Exchange Rates: Love the one you're with

The euro area should learn to embrace a strong currency


AFTER a jittery summer in financial markets, it is a little strange to see analysts revising up their estimates of how America's economy fared during the tumult. Many now think GDP rose by 3% or more in the third quarter, a healthy pace even in less anxious times. That the source of much of the good cheer is a better trade performance seems odder still. America has habitually been more consumer than supplier: it has chalked up big deficits on its current account for years.

That may be changing. A weaker dollar—the greenback has slumped by more than a fifth since 2002 against the currencies of its trading partners—is helping America sell its wares abroad and is curbing its spending on imports. The trade deficit narrowed for a fourth straight month in August. Exports rose in cash terms by 12.8% from a year earlier and imports by just 3.0%. A welcome rebalancing of demand away from domestic spending towards exports seems to be under way.


Not everyone is celebrating, though. If America's goods are priced more keenly, others' must be relatively dearer. G7 finance ministers meeting on October 19th, ahead of the IMF/World Bank annual meetings between October 20th and 22nd, are likely to discuss renewed complaints that the euro has borne the brunt of the dollar's fall. Such grumbles have some substance. The euro area, Canada, China, Japan and Mexico together account for two-thirds of America's trade, but their currencies have fared rather differently against the dollar in recent years (see chart). Since the start of 2002 the euro and the Canadian dollar have risen most, the yen and the yuan by much less. The peso has fallen by nearly a fifth.

Although the euro has done more than its fair share of flexing, Canada may have more reason to carp about a weak greenback, as three-quarters of its exports go to America. And in many respects, the euro is well placed to bear an unequal share of the dollar's adjustment. As the oil price reaches a new high, activity in the euro area suffers least because of its energy efficiency. David Woo, currency strategist at Barclays Capital, points out that a big slice of revenues from oil-rich countries is spent on exports from Europe. Moreover, says Mr Woo, the euro area sells more than twice as much as America to the buoyant BRIC economies (Brazil, Russia, India and China) as a share of its GDP.

This exposure to such fast-growing markets helps mitigate the harm done to exports by a dear euro. Too often, though, the harmful effects of a strong currency are stressed, while the benefits are overlooked. Although a strong euro crimps sales abroad, it boosts spending at home: what exporters lose in pricing power, consumers gain in purchasing power. Cheaper imports raise households' real incomes, fuelling consumption. And by keeping a lid on inflation, they permit lower interest rates, which in turn stimulate domestic spending.

In the euro area, where household spending has been sluggish, a shift in demand away from exports and towards consumption, a mirror image of America's rebalancing, would be welcome. Leo Doyle, an economist at Dresdner Kleinwort, says the rise in the euro both anticipates and reinforces a changing mix to spending, much as the pound's sharp rise did in the mid-1990s. Indeed, the currency markets are paying the euro area a compliment: whatever the immediate doubts, the outlook for consumers appears brighter there than in either America or Britain, where saving rates are lower and debt levels are higher.

So why the complaints? One concern is that the dollar's steady decline will turn into a destabilising rout if investors lose faith in the greenback. Another worry is that an expensive euro will create unwanted trade deficits in Europe—though swapping cheap goods for assets in an expensive currency is surely a good deal.

Euro-area governments are not united on the issue. Earlier this month Germany's finance minister, Peer Steinbrück, said the euro's rise was “nothing sensational”. His French counterpart, Christine Lagarde, has sounded rather more agitated—about the weakness of the yen and yuan as much as about that of the dollar. Italy too has expressed alarm.

This split mirrors a shift in competitiveness within the currency zone. After a decade of low wage growth, Germany can price its exports far more keenly than either France or Italy. There is also a divide that reflects differences in each country's product mix. Germany's capital-goods industry has profited from, rather than been hurt by, growth in emerging economies. But for exporters who compete directly with China, a strong currency hurts more. Euro strength is a “powerful market signal” that speeds up a necessary shift in resources to more profitable lines of work, says Mr Doyle. Perhaps that is what policymakers fear most: an exchange rate that is an agent for structural change.

Learning to love a strong exchange rate will be difficult, as long as anxieties about the global economy remain. In its semi-annual World Economic Outlook, released on October 17th, the IMF cut its forecast for growth in 2008 from 5.2% to 4.8%. America suffered the biggest downgrade, with expected growth slashed from 2.8% to 1.9%, hardly a dollar-friendly prospect. The euro area's GDP is expected to rise by 2.1% next year, marked down from 2.5%. The fund's economists note the euro's strength, but reckon “it continues to trade in a range broadly consistent with medium-term fundamentals”. So not everyone thinks the euro's rise has yet gone too far.