Rising budget deficits - a threat to future economic growth?

With the issue of aid to Greece still brewing, sentiment for the euro was very mixed, taking directions on any positive or negative comment from key people. The euro was down against most of its major counterparts for the first half of the week. With all probability, uncertainty will continue to reign until the rescue package is confirmed and is made available by member states and the IMF.

Concerns revolve around the likelihood that the European Union needs to introduce more disciplined fiscal measures, given its larger-than-expected 2009 budget deficit, but also because of the concerns on the integrity of the Greek statistical data. The risk of contagion to other EU members is also cause for concern.

With the German Parliament having to wait until after the May 9 state election to take a vote, it is unlikely that other EU countries will opt to provide funds before - thereby causing a delay in the availability of funds. Although Germany said on Monday it was ready to commit funds, it was demanding more painful austerity measures.

Given the size of Greece's problems the stricter fiscal policies required to get public finances back to a safe area are likely to keep concerning the markets, unless the donors of this aid can commit to a multi-year funding package.

With regard to the United Kingdom, concerns of a hung Parliament (with no political party having an absolute majority of seats) keep limiting the British pound's support, despite the fact that it did find support by improving data and enjoyed a few rallies during spasms of decreasing risk aversion.

The issue is more than just not having a clear majority, because it may be common in Germany and Italy, but it is rare for the United Kingdom - the last hung Parliament dates back more than 35 years and lasted only a few months. The implications of this are that a hung Parliament will most likely cripple efforts to tackle the country's debt. A hung Parliament is the worst-case scenario for the British pound.

A mild appreciation of the Chinese yuan by a tentative five per cent would cause losses to Chinese exporters, according to a Reuters poll conducted at China's top trade fair. On average exporters' response was that they could at most withstand an exchange rate of 6.5 yuan to the US dollar (currently at around 6.82 yuan to the US dollar) after which they would start losing money - given that the sector is already facing increasing material and factor costs and hence thinning margins.

Even though the export sector (considered as the backbone of the Chinese economy) experienced a rebound in these last few months mainly attributed to growing Western orders, exports have been less profitable due to contemporary rises in these material and factor costs. Many analysts see this as one of the main reasons why China has played down the issue of letting the yuan appreciate.

The currency issue is not the only stress for profit margins. Many argue that shortage of labour across China is even worse, limiting production capacity and increasing the wages bill. All this should however deflate expectations of any drastic changes in China's currency management: any change will be very gradual and contained.

Analysts continue to see further US dollar strength as markets continue to reflect the likeliness of policy rate hikes by the Federal Reserve before the European Central Bank, Bank of Japan and Bank of England.

A major event on the economic calendar was expected yesterday evening when the Federal Reserve was expected to announce whether or not to effect any changes in its interest rate.

While the Federal Reserve was widely expected to hold interest rates near zero, in anticipation to this there have been rumours that policy-makers could revise their pledge to keep rates near zero for an "extended" period.

Upcoming FX key events

Today: German Unemployment Rate & Eurozone economic sentiment.
Tomorrow: Eurozone enemployment rate, US Advanced GDP & US PCE.

FX technical key points

EUR/USD is bearish, target 1.3000, key reversal point 1.4200
USD/JPY is bullish, target 98, key reversal point 85
GBP/USD is bearish, target 1.4750, key reversal point 1.5700
USD/CHF is bullish, target 1.1000, key reversal point 0.9950
AUD/USD is bearish, target 0.7800, key reversal point 0.9400
NZD/USD is bearish, target 0.6200, key reversal point 0.7650

Mr Bovay is senior trader at RTFX Ltd.

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