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The great European bank clean-up has started. The European Central Bank has put its credibility on the line with its broad review of the region’s weakened financial sector.
The ECB is failing, however, to tackle another more immediate danger to eurozone economies: the increasingly strong euro, which could set back the region’s gradual return to economic growth.
The two issues are related. If the ECB is serious about getting tough on European banks, its asset quality review and stress tests will have to result in remedial action at quite a few banks. If so, the ECB’s monetary policy will have to remain loose for longer – which should be negative for the currency, or so the argument goes.
But the euro is not paying attention. Against the dollar, Europe’s single currency has risen to the highest level for two years. On a trade-weighted basis, it is up 4 per cent since the start of the year and 10 per cent since mid 2012 – a significant blow for exporters.
What is driving the currency’s appreciation is not euro strength but dollar weakness, and the diminishing prospects of the US Federal Reserve winding down its asset purchases – quantitative easing – in coming months.
The ECB could retaliate. It could cut its main policy interest rate, currently 0.5 per cent. Or it could announce another offer of long-term cheap loans – perhaps on even more favourable terms than in late 2011 when it launched its three-year longer-term refinancing operations.
The snag is that the previous cut in interest rates – in May – failed to stop the euro appreciating; such is the influence of the Fed. It is also unclear whether another LTRO would work. Banks have paid back much of the previous offer. When finances are under official scrutiny, only the desperate would borrow more.
The ECB will be loath to put its credibility further at risk by taking action that could backfire. Eurozone economies and banks may simply have to live with a strong euro.
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