so many problems on its plate! Now, I wonder what this means for the euro…

Judging from its weak fundamentals, investors wouldn’t be too eager to purchase euro zone securities, much less its local currency. Top that off with worsening debt problems from several euro zone nations and the euro gradually loses its appeal. Of course, let’s not forget the growing challenges to the ECB’s policies which threaten the stability of the entire economic region. Heck, even the existence of the euro could be in jeopardy!

But lately, as doubts concerning the sustainability of a global recovery surfaced, we’ve been seeing a revival of risk sentiment as the main driver of price action. The question is: Would this help keep the EUR afloat? Quite the contrary, I suppose. Fiscal instability in one of the largest economic blocs in the world reminds investors to keep their guard up in terms of investing in riskier assets. With other nations close to joining Greece in suffering credit rating downgrades, a flight to safety may be in the cards. The EURUSD has already plummeted by more than 800 pips in the previous month and may continue to lose ground. Ouch! Euro zone better find a fix for all its problems and do it quick!