ECB frets over risks from China, Fed rate hike

By Balazs Koranyi and Frank Siebelt

FRANKFURT (Reuters) - Volatility in Chinese markets may have more impact than expected on the euro zone's fragile economy, and an increase in U.S. interest rates might also slow its recovery, the European Central Bank said in the minutes of its last meeting.

Economic recovery in the 19-member euro zone was moderate and gradual, a trend the ECB called "disappointing". Real GDP remained near 2008 levels, while the U.S. economy has rebounded significantly, the ECB said in the minutes, released on Thursday.

The risk that growth would be slower that forecast remained, it said. Chief economist Peter Praet, a member of the executive board, noted that the ECB needed to continue communicating that it was ready to use all its instruments given the "challenging environment".

"In particular, financial developments in China could have a larger-than-expected adverse impact, given this country's prominent role in global trade," the ECB said. "This risk could be compounded by negative knock-on effects from interest rate increases in the United States on growth in EMEs (emerging market economies)."

The Shanghai stock market fell by more than 20 percent in the month before the ECB's July 15-16 meeting, and China's growth outlook has appeared to erode further in recent days.

The Chinese currency has weakened around 4 percent in the past three days, and economic growth is expected to slow from 7.4 percent in 2014 to 7 percent this year, its slowest pace in a quarter of a century. Weak exports, sluggish domestic demand and a cooling property market are all weighing on the economy.

Even as China struggled and European growth remained sluggish, the U.S. Federal Reserve was expected to raise interest rates as soon as September. Analysts expect the Bank of England to follow suit in the following months.

Assessing its 60 billion-euro-a-month asset-buying scheme, the ECB said the programme was on track and the inflation outlook was consistent with its medium-term target of close to 2 percent. But the ECB added that it needed to see through the programme, which is set to run until at least September 2016.

Early data appear to indicate that the asset purchases are making an impact, but falling prices for commodities like oil and iron ore, along with China's economic slowdown, have increased talk that the ECB may need to do more to get prices up.

The 5-year/5-year swap rate, one of the bank's favourite indicators for long-term inflation expectations, has been falling steadily for the past month. It dropped to 1.5 percent after soaring to 2 percent in the spring when the bank launched its quantitative easing programme.

(Editing by Larry King)