On October 21, the value of the euro rose above the psychological barrier of US$1.50. The last time the European Union currency reached that level against the dollar was on August 11, 2008, when it peaked at US$1.5083. The U.S. currency is experiencing some painful moments because of a decline in its value.
According to Bloomberg and other sources, the euro has appreciated by 6.19% relative to the dollar this year, and by 18.38% from its low point for the year in February. But that’s not the end of the story: The U.S. Dollar Index, which measures the progress of the currency against the six main trading partners of the U.S., has also reached its lowest level in 14 months, having fallen by about 7% this year.
"To put it mildly, the outlook for the dollar is very confusing," notes Mauro F. Guillén, director of Wharton’s Joseph H. Lauder Institute of Management and International Studies. "We have certain long-term structural forces that are likely to undermine the dollar," he says. "At the same time, the dollar is still the leading reserve currency and serves as a safe haven for investors when there is too much economic uncertainty. So it’s important to keep one eye on short-term movements, but keep the other eye on long-term trends affecting the dollar."
These days, there is a lot of uncertainty about which direction the value of the dollar will be moving in coming months. Generally speaking, analysts agree that its depreciation will continue. In a recent report, Goldman Sachs analysts forecast that the euro will reach US$1.55 within three to six months. “It now seems as if the collapse of the dollar will be slightly deeper,” wrote Thomas Stolper (based in London), Mark Tan (in New York) and Fiona Lake (in Hong Kong), in the October 18 report. “The underlying long-term view is that the dollar is undervalued and will recover to some extent,” they added.
“The dollar will continue to fall in coming months,” predicts Rafael Pampillón, professor of economic environment and country analysis at the IE Business School in Madrid. “The cause of the decline is the doubt that exists at this time about whether the United States will recover before the euro zone, where countries such as Germany and France are showing significant signs of recovery.” At the same time, he notes that the divergence in interest rates is another factor behind the depreciation of the dollar. At this time, the U.S. Federal Reserve Board is keeping the price of money at 0.25%, while the European Central Bank (ECB) has kept it at 1%. “In the United States, rates will continue to be lower for a while because fear of inflation is less [there] than in Europe, where the ECB has an explicit mandate to maintain the increase in consumer prices at below 2%, and [the ECB] is more prepared to raise rates whenever there is an inflationary threat,” says Pampillón.
Federico Steinberg, chief researcher on economics and international trade at the Real Instituto Elcano, and a professor at the Autonomous University of Madrid, notes that after the “panic in the markets that followed the bankruptcy of Lehman Brothers, there was a flight toward safety, which produced a sharp appreciation of the dollar, despite the fact that the crisis had [originally] exploded in the United States.” Nevertheless, he adds, “once normalcy begins to return to financial markets, the pre-crisis tendency returns — in which the foreign deficit and the accumulation of the U.S. debt, added to the rigidity of Chinese interest rates, mean that the weight of the adjustment of global imbalances [will lead] to an appreciation of the euro.”
The End of the Dollar’s Hegemony
According to Steinberg, “The depreciation of the dollar, along with the appreciation of gold and declarations by China about the need to substitute for the greenback as the global reserve currency have once again opened the debate about the prospects for the euro to be able to replace the dollar as the world’s leading currency.” He cites a recent essay in Foreign Affairs magazine in which Fred Bergsten, one of the leading specialists in the geopolitics of currencies, asserted that the United States should realize that maintaining the dollar as the only reserve currency no longer addresses its national interests because that policy makes it harder to maintain the internal discipline that the U.S. economy needs in order to reduce its enormous deficit.
Some analysts, such as Jane Foley of Forex.com, say that at this time, the market finds itself facing “a plot against the dollar as the predominant global reserve currency.” On October 6, The Independent, a British daily newspaper, reported that the Middle Eastern Gulf countries, as well as China, Russia, Japan and France were studying the possibility of replacing the dollar as the currency for petroleum trading with a basket of currencies that would include the yen, the yuan, the euro, gold and a future common currency of the Gulf. When this report was published – it was denied by Kuwait and Qatar – it coincided with a call by the U.N. in favor of a new global reserve currency that would do away with “the privilege of maintaining external deficits” that the U.S. currently derives from the supremacy of the dollar.
This sort of plan, which some critics are calling a “plot,” has been brewing for a while. Last March, China had already called for replacing the dollar with a new currency that would be used in the transactions of the International Monetary Fund. Its value would be determined by the values of the dollar, the euro, the yen and the pound sterling. “The outbreak of the crisis and its spread throughout the world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system,” wrote Zhou Xiaochuan, governor of the People’s Bank of China, in a statement released on March 23.
Pampillón notes that “in international trade, the dollar is an unbeatable currency despite the depreciation that it is suffering at this time.” He believes that it would be “difficult” to change its hegemony. Nevertheless, he predicts that the trend will be for the dollar to continue to lose global leadership, and for the euro to gain ground in that respect. He adds that it would take some time for the euro to definitively grab the top spot from the greenback. Markets will need to be convinced that the euro is a secure currency, and one that they can trust. He cites some studies that forecast that the euro will become the global currency “par excellence” in 2015.
“The most likely thing is for the euro to gradually appreciate, and to gain market share in international reserves and transactions but not manage to challenge the hegemony of the dollar,” predicts Steinberg. “Despite the fact that, ever since its creation, the euro has managed to have a greater international importance than the sum of its previous national currencies, the dollar continues to clearly dominate international asset markets.” At the end of 2008, Steinberg notes, 45% of all debt issued was denominated in dollars, and only 32% was in euros, although the euro had increased its share by 12 percentage points since it was created, and the dollar had lost five percentage points. Meanwhile, when it comes to the reserves of central banks, the dollar’s domination is even greater: 64% of their total value compared with 27% for the euro, despite the fact that the euro has gained almost 10 percentage points since it was created.
“It is likely that the euro will get stronger and stronger as a currency, and will have regional hegemony, yet not be the sole global currency,” Steinberg says. “Looking ahead two or three decades, the most probable thing is that there will be three reserve currencies that coexist: the dollar, the euro and the yuan, with none of those clearly dominating the others.”
Latin America is one of the regions of the world in which the dollar carries the greatest weight. That’s because the countries of the region are obliged to make their moves with the hypothesis that the U.S. currency is the global reserve currency. “I believe that [Latin American countries] could take the road pioneered by China and Brazil, and stop using the dollar in their commercial exchanges; [that would involve] signing a direct agreement [linking Latin American countries] with other countries,” notes Pampillón. Zhou of the People’s Bank of China and Henrique Meirelles, president of the Brazilian central bank, reached an agreement in principle at the annual meeting of the Bank for International Settlements in Basel at the end of June to trade between themselves in their respective currencies, and cast aside the U.S. dollar. Nevertheless, Pampillón stresses the “importance that trade with the U.S. has for Latin American countries.” The U.S. is the leading market for Latin American exporters and importers.
The Problems of a Strong Euro
Seeing the euro as an alternative to the hegemony of the dollar needs to be done in the context of an international crisis, however. “European authorities have not made any declaration that indicates that they would like to strengthen the international use of the euro because for the European mentality, traditionally removed from arguments about geopolitical hegemony, the costs associated with a short-term appreciation of the euro clearly exceed the possible, but uncertain, future benefits,” notes Steinberg.
The countries of the euro zone, along with the European Central Bank, have declared that they are worried about the strength of the euro because it damages exports from the European community and puts their recovery at risk. The progress of euro exchange rates “is a problem that does worry us,”, admitted Jean-Claude Juncker, Luxembourg’s prime minister and current president of the Eurogroup, which brings together euro zone economics ministers, at a press conference on October 20. However, so far, the clearest comment about the situation has come from Ivan Sramko, a member of the ECB governing council and governor of the National Bank of Slovakia. “The dollar is weak at this time; the trend is clear and obvious. The strength of the euro can begin to cause problems for the region,” he said at a press conference on October 23. “We need to coordinate activity with respect to exchange rates,” he warned.
According to Pampillón, “The strong euro is going to damage exports to the region but some countries, such as Germany, will suffer less because of the high-added-value of the technology in their products, while other countries like Spain will be less affected.” Along the same lines, Steinberg believes, “a strong euro helps to contain inflation and make the price of petroleum cheaper — but in a situation like the one we have now, with deflationary pressures and weak demand, a strong currency could undermine the incipient recovery of the euro zone.”
A similar situation could happen in Latin America as a result of the weakness of the dollar — bringing advantages to the economies of that region but also serious disadvantages. “Latin American exports to the United States can lose competitiveness because Latin currencies are appreciating with respect to the greenback, which can also mean that the dollar remittances that come from [Latin American] immigrants [to the U.S.] are worth less in the local [Latin American] currency [when they are repatriated to Latin American countries],” says Pampillón. On the other hand, he notes, the value of those countries’ debt, the great majority of which is in dollars, “will decline in terms of their local currencies, and they will pay less interest [on their debt] because interest rates are so low in the U.S.”
In any case, both the euro zone and Latin American nations will have to get used to living with a weak dollar, according to Guillén. The most probable scenario in coming years, he says, is for a continued depreciation of the dollar, and for international currency markets to adjust gradually so that the United States can reduce its massive debt.