A Stronger Euro Would Not Help Reforms edit

Nov. 30, 2006

As currency markets start to question the soft landing scenario for the US economy and are impressed by growth prospects in Europe, the volatility of exchange rates is increasing and the euro is on the rise, both on a trade weighted basis and against the US dollar. Whether the rally will last or not is a relative issue. Assuming that the US housing market downturn remains contained and does not spread over the whole US economy, markets should be mostly sensitive to the news flow from Europe. In this regard, the latest batch of business surveys, starting with the Ifo index, was bullish for the European currency. So was the conspicuous silence of ECB's President Jean-Claude Trichet who, although repeating that Asian currencies should be more flexible, has not commented on the recent strength of the euro.

-->As long as key policy makers do not express serious worries about the strength of the euro, the markets are likely to take their clues from real economies. On our reading of November business surveys the first signs of a forthcoming slowdown have appeared. December or January surveys are likely to report a slowdown in demand, as forecasted by the Belgian inventory index, which typically leads the euro area cycle. We believe that demand will slow more than production, i.e. GDP, because surveys indicate that euro area producers have already anticipated the forthcoming slowdown. However, the market is unlikely to enter into such details, and is more likely to see a decline in the Ifo index as an opportunity to take profits. If our analysis proves correct, the correction in business sentiment should be limited, both in scope and in time. Accordingly, the euro is likely to remain relatively strong for some time, a natural consequence of the cyclical divergence between Europe and the US.

Although the rise of the euro over the last four weeks was quite sharp (+1.6% so far in November on a trade weighted basis), it came after small declines in September and October and still leaves the average trade weighted index (TWI) 0.4% in 4Q than in 3Q. Because the recovery is mostly driven by domestic demand (+2.5% year-on-year in the third quarter in the euro area), such small currency gyrations are not serious causes for concerns. In this regard, French policy makers' anxiety seems to reflect a competitiveness issue vis-à-vis European competitors such as Germany or Italy rather than an external exchange rate challenge, in my view. On our estimates, based on simulations using a quarterly model (Insee's MZE-2003), past changes in the euro TWI, which have been positive for GDP growth in 2004 (+0.3%), 2005 (+0.5%) and roughly neutral this year, would cut growth by 0.3% next year, assuming an exchange rate freeze from now on. The same methodology indicates that past changes in crude oil prices in euros have practically offset the positive impact of the exchange rate in 2005 and this year would add 0.3% to GDP next year. Not totally by coincidence, currency and oil price gyrations would continue to offset each other next year, if prices were frozen at current values. This is already priced in our GDP growth forecasts for next year, 1.9% for the euro area, after 2.6% this year. However, since the euro is already strongly, if not over-valued, a further rise from current levels would probably become a threat for the recovery.

To take a practical example, if the euro TWI appreciated by 5% before year-end, that is climbed to 110, GDP growth would be cut by 0.7% in 2007, that is 0.4 percentage points more than assumed in our forecasts. This would cut average GDP growth to 1.5%, with possible GDP contractions in one or two quarters. In my view, this would certainly qualify as a pain threshold. So, if 110 for the euro TWI is an upper limit to what euro area policy makers may accept, is there a similar threshold on the euro/dollar axis? Although the trade weighted exchange rate is the only one that matters for the real economy, 90% of the volatility of the trade weighted index was generated by the US dollar, over the 2003-2006 period, during which the elasticity of the TWI relative to the EUR/USD rate was 0.42. Accordingly, a 5% appreciation of the euro on a trade weighted basis is typically associated with a 12% (5%/0.42) rise of the euro against the US dollar. Within this framework, the 110 TWI pain limit is equivalent to 1.44 on the euro/dollar axis.

If this scenario, i.e. the euro rising to and above US$ 1.45, unfolded, could the ECB soothe the pain by acting on interest rates if it wanted (which is not warranted, given the mission of the central bank)? The answer provided by standard models is partially negative, for two reasons. First, time lags seem to differ quite significantly: while exchange rate moves have a relatively rapid effect on corporate investment (via changes in profitability and expected demand) and thus on GDP growth, changes in interest rates are much slower to pass through the economy. Second, exchange rates, provided that they do not move too much, do not have a lasting impact on GDP because, in the long run, prices are flexible. Practically, after 3 to 4 years, GDP would be back to its initial trajectory, if nothing irreversible had happened. On the other hand, interest rates have a permanent effect on the level of GDP (although not on growth). Using the same tools as in the previous section, a 100 bp rate cut would not even be sufficient to offset the short term negative impact of a 5% rise of the euro TWI, but, after two years, would have an unwanted permanent effect on GDP and on inflation. So the 100bp stimulus would have to be removed relatively quickly, at the risk of destabilising financial markets. This is clearly not an option, in my view. In fact, the very idea of a trade-off between monetary policy and exchange rates is flawed, I believe. That said, a 5% TWI rise would be offset by a 50bp rate cut (followed by rate hikes one year later), after around 18 months. A central bank focused on the medium-term may have this kind of rule of thumb in mind.

Each time the euro rises without triggering reactions from the ECB, a plot theory resurfaces: ECB Council members would favour a strong euro in order to twist the arms of governments on structural reforms. As this line of reasoning goes, the ECB is worried by the lack of flexibility of most euro area economies, which could jeopardize the very existence of the single currency in the long run. A moderately over-valued currency would force corporate restructuring and convince governments that supply side and labour market reforms are the only way out. I do not share this view and suspect that the opposite could be true. As far as corporate restructuring is concerned, the main challenge to European companies operating in the internationally traded sector (not only exporters but also companies competing with overseas exporters on the domestic market) comes from globalisation, not from the exchange rate. The gap between euro area countries and low cost emerging economies such as China and India is so wide that a 10% change in the currency value is of second order. Whether the euro is strong or weak vis-à-vis the US dollar or the Japanese Yen does not make European companies more or less exposed to globalisation.

On the other hand, the non traded sector, i.e. most of consumer services and many business services, the retail industry, public utilities and government sponsored entities (such as central banks, to take an ironic example) is the first to benefit from a strong euro: more favourable terms of trade increase demand for services by boosting consumers' purchasing power without affecting its competitive environment. At the top of the list of reforms that euro area countries need to push forward in order to create wealth and jobs, are: deregulating domestic services, reducing the size of governments and making labour markets more flexible (for labour intensive industries, such as services and retail). Implementing these reforms when an overvalued currency generates an illusion of sustainability in non traded sectors is in my view politically more challenging than in the opposite situation.