Smaller economies in focus

Smaller economies in focus

Good morning and welcome to today’s foreign exchange market commentary on Monday, the 11th of February.

Smaller countries generally don’t receive much attention from the specialists. But at times success or failure of smaller economies are discussed in detail to prove or disprove certain policy matters. For example Nobel winning economist Paul Krugman has argued that austerity and wage-depression policy does not work. Latvia is the case in point; its GDP is still more than 10 percent below its pre-crisis level. Iceland, he argues, was not subjected to any externally-imposed austerity and seems to be much better off by devaluing its currency.

The opponents argue Greece delayed fiscal adjustments for too long and is still struggling with deep recession while Estonia pursued strict austerity when the crisis broke out and is experiencing robust growth now. But both sides forget to mention key differences that will direct comparisons meaningless.

To be sure, Latvia was running huge current-account deficits like most Baltic States when the crisis broke. It means the pre-crisis level growth was not sustainable since it required capital inflows in excess of 20 percent of GDP to sustain the consumer demand and the construction boom. So it seems logical that the GDP contracted when the capital inflow stopped. No country can survive a current-account-deficit of 25 percent of GDP forever. Seen in that context, the performance of the Latvian economy is no bad.

A better metric would be to judge the output gap, i.e. the difference between potential GDP and actual GDP. A European Commission estimate suggests Latvian GDP was 14 percent above potential at the pre-crisis era peak and fell 10 percent below potential when the crisis struck. It’s back to full potential though that is below the unsustainable peak of the boom.

Latvia thus enjoys a sustainable fiscal position with a growing output today. Austerity had aggravated the slump temporarily, but brought back fiscal sustainability without permanently damaging the economy, thus allowing the government to balance its books. Greece, by contrast, dragged its feet on austerity and the economy is 12 percent below potential today and still shrinking.

Iceland is no outlier as well. Unlike Latvia, Iceland let its currency to devaluate massively. But despite its devaluation of the krona, Iceland continues to run a large current-account deficit, adding to its large foreign debt. A debt/GDP ratio of 100 compares poorly with Latvia’s 42 percent, making debt sustainability a real issue for Iceland. Furthermore, the large cash outlay required to service the debt may constrain the country’s future growth.

The conclusion, therefore, is that shunning austerity may not allow any economy to achieve both external debt and fiscal sustainability.


GBP/EURO – 1.1784
GBP/US$ – 1.5768
GBP/CHF – 1.4468
GBP/CAN$ – 1.5861
GBP/AUS$ – 1.5324
GBP/ZAR – 13.9964
GBP/JPY – 146.07
GBP/HKD – 12.2123
GBP/NZD – 1.8936
GBP/SEK – 10.1230

EUR: The single-currency continued to weaken against the USD and the pound on Friday despite German trade balance data coming in better-than-expected after ECB President Mario Draghi said the central bank will keep an eye on euro for signs of it hurting the region’s inflation outlook. German data showed exports continued to surge and hit a record high in December, highlighting the disparity between the strength of Europe’s largest economy and the rest of Europe. The EU leaders managed to agree on a three percent budget cut after a marathon meeting on Friday in Brussels. The meeting continues today and the ECB president is due to speak tomorrow. The euro’s ascendency can be curbed by Mario Draghi given his influence on the common currency. European data is thin for the week with only Flash GDP due for release on Thursday. Markets remain concerned as political turmoil reaches boiling point in Spain over calls for Rajoy’s resignation and Berlusconi racing ahead of the competition in Italian polls two weeks hence.

USD: The greenback weakened against the cable on Friday, with the GBP/USD pair testing a high of 1.5850 following the comments from incoming Bank of England Governor Mark Carney where he suggested the central bank would hold back further expansionary measures. Better than expected US trade deficit data supported the dollar, but profit booking by traders before the weekend weighed on the US unit. In the absence of any major releases today in the US and the UK, the cable is expected to position ahead of tomorrow’s UK CPI release for January. We also have the BoE’s Quarterly Inflation Report due on Wednesday. Furthermore, the two-day G20 meeting commences on Friday while weekly unemployment data along with consumer sentiment and retail sales figures are due from the US later this week.

Have a great day!


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