Can Europe Cope with a Strong Euro?

Rapid euro appreciation could bring some problems for growth, but officials think the euro zone economy is strong enough to weather it

by Natascha Gewaltig

Though officials have remained relatively relaxed on the issue thus far, exchange rates are moving back into the policy foreground as the euro approaches historic highs against the U.S. dollar. Current foreign exchange levels should do little to curtail the euro zone recovery or prevent further monetary tightening. Yet there is the risk that if imbalances continue to build, there could be a sudden correction later on, which could have destabilizing effects.

The euro-to-dollar rate appreciated 10% year-over-year in March, and it is trading at levels last seen at the end of 2004. With diverging interest rate levels supporting further appreciation, it seems only a matter of time before the euro reaches its cyclical high of $1.3637, set on Dec. 30, 2004. The next barrier would be the 27-year high of $1.44 calculated retroactively (since, of course, the euro didn't exist then) to January, 1980.

The euro is also again rising steadily against the yen, with carry trades and the prospect of further European Central Bank (ECB) rate hikes one of the factors supporting further euro strength. The trend was exacerbated by the lack of a clear signal from the G7 on exchange rates, beyond the familiar line that "excess volatility" in exchange markets is undesirable and that exchange rates should reflect fundamentals.

Hurting Foreign Demand?

Despite this, euro zone officials have been quite sanguine on the issue, and we agree that the euro zone should be able to cope with recent appreciation of the currency used in 12 European nations. Note that on a real trade-weighted basis, the appreciation looks much less dramatic. The trade-weighted TWI index rose just 3.7% year to year in February, compared with a 10.1% year-to-year appreciation in the euro-to-dollar exchange rate that month. Nevertheless, the TWI is also approaching historical heights.

A stronger euro does undermine the competitiveness of euro zone goods on international markets and could potentially cut foreign demand, which has been a supporting factor for euro zone growth. However, low wage growth and larger productivity gains mean that real exchange rate increases are less significant. Furthermore, world growth remains very strong, which ultimately is more important for export growth than the exchange rate.

In a 2004 report, the European Commission showed that export demand is relatively insensitive to changes in exchange rates, and that a 10% appreciation of the real effective exchange rate would cut overall exports by only around 2%. One reason for that is that exporters typically hedge their short-term exposure, and that longer-term shifts depend on whether exchange rate moves are deemed to be transitory or permanent.

Importance of World Growth

If swings are seen as temporary, exporters adjust their profit margins. For instance, they cut prices when exchange rates rise, if domestic products are expensive on foreign markets, and vice versa. Some firms have sufficient margins for more permanent adjustments.

But more important for export demand is overall world growth. According to the European Commission, a 10% drop in world demand would cut euro zone exports by 8%. And so far world growth remains very robust. The IMF predicts world economic growth of 4.9% this year and next, which is just marginally lower than the 5.3% in 2006. Assuming the correlation is symmetric, the positive impact from strong world growth would far outweigh the impact of 10% appreciation in the euro.

This explains why the EC's survey shows that the industrial sector remains very optimistic with regard to the growth outlook. The reading for export order books continued its ascent in the first quarter of this year, and the reading of five in February and March is the highest for at least 12 years. This is a very different situation from back in 2004, when the euro reached its last peak against the U.S. dollar.

Additional Tightening

Furthermore, a stronger euro also means lower import prices, which ultimately will have a positive effect on consumer price inflation.