A decade to the month since Mario Draghi, then the European Central Bank (ECB) president, rescued the euro with his “whatever it takes” speech, the now 74-year-old’s unravelling attempts to save his native Italy played a part in pushing the single currency below parity with the dollar this week, for the first time in 20 years.
Draghi was installed 17 months ago as the technocrat prime minister over a left-to-right national unity Italian government with two main tasks: salvaging a faltering Covid-19 vaccination programme, and implementing a series of economic reforms. These reforms ranged from increasing the effectiveness of the country’s public administration and justice system to removing barriers to competition. The goal was securing up to €200 billion of grants and loans from the EU’s pandemic rescue fund.
Progress had looked promising by the end of 2021, with a rebooted vaccination campaign helping to push economic output up by 6.5 per cent for the year, to close to where it was before the pandemic.
That was before Vladimir Putin decided to invade Ukraine, fuelling inflation and leaving Italy particularly exposed due to its high dependence on imported oil and gas from Russia.
The Italian government was thrown into crisis on Thursday when the populist Five Star Movement, a coalition party that has been declining in opinion polls, sat out a confidence vote on a €26 billion package of measures to help families cope with soaring living costs. Five Star had wanted to do more. However, Draghi, conscious of the country’s €2.5 trillion debt mountain – the equivalent of 1½ times the size of its economy – has been seeking to limit new borrowing.
Although Draghi offered to resign, this was rejected by Italy’s president, Sergio Mattarella – for now. Italian foreign minister Luigi di Maio said on Friday that if unity could not be restored swiftly among government parties, it would likely trigger an early election in the autumn, which, he said, would only damage the economy.
Euro slide
Of course, while Italy’s latest political drama may have accelerated the euro’s brief decline below dollar parity this week, it is far from the main reason behind the single currency’s 12 per cent slump against the greenback so far this year.
Most of the movement has been down to a general strengthening of the dollar, with the so-called US Dollar Index, which measures the US currency against a basket of six major currencies, having risen by about 13 per cent since the end of 2021, as the US Federal Reserve has set off on a more aggressive path of rate hikes to stem US inflation (which hit a fresh four-decade high of 9.1 per cent last month).
The ECB, by contrast, is on track to raise rates for the first time in more than a decade next week – and even, at that, by only 0.25 percentage points. This would leave its deposit rate in negative territory and only push its key lending rate to 0.25 per cent.
The main driver of this week’s slide by the euro was a fear in foreign exchange markets that Russia’s scheduled shutdown of the Nord Stream 1 gas pipeline to Europe for maintenance on Monday may be extended indefinitely. “Russia’s invasion of Ukraine is a seismic shock for the euro zone, because so much of the European growth model has been predicated on cheap Russian energy,” tweeted Robin Brooks, chief economist at the Institute of International Finance. “That’s over and done with. Recession and structural headwinds are coming.”
With analysts sketching out the worst case, Deutsche Bank economists reckon that a “tap remains turned off” scenario could lead to the German economy, Europe’s largest, contracting up to 6 per cent next year – compared to its current forecast of a 1 per cent decline.
“It seems reasonable to assume that Russia will continue to look for ways to disrupt economic activity in Europe in retaliation for western sanctions and financial and military support for Ukraine,” said the Deutsche economists, led by Stefan Schneider. “Russia could well start an ‘on/off-strategy’, maybe even blaming ‘technical problems’, which would probably maximise political and economic uncertainty.”
Psychological milestone
To be sure, the euro’s dip this week below parity against the dollar is largely a psychological milestone – but it also underscores a view in the market that the ECB will not be able to move as much as it should to really tackle inflation.
With euro zone inflation running at over 8 per cent in May – four times the ECB’s target – a majority of economists polled by Reuters said that the bank should go all out with a 0.5 percentage point hike next week.
On balance, most see a gradual increase in the ECB deposit rate from minus 0.5 per cent to plus 0.75 per cent by the end of the year. Moving the main ECB lending rate – to which tracker mortgages are linked, and against which other loans are benchmarked – at the same pace would bring it to 1.25 per cent, well below the 3.25-3.5 per cent range in which Fed rates are expected to close 2021.
The ECB is in a bind. Overall euro area government debt has risen in the decade since the debt crisis, fuelled by massive borrowing by states in recent years – when ECB bond-buying programmes were keeping market interest rates at ultra-low levels. By the end of last year, euro area government borrowings stood at almost 96 per cent of gross domestic product (GDP), up from 87 per cent 10 years earlier.
A politically fragile Italy, while having avoided international bailouts like Greece, Portugal and the Republic, remains the elephant in the room, with its debt ratio having jumped from 121 per cent to 151 per cent over that period. Hike rates too much and there is a real fear that it could trigger a fresh debt crisis (even with the ECB officials working on a plan to avoid market interest rates on some fragile countries blowing out).
Baby-step rate hikes by the ECB may help you curb your mortgage payments – but at the risk of inflation becoming entrenched and inflicting untold damage on households and businesses.
