It’ll all be alright in the end

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It seems that Slovakia has chosen to extend its day in the sun, its parliament having rejected the EFSF expansion in yesterday’s vote and the coalition government having collapsed in the process. But there’s little need to panic, not least because the euro project has a long history of bumps along the road e.g. France and the rejection of the single currency together with Ireland’s initial rejection of the Lisbon Treaty.

These things have a habit of working themselves out, with Slovakia set to vote again later this week. As we mentioned yesterday, it’s more the point that Slovakia can’t afford not to accept the EFSF increase, given it remains one of the poorer nations within the EU. In subsequent comments, German Chancellor Merkel remains certain that the EFSF increase will be passed by the October 23rd EU summit.  Given the need to put together a credible bank recapitalisation plan, then the eurozone needs the Slovakia issues to be resolved this week, otherwise it will be caught in a sideshow to approve a now outdated proposal.

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Commentary

Slovakia’s finance minister issues warning.  Not content with being the last of the 17 eurozone countries to endorse the expanded powers of the EFSF, on Tuesday Slovakia’s finance minister prophesied a crisis worse than Lehmans should it fail to pass. This was something of an overstatement, as subsequent events have shown.  Such a stark warning unsettled the euro-bears with the single currency gradually losing one big figure from the high witnessed earlier on Tuesday. Also weighing on sentiment was the recognition that, despite the promises of both Berlin and Paris, it will require a truly unprecedented degree of policy co-ordination to agree on a roadmap for resolving Europe’s sovereign debt and banking crisis within the next few weeks. Monday’s optimism gave way to Tuesday’s reality-check that Europe will probably (again) disappoint. Little wonder yesterday’s impressive short-covering rally in the single currency is already looking under threat.

Germany’s misguided push on Greek write-downs.  The laws of physics dictate that for every action there is an equal and opposite reaction. The laws of EU politics are that for every show of unity there is an equal and opposite display of disunity. We’re seeing the effect demonstrated perfectly this week. After the weekend showing from Merkel and Sarkozy on the push towards bank recapitalisation in the eurozone, we’ve seen more splits emerging this week, once again centred on the July bail-out agreement. Germany wants to force greater write-downs on lenders to Greece -beyond those agreed back in July (averaging 21%) – on the basis that the slippage in budgetary data since that time has undermined these calculations. There is talk of Germany pushing for a 60% haircut on Greek debt from private sector bond-holders, but this appears to be putting the cart before the horse. Unless a credible deal is put together to re-capitalise the banks and also put a ring-fence around Spanish and Italian institutions, Germany’s demands could well risk shooting the whole process in the foot before it has even started walking. EU leaders need to focus on the bank recapitalisation plan as this remains the pre-requisite for enacting a deal that would see Greek debt written down by the extent required for Greece to stand a chance of ever returning to the capital markets.

Chinese inflation may have peaked.  One of the more critical economic releases this week is Chinese inflation, due out on Friday. In July, the annual inflation rate reached a disturbing 6.6% whereas two years ago China was experiencing deflation. With growth still just under 10%, it was little wonder that China’s policy-makers earmarked the containment of inflation as their number one priority. Over the past year, the one-year bank lending rate has been lifted on five separate occasions by a cumulative 125bp to 6.56%, while the reserve ratio for major banks has been raised nine times to an onerous 21.5%.  There are some encouraging signs that price pressures in China are easing, much like in many other Asian economies. The annual inflation rate fell to 6.2% in August, and may have declined below 6.0% last month. Food prices, which account for around one-third of the consumption basket in China, fell sharply in September. Also, previous tightening measures do appear to be curtailing lending. It is entirely probable that inflation could dip quite sharply in the months ahead. If so, then Chinese officials may be tempted to lower interest rates.

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