iscussions on currencies usually end up being very messy. Ask three different people about the future direction of a particular currency and you are likely to get three different opinions.
Take the discussion on the future direction of the euro. On one side, the current broad consensus – a rather unusual phenomenon in itself – among foreign currency professionals and economists concludes that the euro is likely to weaken in the months and years ahead. Plagued with economic stagnation, record unemployment levels, little fiscal room to maneuver and little political will to support necessary structural changes to achieve a more comprehensive banking and closer fiscal union, the direction of the euro against its major trading partners appears to be straightforward.
Yet, some encouraging developments in the region’s economic fundamentals appear to hint at just the opposite: The meaningful improvement of the eurozone’s current account balance, rising net capital inflows, and GDP growth pleasantly surprising to the upside in the second quarter all point to an increasing probability that the euro will continue to stay strong in the weeks and months ahead. Without a clearly defined roadmap to point the way, where does this leave investors?
A case for depreciation
There are powerful arguments for why the common currency should trade weaker. First, the eurozone economy is still the weakest major global economy. We expect the region to continue to barely grow over the next three to five years, given the mix of fiscal austerity, broader structural reforms and private sector deleveraging the region has prescribed itself. Second, the eurozone crisis is not necessarily solved. As long as it is not 100% clear that the currency union in Europe is irrevocable, investors cannot be sure that, for example, a “Greek euro” will be worth as much as a “German euro” in the future. The unprecedented introduction of capital controls in Cyprus in March this year proved to every investor how relevant this seemingly theoretical issue has become.
It is therefore only rational to expect investors will require an additional political/institutional risk premium for holding the common European currency. The existence of such a risk premium is a new feature for a developed market currency.
Introducing political/institutional risk factors into the euro equation
For investors in emerging markets, the analysis of such risks factors has always been an important part of the daily assessment that informs their investment decisions. We believe one consequence of the New Normal investment environment is that the top-down approaches currently in use to analyze developed market currencies will have to merge to a rising degree with the more bottom-up-oriented emerging market currency analyses. For investors, this means they have to be aware that the true fundamental fair value of the euro may actually be lower than the number that traditional purchasing-power-based analysis suggests.
This brings us to the third argument for a weaker euro. Even traditional “old normal” purchasing power analyses show that the euro does not trade “cheap”, but is still rather expensive. Taking the International Monetary Fund (IMF) fair value measure as an example, the euro is roughly 10% overvalued compared with the U.S. dollar (based on IMF World Economic Outlook as of April 2013), while others, employing a trade-weighted currency analysis, estimate it is 6% overvalued (as of 1 August 2013).
These overvaluations, however, are hard to reconcile with the ongoing weak cyclical position of the eurozone and its inherent political and institutional risks. But what an irony, if these exact factors, which require a weaker exchange rate as a necessary countercyclical stimulus measure for the ailing eurozone economy, would be a key reason behind the current euro strength?
Reversal in peripheral current account positions
The combination of fiscal austerity, private sector deleveraging and structural reforms has led to a substantial drop in domestic demand in European peripheral countries since 2007 (see Figure 1), causing imports in these countries to fall as well.
On the other hand, the economic hardship that came with the necessary structural reforms was not in vain. The international competitiveness, measured by unit labor costs, has improved across the board in the past several years, with Italy the only exception (see Figure 2).
As a logical consequence, the aggregated current accounts of Greece, Ireland, Italy, Portugal and Spain (GIIPS) have now moved from a sizable deficit (−7% in 2008) to a surplus of roughly 1% in Q1 2013 (see Figure 3).
With the current account surplus of Europe’s largest economy remaining stable at approximately 7% of gross domestic product (GDP) over that time horizon, the massive swing of the current account balances in the GIIPS countries is therefore the key driving force behind the rising overall euro area current account surplus to approximately 2% of GDP as of June 2013. The strong momentum points to perhaps an even larger surplus in the coming months.
Figure 4 below highlights this positive current account development and the historical relationship with the direction of the euro. The trend points to a stronger trade-weighted euro exchange rate in the months ahead. A positive relationship between the current account developments and the exchange rate makes intuitive sense. Given the current 2% surplus relative to GDP, more than €200 billion of capital would need to leave the eurozone every year in order for the currency to depreciate against key trading partners. Every euro less will support a rise in the euro exchange rate.
Euro rise as an indicator of political confidence
However, Figure 4 also illustrates that the state of health of the current account balance is only one side of the coin. In today’s world of high capital mobility, the balance of capital flows is the other – at least as important – determinant for the direction of an exchange rate. And there is the rub for the euro.
We recently celebrated the first anniversary of European Central Bank (ECB) President Mario Draghi’s “All it takes” speech at the Global Investment Conference on 26 July 2012. At that time, investor confidence in the institutional setup of the eurozone had become so fragile and undermined that the region was just one step away from facing a classical capital flight crisis. A capital jog from the eurozone was already happening and the euro was in a steep decline, despite the ongoing improvement in the current account balance. Mr. Draghi’s courageous step and subsequent ECB announcement of the Outright Monetary Transactions (OMT) programme on 6 September 2012 helped prevent a financial panic and stabilize the euro exchange rate. Since then, capital has been flowing back into the periphery and into the eurozone as a whole. In that sense the appreciation of the euro over recent months can be seen as a rising vote of confidence for the region by global investors.
Europe’s risk: Strong euro, weak growth
The only fly in the ointment is that a rising euro exchange rate has the potential to undo much of the eurozone periphery’s hard-won international competitiveness and undermine the fragile social consensus to continue with the necessary structural and fiscal reforms. The more capital the eurozone is able to crowd-in from abroad, the higher the probability that these capital flows eventually become self-destructive as they increasingly undermine the ability of the peripheral countries to perform successful structural transformations of their respective economies.
According to ECB estimates, a permanent 10% rise in the euro’s real effective exchange rate results in a cumulative reduction in GDP between 0.6% (Global Vector Auto & Regression model) and 0.9% (Automated Valuation Model model) over three years relative to the baseline growth scenario. Given our subdued growth outlook for the eurozone over the next three to five years, another significant rise in the euro exchange rate could therefore make the critical difference between low, but positive, growth and an outright recession.
Where does this all leave investors?
Considering the ongoing improvement of the eurozone current account surplus in combination with rising net capital inflows – primarily driven by portfolio flows – there is a rising non-trivial probability that the euro will continue to appreciate against the currencies of its main trading partners in the weeks and months ahead. Europe could end up with problems similar to Japan’s: a too-strong, overvalued exchange rate; weak growth; very low overall inflation and deflationary tendencies (at least in some parts of the eurozone).
Unless the ECB shifts gears, its conservative and reactive policy stance only adds to the odds of a “Japanisation” of Europe.