Draghi's Dangerous Bet: The Perils of a Weak Euro
The recent decision by the European Central Bank to open the monetary floodgates has weakened the euro and is boosting the German economy. But the move increases the threat of turbulence on the financial markets and could trigger a currency war.
The concern could be felt everywhere at this year's World Economic Forum in Davos, the annual meeting of the rich and powerful. Would the major central banks in the United States, Europe and Asia succeed in stabilizing the wobbling global economy? Or have the central bankers long since become risk factors themselves? The question was everywhere at the forum, being addressed by experts at the lecturns and by participants in the hallways.
Central banks, said Harvard University economics professor Kenneth Rogoff, are surely the greatest source of uncertainty in the eyes of the financial markets, a statement that was not disputed by others on the panel. The fact that monetary policies at central banks in the US, Europe, Japan and elsewhere are drifting apart poses a major risk for the stability of financial markets, he said.
"It's important for the international community to work together to avoid currency wars which no one can win," Min Zhu, deputy managing director of the IMF, told the conference.
Yet last Thursday's decision by the European Central Bank to purchase 60 billion ($68 billion) a month in government bonds through September 2015 has increased the threat of exactly that kind of monetary conflict. It will further flood the markets with liquidity and will continue to apply downward pressure on the value of the common currency.
A weak euro, of course, is precisely what ECB President Mario Draghi wants. It makes exports to other currency areas cheaper, thereby increasing the competitiveness of euro-zone countries. At the same time, it increases the price of imports, thus reducing the threat of deflation.
Parity with Dollar?
Viewed in those terms, Draghi's policy has been thus far successful. The euro has fallen in value by 10 percent compared to the dollar since September, and many observers expect that the euro may soon achieve parity with the dollar.
But Draghi's policy also has inherent perils. By intervening in the exchange rate mechanisms, the EU is creating unfair advantages for itself globally at the expense of other countries. Those countries surely won't be pleased and are likely to respond by devaluating their own currencies. Ultimately, there can only be losers in such a contest. It will be "interesting to see how the Japanese follow up at this point" -- as well as the US -- Gary Cohn, president of investment bank Goldman Sachs, said at Davos.
It's a development that worries Anton Börner. "A currency war would be devastating for everyone," said Börner, the president of the Federation of German Wholesale, Foreign Trade and Services (BGA). He argues that one of the reasons Germany has become so economically competitive is that companies here have been forced to contend with a strong currency. It forced them to make a greater effort and to be more creative. "Investments are made in places where the currency is strong," the BGA boss says.
Börner's line of argumentation sounds a lot like the hallmark of the monetary policy of pre-unification West Germany. It is rare that a currency becomes such an important part of the national identity as the deutsche mark was to Germans prior to the euro's introduction. Many considered the deutsche mark to be guarantor of prosperity and the Bundesbank a venerable institution that both embodied that promise and commanded international acceptance for the young country.
The job became even easier the more the mark gained ground against the dollar, the British pound and the Italian lira. It slowly came to be seen as a hard currency and ultimately became the world's second most popular reserve currency behind the US dollar. The strong deutsche mark also turned Germany into a nation of travelers.
Now, though, Germans are having to adapt to a new reality. Rather than fighting for a strong currency as the Bundesbank used to do, the ECB is weaking the euro.
In a currency block, of course, the disadvantages of a weaker currency are not immediately felt. Most Europeans tend to vacation in Europe, thus limiting their exposure to stronger currencies abroad. And goods from abroad have not yet become more costly despite the euro devaluation because the price of oil has plunged as well.
Pros Outweigh Cons -- For Now
For the German economy, the advantages associated with a weaker currency outweigh the disadvantages. Coupled with the low oil price, the current euro exchange rate is like an "unexpected economic stimulus," government sources say. When he releases his current forecast as part of his ministry's annual economic report on Wednesday, Economy Minister Sigmar Gabriel is expected to issue an upward correction. The Economics Ministry is expected to forecast growth of 1.5 percent for 2015, up from the 1.3 percent forecast last autumn.
Yet even though that new figure is just now being released, it is already obsolete. Government economists believe that the euro's downward trend coupled with low oil prices mean that the German economy is more likely to grow by 2 percent this year, assuming there are no major geopolitical upheavals. Officially, Berlin doesn't want to sound too optimistic, preferring to be pleasantly surprised with potentially positive developments later this year.
Nevertheless, the downward trend in the euro's value and oil prices has the potential to create new problems for the German government in the foreseeable future, particularly in its relations with partner countries and with international organizations like the International Monetary Fund. They've long complained about Germany's growing current account surpluses. The imbalance threatens the recovery of euro-zone crisis countries and the global economy because Germany imports too little.
Relative to economic output, no other European country exports as many goods and services as Germany. The country had a current account balance surplus in 2013 equivalent to 7 percent of gross domestic product. The figure for 2014 is not much lower.
The surplus could get even bigger in the future. Experts in Wolfgang Schäuble's Finance Ministry have calculated that the combination of the weak euro and declining oil prices could increase the surplus by 0.5 percent.
Experts believe the weak euro may help spur economic growth in crisis countries on the short term. A current analysis by the European Commission suggests that a falling euro exchange rate will result in an increase in exports, particularly for Italy, Portugal, Spain and France. It will also make it more attractive for non-Europeans to take vacations in the euro zone.
At the same time, it is unlikely that the measures announced last week will restore inflation to the ECB's target rate of 2 percent. "Studies show that a low euro exchange rate has little influence on inflation," says Ansgar Belke, an economics professor at the University of Duisburg-Essen.
For the time being, the focus remains primarily on advantages the weak euro has for the economy. The general rule of thumb is that a devaluation of 5 percent will translate to additional growth of 0.3 percentage points in the euro zone. But what side effects will it have? And at what point might it get dangerous?
"At the moment, the situation is still relaxed," says Carl Martin Welcker, the CEO of the Kölner Schütte, the global market leader in grinding machines and multi-spindle automatic lathes and one of the medium-sized businesses that make up the backbone of the German economy. In light of the political situation, Welcker said he considers the depreciation of the euro to be an appropriate move, but says people need to keep an eye on developments. "If the euro were to lose another 15 percent in value, then things would be quite different," he said.
When Weakness Becomes a Problem
At that point, the euro would reach parity with the dollar -- a level at which the disadvantages of a weak euro could no longer be overlooked. Everything that is traded in dollars would then become palpably more expensive, especially commodities. If oil prices hadn't declined so dramatically in recent months, the cost per liter of diesel would be 1.50 today due to the weaker European currency. But at the moment, it costs 1.10 on average.
Investments made by German companies in the dollar zone also get more expensive when the euro's value slips. German chemicals giant BASF is currently planning to spend 5 billion to expand its North American business between 2014 and 2018. The chemical company says it still intends to stick with its plans. "Short-term currency fluctuations have no influence on our investment decisions," BASF officials state. The question is how long the euro will remain weak.
Potentially even more important is the psychological effect devaluation has. A weak euro can give companies a false sense of security. "This kind of thing only provides a temporary boost," warns BGA President Börner. "You can't create any prosperity through devaluation," he says. "It's window dressing."
Thomas Mayer, Deutsche Bank's former chief economist, views the situation similarly. "In addition to reducing the pressure to reform in countries, an artificially depressed euro exchange rate could also stifle innovation in industry," the economist said. With a devalued euro, products practically sell themselves and, experience has shown, companies tend to hold on to older products as well as inefficient manufacturing processes.
But there's an even greater danger that is far more decisive. "If the downward trend in the euro accelerates, in the worst case scenario, investors could lose trust in the durability of the euro zone," warned Clemens Fuest, the head of the Center for European Economic Research in Mannheim. "Then the opposite of what the ECB is trying to achieve would happen."
Is It Contagious?
Last week's decision by the Swiss central bank to unpeg the franc from the euro illustrated just how dangerous markets can be for banks and investors alike. Swiss stock prices dropped sharply and banks, funds and currency traders around the world -- but also many private individuals and German municipalities -- who had invested in Swiss francs suffered painful losses. The move even drove one major US hedge fund out of business.
Still, Axel Weber, the former president of Germany's central bank, the Bundesbank, and currently chairman of the Swiss bank UBS, praised the ECB's decision even though it could ultimately be a burden for his institution. "It has always been clear that pegging the franc to the euro was a temporary thing," he said. "The Swiss National Bank made the right move. It's better to make a painful break than to draw out the agony."
Officials within Germany's Finance Ministry are already concerned that the currency turbulence could prove contagious and hit countries neighboring the euro zone. Like Switzerland, a few other countries have pegged their currencies to the euro exchange rate, and they too may now feel the pinch of appreciation pressures.
This is especially true of Denmark and Poland, which could become the next focus of speculators. The Danish crown and the Polish zloty are more or less pegged to the euro exchange rate. Central bank officials in both countries almost slavishly follow each move made by the ECB in order to ensure their currency values remain stable. But it's an arrangement that will be thrown into jeopardy if the ECB now starts purchasing large quantities of government bonds. In order to prevent speculation against the crown, the Danish central bank recently lowered its key interest rate by 0.15 percent to 0.5 percent.
Still, further upheaval appears inevitable. It's possible that both countries will ultimately have to establish a new exchange rate in relation to the euro or that they will have to unpeg from the common currency completely.
Germany's Finance Ministry has also registered with concern that the euro's role as a reserve currency is suffering as a result of monetary policy decisions made by the ECB. Around one-fifth of global currency reserves are currently held in euros, but that share used to be considerably larger. If the ECB opens up the floodgates for additional quantitative easing, they fear that share could fall even further.
Central banks normally sell their reserves in a weak currency in order to limit their losses. But if they push their euros onto the market, it will further weaken the common currency, triggering a self-perpetuating downward spiral.
For months, the Americans and the IMF have been calling on the Europeans to implement precisely the monetary policy that is now making the euro weaker. They will now have to accept the increasing trade imbalance as the logical consequence of this move. "You can't have both -- a loose monetary policy and at the same time a reduction in imbalances," one government expert in Berlin said.
It's for the same reasons that Schäuble and Economics Minister Gabriel don't believe that the latest developments will lead to competitive devaluations or currency wars. The Europeans are now following precisely the monetary policy Washington has been requesting for years. Now Washington will have to be able to cope with the risks and the side-effects that come with it.
Are Europe and America Trapped?
Efforts by the Federal Reserve to become the first major central bank to reverse its quantitative easing illustrated just how risky the flood of money can be. A year and a half ago, the Fed began suggesting that it would end its loose monetary little by little. The statements led to a reverse in capital flows in large parts of the world, with investors pulling money out of developing nations and investing it in the US. In countries like India, the markets fell sharply and currencies were strained. Quiet has since returned to the markets, but the Fed still hasn't raised its interest rates.
Worry about the possibility of new turbulence may even prevent the Fed from taking that step this year. Conditions for raising the interest rate are actually favorable given that the US economy is currently undergoing its first upswing in many years. But higher interest rates would also attract more capital to the US, leading the dollar to continue its ascent. Developing nations would fall into difficulties and the euro exchange rate would fall even further.
That's why a return to normal monetary policies is unlikely for the time being. Central banks on both sides of the Atlantic appear to be trapped.
If the value of the dollar relative to the euro continues to increase, the Fed may feel forced to take countermeasures. "As long as things are going decently with the US economy, people will accept appreciation of the dollar," says economist Mayer. "But if the mood shifts at some point, the exchange rate will become a political issue." Accusations of currency manipulation, he says, would quickly follow.
In that event, the US Congress has the means of imposing punitive measures against countries or entities deemed guilty of such manipulations. And, as the case of China has shown, US lawmakers aren't afraid of threatening to use those powers.
By Sven Böll, Martin Hesse, Alexander Jung, Armin Mahler and Christian Reiermann
© SPIEGEL ONLINE 2015
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