The eurozone budget conundrum

The eurozone budget conundrum

Good morning and welcome to today’s foreign exchange market commentary on Wednesday, the 12th of December.

As the four presidents of Europe’s major institutions get ready to submit their report on reforming the common currency, a critical question stares at them; does the eurozone need its own budget?

People supporting a monetary union cites US federal monetary union arguing a large federal budget helps in absorbing asymmetric shocks; shocks to individual states. The eurozone, they reason, should have a similar arrangement to provide insurance for its members.

The US experience however, has been somewhat different. True, a federal structure helps in redistributing income across regions and offsets inter-state income differences, but to argue that redistribution mitigates shock is wrong.

The extent to which federal taxation absorbs shock at the regional level is marginal since the main source of federal that is sensitive to business cycles, the federal income tax, contributes less than 10 percent to GDP. The weak correlation between federal revenues and federal expenditures to local business cycles explain why only 10-15 percent of any shock to the GDP of an individual state is absorbed via automatic transfers to and from the federal budget.

Rather, the US arrangement that can really benefit Europe is a federal banking union since it provides sufficient insurance against local financial shocks. Take the example of Nevada. A real estate bust was as severe in Nevada as in Spain or Ireland. But the losses of the state, which is roughly the size of Ireland, was largely absorbed by Federal deposit Insurance Scheme and the mortgage refinancing agencies, Freddie Mac and Fannie Mae. The support of government agencies is estimated at 10-20 percent of Nevada’s gross output. Similar transfer payments would have helped Ireland to cope with the loss much better. Hence a baking union will serve the currency union much better than a budget for the bloc.

CURRENCY RATES OVERVIEW

GBP/EURO – 1.2376
GBP/US$ – 1.6102
GBP/CHF – 1.5002
GBP/CAN$ – 1.5874
GBP/AUS$ – 1.5281
GBP/ZAR – 13.9354
GBP/JPY – 133.32
GBP/HKD – 12.4826
GBP/NZD – 1.9162
GBP/SEK – 10.6812

EUR: The common currency strengthened further against the US dollar and stood at 1.3001 yesterday after German ZEW economic sentiment came in much better than anticipated. Strong demand for Spanish bonds and the successful conclusion of the Greek bond buy-back program sufficient to unlock the next tranche of aid money from the EU and the IMF pushed the currency up further. With little data out today, the focus remains on Thursday’s Economic summit between finance ministers in Brussels. EUR/USD is trading above the 1.3000 level while GBP/EUR remains steady at 1.2395.

USD: The greenback weakened across the board amid speculations that the US Fed will expand its assets purchase plan to supplement the current mortgage-backed debt purchase program to prop up the fragile recovery. Continued deadlock over the so-called ‘fiscal cliff’ negotiations didn’t help the US unit’s cause either. Trade balance data came out close to market expectations though October exports to China fell the most since Jan 2009, failing to boost the dollar. GBP/USD pair has broken the 1.6100 level and sits at 1.6145 now.

Have a great day!

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