Monetary Policy : Myths and facts about a strong euro

When the euro was introduced in 1999 the currency was presented as the guarantee of higher levels of stability and prosperity on the old continent. Today the enthusiasm has been replaced by disappointment and the latest opinion polls point in the same direction : Quite a few Europeans long nostalgically for their old currency. Politicians often criticise the strength of the euro, which is singled out as the scapegoat when it comes to explaining the lack of growth that many European economies suffer from. Instead of drawing such hasty and alarming conclusions on the impact of the euro on the European economy one should, though, take a closer look at the strengths and weaknesses that having a single currency implies.

Translated by Filip ENGEL

One third of total European Union trade is with non EU countries and consequently the economy of the community is very much influenced by the exchange rate fluctuations of the international currencies. From 1 January where the euro was introduced to the autumn of 2000, the exchange rate of the euro to the dollar went from 1,18 to 0,83. Correspondingly, the European currency was heavily strengthened compared to the green bill and after a minor weakening of the euro in 2005, it appreciated once more in 2006 with some 9%.

Besides the debates on the inflationary effects of the introduction of the common currency and the corresponding lack of confidence that the euro has been suffering from lately, the currency has been the object of frequent critiques expressed by a significant number of politicians and business leaders who are worried by the relative strength of the euro vis-à-vis the other important international currencies. The opinions are many and differ as to the consequences of a strong euro and, above all, as to the exchange rate polices that should be adopted. The German coolness clashes with the French fears and without addressing the role of euro in the general European economic dynamics the objective of this analysis is to clarify the more specific circumstances of the evolution of the exchange rate of the European currency.

The strong increase of the euro vis-à-vis the American and Japanese currencies since October 2000 has, above all, been ascribed to two factors. Firstly due to the swiftness with which the European Central Bank (ECB) raises its interest rates compared to the American Central Bank (FED) and the Japanese Central Bank (BOJ). Secondly due to the weakness of the dollar and the yen compared to the euro. This is attributed to the good health of the European economy, which leads the ECB to impose certain restrictions on the economy. A strong euro represents advantages as well as inconveniences for the European economy to which we will now turn.

The disadvantages of a strong euro : Pressure on the exports

When it comes to the negative consequences it is obvious that a strong euro hampers the competitiveness of the companies of the old continent compared with their American and Japanese competitors. To be sure, if the single European currency is strong European products are relatively more expensive than equivalent products from non-euro countries. In this way European exporting companies are forced to lower their prices in order to maintain their market shares, which is detrimental to bottom line profit.

The evolution of the exchange rate of the dollar relative to the euro

The euro, until 2003 underrated relative to the dollar and at present overrated relative to the later.

In addition, the companies that keep their invoices in dollars are directly influenced by a strong euro. Franco-German EADS for instance has a 20 billion dollars yearly turnover but since the expenses are mainly held in euros, a 10% increase of the value of the European currency is translated into a net annual loss of one billion dollars. That corresponds to the entire research and development project of the ambitious A380 project.

In this way, several observers argue that the strength of the euro could, granted that the present situation does not change, harm the European growth and lead to a new increase of the level of unemployment. Econometrics studies have determined that an appreciation of 10% of the European currency vis-à-vis the green bill would reduce the growth rate of the Euro zone with between 0,5 and 1 percent.

According to the Crédit Agricole economists, one should, though, not overestimate the impact of a strong euro on the competitiveness because even if the euro for some years now has gained ground on the green bill, the nominal effective exchange rate has remained relatively stable and has only increased with 2% in 2006. The last couple of years the currencies of the emerging countries have revalued against the euro, which leads to the point that “the effect on the competitiveness of the 12 euro-zone countries is almost zero” and that the appreciation of the euro does not constitute a real danger.

The advantages of a strong euro : the euro as the international reserve currency of the future ?

When it comes to advantages the improvement of the trade conditions for the euro zone constitutes one advantage. Given the fact that the majority of the raw materials are traded in dollars, Europe has strongly reduced the costs of its supplies throughout the last couple of years. Due to the strength of the euro the repeated increases in the costs of crude oil from 2003-2006 have been limited in their impact on the European economy.

Jean-Claude Trichet

The former head of the French Central Bank has since 1 November 2003 been the head of the European Central Bank

A second advantage is that a strong euro creates positive expectations from the evolution of the monetary situation in the euro-zone and from the evolution of the exchange rates of the euro against the dollar. This leads to a level of euro-zone interest rates below those of the dollar-zone and consequently renders the euro-zone more attractive for investors. In this way a strong euro is more profitable for foreign investors. A strong euro can be said to create a positive dynamic where low levels of interest rates, released savings and expectations of general improvements in trade facilitate investments and therefore growth.

Finally, the fall of the green bill vis-à-vis the euro renders the later more attractive for countries in the search of precaution investments resulting in an increased willingness to invest in the euro zone. In the same way a strong euro could in the long run turn the European currency into the international reserve and trade currency. A role that the dollar enjoys at present. This would limit the fluctuations of the costs of energy supplies and be beneficial to the Euro-zone. The massive use of the euro in international transactions could possibly lead to a delicate period of transition but it would turn out to be beneficial in the long run.

This scenario is, however, still nothing but a vision. Contrary to what has been said the assets held in dollars will not be replaced by assets held in euros in international foreign exchange reserves. For now the dollar remains the main reserve currency of the world (65%). To be sure the percentage of central bank reserves held in euros has increased in the last couple of years to 25% but this is above all due to the appreciation of the single currency relative to the green bill on the currency exchange markets. On the other hand, one can note that the euro has become the currency of reference for world monetary transactions (There are more euros than dollars in circulation worldwide), which demonstrates the confidence that the euro has acquired on an international level.

Hence a strong euro has its advantages and its disadvantages and there is no unambiguous argument in favour of either an appreciation or a depreciation of the single currency. What the economists can agree on is the necessity of maintaining a relative stability of exchange rates and on not to go beyond a threshold, which is fixed arbitrarily at around 1,4 dollars per euro. Many are of the opinion that the best arguments for increasing growth are not found in exchange rate debates and, while taking the current performance of Germany as an example, hold that today’s critiques of the relative strength of the euro are misplaced.

(Images : Headquarters of the European Central Bank (copyright : The European Central Bank) / Jean-Claude Trichet (Copyright : Le Monde) )