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Angry protesters surrounded the European Central Bank’s new headquarters in Frankfurt last week, saying its response to the financial crisis had only brought poverty and high unemployment. Some even torched cars. Calling themselves the “Blockupy” movement, they echoed the message of the Occupy Wall Street demonstrations in 2011, when the US economy was just emerging from the 2008-09 global financial crisis.
If that parallel holds, the unrest outside the ECB may be coming just as the region’s economy is finally showing signs of turning the corner. Even as smoke rose over Germany’s financial capital, the eurozone was enjoying the strongest glimmers of economic hope since the credit crunch.
Central to that revival is the euro’s dramatic dive against the dollar. Since the ECB started preparing a “quantitative easing” programme — involving €60bn a month of purchases of public and private debt — the euro has seen its biggest year-on-year declines against the greenback since its launch in 1999. Investors are betting that the weaker euro will boost exports, reviving the eurozone’s fortunes.
Eurozone stocks have risen 18 per cent this year, far outpacing the near 3 per cent rise in the US S&P 500 index. The “pop” in European equities appears to follow a pattern set in American stock markets after the US Federal Reserve embarked on its QE programmes. The prospect of a recovery taking hold in Europe would be welcome news to US policy makers, who have been urging the ECB to take more aggressive action for years. But the sharp decline in the euro’s value — and the resulting strength of the dollar — also poses a challenge to the US just as its own recovery appears to be picking up steam.
Janet Yellen, Fed chairwoman, warned last week of a “notable drag” on net exports this year due to the strengthening dollar. She also highlighted downward pressure on prices for imported goods, which could mean a longer-lasting spell of low inflation — not what the Fed wants as it is mulling its first interest rate rise in almost a decade.
For American multinationals, the stronger dollar is expected to hammer profits over the next two quarters.
“We are already seeing a fair amount of pushback from a lot of companies,” said Fred Bergsten, senior fellow and director emeritus at the Peterson Institute for International Economics.
The effects of the stronger dollar may be offset by further improvement in the US economy, which is being helped by steadily falling unemployment and lower energy costs. Ms Yellen’s warnings last week reversed some of the most recent falls in the euro, which notched up its biggest weekly rise against the dollar in more than three years.
But if the dollar resumes its surge, it could cause political and economic problems. Another 20 per cent rise in the dollar would drive up the current account deficit by another $500-$600bn, Mr Bergsten estimates, prompting a bigger backlash in Congress and the corporate sector. (Congress has already drafted bills to punish governments it found guilty of currency manipulation.)
With a number of major trade liberalisation measures on the table, the gains come at a sensitive time. “Historically an overvalued dollar and a big rise in the trade deficit have been the leading predictor of US trade protectionism,” said Mr Bergsten.
Globally, the boost to economies from widespread “competitive easing” by central banks “needs to be balanced with the risk that such large currency swings get out of control, creating so much volatility that it impacts on world trade,” says Gilles Moec, European economist at Bank of America Merrill Lynch. Deutsche Bank’s index of expected currency volatility has hit highs this year not seen since the eurozone debt crisis — although it remains well below levels seen in 2008-09.
The currency moves highlight the pitfalls central banks will face when they seek to unwind the policies deployed to fight the financial crisis. The euro-dollar relationship is a crucial axis in global finance; big moves in the two currencies ripple around the world, including across fast-growing emerging market economies.
“Our clients in America with big operations in Europe are very much focused on this,” says Erik Nielsen, chief economist at UniCredit, the Milan-based bank. “Significant exchange rate moves and volatility are not good for the economy.”
With the Fed expected to be the first of the world’s main central banks to raise interest rates, its struggles could be a harbinger of the problems others — including the ECB — will have in winding down their easy-money policies. “There are people 30 years old in markets who have never known a Fed rate increase,” says Michael Kushma, chief investment officer for global fixed income at Morgan Stanley Investment Management. “Nobody has a lot of conviction about how it is all going to play out.”
Since May last year, the euro has fallen almost 25 per cent against the dollar. To the surprise of ECB officials, its decline accelerated when the first bond purchases under eurozone QE started on March 9. On a trade-weighted basis, the euro has fallen 13 per cent over the past year — while the dollar has risen 22 per cent on a comparable basis.
A weaker euro is exactly what Mario Draghi, ECB president, had in mind. When campaigning last year to persuade his colleagues on the ECB’s governing council to back his plan for QE, he said a cheaper euro was one of the most important ways more aggressive monetary easing could boost the region’s recovery.
More recently, he has cited the currency’s depreciation as one of three reasons — the others are cheaper oil and QE — why the eurozone’s recovery would begin to broaden and strengthen. The hope is that a weaker currency will provide a much-needed boost to the region’s exporters by making their goods and services cheaper to customers outside the currency area.
“The ECB will welcome the fall in the euro as one of the transmission channels of QE,” says Nick Matthews, economist at Nomura. “A weaker euro has already partly explained some of the upwards revisions to growth and inflation in the central bank’s latest forecasts.”
This view hinges, in part, on whether the recovery in the US, in particular, will prove sustainable. If it stalls, the euro area’s reliance on exports could quickly prove its undoing. Germany in particular has long attracted criticism from US officials because of its massive trade surplus, and its reluctance to pursue policies to stimulate domestic growth. Jack Lew, the US Treasury secretary, has been warning that the US economy cannot go it alone.
On Friday, he reiterated the long-running mantra of American officials in saying that the strong dollar was “good for America”. But he reinforced the US’s longstanding calls for other countries to do more to stimulate their economies, saying that if Europe’s growth improves “you’ll see some movement in relative currency values, because our economy won’t be so much stronger on a relative basis”.
Even if US companies are being hit by a strong dollar, Washington policy makers can hardly complain about the boldness of the actions Mr Draghi has taken — though they may argue it should have happened earlier. Senior US officials have consistently viewed the economic crisis in Europe as one of the key risks to America’s recovery. “Europe needed overwhelming force but didn’t seem willing to apply it,” Tim Geithner, the former US Treasury secretary, wrote in his memoir. In June 2012, as the eurozone debt crisis threatened to spin out of control, Mr Geithner wrote to Mr Draghi, saying the world was looking to him to use “a dose of smart, creative, central bank force”.
With QE finally in effect, the hope is that Europe will begin to see economic growth — and any impact of euro weakness on US companies could be countered by increasing demand for its products. “It could well be that this is a smooth adjustment — and that what we are seeing is simply the depreciation of a euro currency which was overvalued,” says Mr Nielsen at UniCredit.
After Friday’s euro rebound, some currency strategists argued the dollar run may soon draw to a close — assuming there are no great global economic upsets. “If the only thing you have is the transatlantic interest rate divergence — the Fed trying to normalise policy and the ECB doing QE — well, we knew that,” says Daragh Maher, currency strategist at HSBC. “For the dollar’s rally to become destructive would need something else — such as an emerging market crisis or a eurozone break-up threat.”
Even if the dollar is provoking howls from exporters, that segment only drives 13 per cent of the US economy, a far lower share than in countries such as Germany where it is above 40 per cent. Private spending is a far more important driver, as is the resurgent labour market, which has seen jobs gains of more than 200,000 a month for more than a year.
Ms Yellen and Stanley Fischer, her vice-chair, have both emphasised that the dollar’s surge is partly a reflection of the US economy’s momentum. And while the dollar’s strength is being driven in part by an ongoing round of monetary easing by foreign central banks, the Fed has recently sounded a positive note about these moves. Minutes to its January meeting said the actions of overseas central banks had “likely strengthened the outlook abroad”.
As eurozone growth improves, the euro should resume its rise with investors piling back into eurozone assets, including equities. That verdict may well prove too sanguine, however. A weaker euro does not guarantee eurozone QE will work. A serious risk is that the boost to the economy proves shortlived and simply distracts governments from structural reforms. There remains, too, the threat of Greece being ejected from the eurozone, creating turmoil across the continent — and global markets.
For now, there are signs that QE may have averted a prolonged period of dangerously low inflation and weak growth, just as policy makers on both sides of the Atlantic had hoped. Even if the euro’s decline clouds the US economic outlook and provokes discontent in Congress, this may be a lesser evil than a eurozone that is mired in deflation.
Emerging markets: No declaration of currency wars — yet
As the dollar has risen, the currencies of big emerging markets have fallen, writes Jonathan Wheatley. The Brazilian real has lost more than a fifth of its dollar value in two months. The Turkish lira, Russian rouble and South African rand have not fared much better. How much will this hurt?
In some quarters, not much. It was Brazil, after all, that coined the term “currency war” in 2010, in objection to what it saw as a competitive devaluation of the US dollar that was hurting Brazil’s exporters. Now, those exporters are cheering. A study for Valor Econômico, a business daily, shows exporters’ profits rising by 11 per cent in the first half of 2015 with the real at R$3.20 to the dollar — it broke through R$3.30 last week — even though global prices of their exports will be 18 per cent lower.
As exports become cheaper, imported goods and any locally-made products with imported inputs become more expensive. Yet, with falling oil and other commodity prices, those imports are much cheaper, even when paid for in a weaker currency. For commodity exporters such as Brazil and South Africa, domestic growth is so weak that companies will find it hard to pass on rising import costs to consumers.
The “original sin” of borrowing money in dollars that must be repaid in a potentially devalued currency was one cause of the crises that swept emerging markets in the 1990s. Many sovereign borrowers have since cleaned up their balance sheets. But over the past decade, in an environment of cheap money supplied by the commodities boom and quantitative easing, many EM corporates have borrowed heavily. Some of them face serious trouble.
“It’s definitely an issue they will have to deal with,” says Simon Quijano-Evans of Commerzbank. But for economies like Brazil’s, struggling with recession and unemployment, a collapsing currency may be the least of policy makers’ worries.