The G7 Will Get an Earful About the Euro
Exchange rates are once again a primary focus in Europe, as the euro has risen to all-time highs vs. the dollar—recently above US$1.40—and shows no signs of reversing anytime soon. Most finance officials have put on a brave face, but it is clear that there is growing concern that the strengthening euro will curtail European growth prospects.
Thus far there is no sign that the European Central Bank (ECB) is considering rate cuts to stem the currency's rise, despite political pressure from France. Coordinated intervention among major economic powers to drive down the currency's value does not seem to be on the agenda either, and it is clear that unilateral intervention in currency markets by the ECB has little chance of success. Nonetheless, central bankers and politicians in the euro zone—the 12 nations that share the euro as their common currency—will push for some form of verbal intervention and a joint statement at the meeting of the Group of Seven (G7) industrialized nations next week.
The euro has appreciated 8.1% vs. the dollar in the first nine months of the year, after already rising 8.2% in 2006. On a trade-weighted basis, the appreciation looks somewhat less dramatic, as the nominal trade-weighted index (TWI) rose just 3.7% year-over-year in September. Nevertheless, the TWI is also at the highest level since the start of European Monetary Union.
A stronger euro undermines the competitiveness of euro zone goods on international markets and could affect foreign demand, which has been a supporting factor for growth in the region. So far, low wage growth and larger productivity gains have cloaked the impact of the real exchange rate appreciation. Also, world growth has been robust, which helped to offset the impact of the stronger currency.
Euro Strength and World Growth
But while some companies have sufficient margins to tide them over in a period of extended euro strength, it is clear that many will come under pressure. Indeed, while European companies have, for a long time, remained relatively relaxed about the euro's rise, they are now increasingly voicing concern. The German exporters' federation, BGA, has cut its export forecast for next year on the back of the currency appreciation.
This is likely due both to the stronger currency as well as a potential slowing in Europe's major trading partners. In general, world growth is more important for export demand than the exchange rate. According to the European Union (EU) commission, a 10% drop in world demand cuts euro zone exports by 8%. And the fallout from the U.S. subprime crisis will have an impact on U.S. growth that could hit other major economies as well.
On Oct. 9 the International Monetary Fund (IMF) posted surprisingly large reductions in its 2008 growth forecast for major economies as a reaction to financial market turmoil. U.S. growth is now seen at just 1.9%, compared with 2.8% expected previously. And the forecast for world growth has been cut to 4.8% from 5.2%. Yet this is still relatively robust growth and, assuming the commission's estimate of the correlation between world growth and exports is symmetric, the positive impact from still-strong world growth would far outweigh even the impact of a 10% euro appreciation. So far, surveys suggest that confidence about the future for exports has peaked, but remains relatively strong.
Furthermore, a stronger euro also means lower import prices, which ultimately will have a downward effect on consumer price inflation. The stronger euro has helped to dampen the impact of a renewed rise in oil prices. Ultimately, the prolonged euro appreciation will improve purchasing power and may strengthen domestic demand.
Rate Hikes Or Cuts?
To the extent that the stronger euro has a positive impact on the medium-term inflation outlook, it also affects ECB policy. Earlier in the year, the ECB would clearly have preferred a tightening of monetary conditions via interest rate hikes rather than through the exchange rate channel.
However, in the current situation of fragile growth and increased uncertainty about the growth outlook, a rate hike is increasingly difficult to sell and could further weigh on business sentiment. So for now, some tightening of monetary conditions from the exchange rate movement may indeed be welcome to dampen medium-term inflation risks.
This may help to explain why ECB officials have so far remained calm regarding the euro's strength. And with the exception of French President Nicolas Sarkozy, most politicians have also remained optimistic. Politicians continue to say that they prefer a strong euro to a weak currency. Nevertheless, it is clear that concern is creeping in, and with the euro appreciating further vs. the dollar there may be more support for Sarkozy's calls on the ECB to react to the strength of the currency. What options does the central bank have to stem the euro's rise?
Sarkozy has suggested the ECB may follow the Fed and cut rates to prevent currency appreciation. However, while the ECB seems to have shelved the next rate hike for now, it continues to stress that there are upside risks to price stability. ECB policy maintains a tightening bias, and overall growth would have to deteriorate further before the ECB will consider a rate cut. In the central scenario of slowing but still relatively robust growth, a rate hike remains much more likely.
The only alternative is intervention in currency markets. Currency management in the euro zone is split between politicians, who can issue general guidelines or enter global currency agreements, and the ECB, which is in charge of day-to-day management and interventions. Former ECB President Wim Duisenberg famously called himself "Mr. Euro," and the bank's current chief, Jean-Claude Trichet, has also stressed that he has the last word on exchange rates. So Sarkozy has little influence on this, and the ECB is not considering such an option.
In any case, it is clear that unilateral intervention has little chance of success, and even coordinated intervention is problematic if exchange rate movements are indeed driven by fundamentals. The fact is that euro zone growth has outstripped annual growth in Japan over the past year. And the IMF now expects 2007 euro zone growth to be stronger than U.S. growth as well. It is not surprising then that an ECB official said this week that coordinated intervention may not work.
What remains is verbal intervention and exercises in damage limitation. Officials have started to repeat the familiar G7 line that "excess volatility" in exchange markets is undesirable, and that exchange rates should reflect fundamentals. Officials will want to prevent a rapid overshooting of the currency, which does not give exporters time to adjust to a stronger currency. The ECB has also indicated that it will discuss the currency at the G7 meeting next week.
What Trichet will likely want to see is a public message to markets that the U.S. is interested in a strong currency and will not passively encourage an ongoing rapid depreciation of the dollar. The ECB will also look for allies in its attempt to persuade Asian countries to take more of a share in the ongoing dollar depreciation that is mostly driven by the large U.S. current account deficits—largely with Asia—that still leaves the dollar a generally overvalued currency. However, China has continued to indicate resistance to more than a gradual pace of yuan appreciation.
All in all, we are likely to see a currency statement at next week's G7 meeting that will once again stress that "excess volatility" is undesirable, and that exchange rates should reflect fundamentals, while calling for increased flexibility for Asian foreign exchange markets. Any reference to the desire for a stronger U.S. dollar is unlikely, however, given the fundamental driver of the large U.S. current account deficit. And in the unlikely event that the ECB was seeking support for intervention to cool the euro's strength, it is unlikely that Japan or the U.S. would be interested in coordinated action at the moment.