international analysis and commentary

A declining euro-dollar rate: food for debate

553

Since May 2014, the euro-collar exchange rate has seen a significant decline. This may seem remarkable, especially compared to the two-year period before, when the value of the euro steadily rose from approximately $1.20 to almost $1.40. The question is whether the latest 12-month decline was caused only by the low interest rates and the Quantitative Easing program (QE) of the European Central Bank, or whether other factors played a role as well.

According to most experts the relative increase of the euro-dollar rate between 2012 and early 2014 had reflected the fact that the ECB was the only major central bank that was not engaging in some form of quantitative easing. In other words: in that period, the euro did not gain value in absolute terms, it was the US dollar losing part of its value that made the euro look stronger.

It is tempting to ascribe last year’s decline of the euro-dollar rate to similar causes. In October 2014 the FED announced that it would end its monthly asset purchasing program. If nothing else had happened, the euro-dollar rate would have found a new equilibrium-level. However, almost simultaneously the European Central Bank announced a government bond purchase program to be rolled out in the following months. Some experts note that the ECB first hinted QE measures in August of last year (and took the formal decision in early 2015), but that the euro already started to decline in May: an explanation could be that financial markets already anticipated some form of quantitative easing by the ECB, since deflation was already looming at the time. According to this theory, it was therefore foreseeable that the ECB would embrace such unconventional measures.

Although QE plays an important role here, I doubt it tells the whole story. Today the euro-dollar rate floats around $1.14. With comparable QE programs (and interest rates), the euro and the US dollar should have found each other at a level comparable to the period just before the FED started its QE programs: just above $1.20. Therefore, other factors must have had an additional negative influence on the value of the euro. The causes must be sought in decreasing demand for peripheral government bonds by non-euro area investors, or the absence of real economic growth in the Eurozone.

Apart from the important debate on its causes, it is questionable whether the Eurozone will now benefit from a lower relative value of its currency. For the short term this might seem to be the case, at least when you look at the Eurozone as a whole. In general a “weaker” currency is associated with increasing exports and higher competitiveness vis-à-vis other regions in the world.

For many individual Member States this effect has hardly materialized so far. Part of the reason is that a high parcentage of their export can in fact be qualified as “intra-Eurozone”. As they deliver goods and services to other Eurozone countries, these economies do  not benefit from currency devaluation.

Are there different types of positive effects to be expected? An economy with a weak currency will sooner or later experience a rising general price level, in other words: inflation. Inflation in turn causes a decrease in the value of (maturing) outstanding debt. It is often said that this will be an advantage for Europe, since the continent is currently struggling with both a high public and a high private debt level. However, it should be recalled that the greater part of Europe’s current outstanding debt will not be repaid when it matures, but will have to be refinanced in the (near) future. Higher inflation will eventually lead to higher interest rates, so for the greater part of our debt the positive effects of a weaker euro and inflation will be neutralized. In theory a weaker euro could do us some good, but these advantages are likely to be much more modest in reality.

As to whether the euro will stay at its current low level, of course one cannot provide certainty. However, if we look at Central Bank policy on both sides of the Atlantic, it does not seem likely that we will see the euro rise any time soon. In March of this year the Fed hinted for the first time since the start of the financial crisis that the federal funds rate might be raised later in the year, which has probably already been incorporated in a strengthening of the US dollar.

In the Eurozone, on the other hand, seven years after the outbreak of the credit crisis, economic growth has not yet returned to pre-crisis levels. Although some say those growth levels were unrealistic and unsustainable anyway, many view higher economic growth as the only solution to solve the debt problem many countries in Europe are struggling with. Therefore, general expectations are that the interest rate will continue to stay low.

For some countries in the Eurozone a weaker single currency might have some short-term advantages, but it also has become the cause of fierce political debate. Most Southern European countries, including France, applaud the recent depreciation. They believe a weaker euro benefits their exports, but they might overstate this positive effect, as I explained above. Some Northern European countries are wary of a further decline of the currency. Those who worry most are undoubtedly the Germans. They might not necessarily fear the declining relative value (that is, the value of the euro compared to other currencies) as such, but they strongly criticize the root cause of it. Most German policymakers regard quantitative easing to be both irresponsible and unlawful. There are merits to both arguments. The best thing QE could deliver is time. Time for governments and Central Bank policymakers to find structural solutions to the economic problems Europe is struggling with, e.g. a high debt level, high (youth) unemployment and large structural differences in the dynamics of its various economies. Economic research shows that depreciating currencies do not contribute to output and unemployment in the long run, only structural reforms do.

And last but not least: QE definitely does not align with the spirit of the Maastricht treaty, the foundation of the euro and the ECB.