A strong euro: No policy hurdle yet

Over the past month or so, hardly a day has gone by without the euro hitting yet another record high against the dollar. This has raised concerns about the economic implications on the eurozone, with some leaders demanding more political input into euro exchange rate policy.

However, the European Central Bank (ECB) has not yet indicated that it is about to alter the way it sets policy. While acknowledging that an abrupt movement could become problematic, the ECB maintains that eurozone exporters have not suffered from the gradual appreciation and that at a time of increasing oil prices, the stronger euro was a good thing for most enterprises and consumers.

Some are suggesting that, for either political or economic reasons, ongoing appreciation will limit the need for further interest rate increases from the ECB. Yet there is no reason to change the expectation for two further interest rate increases by the end of this year. There are at least three important reasons why this seems to be the case.

First, movement against the dollar and the yen have been grabbing the headlines but the move in the trade-weighted exchange rate has been much less dramatic. Consequently, despite the nearly 13 per cent rise against the yen and the 9 per cent rise against the dollar over the last year, the ECB's daily effective exchange rate is only up 3.2 per cent.

Most importantly, some of the currencies against which the euro has depreciated are also among its largest - and most rapidly growing - export destinations, notably the UK, Poland and Scandinavia. More of the eurozone's exports go to Europe than to the US and Japan.

The second point is that external demand is more important than the exchange rate in driving export growth. A general rule of thumb, based on European Commission analysis, is that a 1 per cent rise in the trade-weighted euro curbs export growth by 0.2 per cent points, whereas a 1 per cent rise in external demand boosts export growth by 0.6 per cent points. The tumbling euro throughout 1999 and 2000 did not prevent a slide in export growth during the collapse in global demand in 2001. It is clear that demand is the major driver of export growth.

The other interesting feature of the Commission analysis is that the negative effect from the exchange rate actually comes through quite quickly, lowering exports by 0.2 per cent in the first year and a cumulative 0.25 per cent over the first two years, with no significant effect thereafter.

There certainly does not seem to have been much of an impact so far this year. Eurozone export growth has been weaker than in 2006, as has world trade growth, but exports still rose 9.5 per cent in the first four months of this year. There is also little sign of EMU losing market share. Exports to Central and Eastern Europe and parts of Western Europe have been particularly robust. Russia, Poland and Czech Republic were among the top five contributors to export growth while the US (the most important contributor to eurozone export growth in 2006) made a negative contribution.

Anecdotal comments suggest that the exchange rate is not currently viewed as a major constraint, interestingly enough even in the UK, where sterling has seen more appreciation than the euro.

A third point to consider in assessing the impact of the euro on future ECB interest rate decisions is that although a currency appreciation amounts to a tightening of monetary conditions, other factors may be having offsetting influences.

This is one limitation of the European Commission's monetary conditions index. It does not incorporate other determinants of financing conditions which have been more favourable: Long rates are falling and the latest edition of the ECB's bank lending survey showed that lending standards for both corporate and household loans were still being loosened.

In addition, for many companies the impact of ECB rate increases in the past two years has been at least partly offset by a lowering of spreads. Clearly, credit market developments over the past weeks are likely to result in at least a partial reversal of this, increasing the likelihood that there will be some moderation in corporate credit growth later this year. However, based on the latest monetary data the ECB is unlikely to be diverted from its current tightening path any time soon.

So what does this mean for rates? The expectation is for eurozone inflation to move easily above target as the base effects from energy become less favourable and the overall effect of rising energy prices is not offset by falling prices of other foods and services. Corporate credit growth, though likely to have slowed a little, is also expected to be in double-digits.

As long as euro appreciation is fairly gradual and largely confined to dollar, yen and Swiss francs (which together account for about 22 per cent of eurozone exports), the ECB is likely to remain relatively relaxed, especially given the favourable impact of a strong euro on the ever-rising oil price.

At some point, however, continued appreciation or a very sharp move will inevitably start to elicit more vocal concerns from ECB members in the coming months, particularly if there is a major move up against sterling and other key trading partners. This would inevitably start to make further rate moves a little more data dependent.

However, this will more likely prevent the ECB from continuing to tighten above 4.5 per cent in 2008, rather than preventing the next 50 basis points of rate increases expected later this year.

This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.


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