Summary:
– Depreciation has a positive effect on the economy, provided that the external balance does not deteriorate and that the most volatile components of the price index remain stable.
– An appreciation of the euro has a negative effect on the economy if it is sustained and likely to cause a structural deterioration in the current account balance.
– The impact of euro fluctuations on economies is difficult to quantify due to the long-term effects of periods of euro appreciation and depreciation.
– Fluctuations in the euro have a short-term impact on cash management, which is a financial rather than an economic mechanism.
The effect of euro exchange rates on the economies of the eurozone is a mechanism that is difficult to define accurately, even though the subject is currently in the spotlight. Two economic policies are being studied: monetary policy and growth policy. Monetary policy refers to exchange rate policies aimed at supporting economic growth and/or price stability. These two objectives define the conditions for the application of growth policies: a cyclical strategy of stimulus through exports or a strategy of inflation stabilization promoting structural recovery of economies. In this respect, the concept of « currency war » is a specific term depending on the targets of monetary policy and the relationship between growth strategy decision-makers and central banks.
But what are the real effects of a change in the real effective exchange rate of the euro? Through an analysis focusing solely on economic mechanisms, this article puts into perspective the means of measuring the exchange rate effect in the euro area, before specifying the advantages of a depreciation and an appreciation of the strong euro.
The exchange rate effect in the euro area: perspectives
An appreciation of the euro against a currency would reduce the price competitiveness of our exports outside the euro area and lower the cost of imports. A depreciation of the euro would increase the cost of imports and therefore intermediate consumption, and could ultimatelyreduce or slow down the growth of value added (value of production minus intermediate consumption). However, these relationships can be exploited under certain conditions:
– we need to know the share of our exports traded in another currency: if this share is insignificant, then the negative effect of the euro’s appreciation against that currency on our exports would have less impact on the economy
– knowing the share of export-related activity. If exporting companies are fully exposed to the exchange rate effect on their exports and on the imports necessary for their activity, non-exporting companies will only be sensitive to changes in the cost of imports. Thus, if 80% of the economy depends on non-exporting companies, then an appreciation of the euro would be preferable.
The euro-dollar exchange rate is often cited as an indicator of the exchange rate effect, due to the importance of international trade denominated in dollars. The euro zone is a special case, as the share of trade denominated in euros is significant for both exports (63% in Germany, 52% in France) and imports (55% in Germany, 45% in France), in contrast to countries whose foreign trade is linked to trade denominated in dollars for both exports (90% in China, 91% in Brazil) and imports (93% in China, 92% in Brazil). Japan, which has a currency traded on international markets, has only 48% of its exports denominated in dollars but remains exposed on its imports (68%). Thus, monitoring the euro-dollar exchange rate is inevitable, as it concentrates the main exchange rate risk for France.
The real effective exchange rate, which takes into account the nominal exchange rate and the ratio of eurozone export prices to those of non-eurozone countries, is used as a measure of exchange rate risk . The real effective exchange rate is a significant measure of the overall impact of the euro on the international market.
The European Central Bank (ECB) takes the exchange rate effect into account as a target variable for its price stability objective, which ultimately enables it to determine the level of the key interest rate in the euro zone. An appreciation of the euro against the dollar could fuel a contraction in the prices of imported goods, since 40 to 60% of imports are denominated in dollars, depending on the country. However, a fall in the prices of imported goods increases the likelihood of disinflationary risk through two mechanisms:
– rendering the interest rate channel ineffective if the inflation rate is too low: liquidity injections have no effect on economic activity since there is no longer any arbitrage between currency and securities (a « liquidity trap » situation).
– not being accompanied by a downward adjustment in consumer prices of the same magnitude: since companies are unable to sufficiently adjust their payroll downward, their ability to pass on the full price decline through a contraction in their profit margins remains limited. Consumer prices for goods and services produced in the euro area are falling at a slower rate than prices for imported goods, resulting in greater competitive pressure from goods produced abroad on the euro area goods and services markets.
Under what conditions is a depreciation of the euro beneficial for an economy in the euro area?
The depreciation of the euro can benefit exporting companies in two ways:
– either they gain market share on the international market: increased external demand boosts their export volumes.
– or they increase their margins in proportion to the exchange rate effect: the prices of exported goods remain unchanged. The increase in revenue will be used to invest and improve production.
These favorable effects for exporting companies are possible under two conditions:
– the first is that the increase in the prices of imported goods is not as significant as the decrease in the prices of exported goods, i. e., there is no deterioration in the external balance.
– the second is that the rise in energy costs (8% of the French price index excluding tobacco) and other goods and services that must be imported does not excessively increase the cost of intermediate consumption for businesses and does not have a lasting effect on the purchasing power of domestic private demand. Non-exporting companies would then suffer from this decline in domestic demand. Only companies whose activity is strongly oriented towards external demand, if possible outside the euro zone, would benefit from a sharp depreciation of the euro against other currencies.
Under what conditions is an appreciation of the euro beneficial for an economy in the euro area?
An appreciation of the euro can also be beneficial for French consumers and exporting companies, provided that the appreciation of the euro reduces the production cost (lower energy prices) of a good by more than the relative price increase of that same good on the international market.
This is a long-term effect that occurs in three stages:
Stage 1 – The appreciation of the euro improves the terms of trade (export prices/import prices) because the price of imported goods falls more rapidly in absolute terms than the price of exported goods rises. The current account balance improves if the ratio of imports to exports in volume terms remains higher than the ratio of the change in import prices to the change in export prices.
Step 2 – In foreign currency, exports are less competitive: they decrease in volume. Imports increase in volume. To maintain their market share, companies reduce their export margins, resulting in a decrease in the current account balance.
Step 3 – Import prices fall, leading to lower imported inflation, which slows the rise in prices of goods produced in the eurozone. This strengthens the terms of trade: exports increase in volume.
These effects are positive in the short term but negative in the long term. Thus, an appreciation of the euro has a negative effect on the economy if it is sustained and likely to structurally degrade the current account balance.
This reasoning is based on two assumptions:
– the stability of energy asset prices, one of the most volatile components of the price index.
– A resilient trade balance that does not deteriorate. This condition assumes that the sum of the price elasticity of imports and exports at the real effective exchange rate is less than 1. Thus, an elasticity sum greater than 1 would not make an appreciation of the real effective exchange rate against other currencies profitable.
The impact of depreciation and appreciation is difficult to quantify.
Identifying economic mechanisms is only useful if the duration and significance of the effects of a change in the real effective exchange rate of the euro can be determined.
In this regard, the OECD’s Interlink model has made a major contribution by showing that a 10% appreciation of the euro in 2008 against all currencies reduces GDP in the euro area by 1.7 points over the following four years, while exports and imports contract by 4.6 and 3.1 points respectively over the same period.
The limitation of the model is that it does not distinguish between intra-zone and extra-zone trade, in short, it does not directly take into account the effect of a change in the effective exchange rate of the euro on exports to markets outside the euro area and imports from countries outside the euro area.
This model also explains why the effect of an appreciation of the euro is spread over time and over several years. The negative effect of an appreciation of the euro on GDP could thus very well be offset in part by the effects of a previous depreciation of the euro.
It is therefore very difficult to quantify precisely the impact of a change in the real effective exchange rate of the euro on the components of an economy, particularly in the euro area.
Conclusion
Quantifying economic mechanisms is complex and estimating the effects on GDP remains uncertain. The effects of an appreciation of the real effective exchange rate of the euro on GDP and through economic mechanisms must be monitored, but their analysis offers no certainty.
While the real effective exchange rate does not have a definite and direct negative effect on production levels, its effects on the cash management of exporting companies are inevitable. The economic and financial scenarios established by the financial departments of these structures determine the significance of an appreciation or depreciation of the euro’s real effective exchange rate relative to a target level.
Reference:
« How much does the appreciation of the euro cost us? », OFCE Analysis and Forecasting Department, April 2004.
« The effects of the appreciation of the euro on the French economy, » Franck Cachia, INSEE Economic Analysis Division, June 2008.
« How to forecast the dollar/euro exchange rate in the long term, » Patrick Artus, Natixis, April 15, 2010.
