Weak euro zone casts long shadows

LONDON Sun Aug 19, 2012 6:52pm EDT

A general view of a structure of the Euro currency sign is seen in front of the European Central Bank (ECB) headquarters in Frankfurt August 2, 2012. REUTERS/Alex Domanski

A general view of a structure of the Euro currency sign is seen in front of the European Central Bank (ECB) headquarters in Frankfurt August 2, 2012.

Credit: Reuters/Alex Domanski

LONDON (Reuters) - Drug dealers, money launderers and assorted cash-only criminals love the convenience of the 500 euro note. Will bankers also soon be clamoring for wads of the high-value bill?

The question arises because the European Central Bank might have to lower interest rates further to revive growth. Business surveys this week are likely to show the euro zone economy remaining flat on its back in August after contracting by 0.2 percent in the second quarter.

But the ECB has already cut to zero the interest it pays banks on excess reserves. So driving the deposit rate into negative territory -- charging banks for the privilege of parking surplus funds -- would force lenders to weigh up the alternative of withdrawing cash and stashing it somewhere safe.

The idea sounds outlandish. Not so. ECB Executive Board member Benoit Coeure addressed it back in February.

"Given the costs associated with holding large amounts of banknotes, it is likely that significantly negative interest rates would be required to trigger a switch from money holding to investment in banknotes," Coeure said.

Since then, the economic recovery the ECB was anticipating has failed to materialize, prompting the move to a zero deposit rate and leading economists to take a closer look at the cost of warehousing notes.

"The physical storage would be easy; if withdrawn as 500 euro notes, 1 billion euros (plus two big security guards) would easily fit into a VW Golf and the cash into existing bank safes. Harder to gauge are the inconvenience and insurance-type costs, which will affect banks' response," Greg Fuzesi of JP Morgan wrote in a note.

Lasse Holboell Nielsen, an economist with Goldman Sachs, has examined the case of non-euro member Denmark, whose central bank set a deposit rate of minus 0.2 percent over a month ago, to tease out the implications for the euro zone.

For a bank with 40 billion Danish crowns ($6.60 billion) on deposit, he reckons it would make economic sense to take out cash once the interest rate drops below -0.52 percent or -0.65 percent, depending on the fixed-cost assumptions for insurance, transport and vault rental.

Because Denmark's central bank has not encountered any unexpected fallout since it went negative, Nielsen concludes that it could cut the deposit rate by another quarter-point.

And based on Denmark's experience, he judges a negative deposit rate at the ECB of 0.25 percent is quite feasible.

ALL EYES ON THE CENTRAL BANKS

Steen Jakobsen, chief economist with Saxo Bank in Copenhagen, said he expected a weak euro zone purchasing mangers' survey on Thursday would ratchet up the pressure on ECB President Mario Draghi to act.

"If anything, it will support the argument that Draghi feels the need to do something about the monetary transmission mechanism because the numbers will just continue to weaken," Jakobsen said.

In particular, he said a marked slowdown in China, which also releases a poll of purchasing executives on Thursday, boded ill for exports from Germany, Europe's biggest economy.

A survey conducted by the International Chamber of Commerce and Germany's IFO institute, released last week, showed a sharp drop in global economic sentiment as fear over the fallout of the euro crisis persists.

"What was surprising in this quarter is that the optimism that things will soon turn around has almost disappeared," said Gernot Nerb, IFO's director of business surveys.

Investors are pinning their hopes not only on the ECB but also on the Federal Reserve. A monthly Reuters poll of economists showed the chances of a third round of asset purchases, known as quantitative easing, had risen to 60 percent from 50 percent in July.

The U.S. central bank's own thinking should become clearer with Wednesday's minutes of its July 31/August 1 policy meeting.

They are likely to show the Fed is waiting to see whether a recent tentative improvement in the economy is sustained.

To that end, a flurry of data on U.S. housing sales and prices this week is expected to provide further evidence that the bombed-out market is over the worst but, like the broader economy, is recovering only modestly. ($1 = 6.0604 Danish crowns)

(editing by Ron Askew)

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