Germany Shrugs Off Exchange Rate Worries

Despite industry fears for exports, Berlin believes the German economic recovery is robust enough to handle a strong euro

German Finance Minister Peer Steinbrück has a tendency to exaggerate. "I love a strong euro," the Social Democratic politician recently proclaimed in his characteristically offhand manner, rebuffing critics who worry about the strong euro's potentially detrimental impact on the German economy.

Steinbrück's declaration of love must have irritated many -- as it was intended to. In particular, it would have got up the noses of the political elite in France. The French, led by President Nicolas Sarkozy, want to pressure the European Central Bank (ECB) to weaken the euro.

German Chancellor Angela Merkel has been equally laid-back about the soaring euro. Recently asked whether she was concerned about the rising euro, she answered laconically: "All things considered, no."

On the Rebound

The powers-that-be in Berlin are practically brimming with their newfound self-confidence. Even with the euro weighing in at $1.38 and reaching a new high last week, the German economy has been growing at a record pace -- as have German egos. The French and the Italians may be groaning under the weight of the strong euro, but the German economy continues to rebound.

Experts predict that Germany's gross domestic product will increase by about three percent this year. Even exports continue to surge forward unchecked. The Federal Association of German Industry (BDI) expects exports to grow by 10 percent for the year, prompting its experts to correct their own growth forecasts upward. "We are not experiencing a significant exchange rate risk," says BDI managing director Klaus Bräunig.

The good news is reason enough for Berlin to turn a deaf ear to Sarkozy's complaints that the costly euro is strangling the French economy. "German exports are also transacted in euros, and yet German companies are world champions when it comes to exports," says a triumphant Merkel.

Berlin's elation over Germany's economic rebirth occasionally borders on exuberance. The federal government's experts see the country's economy as being practically immune to the trials and tribulations of the global market. These days no one in the finance and economics ministries is interested in discussing potential threats to the current boom. On the contrary, they insist that developments prove that German companies are dealing with current exchange rates extremely well, and that there is no cause for concern.

An internal report prepared for Economics Minister Michael Glos, a member of the conservative Christian Social Union, seeks to justify the confident mood: "As a result of only moderate wage and price increases in recent years, Germany has significantly increased its competitiveness." Experts call this phenomenon "real devaluation." As a result of this restraint on wage hikes, German companies are able to sell their products for less on global markets.

No Risk

One of the reasons the experts are so confident is that two-thirds of German exports are subject to no exchange rate risk whatsoever. According to the document prepared for Glos, "the effect of the current appreciation of the euro against the US dollar is initially offset by the fact that a large portion (about 40 percent) of German foreign trade is conducted with countries within the euro zone." Another 20 percent of German trade involves European Union member states that are not part of the currency union. Many of them have tied their own currencies to the euro, so that trading with these countries comes with no exchange rate risk.

Glos's experts already believe that Germany's fixation on the dollar exchange rate is too one-sided. "Effective exchange rates are economically more significant than bilateral exchange rates," they write. The effective exchange rate, to put it simply, reflects the value of one currency against all others.

The calculation takes into account the importance of the countries in question as trading partners of the euro area, as well as the past movement of their currencies' exchange rates. The results are comforting. Between early 2006 and the end of June 2007, the euro rose by only 5.5 percent against the currencies of the 44 most important trading partners.

By comparison, it rose by more than 16 percent against the dollar.

But even the euro's relative value against the dollar is not as alarming upon closer inspection. Adjusted for inflation in recent years, the euro's value has remained essentially unchanged since its inception. "The unchanged price-related competitiveness -- compared with early 1999 -- also helps to explain why Germany's export economy has weathered the euro's appreciation relatively well so far," the authors of the Glos report write.

Besides, they add, exports are not solely dependent on exchange rates. "Instead, growth in foreign markets, in particular, plays a greater role for German exports in the long term."

Part 2: Onwards and Upwards

As well as the luxury automobiles which Germany is famous for, German companies supply products that emerging economies urgently need for their development, such as high-quality machinery and complete production facilities. "In these types of markets, rising production costs can easily be passed on to customers," reads the Glos report.

The experts also believe a stronger euro is not necessarily detrimental in a recovery. "The cushioning effects of currency appreciation will be limited if the appreciation itself is the result of increased economic activity in the euro zone," the report's authors write. In other words, the euro is strong because of the strong euro zone economy.

This strength is attributable to the euro zone outpacing growth in the US economy, which will grow by only two percent this year. "The strength of the European economy has surprised investors, which is reflected in exchange rates," Adam Posen, an economist with the Peterson Institute for International Economics, told SPIEGEL.

Developments in interest rates have given the euro an additional boost. Although the prime rate in the United States remains higher than in Europe, "the key thing is interest rate expectations," say the authors of an internal assessment at the German finance ministry. "These are aimed upward for the euro."

The Currency of Choice

Europe's uniform currency also benefits from its growing international role, as more and more investors see it as an alternative to the dollar. The euro's share of worldwide foreign currency reserves has increased from 16.3 percent in 2000 to 25.8 percent today.

Wealthy oil-producing countries, as well as Russia, are seeking opportunities to invest the profits from their exports of oil and other natural resources. "There are only two suitable financial markets (for such investments) in the world, namely the euro market and the dollar market," write German Finance Minister Steinbrück's experts -- and the euro zone is apparently the investment market of choice at the moment.

A growing number of governments are also tying their currencies to the euro. Credit rating agency Moody's estimates that more than 30 countries, including almost all of Eastern Europe, have already tied their currencies to the euro.

But the biggest impact comes from Asian countries with substantial budget surpluses. In 2005, China abandoned its long-standing policy of pegging its currency to the dollar at a fixed rate, instead tying the yuan to a basket of currencies in which the euro plays a prominent role.

Kuwait followed suit in May 2007. Since then the value of the Kuwaiti dinar is no longer tied solely to the greenback, but also to the euro. The Russian central bank raised the euro's share of its currency basket from 35 to 45 percent.

All of these measures are mutually reinforcing. As the euro gains in value, it also acquires a stronger role in currency reserves and currency baskets, thereby raising its value even further.

And this trend is unlikely to come to an end any time soon. "If the Asian currencies remain stable relative to the dollar and the euro bears the burden of is appreciation almost entirely on its own, rates could climb above $1.40 in the foreseeable future," says Washington-based economist Posen. Even higher rates are possible if the real estate crisis in the US wreaks even more havoc among hedge funds and investors pull out in panic.

Feeling the Effects

Some sectors, especially the auto industry, are already feeling the effects of the strong euro. Because of the weak dollar, German automakers BMW and Volkswagen each reported declines in their North American profits by several hundred million dollars in 2006.

Some are already expressing mild concern. "The euro appreciation has already led to a decline in exports to the dollar zone," says Alexandra Böhne, an expert on the economy with the Association of German Chambers of Industry and Commerce (DIHK). Nevertheless, says Böhne, this does not mean that growth forecasts should be corrected downward. According to Böhne, the recovery will continue because investments and consumer spending are increasingly driving growth.

The experts at the German economics ministry note that an economy benefits as a whole from the appreciation of its own currency, even if individual sectors suffer. "A high exchange rate also translates into lower prices for imports that are priced in dollars," they write. In particular, this reduces the cost of natural resources and raw materials, such as oil, natural gas and steel.

The price benefit, say the experts at the economics ministry, is the equivalent of real income growth. The same amount of money buys more natural resources, and the same volume of imports costs less. According to the experts, the savings free up money to spend on other things: "Both consumers and businesses benefit as a result."

Translated from the German by Christopher Sultan

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