The dollar said goodbye to 2004 with its worst cumulative performance since the stock market crash of 1987. In contrast, the euro ended the year by achieving its historic highpoint of $1.3469 to the euro on December 7. Experts see the strength of the European currency as an opportunity to go shopping in the United States. However, it can also become a danger for companies in the Old Continent, whose exports are getting hit by the dollar’s weakness. There is already some speculation that the euro’s rally could put an end to Europe’s economic recovery.
Antonio Fatas, a specialist on the European economy at France’s INSEAD business school, discounts that possibility. “Multinational companies are prepared to absorb exchange-rate variations because they are diversified and they protect themselves financially.” However, Fatas says that “if the exchange rate stays where it is for several months or years, it will have a noticeable effect on both sides of the Atlantic.”
To some degree, the strength of the euro results from the weakness of the dollar and distrust in the U.S. currency among global investors because of the huge U.S. deficit. For the moment, that doesn’t seem likely to change. The policy outlined by President George W. Bush, who was recently reelected, threatens to lead to even higher U.S. budget deficits.
Rebounding in 2005
“The dollar has been falling against the euro and other currencies such as the yen for a combination of reasons,” says Salvador Rojí Ferrari, professor of international financial management at the Complutense University of Madrid. The dollar’s fall “is based on the perceptions of investors and international companies regarding the U.S. deficit, and the institutional support for maintaining a weak (but not overly weak) dollar as a medicine for cutting that deficit. The fiscal promises that the Bush administration made to voters don’t allow the U.S. government to pursue any other road toward reducing the deficit.”
In his view, the euro’s demonstrated strength in recent weeks reflects the fact that “investors have become exposed to an excessive decline of the greenback, and many foreign institutions that have fixed-income investments and U.S. treasury notes – especially Asian central banks – have decided lately to reduce their exposure; they are selling part of their portfolios, and that is leading to an even greater fall of the dollar that is undesirable.”
The key question for 2005 is, how long can this situation continue? “Until the central banks say, ‘Enough,’” responds Fatas. A few years ago, when the value of the euro approached 0.82 U.S. cents, the euro’s fall was stopped by intervention by central banks, recalls Fatas. “When the time comes for the European Central Bank and the U.S. Federal Reserve to say ‘enough,’ they will put a ceiling – or a floor – on the exchange rate. How close are we to that point? Not very far. In my opinion, if the dollar continues to fall, the central banks will get back into the market.” The intervention of monetary authorities does not have to be direct. “A few words can be all it takes,” Fatas warns.
Alan Greenspan, president of the Fed, has made it clear that he intends to put an end to the expansionist interest rate policy he pursued between 2001 and 2004. He lowered interest rates down to 1%. Since June, the Fed has raised rates five times, each by 0.25%. Currently, they are at 2,5%. However, if the dollar stays weak, inflationary tensions could reappear, as imports rise in price. That, in turn, would force the Fed to act quickly.
“The dollar’s devaluation has hit bottom; from now on, it will begin its gradual recovery,” says Rojí. “Especially if you consider Treasury Secretary John Snow’s statements that the U.S. administration intends to support the dollar. And if you consider possible intervention by the ECB (European Central Bank) and Japan.” Despite such optimism, some investors fear that the dollar will continue its downward slide. That would put the entire burden of readjusting the U.S. foreign deficit on the eurozone, if it decides to let its currency move upward freely.
“I don’t think it will be that way,” says Rojí. However, “it will happen partially. You have to remember that the dollar has appreciated against the Mexican peso, the currency of one of its largest trading partners. As I’ve said, people are waiting for the ECB to intervene in support of reducing the upward pressure on the euro. Ultimately, the U.S. will try, through massive sales of Chinese, Japanese and Korean currencies, to get Asian countries to stop maintaining their currencies far below their equilibrium levels. The U.S. will try to increase its level of savings in the medium term. The deficit is improving, and the U.S. hopes that it will improve more, especially because of an increase in tax revenues and spending restraints.”
“The readjustments in the U.S. foreign deficit will only occur when the U.S. economy saves more,” says Fatas. “Although the exchange rate has an impact on the savings rate, the empirical evidence is not clear. Adjustments in the fiscal deficit or in the rate of private savings are the only way to eliminate the current account deficit.”
The Impact on Companies
The euro’s strength will also have an impact on corporate earnings. On the one hand, the weakness of the greenback creates a very favorable scenario for European companies that go shopping on the other side of the Atlantic. At first glance, it also discourages U.S. companies from making their own acquisitions in Europe. “We assume that, with the euro above its equilibrium level, European companies could acquire shares in U.S. companies, and try to improve their distribution and promotion channels for their products in the U.S.,” stresses Rojí. However, he does not take a positive view of some acquisition plans announced in recent weeks. “We all know that several U.S. investment funds have tried to purchase Auna (the third-ranking Spanish telecom company) for $14 billion, despite the weakness of their currency … I don’t think this is the best time to go shopping in the European supermarket,” he adds.
The advantage of a strong euro is that it cushions Europe against the higher price of oil, and helps contain the inflationary pressures that expensive oil can create. However, the high euro also makes European exports more expensive. Exports have been the major source of income for Europe over the past year; domestic demand has been quite weak. As a result, an overly strong euro threatens the economic growth of the eurozone.
This double-edged sword is forcing the ECB, Europe’s monetary authority, to take a cautious approach to decision-making. Actually, the ECB has not raised rates since June 2003, more than a year ago, when rates were set at 2%.
Nevertheless, Gracia Bodelón, who manages the Spanish division of ACM-Advanced Currency Markets, says, ”People are no longer betting on the euro now that the December report of the European Central Bank shows concern about the oil price hike and its repercussions on eurozone growth. There are also persistent rumors about a possible lowering of interest rates in Europe which have not been silenced by the comments of BCE President Jean-Claude Trichet.
Despite warnings of the euro’s declining strength, some European investors continue to trust the currency. They see current conditions as an opportunity to make deals in dollars, and take advantage of the exchange rate. One option, for example, is to pay mortgages in dollars. However, Fatas believes these sorts of deals run a considerable risk. “Given unpredictable movements in interest rates, it is hard to imagine someone taking advantage of these changes. There is a more likely scenario: Those who try, wind up suffering considerable losses when the interest rate moves in the opposite direction. Don’t forget that the weaker the dollar is, the more likely it will rise in the future.”
Rojí agrees. “The days are numbered for the dollar to move strongly downward. In the medium and long term, the dollar will wind up rising because its imbalances reflect only current conditions. The U.S. economy is solid and paying a mortgage over 20 years in dollars means that the person who holds the mortgage has to assume any exchange-rate risk; that is, risk that the dollar will rise. We have already seen on previous occasions that the dollar goes up, sooner or later. The mortgage holder would have to pay in stronger dollars with weak euros. In other words, a mortgage should not be an instrument for speculation.”