Eurozone crisis continues despite aid for Ireland ECB Council sticks to fixed rate tenders with full allotment Beige Book confirms rosier picture of US economic indicators Euro Remains Weak Despite Bail-out Package for Ireland Initially, the euro continued to fall versus most major currencies this week. Despite the Irish aid package approved at the weekend, EUR-USD slipped to below 1.30 temporarily. But after weaker-than-expected US labour market data, the euro rose to well over 1.33 against the dollar, ending the week above the previous week's level. However, compared to its last high of almost 1.43 about a month ago, the euro has lost 7%. This is mainly due to persistent fears that the eurozone rescue fund will not suffice: judging by the widening of spreads over German bunds, the list of eurozone countries in danger of defaulting seems to be getting longer and longer. However, the dollar could also have been boosted by the relatively upbeat US economic data, which were better than expected in many cases. Last Sunday, EU finance ministers agreed on an €85bn bail-out package for Ireland. The Irish government is to contribute €17.5bn; the remainder will be provided by other eurozone countries, the IMF, the UK, Sweden and Denmark. The outlines of a new stabilisation mechanism to replace the three-year European Financial Stability Facility (EFSF) due to expire in July 2013, were also approved. Unlike under the EFSF, it would then be basically possible to involve private creditors in any future debt crises, but this would not automatically be the case. Subsequently, on Monday morning, the euro strengthened, but relief over the aid package for Ireland was short-lived, as all eyes then turned to Portugal, which is regarded as the next rescue candidate, to be followed by Spain perhaps. There was even speculation about Belgium, because it has the third highest debt level in the eurozone after Greece and Italy. The spread between 10-year Belgian and German government bonds widened to 1.25 percentage points - much more than in spring prior to the Greek bail-out. The sovereign debt crisis is no longer confined to a few countries only; there appears to be a significant risk of financial market contagion spreading throughout the eurozone, and this is weighing on the euro. The crisis in Ireland was originally triggered by a banking crisis, and now the Portuguese central bank has also warned that Portugal's banking sector is facing increasing liquidity problems. In its financial stability report, the central bank said that unless measures to consolidate public finances in a credible and sustainable way were implemented, the risk for the country's banks could become intolerable. Opinions are divided as to whether Portugal should therefore apply for aid from Europe without delay. The ECB would probably prefer Portugal to seek aid. The critical factor is how dependent Portugal's banks are on the ECB's liquidity supply: in October, they borrowed €40bn, i.e. about 7.5% of outstanding ECB liquidity, despite Portugal's GDP only accounting for 1.9% of the eurozone economy. Furthermore, without rescue measures for Portugal, Spain's banks could incur severe losses, because they are heavily involved in that country, albeit more in corporate loans than Portuguese government bonds. On the other hand, some EU Commission members think there is more likely to be a chain reaction if Portugal does apply for aid. Opinions are also divided on the suggestion voiced by Bundesbank president Axel Weber last week to double the rescue fund to €1.5 trillion: the German finance minister Wolfgang Schäuble was at any rate quick to dismiss the idea. Even before the ECB Council meeting on Thursday, the euro managed to gain some ground and the risk premiums for Portugal, Spain and Belgium fell due to speculation that the ECB could announce additional stabilisation measures, or even an extension of its government bond purchases. At the press conference, ECB president Jean-Claude Trichet only confirmed the continuation of the present asset purchase programme, which he did not want to be misconstrued as quantitative easing because the liquidity was being sterilised. After the meeting, however, traders reported of extensive purchases of Portuguese and Irish government bonds, which narrowed the spreads and supported the euro. Mr Trichet also announced that the governing council had decided to continue conducting its 3 month refinancing operations as fixed rate tender procedures with full allotment until April 2011 at least. This extraordinary measure had originally been intended to expire at the end of this year. The adjusted ECB projections are still predicting GDP growth of 1.4% on average next year; this year's growth was revised up slightly to 1.7%. Growth of 1.7% is also expected for 2012. The inflation projection for 2011 was raised slightly to 1.8%, but it is expected to drop to 1.5% again in 2012. The ECB now sees inflation risks as balanced and no longer slightly tilted to the upside, whereas risks to the economic outlook continue to be tilted to the downside. But Mr Trichet emphasised that macroeconomic developments in the last few quarters had always been better than expected, which had in turn led to an upward revision of the growth forecasts. Although the debt crisis is pushing the economic indicators into the background, favourable data from the US are bound to have boosted the dollar too. Private non-farm payrolls have been picking up over the last few months; the positive trend slowed down unexpectedly in November, however. On the other hand, the ISM purchasing managers index for the manufacturing sector remained at its elevated level in November, well above the average level in the previous quarter. The Fed's Beige Book confirms the more upbeat data: the housing market situation still remains depressed despite the recent increases, but consumer spending is increasing and the propensity to invest is higher. Despite the improved economic outlook for the US, the Fed is unlikely to change its extremely accommodative monetary policy stance, especially as it sees no sign of wage or price pressures. Moreover, the unemployment rate is still higher than desired; in November, it actually rose again unexpectedly from 9.6 to 9.8%. The ECB, however, given its overall positive economic outlook, is likely to stick to its exit strategy, despite delay due to the debt crisis flaring up again. Mainly because of the divergent monetary policies and the even more precarious state of US public finances, we are still expecting the dollar to lose ground versus the euro again in 2011.

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