Is the Euro dying?
11/10/22 21:05![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
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talkpoliticsAnalysts describe 2022 as "the worst year in the history of the euro". However, the European currency has been in decline for the past two decades. Its share in the global official reserves reached 20.6% at the end of 2021, down from around 25% in 2003.
The euro has lost 16% of its value against the dollar in the past year and is trading at its lowest level since December 2002. The EU currency is currently 20% cheaper than its average since 1999.
The European Monetary Union is bound to get under even more pressure if the inflationary crisis leads to a prolonged economic recession. During periods of rising inflation and shrinking household incomes, widening political divisions between member states could also contribute to the rise of populism and threaten the political stability of the EU and the eurozone as a whole.
To prevent the euro from collapsing, the body responsible for controlling inflation, the European Central Bank, is supposed to bring inflation expectations back under control, which requires a decisive increase in interest rates. This is a bitter but necessary pill to swallow in order to avoid further negative consequences for the euro.
One of the key drivers of the euro's depreciation against the dollar in 2022 is the widening of the interest rate differential between the Federal Reserve and the ECB. The US Federal Reserve began raising interest rates in March. However, the ECB was slower to act, not announcing its first interest rate hike until as late as July 2022.
However, the euro's fall against the dollar is not solely due to widening interest rate differentials. The conflict between Russia and Ukraine has a significant negative impact on the euro area, weighing on the balance of payments and the confidence of households, businesses and foreign investors. Eurozone consumer confidence is now at an all-time low. The ZEW economic sentiment indicator is at its lowest level since the sovereign debt crisis of 2011. The trade deficit is at an all-time high. Business confidence (PMI) for both services and manufacturing activity is declining.
Rising natural gas prices in Europe have been another major factor that has pushed the euro below parity against the dollar over the summer. Specifically, the wholesale gas benchmark (Dutch TTF spot price) is currently 8 times higher than US domestic natural gas prices, putting European companies and consumers at a competitive disadvantage relative to their US counterparts.
Eurozone record high inflation and a gloomy outlook for the economy may still weigh on the euro's performance in the coming months. Growing pessimism has already led to a significant depreciation of the EU currency, and it is difficult to identify possible catalysts that could reverse the euro's course. Although the ECB has started with delay in its rate hike cycle, it is not entirely clear that it can catch up and outpace the Fed. This means the euro may continue to be cheaper than the dollar for a while.
The possibility of further devaluation is real - in a scenario where the euro falls well below parity if the energy and inflation problems continue into the winter.
According to a recent study by the IMF, the German economy, the engine of the Eurozone, could experience a decline in gross domestic product of approximately 1.5% in 2022, 2.7% in 2023 and 0.4% in 2024. This could have a domino effect on other eurozone members, which are inextricably linked to Germany's economy.
With the announcement of the Transmission Protection Instrument mechanism (TPI) in July, the ECB has temporarily contained the risks of a new sovereign debt crisis in the euro area. However, rising government deficits as a result of the gas crisis, along with the outcome of Italy's parliamentary elections, are risks that could bring the risk differences between government bonds back into focus in the coming months.
If we look at the euro's REER (real effective exchange rate) - a measure of the single currency's value against a basket of foreign currencies after adjusting for inflation - it is already roughly 7% below its long-term average.
Historically, the euro has experienced two significant periods of real devaluation. The first occurred between November 2009 and July 2012 as a result of the Great Recession and the Eurozone debt crisis. The real effective exchange rate of the euro fell by approximately 17% back then.
The second occurred between March 2014 and April 2015. Then the European Central Bank announced a massive quantitative easing program while the Federal Reserve pursued a more restrictive monetary policy. As a result, the REER of the euro fell by about 14%.
Given that we are already are in a period of high inflation, further depreciation of the euro now could lead to an inflationary spiral with severe economic consequences.
After the 2008 financial crisis, the ECB had ample opportunity to cut interest rates as the Eurozone was in a deflationary period. Now the current recession may be different, as it is likely to be marked by persistently high inflation due to the gas crisis, preventing the ECB from using monetary stimulus to revive the economy.
Further depreciation of the euro cannot be easily avoided given the macroeconomic outlook, but the ECB has the tools at its disposal to cushion the fall. To do so, the ECB must implement larger and faster interest rate increases. The risks of escalating market inflation expectations and the failure of the euro to find a bottom could have more damaging effects than a recession.
With less monetary instruments available, the future economic recovery will have to go through a new phase of reforms and productivity growth, led by the Recovery Fund's ambitious commitment to promote the green transition and digitisation of the EU economy. Even if these plans succeed, the eurozone has a long and winding road ahead.
The euro has lost 16% of its value against the dollar in the past year and is trading at its lowest level since December 2002. The EU currency is currently 20% cheaper than its average since 1999.
The European Monetary Union is bound to get under even more pressure if the inflationary crisis leads to a prolonged economic recession. During periods of rising inflation and shrinking household incomes, widening political divisions between member states could also contribute to the rise of populism and threaten the political stability of the EU and the eurozone as a whole.
To prevent the euro from collapsing, the body responsible for controlling inflation, the European Central Bank, is supposed to bring inflation expectations back under control, which requires a decisive increase in interest rates. This is a bitter but necessary pill to swallow in order to avoid further negative consequences for the euro.
One of the key drivers of the euro's depreciation against the dollar in 2022 is the widening of the interest rate differential between the Federal Reserve and the ECB. The US Federal Reserve began raising interest rates in March. However, the ECB was slower to act, not announcing its first interest rate hike until as late as July 2022.
However, the euro's fall against the dollar is not solely due to widening interest rate differentials. The conflict between Russia and Ukraine has a significant negative impact on the euro area, weighing on the balance of payments and the confidence of households, businesses and foreign investors. Eurozone consumer confidence is now at an all-time low. The ZEW economic sentiment indicator is at its lowest level since the sovereign debt crisis of 2011. The trade deficit is at an all-time high. Business confidence (PMI) for both services and manufacturing activity is declining.
Rising natural gas prices in Europe have been another major factor that has pushed the euro below parity against the dollar over the summer. Specifically, the wholesale gas benchmark (Dutch TTF spot price) is currently 8 times higher than US domestic natural gas prices, putting European companies and consumers at a competitive disadvantage relative to their US counterparts.
Eurozone record high inflation and a gloomy outlook for the economy may still weigh on the euro's performance in the coming months. Growing pessimism has already led to a significant depreciation of the EU currency, and it is difficult to identify possible catalysts that could reverse the euro's course. Although the ECB has started with delay in its rate hike cycle, it is not entirely clear that it can catch up and outpace the Fed. This means the euro may continue to be cheaper than the dollar for a while.
The possibility of further devaluation is real - in a scenario where the euro falls well below parity if the energy and inflation problems continue into the winter.
According to a recent study by the IMF, the German economy, the engine of the Eurozone, could experience a decline in gross domestic product of approximately 1.5% in 2022, 2.7% in 2023 and 0.4% in 2024. This could have a domino effect on other eurozone members, which are inextricably linked to Germany's economy.
With the announcement of the Transmission Protection Instrument mechanism (TPI) in July, the ECB has temporarily contained the risks of a new sovereign debt crisis in the euro area. However, rising government deficits as a result of the gas crisis, along with the outcome of Italy's parliamentary elections, are risks that could bring the risk differences between government bonds back into focus in the coming months.
If we look at the euro's REER (real effective exchange rate) - a measure of the single currency's value against a basket of foreign currencies after adjusting for inflation - it is already roughly 7% below its long-term average.
Historically, the euro has experienced two significant periods of real devaluation. The first occurred between November 2009 and July 2012 as a result of the Great Recession and the Eurozone debt crisis. The real effective exchange rate of the euro fell by approximately 17% back then.
The second occurred between March 2014 and April 2015. Then the European Central Bank announced a massive quantitative easing program while the Federal Reserve pursued a more restrictive monetary policy. As a result, the REER of the euro fell by about 14%.
Given that we are already are in a period of high inflation, further depreciation of the euro now could lead to an inflationary spiral with severe economic consequences.
After the 2008 financial crisis, the ECB had ample opportunity to cut interest rates as the Eurozone was in a deflationary period. Now the current recession may be different, as it is likely to be marked by persistently high inflation due to the gas crisis, preventing the ECB from using monetary stimulus to revive the economy.
Further depreciation of the euro cannot be easily avoided given the macroeconomic outlook, but the ECB has the tools at its disposal to cushion the fall. To do so, the ECB must implement larger and faster interest rate increases. The risks of escalating market inflation expectations and the failure of the euro to find a bottom could have more damaging effects than a recession.
With less monetary instruments available, the future economic recovery will have to go through a new phase of reforms and productivity growth, led by the Recovery Fund's ambitious commitment to promote the green transition and digitisation of the EU economy. Even if these plans succeed, the eurozone has a long and winding road ahead.
