The next major move in the currency markets is likely to be a substantial appreciation of the euro. It will probably take place over the next six to twelve months. There are four major reasons:
- the substantial underlying undervaluation of the euro;
- a focus on the euro during the next leg of the fall in the dollar that is inevitable due to America's huge and growing current account deficit;
- the beginning of a substantial portfolio shift into the euro as it asserts a major role in international finance;
- and a pickup in European growth coupled with an American slowdown.
There is a possibility that the rise of the euro could trigger, or be part of, a generalized decline in the exchange rate of the dollar. That fall in the dollar could in turn push up US inflation and interest rates, thereby drive down the stock market, and imperil the continued expansion of the American economy. A "soft landing" is more likely than a "hard landing," however, because of both the outlook in the key countries and the high probability of concerted G-7 intervention to dampen any severe impact on the world economy.
The most striking development in the currency markets in 1999 was the opposite movement of the euro and the yen against the dollar. The euro dropped by over 15 percent from its startup point at the beginning of the year and by about 25 percent from the late-1998 level of the constituent predecessor currencies; it is now almost 50 percent below the peak level reached by the predecessor currencies in early 1995. By contrast, the yen rose by 30 percent from its mid-1998 trough. (The result at one point came very close to the "parity condition" of $1= 1= ¥100, with the Japanese seriously considering a currency reform that would make it 1:1:1).
Viewed from the perspective of the dollar, the central question is: which of these moves in the other key currencies is a more likely precursor of the future? Will the dollar's substantial depreciation against the yen generalize to the euro (and other currencies)? Or will its substantial appreciation against the euro become the broader pattern? Both outcomes have numerous advocates among currency forecasters for 2000.
Over the medium to longer run, fundamental equilibrium exchange rate (FEER) considerations almost always prevail. These calculations are based on judgments concerning sustainable external and internal economic conditions in the major countries.1 The latest comprehensive application of the methodology suggested that, within ranges of 10 percent or so on either side, the equilibrium midpoints were about $1=¥90 and 1=$1.25.2 The FEER calculations suggest that the dollar is much more likely to depreciate than to appreciate. They also imply that the corresponding appreciation is likely to be greater for the euro than the yen-reflecting the substantial rise of the yen that has already occurred and the weakening of the euro during its first year.
Hence the first reason for the coming rise of the euro is its current substantial undervaluation in terms of the medium and long-term fundamentals. The European Commission has implicitly endorsed that view by referring to the "unusually high" surplus in the current account position of Europe, the largest since the middle 1980s, when it reflected the largest dollar overvaluation in history. In terms of bilateral trade with the United States, Europe's surplus in recent months has been almost as high as that of Japan and China.
The Rise of the Euro
The second reason for the projected rise of the euro is simply its reflection of the likely further decline of the dollar. The trade-weighted fall of the dollar has only been about 5 percent to date, with its 30 percent depreciation against the yen since mid-1998 (and its substantial depreciation against a number of other recovering Asian currencies) offset by its appreciation against the euro. This represents about one fifth to one quarter of the ultimate depreciation suggested by the latest FEER calculation for the dollar itself.
The main driver for this projection is of course the unsustainable trajectory of the US current account deficit. That deficit exceeded $300 billion in 1999 and hit almost 4 percent of GDP. It has increased by almost $100 billion in each of the last two years and could rise to $400 billion or more in 2000.
A careful projection of the US external deficit reveals that, under realistic assumptions about economic growth in the United States and the other key countries and with no further currency changes, it would rise to about 5 percent of GDP by 2005 and 10 percent of GDP by 2010.3 Financing of the latter deficits would require the rest of the world to channel almost one half its total additional savings into dollar assets. The rising deficits might be sustainable for another couple of years but probably not beyond.
Even a restoration of "more normal" economic growth patterns, with the United States slowing to 3 percent annually while Europe and Japan moved back up to a similar level, would at best halt the growth of the US deficit. It is therefore almost certain that a substantial dollar depreciation will be required to restore sustainability. As noted, the latest FEER calculation suggests that this fall will need to be on the order of another 15-20 percent.
Market recognition of a similarly unsustainable trajectory for the US external deficit in the middle 1980s led to a fall of 50 percent in the trade-weighted dollar over the three-year period 1985-87. The US economy is of course much stronger today than it was in the middle 1980s, and the overvaluation of the dollar is considerably less. On the other hand, the United States was still a creditor country at that time whereas its net foreign debt has now risen to $2 trillion. A substantial depreciation of the dollar is thus quite likely, and with it a substantial rise of the euro.
The third reason for the likely rise of the euro is the portfolio shift that will inevitably occur as soon as markets realize that it is on its way to being the world's second key currency (and, ultimately, perhaps a rival to the dollar for global financial leadership).4 In its first year, the euro already surpassed the dollar as a vehicle for international bond financing.
Both private investors and monetary authorities around the world have to this point, however, expressed hesitation to convert dollars (or other currencies) into euros for several reasons. One is the multiplicity of voices emanating from Europe with respect to the euro itself, raising doubts about the efficiency of the management of the new currency. Another is uncertainty over the political willingness of key governments in Europe to address the significant structural shortcomings that continue to undermine their growth. Both factors are likely to be temporary, however. In fact, they smack more of market rationalization than of compelling real reasons; the yen appreciated sharply over the past 18 months despite at least as much uncertainty over both management of monetary policy and economic reform.
The most plausible reason for the weakness of the euro during its first year, and the delay in its assertion of a growing role as an international asset, is simply the lagging pace of European economic growth in comparison with the continued robustness of the American economy-coupled with the associated firming of US interest rates and, until lately, the corresponding easing of European rates. The fourth reason for the coming rise in the euro, and perhaps the decisive element in its timing, is thus the pending pickup in European growth (and interest rates) and the inevitable slowdown in US growth (and easing of monetary conditions).
As stressed above, the long-term fundamentals-external imbalances and net international investment positions (and, in the case of the euro, its accession to key currency status)-are bearish for the dollar and bullish for the euro (and the yen). Those long-term fundamentals tend to become decisive in the exchange market, however, only when they become consistent with the short-term fundamentals of growth rates and monetary conditions. The upward turn of the euro is thus likely to coincide with a confirmed escalation of European growth and easing of American growth.
Such a manifestation of cyclical conditions is in turn likely to ensue by the second half of 2000, if not sooner. European growth should attain 3 percent or a bit better, justifying ex post the recent (and pending?) increases in European interest rates. American growth should slow to 3 percent or a bit less by the second half, reversing the recent rise in (especially long-term) US interest rates.
It is of course changes in interest rate differentials, and the associated growth rates, that drive exchange rates. The likely changes in dollar-euro differentials by the latter half of 2000, if not sooner, should trigger the appreciation of the euro that is strongly suggested by the underlying fundamentals. Hence a rise in the euro is likely to be the next major move in the foreign exchange markets.
Soft or Hard Landing?
The most important question, from the perspective of the world economy, is whether these currency changes will occur in an orderly or destabilizing manner. Will they produce a "hard landing," snuffing out the US expansion and jeopardizing global prosperity, or a "soft landing" that can be readily accommodated?
My forecast is for a "soft landing." As noted, a substantial (if minority) portion of the inevitable dollar correction has already occurred with its sharp depreciation against the yen over the past 18 months. This exchange rate decline has been accompanied by some rise in US interest rates, always a worrying juxtaposition, but the increase in interest rates can be explained primarily by the continued robust growth of US domestic demand and inflation has continued benign despite the fall of the dollar. Hence this first leg of the dollar's depreciation has occurred without serious damage to the American (or Japanese) economy.
The next leg of the dollar's fall, via the predicted rise in the euro, should transpire in a similarly orderly manner. The US economy is likely to continue growing, albeit at a somewhat lower pace, and Europe's pickup is unlikely to be dramatic. Hence there will be little motivation for a wholesale shift from dollar into euro assets. Any further appreciation of the yen against the dollar is also likely to be gradual. The continuing correction among G-3 currencies will thus probably remain orderly.
If the euro were to start rising precipitously, or if the dollar were to start falling precipitously across-the-board, concerted G-7 intervention to slow the pace would be virtually certain. The United States, especially with an election looming, would strongly resist any sharp dollar decline with its potential triple hit (higher inflation, higher interest rates, lower stock market) to the US economy. Europe and Japan would similarly resist sharp appreciation of their currencies, in light of the early stages of their recoveries and continuing high unemployment. This would be one of those rare instances where the national interests of the G-3 coincided almost perfectly, suggesting a high probability of concerted response.
There are of course some risks to this relatively benign outlook. The predicted portfolio shift into euros could become a tide, pushing the new currency well above its FEER as calculated above. The G-7 might wait too long to mount an intervention response, as they did to reverse the yen's excessive rise in 1995 and its excessive fall in 1998, or they might be overwhelmed by the market even with a major effort.
The most likely outcome, however, is threefold. The euro is likely to rise substantially. The yen may experience a modest further increase. These shifts will probably occur without severe damage or dislocation to either the countries involved or the world economy. Hence the global currency picture for 2000 is likely to be both active and relatively orderly, permitting needed adjustments in the world economy without generating much damage to prosperity or stability in the process.
1. The concept of FEERs was invented by John Williamson in The Exchange Rate System, Institute for International Economics, Washington, DC, September 1983, and elaborated most recently by Williamson in Estimating Equilibrium Exchange Rates, Institute for International Economics, Washington, DC, September 1994.
2. Simon Wren-Lewis and Rebecca L. Driver, Real Exchange Rates for the Year 2000, Institute for International Economics, Washington, DC, May 1998. The recent yen-dollar range of 100-105:1, representing the weaker end of the band suggested by the FEER calculations, has been fully appropriate in light of the relatively weak performance of the Japanese economy and the continued strength of the United States.