Sunday, February 02, 2003

Euro Rise, Curative Therapy or Very Bad News?

The dollar's decline brings with it the euro's rise. But is what may be good news for some bad news for others? Certainly a falling dollar will produce a bit of much-needed inflation in the US, but in the same way will tend to have a deflationary impact in Germany. According to Joachim Fels & Elga Bartsch of Morgan Stanley (here) the euro has appreciated by 10% against a trade-weighted basket of currencies, and an appreciation of the euro of this magnitude should shave roughly 0.7 percentage point from euro-area GDP growth, mainly via the dampening impact on exports. Using another rule of thumb they calculate that it would take about 150 bp of ECB rate hikes to produce the same effect on GDP. Hence, they estimate the appreciation of the euro over the past year as being roughly equivalent to a 150 bp tightening of monetary policy (in which case the 4% appreciation since early December has already more than fully eaten up the expansionary impact from the 50 bp ECB rate cut). In other words the euro rise is a form of monetary tightening. Add to this the likely impact of such additional tightening on the CPI in Germany and it's easy to see where we might be headed. Let Morgan Stanley's Stephen Jen explain:

On our estimates, a 20% depreciation of the trade-weighted USD (major index) generates around 2.4% import price inflation in the short run, and this translates into 0.75% CPI inflation in the long term for the US economy. Although limited, this should help to alleviate deflationary concerns to some extent, together with the cumulated monetary easing and the ongoing fiscal campaign in the US. On the global balance sheet, the USD depreciation is likely to transfer a similar amount of CPI inflation from the major economies to the US economy, despite the fact that this is unlikely to be a zero-sum game.

Canada’s import price deflation seems to be the most vulnerable to the USD depreciation. If the CAD appreciates 20% against the USD, this results in 8.4% import price deflation in the short run, translating into 2.8% Canadian consumer price deflation over time. Similarly, Italian consumer prices decline about 2.1% in the long term, while the impact for the UK is around 1.1%. For the Euro-3, the overall impact is relatively muted. A 20% USD depreciation causes about 0.86% consumer price deflation for Germany and 0.95% deflation for the Euro-3 in the long term (on a GDP-weighted basis). The impact of USD depreciation is significantly low for French consumer prices.
Source: Morgan Stanley Global Economic Forum

So German prices could be pushed down 0.86% by a 20% dollar rise, or just enough to go below water. Meantime the situation could be even worse in some countries (Italy, Spain?) if we start to thing in terms of asymmetric impacts. What may be seen as positive for the euro zone en bloc, may well be much less so when you go country by country.

A strong currency is rather like cod-liver oil; it might be unpleasant but it is ultimately good for you. By making it harder for an economy to export, a strong currency requires greater productivity. Once the short-term discomfort of currency strength has passed, an economy is in fighting-fit shape and ready to take on the world. That, at least, is the theory - a theory that is about to be put to the test in the eurozone. This week the euro touched $1.0907 against the dollar, within a whisker of its highest level since March 1999 and not far off its starting point in January 1999 at $1.17.

In a relatively closed economy such as the eurozone, where exports make up just 15 per cent of gross domestic product, it is generally better to have lower interest rates than an undervalued currency. Pedro Solbes, European monetary affairs commissioner, yesterday said that, while the fall in the dollar was too rapid, the eurozone could "adapt to the new context". European exporters have already shown they can cope with some strengthening in the euro. Its 15 per cent rise last year did not prevent eurozone exports from rising 1.1 per cent. But to some economists, such arguments appear strikingly complacent. Exchange rate changes only affect exports with a time lag, and if the recent rise in the euro continues, they argue, it will soon start to hit eurozone exports.This threatens to strike the eurozone at its Achilles heel - Germany. The country was only saved from recession last year by net exports, which grew around 1.4 per cent. By contrast, domestic demand contracted by 1.1 per cent.

Weak internal demand in the eurozone overall has resulted in an increasing dependence on exports. For smaller businesses, which tend not to hedge their exposures, this is already a problem. "Some exporters are suffering," said Ludolf-Georg von Wartenburg, director general of the Federation of German Industries. "They are fighting in dollar markets with very thin margins." Many also doubt that a stronger euro will really spur faster structural reform.

Statements from council members are less than encouraging. Otmar Issing, the ECB's influential chief economist, told the BBC recently that he did not currently see a risk of deflation, and suggested that a bigger danger might be letting inflation stay too high. John Llewellyn, global chief economist of Lehman Brothers, argues that it is deflation, not in-flation, which is the greater threat. "Our estimates suggest a 10 per cent rise in the exchange rate causes a 1 per cent fall in prices. So if we get a 20 per cent rise from where we were at Christmas, inflation would be roughly zero. In some places, prices would be falling." If they fail to respond adequately with rate cuts and structural reform, eurozone policymakers could turn the long-predicted and unavoidable correction of the currency markets into a serious problem for Europe.
Source: Financial Times

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