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Prospects Weekly: Positive response to European Financial Stability Facility and Greek debt agreement

Global Macroeconomics Team's picture
This week’s agreement to strengthen the capacity of Europe’s bailout fund and increase private investor’s participation in the restructuring of Greek debt was greeted positively by markets (at least initially). However, many details remain unclear. If market perceptions deteriorate, more adverse trade and financial disruptions could ensue, with Europe and Central Asia and the Middle East and North Africa most exposed if European demand were to weaken further. Recently, increased risk-aversion led to sharp capital outflows from developing countries that prompted several central banks to intervene to stabilize local currencies by selling foreign exchange holdings. In some cases drawdowns were significant and, if continued, could rapidly deplete reserve cushions. While global demand growth for crude oil has slowed, rising seasonal demand is supporting relatively high world oil prices, contributing to sustained upward pressure on global prices. 
The agreement to strengthen the European Financial Stability Facility and to write down 50% of Greek debt has been well received by markets. The deal increases the EFSF by €1trn ($1.4trn), while debt write downs will cut Greece’s debt to 120% of GDP by 2020 (vs. about 170% in 2012). The euro rose 2.2% vs. the dollar Thursday, and equities advanced 3.6% (Stoxx Europe 600), led by bank shares. Yields and CDS spreads on European debt declined by more than 10 basis points. While encouraging, details on bankrecapitalization and fiscal reforms have yet to be spelled out. Should market perceptions deteriorate, as they have following previous announcements, European imports could weaken. The Middle-East and North Africa is particularly vulnerable to a downturn in the high-spread Euro Area countries of Greece, Italy, Ireland, Portugal and Spain, which in aggregate represent 23% of its export market (vs. only 10% for Europe and Central Asia and even less for other developing regions). 
Several developing countries sold foreign currency reserves to stem declines in recent months. Large capital outflows in Q3-2011 led to sharp currency depreciation viz-a-viz the dollar for Brazil (19%), South Africa (19%), Turkey (14%) and India (10%). The reversal in capital inflows (see last week’s brief) prompted several central banks to sell-off reserves. For example, in the first half of October Turkey’s central bank intervened directly, selling an estimated $1bn of reserves, bringing the average monthly decline in reserves since end-July to $3.2bn. Continued support at this level could reducereserves to 3-months of import-cover by mid-2012. Turkey’s reserves are currently at $85.9bn, equivalent to 4½ months merchandise import-cover. Given recent reserve sell-offs, South Africa faces similar exposures, but Brazil, Russia and India’s larger reserve-buffers offer more scope for extended currency support. 
Global oil prices remain firm ($103/bbl for the WBG average price) on low stocks, supply shortfalls and rising seasonal demand. In particular, the loss of Libyan light/sweet crude led to a reduction incrude and product stocks this year. Since the fall of Tripoli in September, Libyan output has recovered to 0.4 mb/d, but a return to pre-crisis levels of 1.6 mb/d will require much more time. While oil demand growth has slowed over 2010, it is picking up on seasonal factors as winter approaches in high-income countries, providing near-term support to prices. Also, the gap between WTI and other world oil prices has narrowed recently, as producers are increasingly shipping crude via truck, rail and barge from the bottle-necked mid-continent to the U.S. Gulf coast, taking advantage of higher prices and access to east-coast markets. 

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