The Euro's Rise: Don't Expect a Rate Cut

The currency's advance against the dollar may hurt euro zone exporters a bit, but it's aiding the European Central Bank's efforts against inflation

by Natascha Gewaltig

With the euro rising above the $1.50 mark—and showing no sign of reversing its recent uptrend—exchange rates are once again returning to the spotlight. European officials are pushing for more verbal intervention from U.S. officials to "talk up" the greenback, but there is no sign of any other action to curb the euro's appreciation. Indeed, the inflation hawks at the European Central Bank may welcome the policy mix of a strong currency and relatively low interest rates.

The euro had already appreciated 12.0% vs. the dollar, year-over-year, in February. This compares to average increases of 9.1% year-over-year in 2007 and 8.2% in 2006.

Growth Has Softened Impact on Exports

A stronger euro undermines the competitiveness of euro zone goods on international markets and could potentially cut foreign demand, which has been a supporting factor for the region's growth. So far, low wage growth and larger productivity gains have cloaked the impact of appreciation in the inflation-adjusted exchange rate. Also, world growth has been very robust, which helped to offset the impact of the stronger currency.

Indeed, a report from the European Union has shown that export demand is relatively insensitive to changes in exchange rates, and that a 10% appreciation of the real effective exchange rate should cut overall exports by only around 2%. One reason: Exporters typically hedge their short-term exposure, and longer-term shifts depend on whether exchange rate moves are deemed to be transitory or permanent. If swings are deemed temporary, exporters adjust profit margins when exchange rates rise by cutting prices if domestic products are expensive on foreign markets and vice versa.

This could help explain why exporters so far have coped relatively well with the stronger euro. Net exports contributed 0.4% to overall euro zone growth last year, despite a strong euro and slowing U.S. growth. Euro zone companies, with their mix of high-quality engineering goods, are well positioned to benefit from the investment boom in Asia. Airbus (EAD.PA) even managed to break into the U.S. defense industry recently. At the same time, luxury goods producers are benefiting from increased profits in oil-producing countries.

Benefits for Import Prices

However, the euro has been appreciating for a considerable time now, and there's no sign that the current trend will end soon. And while some firms have sufficient margins for more permanent adjustments, it is clear that many companies are coming under pressure. Signs are emerging that companies no longer see euro strength as something temporary and are starting to consider more permanent measures to cope with the appreciation.

A German survey this week reported that 82% of companies expect the dollar's fall to affect their U.S. business to a large or very large extent. And 56% said they will boost production in the U.S., with a third seeking to increase production over the next six months. There have already been a number of high-profile announcements of companies planning to move production capacity to dollar-denominated economies or to countries with lower labor costs.

This comes as slowing world growth is adding to the pressure of a strong currency. Moreover, the dynamic of world growth is much more important for export demand than moves in the currency. According to the EU commission, a 10% drop in world demand cuts euro zone exports by 8%. And the fallout from the U.S. subprime crisis will hurt U.S. growth, thereby having ripple effects on other major economies as well.

The latest International Monetary Fund forecast predicts U.S. growth of just 1.5% this year, down from 2.2% in 2006. And world growth is expected to slow to 4.1% from 4.9% in the previous year. However, this is still relatively healthy, and the positive impact could conceivably still outweigh even the consequences of a 10% euro appreciation.