Causes and consequences of the fall of the Euro

Rafael Pampillón and Cristina Mª de Haro. IE Business School and Universidad San Pablo (CEU)

20 January 2015

The falling value of the euro is strengthening exports and attracting foreign investment. If it brings real economic recovery, the result will be a virtuous circle of growth.

On 4th January 2014, the euro stood at $1.39 and it has been falling ever since. Yesterday, it stood at less than $1.18, a drop of over 15%, which has seen it fall to its lowest level in nine years. Spain and other countries in the eurozone have been benefiting from this sharp depreciation in 2014 and at the start of 2015. The reasons for this depreciation are many:
 

  1. More expansive monetary policy. Every day, hopes increase that the European Central Bank (ECB) will put in place a policy of quantitative easing. In December, the eurozone saw negative inflation for the first time since 2009, and the ECB would like to avoid deflation at all costs. Consequently, the ECB will adopt a series of measures, in its meeting on 22nd January, including the purchase of sovereign debt. The eurozone is currently experiencing a period of economic stagnation, causing unemployment to remain exceptionally high, the cause of unemployment being insufficient aggregate demand. In order to stimulate demand, the ECB is prepared to purchase up to half a billion euros of sovereign debt (QE), thus expanding the monetary base and, in so doing, lowering interest rates even further. The market has already factored this in, which explains why the euro has been depreciating.
     
  2. Elections in Greece. The political crisis in Greece, along with the upcoming elections on 25th January, has undermined the confidence of the world's investors in the euro, prompting them to seek refuge in the dollar. The polls are indicating that a victory for Syriza seems likely. This party would like to re-negotiate the Greek national debt - which stands at €240,000 million - with the financial system, the IMF, and the ECB in order to rid themselves of some of the harsh austerity measures imposed by the country's creditors. Germany and France are opposed to Syriza's proposals: making concessions for Greece might lead to other countries in the eurozone that are also heavily in debt demanding similar treatment. It is a difficult situation; one that has led to a loss of confidence in the single currency, despite the withdrawal of Greece from the euro not forming part of Syriza's agenda.
     
  3. A stagnant Germany. Investors are no longer as interested as they once were in bonds issued by German businesses and the German government, on account of the weakened Germany economy. As a result, there is less demand for euros, which has led to a weakening of the German government's position. Yesterday, we learnt a) of the plunge in factory orders in Germany in November, due, for the most part, to the fall in domestic factory orders, which has diminished enthusiasm for variable-yield securities; b) that German export figures failed to grow in the last few months of the year, and that in November, they fell by 2.1% (twice the predicted figure); and c) that industrial output fell in November, registering a decrease of 0.1%.
     
  4. The rise of the United States (US). The strengthening of the dollar (or the weakening of the euro) is a sign of investors' belief that the US economy will continue to grow (it saw an increase of 5% in the third quarter of last year) as will the rate of employment. Consequently, the US economy is expected to do relatively well in 2015, with the Federal Reserve (the Fed) beginning to increase interest rates long before the ECB does. Such a situation would see a rise in the demand for dollars through the increased profitability of variable-yield securities and fixed-interest securities in the US. The Fed has ruled out the possibility of an immediate increase in interest rates, maintaining that the normalization of its monetary policy remains subject to inflation. Consequently, the Fed will, just like any other central bank, be monitoring the price index. Most analysts are anticipating that the United States will begin to raise interest rates this June, which should see the dollar be revalued again at $1.10 to the euro, between April and May of this year. All the same, it shouldn't be forgotten that while inflation continues to be below the target of 2%, which is not difficult, on account of the drop in the price of oil, the Fed will not raise interest rates. The eurozone, on the other hand, is enjoying very low interest rates, and will continue to do so for some time to come. This means that interest on bonds denominated in euros will be less attractive than that on bonds denominated in dollars.

Will the euro continue to depreciate?

Making predictions about financial markets is very complicated. However, some economists argue that the euro is close to hitting rock bottom. One theory is that depreciation such as we are currently witnessing, boosts exports in the eurozone. So, what is the right kind of interest rate? Six months ago, the Big Mac Index informed us that the interest rate, which would see the price of hamburgers on either side of the Atlantic draw level, would stand at 1.2 dollars to the euro, a figure not dissimilar to those provided by far more sophisticated econometric models or the OECD. This would mean that, as things stand, the euro is devalued. We will have to wait until the end of this month, when The Economist publishes new data, to find out just how far the euro has depreciated in comparison with the dollar according to the Big Mac Index.
 
Recovery in Europe
 
We would like to reiterate, therefore, that the weakness of the euro may benefit exports in Europe (which is becoming more competitive), and could create opportunities for European growth. If the eurozone begins to recover, it could start to attract foreign investors once more, and they in turn would require more euros, which could halt the currency's decline.
 
For several decades now, consumption has been, and continues to be, the driving force behind the US economy, while the driving force behind the eurozone economy is, if anything, exports. However, in order for this driving force to function, it is essential that the rest of the world responds by purchasing a greater quantity of goods and services from Europe, as these are becoming very cheap. Consequently, tourists from other parts of the world are visiting Paris, Italy, Greece, and the beaches of Spain in greater numbers. Depreciation is also having a positive effect on the Spanish real estate market, which sees revenue increase when the euro is devalued, as many foreigners wish to purchase houses and other assets in the eurozone, on account of their reduced cost in dollars. Furthermore, we will see other types of foreign investment in the eurozone, since foreigners will be purchasing European assets (factories, properties, bonds, and shares), given that they are all going at sale price. Should this be the case, then it seems likely that there will be a recovery during the course of 2015, which would also encourage significant growth in the world economy.
 
Fortunately, the Spanish economy does not have as many problems as that of France or Italy or, of course, Greece. We are also some way off from the sharp depreciation of the ruble in Russia, which is having a negative effect on the German economy. This week, we have seen evidence of economic recovery in Spain, with the publication of figures by the Department of Social Security relating to official unemployment and social security registration figures. In 2014, an additional 417,574 workers registered, the highest number of registrations since 2007.
 
More employment has meant that consumption, amongst Spaniards, is on the increase, which has, in turn, seen a rise in imports. However, in real terms, import figures continue to rise faster than those for exports, the drop in oil prices significantly affecting their value in euros. This has had a positive effect on the balance of payments and helps to explain why, in October, the country recorded a positive, if modest, current account surplus of €311 million.
 
So, with things as they are, the ECB will continue to adopt an expansive monetary policy or quantitative easing that will see the euro continue to depreciate, which may help economic growth and boost employment. This could also prompt a rise in prices, which would chase away the specter of deflation. The appreciation of the dollar (in anticipation of a moderate increase in interest rates in the US) and the falling price of oil (50 dollars per barrel) clearly favor economic growth worldwide, and particularly in Europe and Asia. Nonetheless, during the course of 2015, we can expect the problems faced by Russia and other oil-producing countries to introduce an element of instability into the currency market. In Spain, the economy continues to grow, thanks to the rise in employment, consumption, and investment. October's increased current account surplus is proof that growth can continue without the need for foreign trade deficit and, consequently, without borrowing from the rest of the world.
 

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