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Euro gains dangerous for euroland – 2159

  • 1 November 2010

The scale of the concern among policymakers over the appreciating euro was expressed starkly only a few days ago by Bas Bakker, an economist at the International Monetary Fund. As reported by Bloomberg, Bakker warned the euro is close to overvaluation and further appreciation of the currency could harm growth in the eurozone.

"A stronger euro clearly means slower growth across the euro zone. Should there be further appreciation, the effect will be larger but it is difficult to comment on day-to-day exchange-rate changes," Bakker says.

Expensive exports

As this SeekingAlpha article explains, a stronger euro means exports from eurozone countries becomes more expensive than goods made elsewhere. The article notes that back in early June, when European markets started to rebound, the euro was worth about $1.20. A euro now buys about $1.40, which means that European exporters are roughly -15% less competitive than before. To make things worse, with the Chinese yuan is pegged to the dollar, the euro is surging against that currency as well.

Azad Zangana, European economist at Schroders shares Bakker's worries. He says: "Once again, the rigidities of the Eurozone are holding back policy action that will hurt growth."

No stimulus

While the US looks set this week to announce the launch of a further round of quantitative easing, and the UK still not having ruled its own QE2 out completely, hawks on the European Central Bank's (ECB) monetary policy committee are refusing to support any new form of monetary stimulus.

Indeed, as Zangana notes, emergency liquidity across euroland is slowly being phased out causing short-term interest rates to rise, with some euro leaders already calling for policy normalisation soon, despite the tragic state of "peripheral economies" like Greece, Portugal, Ireland and Spain.

He warns: "As the only major currency with a central bank refusing to take part in the race to the bottom, the euro is making an astounding recovery from the falls seen earlier this year.

"Though the rebound in the euro partly reflects some success in policy making, continued strength could jeopardise the strength of the recovery, especially for export-orientated economies like German, Austria and the Netherlands. 

Euro outlook bullish

Zangana fears that, short of another flare up in sovereign debt markets, there is little to stand in the way of the Euro over the next six months. A technical currency chartist commenting on TheStreet.com is also bullish on euro versus the dollar, certainly on a horizon of the next one to three months.

Zangana says: "If the Euro continues to appreciate, then we believe that the negative impact it will have particularly on northern Europe will mean that the ECB would then be unlikely to raise interest rates at all in 2011.

"Our growth forecast for the region would be lowered, and the risk of deflation would come screaming back to the forefront."

Given the reluctance of certain parts of the ECB to undertake quantitative easing, Zangana is unsure about whether the central bank can do anything to slow down the appreciation of the euro.

He notes that, like the Bank of Japan (BoJ), the ECB has in the past intervened directly in currency markets. However, also like the BoJ, it has learnt that unilateral action tends to only have a short-term impact on currency levels.

Testing monetary union

This recent BBC article highlights the mixed record of success countries, including Japan, have in intervening in currency markets.  

One possible way out for the EU is low level protectionist measures such as trade tariffs. These have certainly been deployed by Brussels in the past but Zangana doubts whether it will be keen to enter into a tit-for-tat trade tariff conflict after working for many years to increase its trade openness.

So what can Europe do? Zangana concludes that, ironically, it may be that as Ireland decides to return to the bond market in late 2011, and Greece approaches the point when it too needs to return (early 2012), the existence of the euro is once again be questioned and tested by markets, which could violently reverse any gains the euro has so far seen and will see over the coming months."

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