By Michael Landry, Transatlantic Economy Analyst
The success of firms engaged in international trade is, to a large degree, tied to the value of their domestic currencies – a reduction in the value of a given firm’s home currency generally increases demand for its exports, while an increase in value lowers demand. Many investors looking at growth expectations believe there are likely to be significant changes in standing currency relationships during the next two years. According to Deutsche Bank, the euro’s exchange rate against the dollar will fall to $0.95 by 2017, while Barclays predicts the euro will fall to $1.10 by October 2015 and continue to fall thereafter. Goldman Sachs projects parity with the dollar in 2017. From a rate of 1.20$/€ as of early January 2015, this represents a significant slide in the value of the euro and has implications for trade within the transatlantic area and beyond.
Key Drivers
The key driver of the weaker euro, stronger dollar trend is investors’ anticipation of stronger economic performance in the U.S. compared to the Eurozone during the next two years. As investors around the world seek higher returns, more are funneling their money into U.S. equities as its growth prospects improve – increasing the demand for dollars. In contrast, institutional and political constraints are expected to limit Eurozone member states’ ability to escape relatively low rates of economic growth. Ongoing structural reforms are not expected to significantly alter the currency area’s growth prospects during this time frame.
The ECB’s quantitative easing (QE) program, announced last month, points to another major driver of the weaker euro, stronger dollar shift: divergent monetary policy in the U.S. and Europe. As economic growth and unemployment numbers improve in the U.S., and inflation rises, the Federal Reserve is widely expected to raise interest rates later this year – the anticipation of which is already increasing the value of the dollar relative to other currencies. In contrast, low inflation in the Eurozone drove the European Central Bank to embark on a round of QE, through which it purchases “bonds issued by euro area central governments, agencies and European institutions.” Market expectations for the program were already largely priced into the value of the euro prior to its official announcement on January 22nd, but its larger than expected scale depreciated the currency even further.
While a group of Germans filed suit against the ECB in 2012, arguing that its original promise to buy government bonds (known as the Outright Monetary Transactions Program) at the height of the Eurozone crisis overstepped the bank’s authority, a European Court of Justice advocate-general recently issued the opinion that the program is legal. The court will not issue a final ruling for another three to five months, but analysts expect it to reflect the recent legal opinion and, in doing so, uphold the current QE program.
Impact on Transatlantic Trade
So what might a weak-euro, strong-dollar outcome look like for Europe and the U.S.? Foremost, the impact of the currency shift is likely to be felt in transatlantic trade. With a relatively weaker currency, European exports will be cheaper than they have been in the American market. This is a win for European exporters and American consumers; however, U.S. producers of now relatively more expensive goods and services are likely to lose business. The situation within the Eurozone will be somewhat different since imports from the U.S. will be increasingly expensive as the euro weakens, which would likely increase demand for domestically produced goods and services.
It should be noted that in the highly connected international market, inputs may be manufactured in one country, then exported for further processing in another, before being finally shipped to their final destinations. What this means is that while American businesses will likely be hurt by cheaper European products overall, some American companies will benefit from cheaper inputs for their own products. Conversely, in the Eurozone, businesses are largely expected to benefit although some firms relying on goods and services imported from the U.S. will be hurt. The primary determinant of whether particular firms and industries will be better or worse off is whether they are competing with the imports or consuming the imports. For example, according to a European Commission report, the largest SITC (Standard International Trade Classification) product sections exported to the U.S. from the EU in 2013 include “Machinery and Transport Equipment” (40.8%) and “Chemicals and Related Products” (15.7%). According to data pulled from the International Trade Administration database, the largest component of Machinery and Transport Equipment exported to the U.S. is motor vehicles, valued at almost $47 billion, while the largest component of Chemical and Related Products is “Medicinal and Pharmaceutical Products,” valued at nearly $39 billion. Therefore, if some of these products are sufficiently similar to those produced by American companies, those U.S. firms would see heightened price competition.
Intensified Competition in External Markets
European exporters will also find that their products are increasingly competitive vis-à-vis their American counterparts in key markets outside the transatlantic area. Of the top 10 non-EU trade partners of the Eurozone, three noteworthy countries besides the U.S. have experienced a significant appreciation of their currencies against the euro in the past year – the Chinese yuan: 19.76%; the Indian rupee: 19.66%; the South Korean won: 18.67%. Likewise, the British pound rose 10.3% against the euro during this timeframe. The proximity of Britain to the Eurozone means it will likely be an attractive destination for production from the continent, especially because its income levels are comparable. South Korea may prove to be a solid export destination for Eurozone firms, given its currency’s appreciation, its relatively high per capita GDP and its relatively low income inequality, as measured by the Gini index (0.307 in 2012), which will allow a large swath of the population to demand imported products. The strong appreciation of the Chinese yuan and Indian rupee will likely make European goods and services more competitive compared to goods and services produced in China and India as well.
Complications
For the Eurozone, there are two noteworthy complicating factors that are likely to diminish the benefits a weaker currency. One is that growth is slowing in many major markets, aside from the U.S., and there is no glut of demand to absorb vast exports. And while U.S. economic performance is improving, American consumers are still laden with debt. It is therefore unclear that the American economy has the capacity to absorb the increased production for which the Eurozone (among others) so earnestly strive. The second complicating factor goes hand in hand with the weak global economy, and that is the fact that central banks outside the euro area recently adopted measures to depreciate their own currencies – undercutting the benefits of a weaker euro.