Eurozone bank credit to government surges; credit to business and household plummets - - 1) Data refer to the changing composition of the euro area.

The European Central Bank (ECB) on Tuesday drained €169.7 billion in overnight funds from the Eurozone money market in a signal that there is ample liquidity as banks continue to be cautious in lending to business and households. Meanwhile, the rise of the Euro is an issue of increasing concern for ECB policymakers.

The ECB absorbed funds from the banks paying them 0.8%, which was above the overnight interbank interest rate of 0.5%.

Data published Tuesday showed that on Monday banks parked €147.218 billion overnight with the ECB at a below-market rate of 0.25%, rather than lend it elsewhere at higher rates.

ECB President Jean-Claude Trichet in Venice last Thursday, was critical of Eurozone banks for failing to pass on more liquidity to households and businesses.

The unsecured part of the market, where lending isn't collateralised but based on the strength of counterparties' credit ratings, is still being affected by the credit crunch as banks remain reluctant to lend because of fears borrowers might default.

These are not irrational fears.

The US dollar is trading against the euro in Asia Wednesday, at $1.4875 from $1.4854 in New York yesterday, when it reached $1.4876, the weakest level since Aug. 22, 2008.

In Europe, sterling fell to six-month lows against the euro after inflation data showed that annual UK consumer prices dipped to a 5-year low of  1.1% in September, strengthening the view that interest rates would remain close to zero for sometime.

The euro is trading Wednesday at £0.9337 having fallen as low as 94 pence per euro on Tuesday - - a six-month low.

Bloomberg reports that the UK currency’s 50-day moving average, currently at 88.75 pence, dropped below its 200-day level on Tuesday  - - a so-called dead cross. The last time it happened, on April 9, 2007, the pound closed at 68.04 pence per euro, before weakening 8% to end the year at 73.50 pence.

Sterling will probably weaken to $1.54 in the coming month, compared with a previous estimate of $1.63, Swiss banking group UBS said Tuesday.

UBS, termed by Euromoney Institutional Investor as the world’s second-biggest currency trader, changed its one- month pound forecast against the euro to 94 pence from 89 pence.

The $/£  rate on Wednesday morning, is $1.5940.

 The rising euro is a serious risk to the Eurozone economy while the fall in sterling is a continuing threat to indigenous Irish exporters who ship more than half of their output to the UK.

The Italian-controlled UniCredit Group, which has  a payroll of over 168,000, said in a commentary this week that rebalancing of the world economy could have serious implications for Europe.

An article published in the latest Quarterly Report on the Eurozone published by the European Commission (EC) argues that although the common currency area played a negligible role in the building up of global imbalances, it may be one of the casualties of the ongoing rebalancing process.

In the EC’s opinion, in a more benign scenario, the Chinese economy would take care of absorbing all the projected reduction in the US trade deficit via a significant appreciation of the real effective exchange rate. In this scenario, the Eurozone will experience a significant narrowing of the trade deficit with China, and a fall in the trade surplus with the US as a consequence of a mild appreciation of the euro. The worst case scenario is one where China could resist absorbing US products or allow only a very modest appreciation of the renminbi. In this case, a significant trade deficit for the Eurozone would emerge because of the likely very sizeable appreciation of the euro.

UniCredit says that in the current beginning of a very fragile recovery (apart from the rebound expected in the third quarter), the ECB is becoming increasingly aware that a stronger euro must be absolutely avoided.

The banking group says some years ago, it developed a model aimed at providing a rule of thumb to determine the dampening effect of currency appreciation on economic activity. Rather than exports, GDP was chosen as the endogenous (within the system) variable of the model because the economists wanted to allow for spill-over effects of changes in export demand onto domestic variables - - mostly investment spending. The dampening effect on GDP of a 1% appreciation in the nominal trade-weighted (TW) euro is about 0.1% in a two year time: the impact is negligible in the first two quarters, but becomes significant thereafter and the largest single-quarter effect (50% of the total cumulative response) is felt after nine months.

This means that the 2% appreciation seen since the beginning of Q3 2009, may shave off 0.2% from an already-anemic GDP over the forecast horizon. Further euro strengthening in the remainder of the year will bring down the baseline 0.8% growth forecast for 2010 worryingly closer (or even below) to the 0.3% that the ECB staff is currently envisaging.

UniCredit says this is a new era for lots of aspects of monetary policy.

"We think that it may also become a new era of ECB’s rhetoric on the exchange rate. It would be paradoxical that one of the few balanced economic areas of the world bears the burden of the global readjustment. What can be certainly said is that, irrespective of how the ECB decides to tackle the exchange rate issue, a strong euro is another solid argument in favor of our view of a refi rate stuck at 1% throughout 2010," the economists say.