Euroland Needs Further Euro Depreciation

January 13, 2012

The euro area is in a recession that European Central Bank officials think and hope will prove much milder than the last one.  However, growth risks are skewed substantially to the downside, and all other parts of the world are enjoying positive growth.  It is natural in light of this contrast for the euro to be falling.  Against the dollar, it has dropped about 12.5% since Fed Chairman Bernanke dissuaded markets in late August from expecting a third round of quantitative easing.  The euro was trading around $1.45 then, $1.38 in early November, and $1.35 a month later when Standard & Poor’s dropped the bombshell that France and several other EMU members could see their credit ratings cut this month.  That possibility is about to become reality, and it will hinder EU efforts to fashion a credible rescue facility for fiscally stressed members.

The euro has been weak against other currencies, too.  Since peaking against sterling in mid-2011 at 0.9083, the common European currency has fallen marginally over 8.5%.  Similarly, the trade-weighted euro peaked last May 4 at 108.51 and has lost about 8.5% subsequently.

2012 figures to be the euro’s last stand.  It seems unthinkable that European officials could muddle through another twelve months, this time in widespread recession, without implementing a credible plan to correct the fiscal excesses, recapitalize the banks, and build a foundation that will promote renewed expansion.  Either those conditions are met significantly, or the euro area will not be the same 17-country grouping in a year’s time.  Whatever happens, the euro zone is going to need a sustainably softer exchange rate to assist the task of rebuilding competitiveness and mitigating the severity of the recession.

The euro’s value navigated through three broad stages over its first thirteen years.  In the first of those periods lasting six years, the euro came full circle.  It was launched with a value of $1.17, slumped extensively to $0.823 by October 2000 and took four years before it had solidified a net gain from its opening.  For much of 2004, the euro traded in the low 1.20s against the dollar, but its average value in 1999-04 of $1.0350 barely eclipsed par.  The middle and shortest stage of the euro’s life ran from 2005 until just past mid-2007 when the euro settled into a range with an average value of $1.2690, which is also the currency’s current value.  The final stage began with the onset of the world financial crisis in August 2007 and includes the first two years of the European debt tribulations. The euro performed well in this span, peaking at $1.4968 in 2007, $1.6038 in 2008, $1.5144 in 2009, $1.4582 in 2010, and $1.4939 last year. 

Suppose the euro were to average its 1999 starting weight of $1.17 in 2012.  Such a drop would represent a 16% depreciation from its 2011 mean, and conversely a 19% advance in the dollar.  It would also constitute an 8.8% loss from its mean value in the first half of January.  A drop of 16% in sequential annual averages would be an impressive move, surpassing the 13.5% drop from a mean of $1.067 in 1999 to one of $0.924 in 2000, but that’s probably the minimum movement that the region is going to require to escape from its present hole.  In trade-weighted terms, the euro would not be falling as steeply as against the dollar.

Needing a 16% devaluation of the euro and actually attaining such a drop are very different things.  The euro’s recent slide was promoted by a string of better-than-expected U.S. economic data.  One can think of a number of reasons why this run of pleasant surprises might not long continue.  Consumption will be constrained by soft income growth and high unemployment.  Housing still has too much excess inventory to stage a breakout year.  Fiscal policy remains shrouded in uncertainty, and U.S. net exports will be squeezed if the dollar indeed does climb substantially.  Although the dollar has lately shown a good head of steam, quite a few currency analysts are predicting that the euro will be closer to $1.40 than $1.20 a year from now. 

Three currencies to watch if the euro sinks much further in the near term will be the yen, Swiss franc and sterling.  Japanese authorities have shown keen sensitivity to a strong yen, citing such as a promoter of deflation and major risk factor to Japanese economic growth. If the euro keeps sliding against the dollar, yen/dollar stability will not be satisfactory to Tokyo officials.  In spite of the threat of currency market intervention by the government of Prime Minister Noda, the yen has not backed away from hovering near record highs against he dollar.  For the past half-year, it has traded in the upper half of the 70s.  Sooner or later, either 75.0 per USD or 80.0 is going to get tested, and 75 seems like the more probable boundary of least resistance so long as the euro performs poorly.

A political assault on the authority of monetary policymakers usually hurts a currency.  Just look at the Hungarian forint.  While it seems doubtful that Ron Paul will get the U.S. Republican presidential nomination because of his age and unorthodox views, the dollar would almost surely stumble if Paul contended seriously much longer since he wants to close down the central bank.  The effect of a central banking scandal such as experienced in Switzerland is more ambivalent, on the other hand.  The last head of a major advanced country central bank to step down in scandal was Bank of Japan Governor Yasuo Matsushita in March 1998.  While the yen weakened 4.2% during the second quarter of 1998 from 132.98 per dollar to 138.85, Japan’s currency roared back 22.3% to 113.5 per dollar by the end of the year.  If the going gets tough for the euro generally, the franc’s central bank-imposed ceiling of 1.20 per euro will be challenged by market speculators more seriously than seen thus far. 

As noted, sterling has been creeping higher against the euro, but at EUR 0.83 is weak historically.  In the dozen years before the euro was created at end-1998, the pound’s euro cross rate averaged DEM 2.7623.  (Parenthetically, that’s 20 pfennigs weaker than the DEM 2.95 central parity rate when sterling was part of the ERM in 1990-92).  Since the start of January 1999, a span of 13 years, sterling’s implicit D-mark value has averaged 2.7525, extraordinarily close to the earlier period’s mean.  The pound’s current implicit D-mark translation value is DEM 2.36, marginally more than 14% weaker than its long-term tendency.  To be sure, Britain chronically runs a current account deficit, experiences higher inflation than the euro area, has a bigger relative budget deficit than Euroland, and is also threatened by recession.  There is additional concern that the U.K.’s increasing isolation from Europe will harm the all-important financial services sector.  Against these negative is not only the pound’s historical tendency to be stronger than present levels but also the fact that U.K. long-term interest rates are functioning properly.  The pound’s recent rise has coincided with lower bond yields in Britain than many euro area economies.  This connection suggests that sterling may appreciate additionally so long as the extreme elevation of peripheral bond yields in the euro area persist.

Copyright 2012, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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