Strong euro 'fling' could end in German tears
Tuesday, 24 July 2007
Wolfgang Munchau
"I'm not worried about a strong euro. I love a strong euro" - Peer Steinbrück, German finance minister, early July, 2007.
Falling in love with a strong currency is not unusual for a German finance minister. I would expect Peer Steinbrück's fling to be nasty, brutish and short. Since his recent statement, the euro's exchange rate has risen even further. If the euro continues to appreciate, Germany in particular will suffer from a sustained exchange-rate overshoot, as its economy remains as dependent as ever on a successful export sector. Even though the Germans have a slightly higher exchange-rate pain threshold than the French, we are nevertheless not too far away from that threshold.
Predicting exchange rates is a mug's game, as they say. It is clear that the euro is significantly overvalued. But there are non-trivial structural risks that the euro may appreciate further in the short-to-medium term. Of course, it may never happen. But if it does, Mr Steinbrück will not only have to eat his words. More worryingly, he and his European colleagues will have no idea what to do under these circumstances.
What are those structural risks? The first, we have seen recently. The foreign exchange markets react very sensitively to bad news about the US housing market and spillovers to US consumption. A bigger than expected economic downturn in the US could accelerate the trend of portfolio shifts from the US to the eurozone.
The second factor is distress in the credit markets. It is not clear how a credit market crunch will affect the euro/dollar exchange rate. My hunch is that it will be bad for the dollar. One factor that weighed recently on the dollar was the prospect of downgradings of US subprime mortgage debt and the prospect of spillovers to other segments of the credit market, including the market for collateralised debt obligations. The view that a credit market crisis could be bad for the dollar appears to have been a factor in early July sell-off. The eurozone is increasingly viewed as a safe haven. Ashraf Laidi, currency analyst for CMC Markets, has pointed out that the euro has been one of only three currencies in the industrialised world that has risen against gold this year.
A third factor is a potential shift in foreign currency reserves. There is a lot of talk about such a shift, but it has not happened yet. The dollar still accounts for about 65 per cent of the world's foreign exchange reserves, against the euro's 25 per cent. But if the euro's strength prevails, such a shift may happen at some point.
Many economists argue that there is no question of the euro ever challenging the position of the dollar. US financial markets have been far more liquid, and the US has enjoyed an admirably long spell of macroeconomic stability. Furthermore, there is a high degree of inertia in the system. Shifts occur rarely.
But since its launch, the euro has become an increasingly popular choice for official and de facto currency pegs. Furthermore, the lack of liquidity of European financial markets, which constituted a serious drawback for the euro only a few years ago, has improved markedly. This has been possibly the single most important factor in raising the euro's international role, especially as a currency for the issue of corporate and sovereign debt. I would expect that a sustained period of dollar weakness would strengthen the euro's international role significantly. This process would be accelerated, as more countries abandon the dollar peg and move either to a mixed basket or to a floating rate system. The result would be a self-reinforcing mechanism whereby a rise in the euro's exchange rate strengthens its position as a global reserve currency, which in turn could lead to a further appreciation in the euro's exchange rate.
So there are at least three reasons why the euro's exchange rate may go up even further. What will the Europeans do in that case? My prediction is that they will first have a fight about who is in charge. The legal and institutional set-up of the eurozone is ambiguous about the division of responsibilities. If this was purely a fight between politicians and central bankers, the politicians would probably win. But this has now turned into a fight among politicians, specifically between President Nicolas Sarkozy of France, who has asked for a more interventionist exchange-rate policy, and Angela Merkel, the German chancellor, who has said she will not permit this.
So what if the euro rises above $1.40? Germany's ability to improve its competitive position through a devaluation of the real exchange rate has run its course. With unemployment down sharply, conditions in the labour market are gradually returning to normal. The latest wage settlements, and reports of capacity shortages are a clear indication that Germany's competitive adjustment process has now been completed. Once the euro hits $1.45, it will be too strong even for Mr Steinbrück's taste.
My hunch is that the German government will find it difficult to stick to its current position and that Mr Sarkozy will win this argument. It would be much better if the eurozone adopted a more structured process to deal with exchange rate overshoots. But in the absence of such a strategy, what we are most likely to get is confusion followed by panic.
Under syndication arrangement with FE
"I'm not worried about a strong euro. I love a strong euro" - Peer Steinbrück, German finance minister, early July, 2007.
Falling in love with a strong currency is not unusual for a German finance minister. I would expect Peer Steinbrück's fling to be nasty, brutish and short. Since his recent statement, the euro's exchange rate has risen even further. If the euro continues to appreciate, Germany in particular will suffer from a sustained exchange-rate overshoot, as its economy remains as dependent as ever on a successful export sector. Even though the Germans have a slightly higher exchange-rate pain threshold than the French, we are nevertheless not too far away from that threshold.
Predicting exchange rates is a mug's game, as they say. It is clear that the euro is significantly overvalued. But there are non-trivial structural risks that the euro may appreciate further in the short-to-medium term. Of course, it may never happen. But if it does, Mr Steinbrück will not only have to eat his words. More worryingly, he and his European colleagues will have no idea what to do under these circumstances.
What are those structural risks? The first, we have seen recently. The foreign exchange markets react very sensitively to bad news about the US housing market and spillovers to US consumption. A bigger than expected economic downturn in the US could accelerate the trend of portfolio shifts from the US to the eurozone.
The second factor is distress in the credit markets. It is not clear how a credit market crunch will affect the euro/dollar exchange rate. My hunch is that it will be bad for the dollar. One factor that weighed recently on the dollar was the prospect of downgradings of US subprime mortgage debt and the prospect of spillovers to other segments of the credit market, including the market for collateralised debt obligations. The view that a credit market crisis could be bad for the dollar appears to have been a factor in early July sell-off. The eurozone is increasingly viewed as a safe haven. Ashraf Laidi, currency analyst for CMC Markets, has pointed out that the euro has been one of only three currencies in the industrialised world that has risen against gold this year.
A third factor is a potential shift in foreign currency reserves. There is a lot of talk about such a shift, but it has not happened yet. The dollar still accounts for about 65 per cent of the world's foreign exchange reserves, against the euro's 25 per cent. But if the euro's strength prevails, such a shift may happen at some point.
Many economists argue that there is no question of the euro ever challenging the position of the dollar. US financial markets have been far more liquid, and the US has enjoyed an admirably long spell of macroeconomic stability. Furthermore, there is a high degree of inertia in the system. Shifts occur rarely.
But since its launch, the euro has become an increasingly popular choice for official and de facto currency pegs. Furthermore, the lack of liquidity of European financial markets, which constituted a serious drawback for the euro only a few years ago, has improved markedly. This has been possibly the single most important factor in raising the euro's international role, especially as a currency for the issue of corporate and sovereign debt. I would expect that a sustained period of dollar weakness would strengthen the euro's international role significantly. This process would be accelerated, as more countries abandon the dollar peg and move either to a mixed basket or to a floating rate system. The result would be a self-reinforcing mechanism whereby a rise in the euro's exchange rate strengthens its position as a global reserve currency, which in turn could lead to a further appreciation in the euro's exchange rate.
So there are at least three reasons why the euro's exchange rate may go up even further. What will the Europeans do in that case? My prediction is that they will first have a fight about who is in charge. The legal and institutional set-up of the eurozone is ambiguous about the division of responsibilities. If this was purely a fight between politicians and central bankers, the politicians would probably win. But this has now turned into a fight among politicians, specifically between President Nicolas Sarkozy of France, who has asked for a more interventionist exchange-rate policy, and Angela Merkel, the German chancellor, who has said she will not permit this.
So what if the euro rises above $1.40? Germany's ability to improve its competitive position through a devaluation of the real exchange rate has run its course. With unemployment down sharply, conditions in the labour market are gradually returning to normal. The latest wage settlements, and reports of capacity shortages are a clear indication that Germany's competitive adjustment process has now been completed. Once the euro hits $1.45, it will be too strong even for Mr Steinbrück's taste.
My hunch is that the German government will find it difficult to stick to its current position and that Mr Sarkozy will win this argument. It would be much better if the eurozone adopted a more structured process to deal with exchange rate overshoots. But in the absence of such a strategy, what we are most likely to get is confusion followed by panic.
Under syndication arrangement with FE