Newsletter article

Currency Report - March 2013

"Economic conditions have deteriorated lately, reflecting weak external demand, private sector debt reduction, and lack of business and consumer confidence." That was the opening sentence of a report by a team from the International Monetary Fund after its visit to Zagreb in February but it could have been written about almost any western economy. Like just about everywhere else in Europe, Croatia must grapple with the overhang of the global financial crisis and the economic slowdown which it provoked. Gross domestic product shrank by an estimated -2.0% in 2012 and the recession is expected to persist through this year with a further contraction of some -1.5%.

Accession to the European Union, scheduled for 1 July this year, could help matters but the European Union is not itself immune to economic difficulties and the baggage that goes with them. To the north, neighbouring Hungary has just installed Gyorgy Matolcsy, previously the economy minister, as governor of the central bank. Mr Matolcsy has earned a reputation for unconventional policies and the fear is that he might further weaken the forint, so making Croatian goods and services less competitive.

The kuna has been weakening too, but only against the euro and even there only by -0.5% since the turn of the year. Against the pound the kuna is 4.5% stronger than it was on New Year’s Eve. However, most of the pound's weakness arrived in January. Last month was rather kinder to sterling, even if that generosity did not extend to allowing it to recover.

Working against the euro was another hangover from the global financial crisis and recession; a political crisis in Italy (actually it isn't really a crisis yet but they are working on it). An unprecedented protest vote at the general election in late February gave a quarter of the vote to the upstart anti-establishment Five Star Movement, whose aim is to bring an end to austerity, root out corruption and upend the status quo. A week after the election there is still no sign of a coalition agreement..

It could go three ways: a re-run of the election in the near future, a "technocrat" government similar to that of Mario Monti in 2012 or a cobbled-together coalition that would postpone the election re-run for a few months. None of the alternatives is ideal and some are less attractive than the others. The worst-case risk is that an ungovernable Italy could abandon the fiscal prudence and austerity put in place by Sig. Monti. If that were that to happen, Italy would probably lose the support of the European Central Bank safety net and Club Med governments would once again have
difficulty borrowing at sensible rates of interest.

A great deal must go wrong in Italy to achieve the worst case scenario but the risk is there and investors are no longer so head-over-heels in love with the euro. That is not to say they have transferred their affections to the pound. For that to happen, either Italy will have to go to the dogs or Britain will have to get its economic act together. Neither looks imminent, so look for a continuation of February's seesaw movement between €1.14 and €1.18.

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