Jamal Mecklai: Congratulations, Europe

ECB will increasingly sound like the Fed, keeping interest rates near-zero for as long as it takes. Germany will live with higher inflation, euro will soften steadily

The somewhat strange selection of the European Union as the winner of the Nobel Peace Prize is, perhaps fortuitously, a signal that the European market trauma may be entering its last phase. I had begun to suspect this on October 3, a few days before the announcement, when, at a party to celebrate German Unification Day, the Consul General in his speech said that, despite its current problems, the euro was here to stay.

This was extremely unusual. Unification Day speeches (in India) are always about Indo-German relations, how far they have progressed and how much more can be done. That the Consul should step way off track and talk about the euro – a speech no doubt repeated at other Unification Day celebrations in different countries – made me realise that the public relations offensive on the euro has gone retail.

The German government (mostly through Ms Merkel) has frequently said that its full faith and strength are behind the single currency, and while that “jawboning” has had some impact, it has not – yet – succeeded in sustainably lifting the clouds of doubt surrounding the euro. Recognising, perhaps, that “it is impossible not to become what the world thinks you are”, the euro zone has now unleashed a “retail” PR blitz to convince more and more plain people in countries across the world that the euro is, indeed, a fait accompli. The expectation/hope is that, as more and more people begin to believe this, the market will calm down. Expect more German parties in the months to come — I have been invited to two more in October alone.

All this and the calm certainty with which the Consul made his statement have served as a turning point for me. I have been as outspoken as I could about my belief that the euro cannot be sustained over time — there were/are just too many illogical threads for it to work.

But, then, as I know so well yet often have to relearn, the brain is like a toothbrush. It works wonderfully well for many, many activities, but it certainly can’t explain everything, particularly forecasting how you or I or large groups of yous and Is will react to events. Unfortunately, most people end up using the brain’s tyrannical prowess to filter all aspects of life, leading to misjudgements — and, much worse, missing the flowers and the cowpats that fertilise them.

Acknowledging that my reasoning on the euro – like that of many, many others – was inadequate to comprehend the “complete” picture, I bow to the grand European experiment and wish it Godspeed.

This is good news for the world. As more and more of us euro-sceptics come under the spell, the cloud of risk that has hampered the return of global growth will begin to lift and a healthier risk appetite will emerge in world markets — enough already with this “risk-on, risk-off” stuff.

The European Central Bank will increasingly sound like the Fed, keeping interest rates near-zero for as long as it takes. Germany will live with higher inflation and the euro will soften steadily, bringing some support to the weaker European nations.

The dollar will, once again, get onto a fast track upwards, particularly after the presidential election is out of the way. The US economy appears to be recovering more visibly, which should ensure that the interest rate differential with Europe will widen in favour of the dollar. Commodity prices will weaken, giving India, and other commodity-buying nations, some breathing space.

The cost of capital, though, will remain high. Accelerating banking reform in developed markets will ensure that the cost of risk is more correctly measured — as I said, the new risk appetite will be sounder. This is fundamentally good for the long term, but in the near term, global growth expectations will need to be recalibrated. While China and the US, to some extent, are finally showing some signs of recovery, the odds are that it will still be some time before global markets are back to any sort of reasonable demand levels.

This means that India’s export growth will also remain weak, keeping pressure on our current account and the rupee. Again, the weaker euro (stronger dollar) also portends rupee weakness. On the other hand, being one of the fastest-growing economies – both actually and potentially – India can benefit hugely from the settling down of European nervousness, assuming, as always, that the domestic circus doesn’t deteriorate very much beyond its current state.

Thus, capital flows will continue to support the rupee against the still negative sentiment. Volatility will remain high; options – preferably, call and put spreads – remain the preferred hedging route.

 

jamal@mecklai.com