Beware a weak dollar!
by Simon Tilford
When Claude Trichet, president of the European Central Bank, announced yesterday’s increase in eurozone interest rates, he did not even mention the threat a weaker dollar could pose to the outlook for the eurozone economy. At the current exchange rate between the euro and the dollar, his apparent complacency may be right. In trade weighted terms, the euro has only strengthened very gradually over the last 12 months. However, European policy-makers are being too sanguine about the implication for Europe of a sustained fall in the dollar. As a result, they risk repeating the mistakes of early 2001, when they dismissed the threat posed to the European economy from a weaker dollar.
What has changed since 2001 to make European policy-makers such as Mr Trichet so relaxed about the impact of a fall in the dollar on the European economy? One argument is that the eurozone economy has become less dependent on exports for growth. There are at last signs that the German economy could start growing under its own steam rather than depending on exports for external stimulus. However, it is far from clear that the recovery would remain on track if exports took a big hit.
In fact, the trade dependence of most EU economies has, if anything increased since 2001. For example, German exports as a percentage of GDP have risen rapidly in recent years. The proportion of total exports accounted for by the US may have declined, but that ignores the fact that a sizeable proportion of the growth has been accounted for by rising exports to countries whose currencies are effectively tied to the dollar, notably China.
Another argument is that the reforms made by European economies over the last five years have boosted their competitiveness and left them better able to cope with a weaker dollar. The competitiveness (and profitability) of German industry in particular has certainly improved, with the result that German companies will be relatively better able to cope with a weak dollar than five years ago. The same cannot be said of other eurozone economies. The competitiveness of the Italian and Spanish economies has deteriorated very sharply since 2001.
If the Chinese and the other East Asian central banks were to allow their currencies to rise in response to a fall in the dollar, then the European economy would not have to bear the full cost of adjustment of a decline in the value of the dollar. So far, there is no indication the East Asians intend to allow their currencies to rise against the dollar. In the event of a run on the dollar, European companies are likely to experience a loss of competitiveness not just in the US, but in fast growing Asian markets as well as in third markets, where US and Asian companies will be much more competitive.
In any event, a focus on the direct trade impact risks underestimating the scale of the threat. When measuring the vulnerability of the EU economy to a fall in the dollar and downturn in the US economy direct trade flows are a relatively small part of the story. The importance of the direct trade with the US is far outweighed by indirect links. For example, the sales of British and Dutch-owned companies in the US outweigh exports from the Netherlands to the UK many times over. Even in export-dependent Germany, sales from German-owned companies in the US are five times higher than the value of German export to the US. Declining profits from the US affiliates of European businesses would hit business confidence and investment in Europe hard.
The ECB should not rush to raise interest rates further. Of course, a stronger euro will present benefits as well as impose costs. Import prices will fall, especially those of commodities priced in dollars, such as oil. This will lower inflation pressures in Europe and reduce the likelihood of further interest rate rises. However, the European economy is not as resilient as many are assuming. A rise in the value of the euro to €1.50:$1 or €1.60:$1 – a very plausible assumption – would not just be shrugged off. Indeed, it would in all likelihood put an end to the long-awaited eurozone recovery, which is currently not powerful enough to absorb the shock of a much weaker dollar.
Simon Tilford is head of the business unit at the Centre for European Reform.
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