As the risk increases of a US default in the absence of Congressional approval to raise the Federal debt ceiling, it might be reasonable to see the dollar weaken against the euro, though it would be more reasonable to expect this were there not already a raging debt crisis in the Eurozone. Further to that, yields of less than 3% on Treasury Bills indicate that investors do not really expect that a US debt crisis will come to pass, which makes the relative weakness of the dollar against the euro stranger still. In fact, over the course of the roughly fourteen-month debt crisis that has so far engulfed Greece, Ireland and Portugal, as compared with a recent hypothetical US debt crisis, the euro has tended to trade with or move higher than the dollar. I submit three main reasons for this trend.
One piece of this puzzle is the purchase of Eurozone debt by China. Largely as a result of worsening relations between China and the US, the Chinese have been intent on diversifying foreign assets away from the dollar, which explains the massive inflow of Chinese money into the Eurozone, including the purchase of government bonds from indebted peripheral states. In fact, according to a recent article in The Economist, it is estimated that China has purchased an amount of sovereign debt from struggling Eurozone states that is roughly equal to the amount purchased by the European Central Bank (ECB). While this act of faith in the troubled Eurozone may have more to do with the US than with the economic prospects of the former, it has helped to maintain the value of the euro at rates much higher than would be expected given current circumstances.
A second reason behind the euro’s strength is a strong recovery in the core of the Eurozone, led by Germany’s booming manufacturing sector and a surge in German exports. Last July, just months after the first of the Eurozone’s troubled economies required a coordinated EU-IMF bail-out, the German government recorded a 5% increase in manufacturing over the previous quarter, after the month of May had shown export growth of 9%. This export boom continued as the debt crisis spread, with German exports totaling 98.3 billion euros in March 2011. While the weakness of the euro relative to the counterfactual of a strong D-Mark contributed significantly to this growth, the strength of the German economy has in turn sustained the euro at a level higher than reflects the performance of the Eurozone’s periphery. This would be highly beneficial if the growth of the German economy prompted an increase in consumer spending, which might correct some imbalances between the core and periphery of the Eurozone, but instead Germany is playing the role in the Eurozone that China plays on the global stage, with the indebted periphery and the US as their respective enabling co-dependents.
Finally, a third reason for the strength of the euro versus the dollar is the consistently high interest rate of the ECB relative to the Federal Reserve rate. Following the most recent rise on 7th July, the ECB interest rate is currently 1.5%, while the Fed. rate has remained at 0.25% since December 2008. In May last year, during what was at that point the height of the debt crisis, the ECB interest rate was at 1%, while the Fed. rate was at its current level of 0.25%. I remind you that there was not even a scent of the potential debt crisis facing the US at that point, and the Eurozone crisis was, again, in full swing. The reasons for this rate differential are relatively clear: the ECB is incredibly hawkish on inflation and is mandated by the Treaty establishing EMU to target price stability, while the Fed. has more scope to combat economic downturn through policies such as quantitative easing, in addition to rock bottom interest rates. The argument could be made that the ECB has implemented its own course of quantitative easing by purchasing sovereign bonds of indebted Eurozone states, but this was in response to some of the worst debt crises facing rich world economies in recent history, and still has met with resistance from some ECB board members and national central bankers. As I have argued previously, a second, related reason why the ECB has increased rates of late is that the core of the Eurozone, and Germany in particular, appears to require higher interest rates than the indebted periphery, to combat inflation.
Thus, we find two of the world’s biggest economies – the US and the Eurozone – in the midst of dismal economic periods, yet the latter, which may be truly on the brink of breakdown, has a currency that has consistently outperformed that of the former. Excluding the impact of Chinese investment, which appears somewhat separate from the economic health of the Eurozone, might this trend point to the fact that the markets continue to place too much emphasis on Germany as the face of the Eurozone? As long as German consumers fail to redistribute wealth across the Eurozone and the ECB seems more willing to act on the behalf of Germany than to avoid imposing painful rate rises on the indebted periphery, the booming German economy may in fact be a liability that will lead ultimately to the weak euro many anticipated, or perhaps even a return to the D-Mark.