ECB must act to prevent euro aping strong yen The euro is at risk of resembling the yen of the 1990s and 2000s - a strong currency with weak economic fundamentals - if the eurozone keeps following Japan's post-bubble path of slow bank deleveraging and poor credit expansion. Prolonged financial sector weakness in Japan eventually led to sustained deflation, faltering economic growth, subdued imports and substantial trade surpluses. That caused the yen to be overvalued for much of the past two decades. To prevent the euro suffering the same fate, the European Central Bank must not follow the Bank of Japan's historic record of easing monetary policy too little too late. This year the ECB's policy makers have rightly urged eurozone governments to strengthen the region's banks. But until a full banking union is up and running - with the ECB as its single supervisor, a separate resolution authority able to close down or recapitalise weak institutions, and fiscal guarantees for bank deposit holders across the single currency area - local banks are unlikely to be in a position to provide new credit vigorously. During Japan's two lost decades, domestic banks were too weak to cut non-performing loans and absorb the losses. That prevented them from supplying fresh credit to the economy. Only when Tokyo began substantially recapitalising the financial sector - a full 13 years after the country's bubble burst in 1990 - were Japanese banks able to start expanding their loan books. Deflation risk The eurozone's banks are in a similar position to Japan's in the 1990s. Six years after the credit crunch began in the western economies, eurozone banks have only hesitantly shrunk their balance sheets. Loans-to-deposit ratios remain roughly 110 per cent, at levels comparable to Japan's ratios during its first lost decade. In contrast, US banks, forcefully recapitalised by the US Treasury in 2008, have been able to reduce bad credit and now only have loans accounting for 75 per cent of deposits. That rapid deleveraging has allowed the financial sector to provide stronger credit growth to the US economy. Tokyo's inability to strengthen quickly its banking sector led to Japan's economy falling into recession frequently throughout the 1990s and 2000s. In addition, the country suffered entrenched deflation for most of the past decade. Likewise, the eurozone has already endured two recessions since the credit crunch started in 2007, with the second downturn lasting six consecutive quarters until this year. Furthermore, the eurozone's latest inflation data show consumer prices are increasing only 0.7 per cent year on year, increasing fears that the region will also fall into deflation. Paradoxically, such economic weakness has been accompanied by persistent exchange rate strength. In both economies faltering gross domestic product growth has constrained demand for imports. Until the 2011 earthquake, Japan ran consistently large trade surpluses. That year the yen hit an all-time high of Y75 against the dollar. Similarly, the eurozone's trade balance has become strongly positive over the past couple of years, pushing the euro up to a two-year high of $1.38 last month. Proactive easing The ECB now faces a crucial test. The overvaluation of the euro risks tipping the eurozone into deflation much as the yen's strength helped force consumer prices lower in Japan. But in contrast to the BoJ, the ECB has always had a formal mandate to keep consumer prices rising at close to 2 per cent a year. If the ECB is to successfully pursue its inflation target and avoid deflation, it will need to be far more proactive in easing monetary policy than the BoJ historically has been. The ECB's decision last week to cut its refinance interest rate from 0.5 per cent was an essential first step. The warning from Mario Draghi, ECB president, that the ECB was willing to lower its deposit rate below zero in future if the eurozone heads closer towards deflation was also a critical signal. The prospect of negative interest rates will buy the eurozone time by helping cap rallies in the single currency until the Federal Reserve starts to taper its asset purchases in the next few months. Reduced bond-buying by the Fed would help take the pressure off the euro in the longer term as it would probably lead to a broad-based rally in the dollar against the rest of the major currencies. But if the ECB prematurely reconsiders its dovish stance before the Fed begins cutting its asset purchases, the eurozone is likely to suffer from renewed appreciation of the euro. That would increase the risks of the region falling into a deflationary trap. As Japan's experience shows, the ECB may then have to undertake massive quantitative easing in future to revive growth and inflation while still aiming to curb excessive exchange rate strength. Mansoor Mohi-uddin is managing director of foreign exchange strategy at UBS