Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Friday, 3 May 2013

Euro's Extraordinary Resilience

Many a bear has perished shorting the Euro but the currency still stands. Various reasons for the Euro’s strength have been expounded but believed only half-heartedly. Ignoring short-term price fluctuations caused by sentiment driven flows (Euro is doomed! No Draghi has saved it!), a longer term picture suggests that it is in a downtrend (Graph 1). Although it may be like a slowly sinking ship but most traders are too impatient. Reporting periods are too short and investors too unforgiving for them to weather the volatility and stick around until the end.

Graph 1
Source: Oanda.com

Short-term ups and downs are mainly sentiment driven responses to policy actions. Extreme blundering has led to sharp falls which have usually reversed by anodyne statements and empty deeds. But the reason that the Euro has remained resilient even in the face of so much negativity is because the Eurozone’s balance of payments situation has been supportive. Starting with the onset of the sovereign debt crisis in 2010, the balance of payments (current account + capital account excluding central bank reserves) has seen an increasing surplus (Graph 2). This has offered natural resistance against short-selling.

Graph 2
Source: Eurostat

Since the current account, being much larger than the capital account, is responsible for most of the Balance of Payments deficit/surplus, therefore an increasing surplus should be cause to cheer. After all, it seems to indicate that the Eurozone is becoming more competitive. However as Graph-3 shows, the surplus is mainly due to a stagnation and decline in imports. Export growth is moribund and below trend which would not have been the case had a rapid improvement in competitiveness occurred.

Graph 3
Source: Eurostat

Austerity and the straitjacket of the single currency seem to be killing off demand. This is quite apparent looking at trade in consumer goods. While exports of consumer goods have regained the trend growth path, imports from outside the Eurozone have been stagnant since middle of 2010 (Graph-4). Moreover intra-Eurozone trade in consumer goods is also stagnating which means that there is little import substitution (Graph-5).

Graph 4
Source: Eurostat

Graph 5
Source: Eurostat

Therefore the current account surplus is due to demand destruction rather than competitiveness gains. Merely looking at the headline may seem to indicate that the policy of austerity and internal devaluation is working to generate export-led growth but the reality is different. Paradoxically, by contributing to Euro strength, it only increases the pressure for further internal devaluation.

The current backlash against austerity is quite understandable since it is an untenable situation where living standards are stagnant and unemployment rife. Unless a weak Euro policy is pursued, the currency will continue to confound sceptics despite growing tensions within the Union. But resilience always has a limit.

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