The Crossing of the re line of Euro-dollar Parity

Published on Aug 26, 2022 12:19 PM IST

The article has been authored by Partha Ray, director, National Institute of Bank Management.

As per the July 2022 estimates (the latest available) of the Eurostat, the statistical office of the European Union, seasonally adjusted GDP increased by 0.7 per cent in the euro area in the second quarter of 2022, compared with the previous quarter.(HT File)
As per the July 2022 estimates (the latest available) of the Eurostat, the statistical office of the European Union, seasonally adjusted GDP increased by 0.7 per cent in the euro area in the second quarter of 2022, compared with the previous quarter.(HT File)
ByHindustan Times

The Euro as the currency of 19 EU countries and over 340 million Europeans, is the second most used currency in the world – next only to the dollar. Typically, over the last two decades, despite the fluctuating tendencies of Euro’s exchange rate (being a freely floating currency), its value has been higher than the dollar. However, on July 13, 2022, it got a jolt and touched 0.9998 and thereby crossing the Lakshmana Rekha of the parity. In fact, over the last one year or so, the Euro-dollar exchange rate experienced a steady fall. Since then it has gained marginally. The euro-dollar exchange rate, in fact, depreciated by almost 12 per cent so far in 2022 and the threshold of 1 euro = 1 USD has been crossed after nearly two decades (Chart). What went wrong? Why is this steady fall of the euro? Does it anyway indicate a weakening euro area economy? Or, is it in tune with the generalized strengthening of the dollar?

Insofar as short-term depreciating tendencies of the euro are concerned, three basic factors may be highlighted.

First, the primary reason could have been the increased likelihood of a recession in the euro area. The post-Covid turnaround in the euro area was extremely shallow. As per the July 2022 estimates (the latest available) of the Eurostat, the statistical office of the European Union, seasonally adjusted GDP increased by 0.7 per cent in the euro area in the second quarter of 2022, compared with the previous quarter. Earlier, in the first quarter of 2022, GDP had grown by 0.5 per cent in the euro area.

Second, added to this, Europe has been one of the worst victims of the Russia-Ukraine war, so much so that, after being hit by the unstable supply of Russian gas, advanced countries like Germany started looking for coal-based electricity generation plants. Thus, the possibility of an energy crunch and a recession is looming large over the euro area.

Third, apart from the possibility of a recession, the other crucial factor that can be held responsible for the steep depreciation of the euro is the interest rate differential between the two geographies, viz., the US and the euro Area. The idea hails from a theoretical notion, known as “uncovered interest parity” in economists’ jargon. As per this theory, the exchange rate between two currencies seems to be moving in sync with the interest rate differential between the two countries. Consider the following. A ten-year U.S Treasury bond offers a return of 3% as against the return on German bunds (debt securities issued by the German government) return at as low as 1.2 per cent. Moreover, if the yield on US Treasury bills rises relative to German bunds, then it is likely that dollar will strengthen. Given the US inflationary situation, the US Fed is expected to be more aggressive in increasing interest rates than the moves of the European Central Bank (ECB). Thus, as long as the ECB lags behind the US Fed in hiking the interest rates, such weakening of the euro could continue for some more time.

But apart from this short-run depreciating tendency in the euro-dollar exchange rate, there are underlying long-term dynamics. Admittedly, after its lunch in 1999 with an exchange rate of 1.17 dollars, the Euro experienced an initial depreciating tendency and fell below parity since the beginning of 2000. The euro continued its downward trend to reach a low of 0.8270 dollar in October 2000. But from 2001 till the advent of the global financial crisis, the euro was on a generalized appreciating trend. It was also during this period that the euro emerged as a major currency giving credence to the hope that in due course it could challenge the hegemony of the dollar.

Nevertheless, since 2008 despite the year-on-year wide gyrations in the euro-dollar exchange rate, a distinct medium-term downward trend is noticeable. Two consecutive crises hit the euro area. First, the global financial crisis, despite having its epicentre in the US mortgage market, had affected the euro area badly. Second, as the euro area was coming out of the onslaught of the global financial crisis, a fiscal debt crisis had affected a number of euro area economies. Specifically, the countries known popularly as GIIPS (viz., Greece, Ireland, Italy, Portugal and Spain) were affected severely. In many of these crisis countries, the immediate trigger of the crisis was a twin deficit problem, i.e., a coexistence of a lax fiscal policy (characterized by a sizeable fiscal deficit, leading to a zooming debt-GDP ratio) along with a current account deficit. End of the day, the euro area crisis revealed the Achilles heels of a group of countries with a uniform monetary policy (implemented via the ECB) but with multiple fiscal policies (operationalized via the country-specific Treasuries). Since ultimately statehood is what matters for fiscal policies, the uniform monetary policy across the euro area was no substitute for the fiscally irresponsible behaviour of a number of euro area countries.

While by 2018 the crises countries have effectively come out of the euro area crisis, there were dip-rooted rifts in the notion of the euro area. In particular, the ECB was unable to exit from its policies of negative interest rates and ultra-easy monetary policy. Thus, when the pandemic hit the euro area in 2020, there was a distinct lack of policy space. The recent Russia-Ukraine has further exposed that limited policy space.

On July 21, 2022, Christine Lagarde, ECB President, hiked the key interest rates by 50 basis points – much more than what was expected by the market participants. With its main refinancing rate being hiked to 0.50 per cent, the eight-year experiment with negative interest rates also came to end. Euro has staged some small gains since then. It remains to be seen whether such gains are short-term blips or in the nature of some long-term trend.

Chart: U.S. Dollars to Euro Spot Exchange Rate (Monthly Averages) (U.S. Dollars to One Euro)(Federal Reserve Bank of St Louis)
Chart: U.S. Dollars to Euro Spot Exchange Rate (Monthly Averages) (U.S. Dollars to One Euro)(Federal Reserve Bank of St Louis)

The article has been authored by Partha Ray, director, National Institute of Bank Management.

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