in collaboration with Emil Stavrev
The exchange rate of the euro is in the headlines, as it has been steadily appreciating over the past year and a half. Views on this development among euro-area policymakers were initially quite different but have now broadly converged to one of concern. Softening global growth prospects have probably played a role, as has the ongoing financial turmoil. Against the backdrop of these various cross currents, what is the challenge posed by exchange rate developments thus far?
Both against the US dollar and in real effective terms––i.e., trade weighted against the euro area’s partner countries and adjusted for any inflation differentials––the euro has reached all time highs. Currently the euro’s real effective exchange rate stands about 10 percent above its 1993-2006 average, which is slightly above one standard deviation of its variation over that period. What is the likely effect of such movements on economic activity? Many estimates suggest that a 10 percent real effective appreciation of the euro reduces output growth by ¼-¾ percentage points (see O. Blanchard, “Macroeconomic Survey of Europe” (2004) and “Quarterly Report on the Euro Area”, Volume 6, No.: 2, EC (2007)). But, can one simply apply such estimates to gauge recent developments?
The latest appreciation of the euro is broadly comparable to developments in late 2004 and early 2005, as the euro real effective exchange rate is not significantly above the 2005 peak. Also, the latest appreciation should not have come as a surprise against the backdrop of global imbalances and the related risks that have for years been underscored by policymakers and observers. To the extent that exporters internalized these risks for the euro, the latest appreciation might not have a large effect on growth. In fact, the appreciation through early 2005 seems not to have undercut a robust recovery. So, why worry now?
Gauging the potential impact of the euro’s appreciation on economic activity requires looking beyond back-of-the-envelope estimates. What matters for the impact on growth is the nature of the shocks that are driving the exchange rate. A 10 percent real effective appreciation of the euro can have very different effects on output growth depending on what is its driving factor. This point was illustrated in an IMF paper prepared for the 2004 Article IV consultations with the euro area. Using a three-country version of the IMF’s Global Economy Model (GEM) the paper simulates the potential impact of adjustment of global current account imbalances on the euro area. In the benign scenario, which assumes an increase in productivity in the euro area and the rest of the world as well as some decline in the risk premia on non-dollar assets, the euro appreciates by some 9 percent in real effective terms. This appreciation shaves off 0.2 percentage points of the area’s real GDP growth. However, in the “challenging global rebalancing” scenario a similar appreciation comes with a 1.4 percentage point decline in real GDP growth. The reason for the much stronger decline of growth in this scenario is that the exchange rate appreciation is driven by a much stronger fall in the relative risk premium on euro assets.
So, what does all this tell us about developments today? First, the exchange rate affects economic activity with a lag. Assuming a pass-through to growth of one year, what matters today is the appreciation in the 12 months through December 2007, which has been about 5 percent in real effective terms. Second, fundamentals are important––while weakening in the face of financial turbulence and high commodity prices, they still appear stronger than in 2004: (i) growth has been fairly robust thus far, employment has been strong and unemployment low, and wages are well behaved; (ii) there are even some signs of re-accelerating productivity, although the structural component is difficult to determine; and, (iii) the external current account of the euro area has remained broadly balanced, despite soaring commodity prices, as increased demand for euro-area exports has compensated for the deterioration of commodities terms-of-trade.
Accordingly, euro-area growth in 2008 is still widely forecast to be stronger than in 2005, even if most forecasters see the risks to the downside. Similarly, fundamentals in many emerging market countries have held up well. Thus, on the whole, we still see the world not too far off a benign current account rebalancing scenario. However, the situation is fragile and the currently most pertinent risks lie mainly in financial not exchange markets, while global imbalances continue to lurk in the background. If, for example, the subprime-triggered problems turned out to be much worse than expected in the United States than in the euro area, this might lead to a sudden rise in the risk premium in US relative to euro-area assets. A flight from US dollar to euro-denominated assets could then trigger a further rapid, substantial real effective appreciation of the euro. This would probably move the world into a “challenging global rebalancing” scenario.
So, what is the bottom line? The risk that the further decline in the dollar that is needed for global rebalancing will take place against the euro if surplus countries don’t appreciate has not disappeared. Accordingly, developments in exchange rate markets bear careful scrutiny. In interpreting them it is crucial to bear the overall macroeconomic and financial picture in mind. The key issue currently is whether the shocks to risk premia continue to be overwhelmingly common—in which case the implications of the euro appreciation would be manageable—or not.