Currencies: Super-euro

Date: 10/05/03

Europe's once sickly single currency is flexing its muscles

THIS week the euro rose to $1.14, 36% above its low point of two years ago and within spitting distance of the rate of $1.17 at which it began life in January 1999. Yet despite the currency's recent strength, which will surely squeeze growth in the euro zone, the European Central Bank left interest rates unchanged at 2.5% at its meeting on May 8th - in line with most economists' expectations.

The euro was clearly undervalued early last year, but the speed of its appreciation has taken many by surprise. The dollar's ascent against the euro in 1999-2001 was popularly explained by America's superior economic performance. Yet America's growth is still outpacing Europe's, so why is the dollar falling?

Over the years, currency theories move in and out of fashion. Growth differentials are, it seems, no longer relevant; currencies are being driven instead by trade imbalances and differences in interest rates. Investors have become less willing to finance America's huge current-account deficit and are taking advantage of higher European interest rates. The large flows of capital from Europe into the United States seen a few years ago have now dried up. European investors, who suffered big losses on their dollar assets, are wisely keeping their money at home. Since its low point in March, Germany's DAX share index has gained 36%, more than double the rise in the S&P 500.

Judged by purchasing-power parity (PPP) - ie, by comparing relative prices - the euro is now slightly overvalued against the dollar, but there are good reasons why the euro could rise further still. First, as a result of years of external deficits, America has built up large foreign liabilities and hence debt-service payments, so it needs to run a trade surplus if it is to move towards current-account balance. This means that the dollar needs to be cheaper than its PPP.

Another reason why the euro is likely to overshoot is that it will have to shoulder a disproportionate share of the dollar's decline. This is because several of America's trade partners are resisting a rise in their currencies. Japan has been intervening to hold down the yen, while the Chinese yuan is fixed against the dollar. So, for any given fall in the dollar's trade-weighted value, the euro will have to rise by more.

Many forecasters are betting on a 10% increase in the euro over the next year or so. A much steeper rise is possible. After hitting its low in February 1985, the D-mark climbed by 90% against the dollar in the next two years. If the euro were to rise by this much from its lowest point, it would reach $1.60.

American policymakers would probably be happy with a cheaper dollar to help reduce the risk of deflation. The Federal Reserve's open market committee gave warning this week that inflation could fall from its already low levels. The Fed left interest rates unchanged but with rates at 1.25% it has little room for further cuts. A falling dollar, on the other hand, has a similar impact to lower interest rates on growth and inflation.

According to the Fed's economic model, a 5% fall in the dollar's trade-weighted value has roughly the same impact on GDP as a half-point cut in American interest rates. Since January 2002, the dollar has fallen by 17%, and interest rates have been cut by half a point. The overall loosening of monetary conditions has therefore been equivalent to a cut in interest rates of about two percentage points.

In contrast, in the same period the euro's trade-weighted value has risen by 16%, while the ECB has cut interest rates by three-quarters of a percentage point. In the euro area a 5% rise in the exchange rate is estimated to be equivalent to a one-point increase in interest rates (more than in America, because exports account for a bigger share of GDP). This implies an overall monetary tightening equivalent to a 2.25-point rise in interest rates. No wonder the economies of the euro area have continued to underperform America's.

Europe's once sickly single currency is flexing its muscles.

• Primary Source