The G7 Will Get an Earful About the Euro

The currency's rise—which is sparking concerns that it will slow European growth—will be high on the agenda of the upcoming multinational gathering

by Natascha Gewaltig

Exchange rates are once again a primary focus in Europe, as the euro has risen to all-time highs vs. the dollar—recently above US$1.40—and shows no signs of reversing anytime soon. Most finance officials have put on a brave face, but it is clear that there is growing concern that the strengthening euro will curtail European growth prospects.

Thus far there is no sign that the European Central Bank (ECB) is considering rate cuts to stem the currency's rise, despite political pressure from France. Coordinated intervention among major economic powers to drive down the currency's value does not seem to be on the agenda either, and it is clear that unilateral intervention in currency markets by the ECB has little chance of success. Nonetheless, central bankers and politicians in the euro zone—the 12 nations that share the euro as their common currency—will push for some form of verbal intervention and a joint statement at the meeting of the Group of Seven (G7) industrialized nations next week.

The euro has appreciated 8.1% vs. the dollar in the first nine months of the year, after already rising 8.2% in 2006. On a trade-weighted basis, the appreciation looks somewhat less dramatic, as the nominal trade-weighted index (TWI) rose just 3.7% year-over-year in September. Nevertheless, the TWI is also at the highest level since the start of European Monetary Union.

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

Euro Strength and World Growth

But while some companies have sufficient margins to tide them over in a period of extended euro strength, it is clear that many will come under pressure. Indeed, while European companies have, for a long time, remained relatively relaxed about the euro's rise, they are now increasingly voicing concern. The German exporters' federation, BGA, has cut its export forecast for next year on the back of the currency appreciation.

This is likely due both to the stronger currency as well as a potential slowing in Europe's major trading partners. In general, world growth is more important for export demand than the exchange rate. According to the European Union (EU) commission, a 10% drop in world demand cuts euro zone exports by 8%. And the fallout from the U.S. subprime crisis will have an impact on U.S. growth that could hit other major economies as well.

On Oct. 9 the International Monetary Fund (IMF) posted surprisingly large reductions in its 2008 growth forecast for major economies as a reaction to financial market turmoil. U.S. growth is now seen at just 1.9%, compared with 2.8% expected previously. And the forecast for world growth has been cut to 4.8% from 5.2%. Yet this is still relatively robust growth and, assuming the commission's estimate of the correlation between world growth and exports is symmetric, the positive impact from still-strong world growth would far outweigh even the impact of a 10% euro appreciation. So far, surveys suggest that confidence about the future for exports has peaked, but remains relatively strong.

Furthermore, a stronger euro also means lower import prices, which ultimately will have a downward effect on consumer price inflation. The stronger euro has helped to dampen the impact of a renewed rise in oil prices. Ultimately, the prolonged euro appreciation will improve purchasing power and may strengthen domestic demand.

Rate Hikes Or Cuts?

To the extent that the stronger euro has a positive impact on the medium-term inflation outlook, it also affects ECB policy. Earlier in the year, the ECB would clearly have preferred a tightening of monetary conditions via interest rate hikes rather than through the exchange rate channel.