The Russia- Ukraine war continues to threaten the Euro

The euro is vulnerable to the Russia- Ukraine war.

It is increasingly clear that the conflict between Ukraine and Russia is entering a new and potentially much more dangerous phase. Ukraine’s long-promised counter-offensive to try to take back lost territory has started and, if the stories are correct, Russia may be taking ever-more desperate means to regain the upper hand following the destruction of the Nova Kakhova dam. It serves as a reminder to us that the euro zone economy – and the euro – are vulnerable to events in Ukraine.

It had seemed for some time that the conflict in Ukraine was no longer undermining the euro. The dramatic deterioration in the region’s terms of trade following Russia’s initial attempt to invade in February 2022 has long since reversed as gas prices have slumped.

In addition, the ECB has slowly started to get on top of the inflation problem created by the initial surge in energy costs. It looks as if there might still be a bit more work to do here but if more ECB rate hikes occur at a time when the Fed stays on pause it could lift the euro still further. And then, of course there has been the performance of the euro itself with euro/dollar recovering from the lows of around 95 cents last September to highs of over 1.10 this spring. But if all had seemed set fair for further euro strength, events in Ukraine recently may have pulled the rug out from under the currency.

While events in Ukraine might provide a very visual sign of potential problems for the euro, we actually feel that the problems could run a little deeper. For instance, why has the euro started to fall against some other regional currencies such as the pound and the Swiss franc when adverse events in Ukraine would seem to be just as damaging, at least for pound?

The slide against the Swiss franc has been some time in the making with even the debilitating “forced” takeover of Credit Suisse by UBS in March failing to produce sustained euro strength against the franc. Hence, it seems that there might be something wrong with the euro that runs a little deeper than its vulnerability to events in Ukraine.

But what could be wrong? One theory that we have is that Germany’s very weak economic position within the euro zone, with its relatively high inflation and relatively weak growth is limit ing the euro’s ability to rise. Before EMU began the German deutschmark dominated in Europe and it was arguably the anti-inflation resolve of the Bundesbank and the might of the German economic machine that managed to drag the other currencies up.

For Germany, the effective exchange rate more than doubled from the start of floating rates in the early 1970s through to the start of the single currency in 1999. Since then, the euro’s effective exchange rate has more or less flatlined. In other words, Germany seems to have sacrificed persistent currency strength by entering EMU. This may be one reason why Germany has fallen from being one of the best inflation performers to one of the worst (at least amongst the original EMU members). This dilution may, in turn, be holding back the performance of the euro against other currencies such as the dollar.

For if the German economy were strong, and Germany was imposing anti-inflation discipline on other euro zone members, we dare say that the euro would probably be stronger than it is now. Buyers of the euro in Mr. Steve Barrow, Head of Standard Bank G10 Strateg’s opinion would prefer to own a currency that seems to be driven by its traditionally strong members, like Germany, not the traditionally weaker ones. Of course, ECB members would argue that the bank has hiked policy very aggressively and shown none of the signs of weakness that might have been displayed by national central banks before EMU when they opted for the easy way out (devaluation) rather than tighten policy in line with the Bundesbank. But Mr. Steve Barrow would take issue with this.

“If EMU did not exist, we dare say that German rates – and hence those of other nations – would probably be much higher than they are now. This might leave investors fearing that the ECB is actually not being tough enough, and if we add this to the growing risks from Ukraine again, could keep the euro down on its haunches for a little while yet”, said Mr. Steve Barrow.