Eurozone Watch

On Friday, the euro has reached a new all-time-high vis-à-vis the US-dollar. After the US Department of Commerce published figures showing that the US economy has grown by only little more than 1 percent in annualized terms in Q1, the euro passed its old all-time-high of $ 1.3670 and was traded at $ 1.3682, before it again lost some of its strength. The euro is now trading roughly 60 percent above its low from the beginning of the decade.

Figure 1: Euro/Dollar exchange rate

What is really startling, however, is the complacency with which business leaders, lobbyists and governments are actually reacting to the strength of the still young currency. When the euro first reached the mark of $1.34 in late 2004, the German chancellor Gerhard Schröder publicly proclaimed that “we can not accept an ECB policy that accepts an exchange rate of $1.34″. Analysts at that time saw the danger of recession in both Germany and the euro-zone should the euro hit $1.40. Employers’ federations at that time also complained about the euro strength’s consequences for their profits, investment and hiring plans.

Today, business leaders especially in Germany boast that the exchange rate is no problem and that they could easily deal with the euro at $1.40. Analysts forecast strong economic growth despite the euro strength and politicians are also mostly silent about the euro.

To a certain extent, the optimists are surely correct. A euro at $1.40 today is a completely different story than a euro at $1.40 in 2004.

First, the economic environment matters for the effect of an exchange rate appreciation. If domestic demand is relatively strong, as it is now in Europe, firms do not feel the appreciation as much as they might otherwise, as the domestic market is an important source of growth. In 2004, especially in Germany, basically all of the economic growth came from expanding foreign demand. On average, all the new business for companies thus came from abroad. In such a situation, an appreciation can easily push an economy below “stall speed”, depressing investment and hiring intentions so much that a recovery is aborted. If the domestic dynamics are sound, in contrast, an upswing is little hindered by some appreciation, a fact that we have already witnessed in the US when the US-dollar appreciated sharply in the New Economy Boom.

Second, it is often the speed and rate of change of an appreciation that matters for its consequences, not only the level of the exchange rate. If firms have time to adjust, an appreciation usually does not pinch as much as if the currency gains value suddenly. In 2004, the euro had just gained 10 percent over six months, just after having gained another 25 percent over the prior 18 months. Today, the euro is not even yet 10 percent more expensive than on average since 2005.

Third, only looking at the dollar exchange rate is misleading. While it is true that the euro has also gained enormously against the Japanese Yen (which by itself is a problem for certain sectors), it has not gained as much towards other Asian currencies. The Chinese Renminbi is now more than 5 percent more expensive compared to the euro than in late 2004, the Korean won has gained more than 10 percent and the Thai Bath even more than 15 percent. Similar observations can be made in Eastern Europe. The Polish Zloty and the Czech coruna, for example, have gained more than 5 percent against the euro compared to the end of 2004.

Fourth, only regarding the nominal exchange rate misses an important part of the development. Inflation as well as growth in unit labour costs in the euro area has been lower than in other industrialized countries (with the exception of Japan), and much lower than in emerging economies of central and eastern Europe or Asia. If we look at the ECB’s unit real effective exchange rate in terms of unit labour costs, we see that – while EMU has lost competitiveness since 2002, the economy still looks much more competitive than in the 1990s, and even more competitive than in the boom years 1999 and 2000.

Figure 2: Real effective exchange rate of the euro, unit labour cost based, ECB data

However, even if the current level (or even a level of $ 1.40) of the euro exchange rate might not pose excessive problems, the question is whether complacency is the right approach. Foreign exchange markets tend to overshoot, if they gain momentum. And even if the euro area weathers well an euro at $ 1.40, a euro at $1.50 or $1.60 might pose problems for the companies and might slow growth and employment dynamics. Public finances as well as economic self-esteem in EMU badly need a stable, long upswing. The ECB and politicians should thus still be vigilant should the euro appreciate much more.

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