Sharing the burden of a weaker dollar

Written by Simon Tilford [1], 01 December 2009

The eurozone has suffered a deep recession – bigger than the US and about as bad as that in the UK. Public finances across the eurozone have worsened dramatically, and in some cases now look perilous. The eurozone’s average fiscal deficit is lower than that of the US or UK but public debt is much higher. Moreover, it is hard to see where economic growth in the eurozone is going to come from. It certainly will not come from indebted economies like Spain, which provided a disproportionate share of the growth in eurozone domestic demand in the run-up to the financial crisis. Nor will growth come from export-led economies like Germany.

Despite this inauspicious backdrop the euro is incredibly strong. The single currency is trading at around €1:$1.50, way above the level that would equalise purchasing power between the eurozone and US. In trade-weighted terms, the euro is at an all-time high. The UK is the eurozone’s biggest trade partner and sterling has slumped against the euro. China is the eurozone’s third biggest trader partner (after the UK and US), and the Chinese renminbi is effectively tied to the dollar, so it has weakened in line with the US currency. The currencies of the Czech Republic and Poland (the eurozone’s 6th and 7th biggest trade partners) have also depreciated sharply against the euro.

A strong currency has advantages. For example, it reduces the prices of imported goods and hence inflation. But excessive currency strength spells trouble for exporters, and threatens to depress the eurozone’s already poor growth prospects. If the euro remains at its current level, eurozone firms will see their profit margins (and hence readiness to invest) squeezed, and many will be forced out of export markets. Of course some economies are more vulnerable than others. In relative terms, Germany is better able to cope with a very strong euro than Italy or Spain, but history shows that even in Germany there is a close correlation between export orders and the exchange rate.

There is no doubt that the dollar needed to fall in order to rebalance the US economy. But the burden of accommodating a weaker dollar needs to be shared among America’s trade partners, rather than being borne largely by the eurozone. Some estimates suggest that the renminbi is now undervalued by as much as 40 per cent on a trade-weighted basis. If the Chinese (and other East Asians economies with currencies pegged to the dollar) were to allow their currencies to rise against the dollar, the euro would need to appreciate by much less in order to bring about the necessary fall in the dollar’s trade-weighted value. European frustration is mounting, exacerbated by the size of the eurozone’s trade deficit with China, which totalled €170 billion in 2008. Jean-Claude Trichet, ECB president, has called for orderly appreciation of East Asian currencies,as have Jean-Claude Juncker, the chair of the Eurogroup, and Joaquin Almunia, the commissioner for economic affairs.

By contrast, the decline of sterling has generated little controversy within Europe, despite widespread concerns over the impact of currency movements on competitiveness. One reason for the apparent lack of concern is the widespread misconception that Britain does not make anything, and hence will not benefit from the weakness of sterling. But contrary to myth, Britain exports a similar volume of manufactured goods as France or Italy, and is easily the biggest exporter of commercial services in the EU.

Forecasting exchange rates is a fool’s errand: even the best forecasters struggle to get it right. Nevertheless, there are a number of reasons to believe that the euro could remain very strong for sometime. The first reason is divergence in monetary policies. The central banks of the US and the UK are less concerned about inflation than the ECB. As such, they will delay raising interest rates and withdrawing other monetary stimuli until they are confident that the economic recovery has taken hold, even if this runs the risk of a pick-up in inflation. All things being equal, this is likely to encourage investors to buy the euro because they believe it will be a better store of value.

The second reason is China’s exchange rate policy. China has prevented the renminbi from appreciating against the dollar by purchasing vast quantities of the US currency. The country’s international reserves, at $2.3 trillion, are now equivalent to over 40 per cent of its GDP. As a result, China is exposed to huge exchange rate risk: at some point the renminbi will have to rise substantially, reducing the value of China’s foreign holdings. The Chinese authorities are also struggling to prevent massive inflows of capital from pushing up asset prices and causing a surge ininflation. However, they fear that a steep rise in the renminbi would hit economic growth and unleash social tensions. Att he China-US summit in November2009, President Obama’s call to allow the market to determine the value of the renminbi fell on deaf ears. At best, China looks set to concede a series of small revaluations against the dollar.

Where does this leave the eurozone? Any attempt to pressure the ECB into pursuing a looser monetary policy would backfire – the central bank jealously guards its independence. Demands that the US and UK adopt more conservative monetary policies are likely to be ignored too. If the medicine the British authorities have prescribed succeeds in stimulating the UK economy, monetary policy will be tightened rapidly and sterling will recover. But if the UK economy remains weak, so will sterling. However, Europe can step up pressure on China. Unlike the Americans, the Europeans are not dependent on Chinese capital to help fund their fiscal deficits. When the trio of Trichet, Juncker and Almunia visit Beijing in December they must not pull any punches. They should rule out granting ‘market-economy status’ – a longstanding demand of the Chinese –and make plain that China’s refusal allow a substantial rise in the renminbi’s trade-weighted exchange risks triggering a protectionist backlash.