Will the euro claw back some lost ground?

The euro will claw back some lost ground

>> The UK and euro zone may stay in a low growth

The euro might be the single currency for the euro zone region, comprising some twenty countries, but it is reasonable to forecast the euro as we would for a single entity? For while the euro might be the currency that those who invest in the euro zone have to buy, they don’t generally buy a euro zone bond or stock. What they buy – or sell – is an Italian bond, or a Spanish stock. Or if they undertake foreign direct investment they might buy into German construction, or French agriculture.

In other words, the perception of the various individual countries that go to make up the euro zone is important when it comes to the determination of the euro’s value.

This is a pretty obvious point and, perhaps ordinarily, does not attract too much attention when it comes to forecasts for the euro. The last time it was important, perhaps, was during the 2010-12 euro zone debt crisis, when certain countries, such as Greece, really came under the spotlight. But just because country issues seem to be swept under the carpet these days does not imply that they are unimportant.

For instance, if we think about the pre-EMU economic landscape, it was largely one of German dominance in both an economic and policy sense. The German economy was deemed to be strong and the anti-inflation discipline of the Bundesbank was not just notorious; it set the standard by which other central banks had to act.

In short, Germany’s strong performance kept the deutschmark strong and other countries hung onto the deutschmark’s coat-tails by virtue of the fact that their currencies were locked against the German currency in the Exchange Rate Mechanism (ERM). For instance, if we look at the performance of the pound against the deutschmark we see that sterling toppled all the way from near 9.0 in the 1970s to around 2.77 when the single currency came into being at the start of 1999.

However, since EMU started the equivalent GBP/DEM rate has been very stable. In other words, the pound’s strong downtrend against the deutschmark – and other ERM member currencies – that existed up to the start of EMU has been replaced by stability. This has been particularly true since sterling settled down after the shock of the Brexit referendum outcome in June 2016.

>> A setback for the euro?

Has the end of sterling’s downtrend been due to some sort of improvement in the UK and the pound? Mr. Steve Barrow, Head of the Standard Bank G10 Strategy doesn’t think so. He said if we look at the deutschmark against the Swiss franc, we see that the deutschmark held its own against the franc during the 1980s and 1990s, and even through much of the first decade of EMU. But since the 2008 financial crisis the franc has made substantial gains against the euro. Again, is this a reflection of some sort of autonomous strength in the franc? Here too Mr. Steve Barrow is sceptical. Instead, what we think has happened is that the introduction of the euro has rather diluted the strength, not just of the deutschmark, but of other currencies as well given that they were tied to the deutschmark through the ERM. Perhaps a simpler way to put this is as follows. If EMU had not happened, would the deutschmark be stronger today than the levels implied by the current euro rate?

Mr. Steve Barrow thinks the answer is ‘yes’. But why go over all of this now, after all it is in the past and forecasts are about the future. He thinks it is relevant because if we look at the recent, and likely future performance of Germany within EMU, both in an economic sense given the economy’s relative weakness, and a political sense given the stern challenge from the far-right AfD Party, the outlook gives cause for concern when it comes to the euro.

This being said, Mr. Steve Barrow doesn’t doubt that as a cyclical economic recovery takes hold, the euro will claw back some lost ground, perhaps particularly against the US dollar. But this takes nothing away from the fact that the countries within EMU, and hence part of the euro, have experienced, and will likely continue to experience, a currency performance that is worse than the one they would have seen if EMU had not happened at all.