FX: The Rising Euro


By Jonathan Gregson

After a year in the doldrums, the euro’s rise has caught many by surprise.

Europe currently looks like the unintended fall guy amidst the beggar-thy-neighbor round of central bank interventions in foreign exchange markets, whose primary aim is to keep the local currency—whether it be the Japanese yen, the Korean won or the Brazilian real—from appreciating so strongly against the weakening US dollar that their export industries fear they are losing global competitiveness.

The euro has strengthened against the US dollar by 10% over the past six months and looks like it is being driven even higher through huge capital flows that are seeking better returns than can be found in the United States, with its near-zero interest rate and ultra-loose monetary policy. Moreover, the euro has strengthened not only against the dollar but against all those currencies which, like China’s renminbi, are more or less pegged to the greenback, or which like Brazil or Japan have recently taken action to hold down their currencies.

As a result, the pain is being felt right across Europe. Exporters are being undercut by competitors in countries with far stronger growth prospects than most eurozone members, purely because their authorities have joined in the so-called currency wars of competitive depreciation while the European Commission and the European Central Bank (ECB) do nothing apart from voicing concern and calling for China to permit “an orderly, significant and broad-based appreciation” of the renminbi.

Following an apparently inconclusive meeting with Chinese premier Wen Jiaobao in Brussels, Europe’s commissioner for economic and monetary affairs, Olli Rehn, warned: “If the euro continues to bear a disproportionate burden in the adjustment of global exchange rates, the recovery of the euro area might be weakened.”

Such pronouncements are unlikely by themselves to stem the euro’s largely unwelcome resurgence. Klaus Baader, chief eurozone economist at Société Générale, describes the currency markets as being in the grip of two opposing forces. “Concern over some European sovereign debt [is] weighing negatively on the euro, while the expectation of the Fed embarking on further quantitative easing (QE2), thereby chasing interest rates ever lower at the long end, is fueling positive sentiment,” he says.

For the time being, foreign exchange markets seem to have forgotten the sovereign debt problems of Greece, Ireland and Portugal. Instead it is the expectation of the Fed embarking on QE2 that is driving the dollar, the renminbi and most other major currencies down against the euro. “Europeans hold much the same position as the US on China’s keeping the renminbi undervalued,” says Baader. And with the Chinese currency following the dollar down, he notes that “exchange rate pressure is even greater in Europe than in the US.”

However, the European authorities see loose monetary policy in the US and UK as the root cause of their problems; and since their trade deficit with China is much smaller than that of the US, an undervalued renminbi poses less of a threat. “The European approach is not to let currency wars deteriorate into trade wars,” adds Baader.

Simon Derrick, managing director and head of currency research at BNY Mellon in London, says the euro’s strength has nothing to do with domestic economies in Europe or a recovery in sentiment toward the eurozone. “It is driven by market dynamics,” he says. “Since the other reserve currencies are all taking depreciation measures, it boils down to “What’s left to buy?”‘

Reserve Diversification
While Asian central banks are mainly buying dollars to hold down their currencies, some of their reserves are going into the euro. Part of the massive inward investment flows into emerging markets that have driven up free-floating currencies such as the real, the ringgit or the rand, are being effectively ‘returned to sender’ by central banks’ buying of dollars and euros. Raghav Subbarao, a foreign exchange strategist at Barclays Capital, says the “political risk premium”—the currency wars breaking out at the G20 meeting in Seoul, the US mid-term elections and the possibility of its labelling China a currency manipulator—is pushing the dollar lower against the euro. “What we are seeing is more depreciation of the dollar rather than appreciation of the euro,” says Baader. The effect is the same, however.

How far will it go? Derrick sees the euro rising to $1.50 unless the European authorities come up with a credible plan to deflect the momentum. And on the policy front the ECB has wavered between inaction and hawkishness. Axel Weber, president of Germany’s Bundesbank and member of the ECB’s governing council, is an influential proponent of an early exit from accommodative monetary policy and raising interest rates sooner rather than later. He also argues that the ECB should stop buying Greek and Irish sovereign debt. Given that Weber is widely regarded as a likely successor to ECB president Jean-Claude Trichet, his views carry weight.

Certainly, the ECB’s combination of inaction and conservatism have contributed to the euro’s rise. But at what levels will the pain really start to be felt? Wolfgang Münchau, president of the online think-tank eurointelligence.com, says the French are suffering with the euro at the current rate of $1.40, while the German exports will suffer at $1.50 to the euro. “At $1.60 there will certainly be pain,” he says.

The impact on GDP could be significant: Baader contends that a 10% exchange rate rise reduces GDP growth across the eurozone by between 0.4% and 0.7% after one year. But, since the combination of a strong currency and weak growth should feed through into lower inflation, then there is less cause for the hawks on the ECB council, like Weber, to demand tighter money or a hike in interest rates.

The 10% hike in exchange rates has been accompanied by a near doubling of Libor, the short-term rates at which banks lend to each other. “Money market rates are being pushed up,” says Baader, “with three-month money now close to the ECB’s 1% policy rate.” That is hitting countries such as Spain especially hard, explains Münchau, because their bank rates are dependent on Libor. “Spain desperately needs export-led growth,” he says, but with an overvalued currency and higher borrowing costs than elsewhere “that is simply not happening.”

Areas of Europe that have already achieved significant productivity gains are less affected. Münchau points out that the German export machine, built around precision industrial equipment and high end automobiles, will continue to benefit from high demand in emerging markets. Industrial orders rose by 3.4% in August, and automakers such as Daimler-Benz, Volkswagen and BMW see that trend continuing. “Germany’s exports are significantly less sensitive to exchange rates than other eurozone members like France or Italy,” says Baader. It is the mass-market manufacturers such as Fiat and Peugeot-Citroën that are likely to be hit hardest by the strong euro, along with suppliers such as steel maker Mittal which recently acquired Arcelor. And, while luxury goods–makers like champagne-to-handbags group LVMH are reporting bumper sales, the strong euro will not flatter profitability. Nor will currency volatility help construction or infrastructure groups like Veolia, which operate major turnkey projects in countries such as China whose currencies are falling against the euro. Add in the increasingly high costs of currency hedges, and the burden on Europe’s global companies is compounded.

The erosion of competitiveness is being felt more keenly in Spain, Ireland and Portugal, where private sector deleveraging and cutbacks in government spending mean that the only way to grow the economy is through exports. The same is true of non-eurozone central and eastern European countries, some of which have had to participate in IMF programs that invariably prescribe a combination of fiscal austerity and export-led growth. Although they are outside the eurozone, their currencies are rising compared to dollar-linked ones because, as Franziska Ohnsorge, Senior Economist at the European Bank for Reconstruction and Development (EBRD), explains: “Most currencies in this region are closely aligned with the euro though currency boards, fixed pegs, or tightly managed exchange rate regimes. It is therefore unlikely that an appreciation of the euro by itself would translate into a substantial depreciation of local currencies against their main trading partner.

It is possible the storm will blow over of its own accord. Baader believes worries about the fiscal situation in peripheral eurozone countries, particularly Ireland and Portugal, are likely to flare up again so the current euro rally will lose steam. Subbarao is equally confident that fundamentals will come back into play and expects the euro to be worth around $1.30 in a year’s time.