Download Euro Strengthens With European Economy

Chapter 13: Exchange Rates and the Foreign Exchange Market: An Asset Approach
Euro Strengthens With European Economy
By CARTER DOUGHERTY – May 09, 2006
FRANKFURT, May 8 - After a roller-coaster year, the euro appears to be headed
firmly on an upward track as Europe’s once-sputtering economy starts firing on all
cylinders and the United States dollar weakens against major currencies.
A mixture of brisk exports and accelerating economic growth is persuading investors
to take shelter in the euro as the dollar continues a relentless downward trajectory.
The dollar’s decline - which affects Asian currencies as well - has gained speed since
the end of March as the huge United States current-account deficit widens further, and
the Federal Reserve signals that it may take a breather in its two-year cycle of raising
interest rates.
But while the euro has seen its rising fortunes fade in the past, things look different
this time, since its fate is not tied solely to the dollar’s whims. Now, a generally
upbeat mood in Europe is contributing to its strength -in stark contrast to even a year
ago, when the collapse of the European constitution underscored deep uncertainty
about the future of the Continent.
"Now, things are really happening in the European economy," said Erik F. Nielsen,
chief Europe economist for Goldman Sachs.
On Monday, the euro hit $1.2787 before slipping to $1.2704, still up sharply from
$1.22 in early April. The dollar also eased to 111.69 yen from 112.43 yen on Friday,
and continued a decline against the British pound.
Jean-Claude Trichet, president of the European Central Bank, cautioned Monday that
Europe’s renewed growth could still fuel concerns about inflation at a time when
commodity and energy prices were also surging.
"It is not the time for complacency if we want this global growth to be sustainable,"
Mr. Trichet said at a gathering of central bankers in Basel, Switzerland, according to
Reuters. "We have to be careful to see that this period of global growth does not end
up in inflation."
A year ago, the euro’s rise was cause for concern among European businesses and the
European Central Bank for a different reason. They worried that a rising currency
would make Europe’s exports - then, as now, the backbone of the European recovery more expensive, choking growth.
But further evidence of broad economic gains means European officials now view the
euro’s strength with interest, and possibly concern, but not alarm.
"Life is pretty decent right now in Europe, and European officials feel pretty positive
about the economy despite the rising euro," said Simon Derrick at the Bank of New
York in London. "There has been a considerable shift in viewpoints."
On Monday the European Commission raised its growth forecast for countries using
the euro currency to 2.1 percent for this year, up from a prognosis of 1.9 percent in
February. Most encouragingly, the commission lifted its outlook for Germany,
Europe’s largest economy, to 1.7 percent, slightly higher than its previous estimate of
1.5 percent.
Evidence is mounting that consumer spending, an engine of growth that has not fully
kicked in, is starting to pick up after a long lull. On Monday, an index of the 12-nation
euro zone’s retailing industry by NTC Economics reached its highest level since
January 2004, when the poll began.
For much of 2004, the dollar was buoyant as the Federal Reserve lifted interest rates
far above European borrowing costs, drawing money from around the world into
dollar-denominated assets. A speedy American economic expansion also cast a
favorable light on the world’s largest economy.
Analysts expect the Fed to raise its benchmark rate a quarter-percentage point, to 5
percent, on Wednesday and to signal that future increases will come much more
slowly, if at all. In Europe, by contrast, the central bank has made clear that it is
determined to lift rates from their present level of 2.5 percent, which is still near
historic lows.
As the year wears on, growth in the American economy also is likely to slow thanks
to higher borrowing costs and ebbing consumer spending. That helped persuade
currency traders to begin dumping the dollar now.
"This is the beginning of the dollar downtrend that we’ve all been waiting for," said
Tony Norfield at ABN Amro in London. "It has arrived."
The U.S. current-account deficit, which rose to $804.9 billion last year and is set to go
higher in 2006, also haunts the dollar, economists said.
The dollar would fall sharply if the rest of the world lost the appetite that is financing
this deficit, a potentially nightmarish situation.
One reason the rise of the euro has failed so far to ignite much controversy in Europe
is that the dollar is falling against a broad range of currencies, economists said.
"The euro is playing its part, but not the only part in bearing the brunt of the dollar’s
weakness," said David T. Bloom, a currency strategist with HSBC Holdings in
London. "That helps mute the political reaction."
In late 2004, the euro zoomed upward against the dollar even as other currencies,
notably the yen, remained relatively stable, ensuring that European exporters would
pay the price for the dollar’s weakness. The development prompted Mr. Trichet to call
the fluctuations "brutal and unwelcome," and generated considerable friction with the
United States, which at times explicitly encouraged the dollar’s fall.
This time around, the dollar has declined against several currencies in Europe and
Asia. One result, Mr. Bloom noted, is that the euro’s rise on a trade-weighted average
- an important measurement that reflects the impact on exports - has been much more
modest, and at the European Central Bank’s monthly meeting last week, Mr. Trichet
avoided expressing any worries about the rise of the euro.
The central bank’s own trade-weighted index of the euro is still below 104, well under
the range of 106 to 109 that inspired Mr. Trichet’s remarks in 2004.
Unless the euro rises to about $1.30, or begins swinging wildly, the bank is likely to
see little reason for worry, economists said. "As long as the exchange rates do not get
erratic, there is not going to be much cause for concern," said Audrey Childe-Freeman
with CIBC World Markets in London.
1. The article states "brisk exports" are causing investors "to take shelter in the euro" versus the
dollar. What is wrong with this claim? Hint: the author of the article later states "A year ago,
the euro's rise was cause for concern among European businesses…" According to the model in
chapter 13, what is the real reason why investors want to invest in euro-denominated assets versus
dollar-denominated assets?
Answer: The statement is unclear. By itself, a rise in exports should not cause a currency to
appreciate. A depreciated currency causes exports to become less expensive over time, so that
brisk exports should be caused by a depreciated currency. (The effect of economic growth on the
exchange rate is ambiguous. As chapter 15 discusses, economic growth in the long run is
predicted to cause the real value and cost of a country's goods to fall, but chapter 16 predicts that
increased demand of a country's goods—either within a country or in world markets—that can
cause accelerating growth in the short run is predicted to cause the value of a country's currency to
rise.) What the author of the article probably means is that increased demand of European goods
in world markets (which is caused by some unstated factor) is causing European exports to rise
and is causing the demand of euros in foreign exchange markets to rise, which causes the value of
the euro to rise. Given this trend, investors should expect the value of the euro to rise, which
makes assets that will pay in euros seem more attractive. The model in chapter 13 predicts that
when the expected rate of return on euro-denominated assets rises, investors increase the demand
of euro-denominated assets and euros, causing the value of the euro to rise and the value of the
dollar to fall (and the exchange rate to rise).
2. The article states, "an upbeat mood in Europe is contributing to the [euro's] strength." Please
explain this scenario using the terms of the model of the foreign exchange market in chapter 13.
Answer: Answers may vary. Here is one: An upbeat mood can make European and foreign
firms want to invest and produce in Europe instead of elsewhere, which would increase the
demand of euro-denominated goods and of assets relative to the demand of dollar-denominated
goods and of assets, so that the value of the euro would rise relative to the dollar. Also, an
upbeat mood can lead to increased demand of euro-denominated goods which can lead to
increased economic production and profits at European firms, thereby increasing rates of return on
their stock and yields on their bonds. If individuals and institutions are expected to want to buy
more euro-denominated goods and assets, then the value of the euro is expected to rise and we
would represent this by increasing the expected exchange rate in the model. As the model
adjusts towards equilibrium, the current value of the euro would rise and the current exchange rate
would rise.
3. The article states in 2004 "the dollar was buoyant as the Federal Reserve lifted interest rates
far above European borrowing costs, drawing money from around the world into
dollar-denominated assets" and that "future increases [of U.S. interest rates] will come much
more slowly, if at all. In Europe, by contrast, the central bank has made clear that it is
determined to lift rates…." Please explain this scenario using the terms of the model of the
foreign exchange market in chapter 13. Hint: see figures 13-5 and 13-6.
Answer: When the Federal Reserve System was raising interest rates, rates of return on
dollar-denominated assets were increasing so that the value of the dollar was increasing and the
dollar/euro exchange rate was decreasing. This scenario is shown in figure 13-5. When the
Federal Reserve System appeared finished with increasing interest rates and the European Central
Bank was expected to raise its rates, then the expected rates of return on euro-denominated assets
increased, so that the value of the euro increased and the dollar/euro exchange rate increased.
Figure 13-6 shows the case where European interest rates increase. The model makes a similar
prediction when European interest rates are expected to increase because expected increases in
European interest rates would cause the expected value of the euro and the expected exchange rate
to increase, thereby causing the current value of the euro and the current exchange rate to increase.