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What has made the euro exchange rate defy the pessimists?

What has made the euro exchange rate defy the pessimists? Mindful Money

One of the features of the euro area crisis has turned out to be the opposite of so much media spinning and speculation. Whilst there has been regular talk of it being hammered and hit, the exchange rate of the euro is rather strong and has been so since the summer of 2012. Indeed, since its dip to 94.6 on a trade weighted basis last summer, it has been  rallying and was at 102.64 as of last week. As it was set at 100 back when it started, you can see that this is in fact just higher than it’s opening value. Indeed, one could argue that overall it has been on a road to nowhere as its average since inception has been 100.11 on this basis. If Jean-Claude Trichet were still President of the European Central Bank (ECB), we could expect a speech on how this is a triumph of policy.

Some perspective

If we look back, we see that currency markets did not think much of the euro in its early days as it was pushed lower to 81.3 in October 2000; so if one were to argue that there was a currency crisis, there was your time! Next came the rally and it was both long and strong, with inevitable ebbs and flows, but the trend took it up to nearly 113 in the spring of 2008. So these were apparently the peak in pro-euro sentiment at the sort of time when the President of the ECB could welcome Cyprus into the euro saying that it would be sheltered from destabilizing financial imbalances, that sort of thing. Oops! Or for the French President Nicolas Sarkozy to tell the world that the credit crunch was an Anglo-Saxon problem. The credit crunch itself was an example of the Grand Old Duke of York rhyme, with the euro dropping then rising to a new peak ( 114.26 on the 18th of December 2008) and then falling again to the low seen last summer.

So there you have it: the euro did fall on a trade-weighted basis, but it did so from a position of strength and it only fell to just under 5% below its starting point even when the peripheral crisis was at its height. The actual currency crisis was much nearer to home for the UK media at least as the pound fell from an average of 103.66 in 2007 (100 in 2005) to an average of 80.56 in 2009 for a fall of just over 22%. At 82.4, it has not bounced back much overall since then.

The actual exchange rate crisis, if I may put it like that, was back in 2000. I do not know what the media position then was but, during their October 2000 press conference, the ECB put it like this:

"Including today’s adjustment, since November 1999 we have raised ECB interest rates by a total of 225 basis points."

Bit of a rough start was it not? The ECB was at least operating on a (now) familiar theme:
"The low external value of the euro has heightened the risks of increases in import prices gradually being passed on to consumer prices."

Such that it also did this:
"In order to address these concerns, on 22 September, at the ECB’s initiative, the monetary authorities of the United States, Japan, the United Kingdom and Canada joined the ECB in a concerted intervention in the foreign exchange markets."

Now that looks like a real currency crisis!

The easy bit

It is often forgotten that, for a currency to fall, it has to fall against something. So rather than the future looking weak, it furthermore has to be weaker than its protagonist. Everywhere we look, we see currencies which would like to go lower with even the previous strong “currency twins” of the Japanese yen and Swiss franc taking measures to weaken their currency. An example of this has occurred just last week, as the downgrade of the credit rating of the United States by the Dagong credit rating agency from A to A- has seen the euro surge higher to 1.363 versus the US dollar.

Here we see the tangled web of the modern financial world. As the Chinese review the way that the Americans are running risks with their enormous holdings of US Treasury bonds, they respond and the collateral damage is a weaker US dollar.

An ersatz Deutschemark

Throughout the recent period, the currency markets seem to be aping the football terraces by singing “Are you the Deutschemark in disguise?” allowing the euro to sing to some of its opponents “Can we play you every week?”. So, the weaker periphery finds itself being ignored as the concentration goes to the stronger Germanic sector. This of course has a reinforcing factor that it reminds everyone that, compared to where the Deutschemark would be right now, the euro is at a lower and probably much lower level. So, in a type of intellectual round-tripping, Germany looks even stronger via a perceived currency depreciation and the euro gains strength.

Whatever it takes

Back on the 26th of July, President of the ECB Mario Draghi said this at an investment conference in London:
"Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough."

This is often invoked as a backstop for peripheral bond markets, but it also saw a turn in the fortunes of the euro exchange rate as I have described above. If you like, it was an example of what in Star Wars fashion are called "Jedi Mind Tricks".

However, it did come with something that could yet turn out to be an example of a double-edged sword:

"We think the euro is irreversible."

The Bumblebee analogy was intriguing because, whilst they are perceived favorably as hard workers, had nobody told Mario that their numbers are in decline?

Trade figures and balance of payments

This is a factor often ignored, but not on here (I discussed the UK’s perennially weak position on the 9th of August) and as we look at the euro area we see something which must be an influence on demand for euros and hence its price - from ECB statistics.
"The seasonally adjusted 12-month cumulated current account for the period ending in August 2013 recorded a surplus of €192.8 billion (2.0% of euro area GDP), compared with a surplus of €88.2 billion (0.9% of euro area GDP) for the 12-month period up to August 2012.

"The increase in the surplus on the current account was due mainly to a higher surplus for goods (from €66.2 billion to €155.7 billion)."

So, not only a surplus but a growing one and, whilst in foreign exchange terms 192.8 billion euros over a year may seem small beer like water dripping on a rock, it has effects - after all, there would be no Grand Canyon otherwise.

However, as ever some care is needed as the unwary might conclude from this that goods production is in great shape.

"In August 2013 compared with August 2012, industrial production dropped by 2.1% in the euro area."

Oh what a tangled web and all that…


The apparent strength of the euro may be just that if we concentrate on the word "apparent". But, over the credit crunch it has considerably outperformed the UK pound for example. Also, if we look at the trade figures, we can see the beginnings of a basis for this perhaps on fundamental grounds - and if we add the psychology of “whatever it takes”, we have perhaps a combined double act.

On the other side of the coin, there have been issues too. For example, the last Governor of the Bank of England called for falls in the value of the UK pound’s exchange rate on more than one occasion, and the Japanese authorities have a fall in the value of the yen as one of the arrows of Abenomics. That is before we get to the shambles that US government has just chosen to parade to the world. So there you have it - one way of appearing strong is to have weak opponents!

Oh, and I have left this bit 'til last. For the peripheral nations in the euro area, a strong euro is something of a poisoned chalice. Yes - it helps with inflationary pressure, but as they start to face the prospect of disinflation or falling prices with high debt burdens, there are complications. Then of course we get to the issue of what a higher exchange rate does to the competitiveness agenda.

More falls in real wages anyone?

This article was written by Shaun Richards and was originally published in MindfulMoney under the title What has made the Euro exchange rate defy the pessimists?

Tags: Bank of England , bond market , China , credit crunch , Cyprus , Dagong , ECB , euro , euro crisis , European Central Bank , exchange rates , Japan , Jean-Claude Trichet , Mario Draghi , Nicolas Sarkozy , UK
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