Newsletter article

Currency Report - April 2014

"Economic conditions remain very difficult, with real GDP [gross domestic product] projected to contract for the 6th consecutive year in 2014. Fiscal policy has run out of space, while monetary policy is constrained by the need to prevent a contractionary revaluation of foreign currency index debts."

Those were the first two sentences of a preliminary report by the International Monetary Fund at the end of its consulting mission at the beginning of March. Put simply, the Croatia economy is between a rock and a hard place and there is little the government can do immediately to improve the situation. Cranking up taxes to fix the budget gap would be inappropriate during a protracted recession and devaluing the currency would create painful losses for banks, businesses and individuals with euro-denominated borrowings.

At the end of the IMF's opening paragraph there is one chink of light though: "The banking system has remained stable, liquid, and on average well-capitalised."

And the kuna remains steady against the euro. As the IMF report put it; "The kuna-euro exchange rate depreciated marginally in the last 12 months, consistent with the central bank's use of the kuna-euro exchange rate as a monetary anchor." It was a marginal depreciation too. On 24 March 2013 the euro/kuna exchange rate was 7.5932; on 24 March this year it was 7.6617. The kuna fell by less than -1% against the euro over the 12 months, not bad for a country toiling through its sixth year of recession.

With the consequences of a devalued kuna apparently too unpleasant to contemplate, it looks as though the central bank will carry on with its loose peg to the euro, allowing gentle slippage along the way. That means the sterling/euro exchange rate will continue to be the main driver for GBP/HRK, albeit with a slight upward bias.

Recently the pound has not been doing as well as it was at the turn of the year.  Any gains made by sterling in January and February have been handed back over the last month, leaving the pound unchanged against the euro from its position on new year's day and three cents off its February peak.

It is not that investors now dislike sterling: after buying it up for nearly a year they see no fresh reason to increase their stock. They are not madly keen on the euro either; at the moment they prefer the US dollar, the Swiss franc and the antipodean dollars. But having been reassured repeatedly by the European Central Bank that it has no intention to stimulate the Euroland economy with quantitative easing - printing money - they feel comfortable with the euro.

Sterling's advantage is the UK economy, which continues to deliver stronger performance than the euro zone. Although the Bank of England has now abandoned unemployment as a marker for eventual interest rate increases, the expectation is still that rates will begin to head north again next year. The current economic evidence suggests that higher rates in Euroland will not come until many months later. On that basis, sterling has the edge, even if it might have to suffer a further correction in the short term.

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