Friday, November 13, 2009

Calls to Cap the Euro

The European Union is a a terrible quandary. Along with other Asian nations they are now paying a huge price for a crisis they did not create, one that centers around the U.S.-China trade imbalances. European exports are getting killed under the weight of a strong Euro. As the U.S. dollar weakens, the euro which has been rallying, is rapidly approaching its all time peak of ~$1.60 - a level where it traded right before the financial crisis started unfolding in August of last year.
The Economy News reports that the European industry federation has called for a cap on the euro after it rallied to $1.50 against the US dollar and 10.25 against the Chinese Yuan. The Telegraph, reporting on the same topic noted that:
In a study by Ansgar Belke from Duisburg University found that even Germany has clear limits [when it came to how much euro appreciation it would tolerate]. Berlin's pleasure in the muscular performance of the euro is likely to prove "nasty, brutish, and short", he said. "Firms with standard products exposed to the biting winds of international competition have a huge problem with a strong euro," he said. Germany's small and medium-sized family firms produce locally and cannot switch plant abroad. Currency hedging is complex and costly.
Mr Belke said the "pain threshold" varies by sector but overall demand for German goods will "fall dramatically" if the euro goes above $1.55 for long. Furthermore, it will do lasting damage as firms lose their global foothold. Many will struggle to re-enter these markets even if the euro falls again. Currency effects are slow but powerful.
A 10 year chart of the dollars/euro exchange rate shows the extent of the Euro rally and the damage it is doing to European exports.

Given that the dollar has much further to fall (based on the enormous deficits, the Fed's massive quantitative easing and foreign central banks penchant for diversification), the euro has only one way to go - up. Additionally, even though China has made some accommodating noise about letting the Yuan appreciate once again (after a pause last year), the path of this appreciation is likely to be extremely slow and controlled, in other words not fast enough to make a big difference.
Based on this back-drop, the future looks pretty murky and volatile, with trade barriers and capital controls most definitely on top of the menu.

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