ECB and Bank of Canada warn of global imbalances, pressure on dollar

Tuesday, May 31, 2005

The European Central Bank reported(pdf) on Tuesday that M3 growth in the Eurozone has accelerated to an annual rate of 6.7 (6.5) percent in April. While this is a long-term concern to the ECB, see this post, the watchdogs of price stability pointed to more looming risks. In its latest Financial Stability Review the ECB warned of a disruptive unwinding of global imbalances that could result in severe pressure on the US dollar. These warnings were also expressed by Canada's central bank governor David Dodge.
The ECB said, "large and growing financial imbalances continue to pose medium-term risks for the stability of foreign exchange and other financial markets." Asian central banks have so far been willing to continue financing the US deficit, but if they lose their appetite for US assets, this could trigger a disorderly correction. "Such concerns could increase the likelihood of a disorderly rebalancing, involving a capital account adjustment and/or the possibility of severe downward pressure on the US dollar, coupled with significant upward pressure on long-term interest rates," it said according to an AFX report. An underestimation of risk has pushed the prices of bonds and some other assets beyond their intrinsic value, it said further, adding that "some euro-area financial institutions, including banks, would likely endure losses - at least in the short term - from any upturn in long-term interest rates."
Governor Dodge essentially repeated these warnings in a speech, saying that a growing imbalance in the global economy, exacerbated by a rampant US deficit as the rest of the world records surpluses, needs to be addressed soon before it gets resolved "in an abrupt, disorderly way. A country's external indebtedness cannot keep growing indefinitely as a share of its GDP. Eventually, investors will begin to balk at increasing their exposure to that country, even if it is a reserve-currency country, such as the United States." "It is clear that, to date, there has not been enough progress on structural reforms," Dodge said. "This lack of progress is somewhat frustrating, given that there is a reasonable consensus on what should be done domestically in all countries." And he said all countries must look to produce a sustainable public debt-to-GDP ratio.
ECB council meets on Thursday
The ECB is scheduled to hold it's monthly council meeting on Thursday. Squeezed between slowing growth and an official inflation rate that hovers around 2 percent no change of policy is expected, especially in the light of the recent strength of the dollar. The leading interest rate will remain unchanged at 2 percent for the 26th month in a row.
These warnings come on the back of the recent surge of the dollar, its reasons and implications described in this post.


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