In about two weeks, a new country will join the Eurozone. Croatia will convert its national currency – the “kona” it used after the breakup of Yugoslavia – and the common European currency will gradually become the only legal tender in theNah. The Balkan country will become the 20th member of the economic bloc, which ranks third in the world in terms of GDP, after the USA and China.
Vacations on Croatian beaches will become easier for European tourists who will not have to convert money, European investments in real estate or business will become more convenient, Croatian workers abroad will save paying fees on the money they send home. January 1, 2023 is expected to be a holiday for coin and banknote collectors, and of course for Brussels and Zagreb.
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But even if the step symbolizes a new momentum, the old problems of the Eurozone have not disappeared. In fact, in the current state of affairs they are perhaps more threatening than ever. The economic attempt to create a monetary union, a common currency managed by one central bank and a uniform monetary policy but with different economies, different national budgets, dramatically different debt rates and diverse fiscal policies is being scrutinized these days, due to the unusual conditions in the market.
Inflation in the Eurozone is in double digits, and it is the highest since it began to operate officially in 2002 and there are only 12 countries. In response, the interest rate hikes of the European Central Bank are also the sharpest since it was established and received its mandate. The value of the euro has already fallen to a low against the dollar (and has since recovered). There is no precedent for what is happening now in the short two-decade history of the euro.
All eyes are now on Frankfurt
This is why, after the “Fed’s” announcement on Wednesday about another interest rate increase, the financial markets shifted to focus on Frankfurt and the decision published on Thursday regarding the interest rate increase by the European Central Bank (ECB) in the Eurozone and the plans regarding its balance sheet.
Inflation in Europe is more severe and deeper, and has already reached rates of 20% and more in some of the Eurozone countries. It stands at an average of 10% in November across the bloc, is much more affected by energy and food issues due to Europe’s dependence on Russian gas and oil, and is considered more “sticky” than in other economies, among other things due to massive fiscal measures of government support in the areas of energy and life. 1.1 trillion euros will be spent in the coming year by EU countries on public assistance, mainly energy subsidies. There is some debate as to whether such measures fuel inflation in the long run, but it seems to be agreed that they will not lower it.
In addition, the European Central Bank has been relatively slow in raising its interest rates. Unlike other central banks, such as in the US or the UK, the ECB in Frankfurt later started the process and adopted more modest steps. It was indeed the sharpest interest rate hike in the history of the Eurozone, but even after today’s announcement of another 0.5% increase, It stands at 2%, compared to 4.25% in the US.
One of the main reasons for this is the fact that the 20 member states of the bloc have conflicting interests as a result of their fiscal policies and the nature of their economies. With a debt-to-GDP ratio of more than 150%, Italy has completely different monetary desires than Germany or Finland, which have a low debt-to-GDP ratio. Southern European countries want low interest rates, gradual increases and continued quantitative expansion, while northern countries want more drastic, faster interest rate increases and quantitative tightening to cool the inflation that erodes savings.
Will the Eurozone undergo quantitative tightening?
What was interesting in the bank’s announcement, along with the interest rate increase, was that for the first time an outline and a possible start date were also presented for a gradual reduction in the monstrous bond balance that the bank had accumulated over the past few years, in which it carried out an almost limitless quantitative expansion. In this respect, the various purchase plans announced in This is as the “breathing machine” for the debt-ridden economies, and as a device to maintain the bloc’s unity.
The mechanism of operation of this machine is about to change, so the heavier question regarding the future of the euro is how the central bank will now deal with the need to start shedding some of the five trillion euros that are on its balance sheet, most of it in government bonds of the Eurozone countries and a minority in the bonds of European companies. This amount is part of what has been accumulated over the past decade, since former ECB President Mario Draghi promised to “do whatever it takes” to preserve the common currency. The fact that the quantitative easing (QE) that has taken place so far will be reduced may be a turning point in the common bloc economy.
When the current president of the bank, Christine Lagarde, was asked last summer how the huge balance sheet would disappear from the bank’s books and what effect it would have to talk about the markets, the liquidity and the yields on the government bonds of the member states of the bloc, she was deliberately vague. “He will shrink,” she told her Dutch interviewer, to embarrassed laughter from the audience, “you will see that he will shrink.” Now it’s time to start pouring content into the dimming process.
The announcement shows that the bank is expected to behave as it has so far, with utmost caution, and when it tries to belatedly imitate the behavior of the Fed. The American central bank has already started reducing its balance sheet in recent months. In recent weeks, the “Bank of England” has also begun to sell some of the government bonds it purchased in huge quantities. The European Central Bank, on the other hand, announced today that the process will only begin next year, and that the sales framework will be between 200 and 300 billion euros over the course of the year. Only a percentage of the holdings.
European Central Bank / Photo: Associated Press, Michael Probst
The bank clarifies that it is not a question of canceling the existing quantitative expansion – a program that was launched in the days of the Corona, stands at 1.7 trillion euros and will continue until at least next year. Instead, the bank is only expected to announce that some of the proceeds from its previous bond purchase program – worth 3.3 trillion euros – will not now be used to repurchase bonds, meaning that a gradual and slow reduction of the balance sheet will take place.
Fear in Europe of a new debt crisis
The question, therefore, is how the Eurozone will deal with a massive non-purchase of government bonds after years of massive purchases. Especially in the current situation of an energy crisis, a rolling recession, a global slowdown and economic uncertainty. The fear is actually of a new debt crisis, which will arise as a result As a result, the southern European debt oath will cease to be inflated by the money of the European Central Bank. The spread between the Italian and German bond yields, a measure of the risk of such a debt crisis, has risen in recent months to high levels of over 2%, second only to those recorded during the Corona crisis, and before In the debt crisis of 2010.
In fact, changing monetary direction at the exact moment when interest rates are rising, recession is threatening and countries are increasing debt to deal with energy crises and inflation is a very complicated task. Maybe even more complicated than the one facing the American Fed.
“The question of whether the debt of certain countries such as Italy is sustainable can resurface, while interest rates in the Eurozone are rising and the central bank is switching from purchasing government bonds to selling government bonds,” reads a review published by “Credit Suisse” this week.
“We could soon see another test of European solidarity, with very few growth opportunities on the continent, high debt levels and rising interest rates,” said an analyst from the German insurance company Allianz. Some analysts predicted another sharp rise in bond yields of Eurozone countries.
In the meantime, Croatia is happy to join
But in Croatia they are happy to join. The small country, which has close to four million inhabitants, sees this as a certain protection against possible currency wars. “In such times of economic uncertainty,” the Croatian finance minister said in recent weeks, “it is good to belong to a powerful economic bloc and a common currency.” The government also points to countries such as Poland and the Czech Republic, union members who have not adopted the euro, and to the fact that inflation in them and the base interest rate set by the central bank in response is higher than in the eurozone. The Croatian Minister of Finance said that joining would in fact “strengthen” Croatia’s ability (with a debt-to-product ratio of only about 80%) to borrow in the international market, and various rating agencies did indeed raise the country’s credit rating after approval to join the Eurozone.
In addition, based on past experience, the Eurozone captains tried to make the exchange as “smooth” as possible for the country. The Croatian kuna was compared to the euro at a constant value, just above 7.5 kuna to the euro. Prices have been formally displayed for months in both currencies, and both will continue to be considered legal tender for cash payment during 2023 and be displayed in stores. The surplus, on the other hand, should always be given in euros, thus taking the buyer out of circulation. The Croats adopted the euro even before it officially happened, and about 80% of deposits in banks are in euros.
Those who will especially benefit from the common currency are many Croatians working across Europe, who will not have to pay conversion fees now to send money home. Banks in the country are expected to lose about 20% of their income due to this. The local coins have already been produced, and they combine national motifs with EU symbols, as is done in other countries. The banknotes, however, are uniform across the EU. The message is clear, you can have fun with small money with local animals and national symbols, but the future of big money will be decided from now on in Frankfurt and Brussels.