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Decimal Digest
11 Apr 2011


ECB Rate Hike in a Two Speed Eurozone

In the last week, as expected, ECB hiked its policy rates. Apart from the singular mandate of managing inflation, the sterling performance of the largest economy in the Eurozone - Germany, would have also played a part in the decision making process.

However, this decision of ECB, in our opinion, may not prove conducive for the peripheral Eurozone. The chart below shows the unemployment rate for Spain and Germany since 2007. We have chosen to compare Spain, the only nation in the so-called PIGS still some distance from a bailout, with the largest economy of Eurozone.

As evidenced from the chart, the German economic engine kept producing jobs throughout the Global Credit Crisis of 2007-2009 and also during the ongoing Euro Debt Crisis since 2010. On the other hand, the Spanish employment situation has deteriorated significantly during the same period.

The Euro Sovereign Debt Crisis is forcing all peripheral economies to tighten their fiscal belts. Now, the decision of ECB has strengthened Euro to 1.44 against USD, apart from raising borrowing costs for businesses. Additionally, the renewed distrust in the banking system of peripheral economies will reduce the ability of banks to lend to local businesses. The headwinds are simply too strong for sustained improvements in employment situation in countries such as Spain, and what is worse, some of those currents are fanned by recent actions of ECB.

To be sure, we are not blaming ECB for the current level of unemployment in Spain. The chart above shows “Unit Labor Cost for Entire Economy Relative to Eurozone (Base 1999 = 100)” for Spain and Germany.

Clearly, Spain lost its competitive advantage to Germany following the rapid increase in relative labor costs over the past decade, and can be ascribed as prime reason for rapid rise in unemployment in last three years.

Going forward, the cost of adjustment will be very painful for Spanish economy, and the ECB is not making it any easier. Will Spaniards revolt against this apparent injustice? Only time will tell.




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