Euro Falls to 12 Year Low against US Dollar- The Way Forward
Posted in Finance Articles, Total Reads: 625
, Published on 25 July 2015
The ongoing Euro Zone crisis has already caused much damage to the European economies in the past with the news of Greece exiting from the Euro zone surfacing from time to time. But so far the fate of Greece is still undecided as the country is still in the process of completing the existing bailout agreements with Eurozone and International Monetary Fund.
At the back of optimistic outlook fuelled by declining crude oil prices thereby stimulating consumer spending, the ECB president Mario Draghi decided to kick off bond buying program, similar to the one started by Federal Reserves in US in the aftermath of global financial crisis in order to boost consumer spending. But as fate would have it, after few days of ECB commencing with its bond buying program, the Euro fell to a 12 year low against greenback on 13-March 2015 closing at $1.0482, the lowest since 2003. This can have both good and bad implications on European economies as well as other emerging economies of the world. It would be noteworthy to discuss the factors that led to the decline of Euro before moving to the impact of falling currency and the way out.
Why Euro has fallen to 12 year low against US dollar?
Four major factors that drove the steep fall in euro against dollar are:
1. ECB’s QE launch
The European Central Bank launched its massive quantitative easing program on March 9 in an effort to pump 1 trillion euros into Europe’s economy, implying that the central bank will be infusing 60 billion each month over the next one and a half years in order to restore the inflation rate to a target level of 2 percent thus facilitating economic growth. The program is expected to conclude by September 2016. By pumping money, the ECB plans to weaken the euro against other major currencies thereby boosting the continent's exports and inflation. A weaker euro can boost the continent’s ailing economy by driving the exports. Through QE program, government plans to lower the bond yields. With interest rates at low levels, investors are looking to move capital overseas into countries such as the United States, where they are likely to expect a better return. This in turn will lead to depreciation of Euro as money flows out of Europe.
2. Looming rate hikes from US Fed
The Fed after spending trillions of dollars in its largest ever bond buying program, is contemplating of hiking the interest rates, owing to the improved economic situation prevailing in the States. The US central bank is thinking of tightening its monetary policy by raising the interest rates in 2015. The timing of the Fed's move to raise the interest rates is adding to the volatility in the euro as the U.S. dollar continues to surge on the prospect of higher rates. U.S. dollar was also in the same plight when the Fed started its QE program in the aftermath of the financial crisis. During the first phase of the Fed's QE program that commenced in November 2008, the dollar nosedived by 16 percent against the euro, remained weak up until the Fed’s bond buying program ended in October. Post that, the U.S. dollar has risen 20 percent against the euro.
3. ECB’s record low interest rates
Image: Wallstreet Journal
A third factor is ECB’s record low levels of interest rates by cutting the rates to a historic low of 0.05% in the month of September in order to fight deflation. The main motive behind doing so is to encourage Eurozone banks and lenders to provide funds easily to businesses and household borrowers at lower interest rates, with an objective to boost private spending by increasing investment and consumption. But reduction in Eurozone interest rates in comparison to interest rates in the U.S. also increases the relative attractiveness of holding dollar-denominated debt offering higher returns as opposed to euro-denominated debt that offers lower interests. Thus the investors, in order to buy the now-more-attractive dollar-denominated assets, sell their euro-denominated assets thereby buying U.S. dollars to complete the purchases and thus increasing the value of the dollar as compared to euro.
4. Greece Crisis adding to Euro’s volatility
Greece government has been granted extensions to the country’s bailout program but as the cash strapped country has been creeping back into the headlines, reigniting tensions over its possible exit from Eurozone, it has been adding downward pressure on Euro.
Impact on Economies
A strong dollar is both a boon as well as bane for the U.S. economy. But whether the dollar's rise results in a net plus or a drag depends on the reaction of Federal Reserve. With unemployment dropping, Fed is most likely to raise interest rates sometime this summer in order to stave off inflation. The issue is that a hike in interest rates would strengthen the dollar further, thus attracting investors, and as investors pile into a currency, it will appreciate. At the same time, cheap imports should keep prices from surging in the near future, just like low oil prices have kept inflation under control for past several months. So, the stronger greenback gives Fed two very good reasons to be happy, by keeping inflation in check and threatening to curtail exports.
Declining Euro against dollar has both pros and cons. The biggest positive is the booming exports. According to the projections of ECB, a 5 percent decline in the euro’s trade weighted exchange rate could boost Eurozone GDP by 0.3 percent. But the downside of the falling euro is that banks will now have to lend at record-low interest rates, and will have to lend at near-loss rates as institutions keep slashing rates across the continent.
With the slide in euro against dollar, the rupee also weakened against dollar, which is a matter of concern for the Indian IT companies due to the lower rupee realization resulting from weaker euro. Because of this, there could be a shift from Europe to US with regards to marketing perspective, but not from the perspective of client concentration because it is important for Indian firms to have long term relationships with its European clients even through difficult times.
The Way Out
Factors that may reverse this trend of euro-dollar exchange rate movement can be following:
1. Continuous appreciation of dollar will weaken US economic activity and therefore drive down inflation. In that case, the Fed will probably become more dovish while raising the interest rates.
2. It is hard to say whether countries in Asia and Middle East will in fact want to shift more reserves into dollars. They have to convert the euros they have got since 2003 at a loss and far below their purchasing power parity. Many countries, for both financial and geopolitical reasons, have spent decades diversifying their wealth away from dollars. With the US increasingly prone to using its currency as an instrument of diplomacy, China, Russia, and Saudi Arabia, for example, may be reluctant to shift excess of their reserves into US Treasury bonds.
3. Huge transatlantic trade imbalance is another factor that may reverse the currency movement. According to IMF’s forecast, the gap is already wide with US running a deficit of $484 billion this year, versus a $262 billion surplus for the Eurozone and this gap is most likely to widen much further, owing to the euro's 20% depreciation since the IMF released its estimate last autumn. The consequence is that hundreds of billions of dollars of capital will have to flow annually to the US from Europe in order to maintain the current euro-dollar exchange rate.
4. While the higher US interest rates may continue to attract some investors, the combination of a more competitive euro, the ECB's enormous QE program, and diminishing fiscal pressures in France, Italy, and Spain can generate a genuine economic recovery in Europe thereby making Europe an attractive destination for investors to park their funds. The resulting capital influx into European shares, property, and direct investment could easily outweigh the cash and bond investments lured by rising US interest rates owing to the cheaper Euro assets than its US counterparts.
As of now, no one can say for sure what can strike a balance between the opposing forces operating on the euro-dollar exchange rate, but one thing out of all this is certain: Whereas the gains from playing transatlantic interest-rate differentials may run to the tune of 1% or 2% per year, investors may easily lose it in a single day or even in an hour by buying the wrong currency in case of reversal of trend. From past Japanese and Swiss experience, we know very well that selling a low-interest-rate currency to chase higher US yields is often a costly mistake.
This article has been authored by Devesh Agarwal from IIFT Kolkata