Euro's New-Found Strength Could Radically Change Economic Playing Field

FAZ ^ | By Benedikt Fehr

[DeaconBenjamin]

The new single European currency has been under pressure since its launch in 1999 because of the strength of the dollar. In the past three months, however, the Euro has gained around 10 percent in value on the dollar because doubts about developments in the United States are increasing.

On June 22, the euro hit $0.97, its highest point since March 2000. Europe's currency recently was also able to improve its rate against the yen, pound and numerous other currencies. That indicates that a new valuation of the single currency is apparently taking place on the financial markets.

Since the mid-1990s, developments on currency markets have been characterized by the impression that the U.S. economy offered the best chances for high yields due to its technological head-start. That attracted foreign capital to a bullish Wall Street.

A side effect of this was that the dollar gained in value. The United States used the capital inflow to finance import purchases, allowing Americans to consume significantly more than was produced. They paid for the imports largely with stocks and other securities, most of which have since lost a large portion of their value.

Meanwhile, investors have become disillusioned. Enron's scandalous bankruptcy, eroding trust in U.S. bookkeeping practices, worries about the state of the economy and general insecurity about the global political situation take things a step further: Investors' modus operandi have changed. They concentrate on avoiding losses, limiting risks. Therefore, capital flows at a slower pace to the United States.

And that -- lower capital inflows -- has pushed into the forefront how the United States will finance its massive current-account deficit, equal to about 4 percent of its gross domestic product. This question is now of the utmost importance for currency markets. An initial consequence is that the dollar is losing value against most other currencies. That's because the exporters that ship goods to America still are able to find takers for their dollar revenues, but only at lower rates.

As far as the flow of goods is concerned, the dollar's devaluation leads to self-regulation in a market economy: From the U.S. point of view, imports become more expensive, hampering demand; at the same time, exports from the United States become cheaper and thus more attractive. Both trends reduce the current-account deficit.

For Europe, it means that the export economy will have a harder time. However, at first exports will only fall off slightly because many exporters hedge with forex futures trading months into the future. But a continued high level of exports should not gloss over the fact that the real danger for total demand and economic growth comes from investment levels. If exporters were to fear that their profits would retreat for the long-term because of the dollar's weakness, then they would lower their investment levels, post haste. That could endanger Europe's recovery.

After years of a positive export economy, politicians and industry will likely have to come to terms with a new reality. A poorly performing export economy could also threaten jobs in this area. That would increase the pressure to reform in Germany if the domestic economy has not jump-started by then. This applies above all to the labor market, which economists have long said needs more flexibility. Germany has a large deficit to make up for in this area.

The euro's current strength also changes the framework in which the European Central Bank operates. The lower dollar exchange rate makes imports cheaper, particularly oil imports. That slows the rate of inflation, which in May fell to 2 percent. The dollar has fallen further in June. The ECB should use this room to delay all thoughts of raising interest rates until after the summer break.

Should the dollar's decline increase its pace, which is still a wide open subject, the ECB would have to react with interest-rate reductions in order to reduce the euro's pull and to soften the blow to the economy.

The catalyst for such a scenario would be capital flows. Foreign holders of dollar-denominated bonds watch their total yield melt away as the dollar loses ground. If they then sell dollar bonds for bonds in their domestic currency, that could unleash an avalanche: a decline of the dollar accompanied by climbing U.S. interest rates. That would have unpredictable consequences for the economy, the real-estate market and for dollar-indebted emerging markets, causing problems for the world economy.

Such grim scenarios do not have to come true. Some observers expect that the euro's climb will lose pace as the year progresses. Nevertheless, more and more investors are choosing to err on the side of caution, something which is reflected in higher demand for government bonds. The demand has sent the yields for 10-year bonds on both sides of the Atlantic below 5 percent already. The flattening of the yield curve, coupled with insecurity, also had contributed to the money supply in Europe growing faster than is liked. However, when the money supply grows because of such factors, there exists no direct danger for price stability.

The dollar and the deficit. They will remain hot topics in the coming months. But beyond that, the euro has become more attractive, since it has gained on the yen and pound, too. Europe's steadfast honoring of the stability pact and its slow but steady progress in pushing through structural reforms have helped. In addition, the seamless transition to euro cash showed the world that Europe is moving forward. That, too, is a reason why the euro is recovering.

[DeaconBenjamin]

A European look at the Euro's new-found strength.