ECB Stimulus Unwind Could Have Broad Knock-On Effect

What happens in the eurozone doesn’t always stay in the eurozone.

On Thursday, the European Central Bank is expected to begin unwinding its extraordinary monetary stimulus, a process that will drag central banks from Ivory Coast to Switzerland in its wake.

That could have a knock-on effect on markets, as investors buy and sell assets in the countries whose monetary policy is most closely linked to the ECB.

The ECB’s influence has become second to only the Federal Reserve in influencing transactions and markets abroad. Over $2 trillion in international bonds — debt securities sold outside of the issuer’s home country — are denominated in euros, for instance.

Then there are the central banks in Africa and countries that border the eurozone whose currencies either track or are hugely influenced by the euro, meaning they often have to mirror what the ECB does.

That has left large swaths of Europe with low rates even as other countries, including the U.S. and Canada, increase theirs.

Analysts predict the ECB will announce on Thursday that it will begin tapering its bond purchases, a move that will also hint at when it will start raising rates.

“The biggest factor for these places is the strength of the euro,” said Piotr Matys, emerging market foreign exchange strategist at Rabobank, “We’ll be watching closely how the currency reacts; that will set the tone for all these other markets.”

When it comes to raising rates, central banks in many countries appear to be waiting for the ECB to move first.

Over much of Eastern Europe, interest rates are still at post-financial crisis lows. Hungary even has negative interest rates, the only emerging-market country in the world to do so.

Even nations with stronger economic growth than the eurozone have had to resist raising interest rates. Raising them would likely boost their currency against the euro, making their goods less competitive while importing the eurozone’s low inflation.

Switzerland’s economy has grown by around 11% in real terms since the beginning of 2008, compared to just 4% for the eurozone. But at minus 0.75% the Swiss National Bank’s deposit rate is even lower than in the ECB’s minus 0.4% rate.

“The SNB won’t act for as long as the ECB doesn’t act, they just don’t want a strong Swiss franc,” said Christophe Donay, head of macro research and asset allocation at Pictet Wealth Management.

A strong Swiss franc has helped to hold down inflation for years, complicating the job for the country’s central bankers.

Low inflation in the eurozone means muted price gains in its imports, keeping inflation lower in the non-euro countries that buy them. A rate increase would likely strengthen their currencies, encouraging even more imports from the monetary union, and putting even more downward pressure on inflation.

To be sure, many analysts believe investors have already priced in what the ECB will do on Thursday.

But for some, signals of tighter ECB monetary policy would offer an opening to make bullish bets on Eastern European currencies, like the Polish zloty. That is because as the ECB tightens policy it will boost the euro, dragging the currencies that track it higher, they say.

In debt markets, Marcin Kujawski, emerging Europe economist at Nomura, believes Romania is the most exposed to tapering from the ECB.

“About half of their debt is foreign currency-denominated, mostly in euros, and about half is owned by nonresidents,” he said.

When a country issues debt in a foreign currency, it is exposed to any appreciation in its value. Repaying investors in euros will cost an increasing amount of Romanian leu if the rollback of ECB bond-buying drives the euro higher.

In 2016, emerging market issuers around the world sold 121 bonds denominated in euros, more than at any time since 1999, the single currency’s first year. Mexican oil giant Pemex issued the largest ever emerging market euro-denominated bond, with a EUR4.25 billion issue in February.

For 14 countries in Africa, the link with the euro is even tighter.

There are two monetary unions that peg their currencies — the central and west African franc — to the euro. Both have their own central banks and interest rates that move independently of the ECB, but shifts in the euro’s value have an economic knock-on effect.

When the ECB introduced negative interest rates and started buying bonds, between March 2014 and March 2015, the euro fell from around $1.39 to as low as $1.05 against the dollar. That offered a lift to countries using the African francs, which followed the euro lower making their exports more competitive. But if the euro rises as the ECB tightens policy, that would have the opposite affect.

“They appreciate against the dollar when the euro does, and that raises questions about the impact on their economies,” said Victor Lopes, senior economist covering sub-Saharan Africa at Standard Chartered.
Source: Dow Jones

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