BSI ECONOMICS FLASH – February 11, 2014
News: According to the CAE,a 10% depreciation of the euro would increase GDP by 0.6 points. Several politicians are calling for a depreciation of the single currency to boost the French economy. Are these forecasts justified, and on what assumptions are they based?
France’s trade balance (the difference between exports and imports of goods and services) is a very significant determinant of the current account balance (the sum of the trade balance, the capital transfers balance, and the current income and transfers balance). The latest figures published on February 7, 2014, by the Ministry of Foreign Trade show a 9% reduction in the trade deficit between 2012 and 2013, supported by (1) a 5.1% drop in the energy bill, linked to a currency effect that accentuates the correction in the price of a barrel of Brent crude in dollars to 5.8%; (2) continued sluggish export growth, with exports making a smaller contribution and the trade balance improving thanks to a stronger positive contribution from imports; (3) a gradual recovery in external demand for French goods, which is returning to sustained positive growth, driven by a recovery in trade with the main developed countries in 2013.
The effect of a 10% depreciation of the euro, after experiencing a year-on-year appreciation in 2013, could improve GDP by 1.2 points over two years, boost the consumer price index by 1.2 points, and create 149,000 additional jobs (2014 Economic and Social Report). This report is accompanied by a publication from the Economic Analysis Council showing the positive effects on the trade balance of a 10% depreciation of the euro against the dollar. What are the limitations of these estimates, which could mean that a depreciation of the euro against the dollar might not be profitable?
According to 2013 figures published by French Customs, 48% of total imports and 46% of total exports are linked to economies outside the euro zone. According to the CAE report of January 2014, a 10% depreciation of the euro would increase the value of French exports outside the euro zone by 7-8% and imports by 3.5%.
Applying these figures and assuming zero growth in imports and exports with the euro zone, total exports would increase by 3.2% and imports by 1.7%. With a coverage ratio (exports/imports) of 0.87, an elasticity of exports to the dollar-euro exchange rate of 0.74, and an elasticity of imports to the dollar-euro exchange rate of 0.04 over the last two years, a depreciation of the euro against the dollar would, in theory, improve the current account balance by 3.58% over one year. The CAE study ultimately assumes an import elasticity to the exchange rate of 0.35 and an export elasticity to the exchange rate of 0.70 to 0.80. Taking the lower end of the range, this would imply a 0.4% improvement in the current account balance year-on-year.
However, the effect on the trade balance and therefore on the current account balance is relatively insignificant given the low contribution of the trade balance to French GDP. On the other hand, the impact of a depreciation of the euro against the dollar on export volumes could prove significant. This increase in export volumes would be made possible by an increase in private investment, but could also stimulate a possible contraction in private demand for imported goods.
The sum of the elasticities (exports and imports) derived from the CAE ratio is, in absolute terms, at least greater than 1. This assumption is essential because it allows us to follow the Marshall-Lerner condition or critical elasticity condition. This assumption implies that a depreciation of the exchange rate has a greater quantity effect than a price effect: the current account must always improve through a significant volume effect on exports.
However, this condition requires (1) a sum of elasticities greater than 1 and (2) a coverage rate of 1. The first condition is not always met in the medium term: over the last year, the elasticity of imports to exchange rate variations has been close to 0%, while that of exports has remained close to the historical estimate proposed by the CAE. The second condition implies that exports must be equal to imports: we have to go back to early 2004 to find a coverage rate (exports/imports) in equilibrium. A trade deficit is initially accompanied by a greater value effect on imports. Thus, the CAE’s assumption of a 2% increase in import prices could be underestimated, resulting in a longer period to reach trade balance (as the volume effect adjusts more slowly before exceeding the value effect).
However, the length of this period will: (1) limit the beneficial effects of a sustained recovery in demand for French goods, requiring even more restrictive assumptions about the margin behavior of exporting companies, (2) increase France’s sensitivity to a recovery in the growth of volatile sub-components of the consumer price index (energy, food), (3) expose the price competitiveness of exporting companies to a possible resurgence in production costs (wage increases if inflation rises, sharp increases in intermediate costs if imported), and (4) could constrain a sustainable recovery in private consumption (56% of GDP) and thus force these companies to increase their exposure to foreign markets and, ultimately, their sensitivity to new fluctuations in the dollar-euro exchange rate.
A.J.
References
References
Economic Analysis Council, « The euro in the currency war, » No. 11, January 2014.
European Commission economic forecasts, fall 2013
2014 Finance Bill: economic, social, and financial report
BSI Economics, « Strong Euro, Weak Euro: An Approach Based on Economic Mechanisms, » March 21, 2013.
