The threats of the strong euro: real and imagined

with S. Guillou (OFCE-DRIC, Nice, France), S. Schiavo (Dipartimento di Economia, Università di Trento, Italy.

 

The strong euro, so the story of columnists, politicians and businessmen goes, reduces the competitiveness of our firms as it increases the price paid by foreign customers to buy our goods. Euro-area (EA) firms are then harassed, hit, wounded, strangled, suffocated, … with serious threats on the export sectors, growth and employment, especially in the export-oriented countries that account for the largest share of the EA (Germany, France and Italy)[1].

When we dig a little deeper, we discover that the foregoing popular argument is far too simple and has two main shortcomings. On the one hand, it overestimates the exposition of EA exports to exchange-rate risk and their impact on the EA economies, while it underscores some benefits. On the other, it falls short of capturing the whole effect of an exchange-rate appreciation, since price competitiveness is not the only channel at work. In other words, the standard reading of the issue is both too much and too little, and here we wish to offer an orderly account, and possibly a balance, of the various effects.  

What does “strong” mean?

A good deal of confusion surrounds the term “strong euro” in the public debates (and not only among uneducated people). Does “strong” mean that the euro is on an appreciation path or that it has too high value of exchange relative to other currencies? Is this attribute referred to the nominal or the real exchange value? And with respect to which currency(ies)?

All these nuances can make quite a difference. To begin with, it is generally maintained that the basic indicator of the external competitiveness of a country with many trade partners is the real effective exchange rate (REER), as it captures the exchange value of export goods vis-à-vis foreign goods. Well established theories and observations also tell that what is actually relevant at the micro and macro level is not so much the value (if it is stable) but the rate of change of the REER (especially if it is volatile). The canonical example is West Germany’s export industry, which from the ’60s to Reunification,  became and remained world leader hand in hand with a steadily high, slowly climbing, real value of her currency. Figure 1 portrays the REER (IMF data, based on CPI) for France, Germany and Italy. As conventional, an upward trend indicates appreciation (loss of price competitiveness). Data decomposition indicates that after 1999 the path of the REER’s has largely been dictated by the nominal exchange value of the euro.  Therefore, we can reasonably say that the euro has pushed these countries on a sustained real appreciation path ever since the historical low in 2000. However, the present exchange value of their euro-denominated goods is not dramatically higher than in 1999 (between +3% and +5%). Moreover, the figure also shows the same data prior to the euro. And with perhaps some surprise – to those who have forgotten how the European Monetary System worked under the Bundesbank – we can see that the present exchange value of  export goods is actually lower than it used to be in the 1990s. Here we cannot dwell on these issues, though they are crucial to a correct understanding of the problems at hand. Yet we can at least say that a sensible definition of the strong euro as a threat should be related to the expectation that the euro will keep the REER’s of the EA countries on their sustained real appreciation path for a significant time horizon.

Figure 1. Real effective exchange rates, 2000 =100 (Source: IMF, International Financial Statistics)

image002_17.gif

Too much or, why the the strong euro is not as relevant as it is claimed.

  1. For changes in the nominal exchange rate to exert important macroeconomic effects, a country should have a large share of exports on GDP, their sale prices should be closely linked to the exhange rate (“pass-through”), and sales should be highly sensitive to the sale price. The EA economies (especially the big three) historically do display a clear export orientation: their exports of goods and services account for more than 30% of GDP against 17% in Japan and 11% in the US. Yet only extra-EA trade is actually dependent on the exchange rate of the euro, and it is well known that the share of extra-EA trade is very limited. It is worth recalling that it averages to less than 30% of total exports (ranging from 20% for the Netherlands and Portugal to 36% for Finland and Ireland, according to IMF trade statistics). These figures say that the share of  cross-currency trade in the average EA country is about 9% of GDP i.e. somewhat less than the US and one half of Japan.[2]
  2. This share may be even less once account is taken of intra-firm cross-border transactions. These occur at notional prices that have little to do with market prices and exchange rates.  As a result of globalization and delocalization, this phenomenon has spread across industrialized countries and dimensional classes of firms and may range between 30% and 40% of total national exports  (OECD, http://www.oecd.org/dataoecd/6/18/2752923.pdf).
  3. Turning to microeconomic considerations, the competitiveness and health of export firms may be a good thing for its own sake. Yet here one has to take into account that the strong euro reduces the cost of imported inputs (e.g. oil) and raises the purchasing power of wages. True, the former cost relieve may not be the same for all industries and all countries (e.g. the benefit is higher for Italy, which imports most of its energy, than for France and Germany, which through nuclear power are less oil dependent), but it is probably effective most of the times. Hence, to conclude that competitiveness is under threat, it has to be shown that these benefits do not fully compensate for the rise of the sale price in foreign currencies.
  4. Moreover, the exchange value of the euro plays a role only where EA exporters compete with foreign home producers or with non-EA exporters (pricing in depreciating currencies) in third markets. Hence, the geographical breakdown of exports is another important element. For example, EA exports in developing and emerging economies, which account for about 30% of total extra-EA exports, are largely immune from competition with local producers in force of specialization (high quality/high-tech goods vs. low quality/low-tech local goods). The competitors of EA exporters in these markets are to a large extent themselves in the EA.
  5. Firms also have the possibility to hedge against exchange rate movements, especially when volatility is not high and the value of the currency is driven by fundamentals (as is much the case for the euro). The last few years have witnessed a marked increase in the diffusion of hedging instruments. True, these remain relatively more costly for SMEs, which often export in one or two foreign markets only and therefore have less means to diversify risk.
  6. A strong euro makes it easier to use it as an international means of payment, and the choice of the invoicing currency is very relevant for the exchange rate effects. In 2002 German, French and Italian firms already invoiced more than 70% of their exports in euros, whereas the dollar was used only in less than 20% of contracts. French data for 2005 report euro invoicing in nearly 85% of transactions. By and large, this practice shields price competitiveness from exchange-rate movements, while appreciation helps keep domestic prices and costs down. On the other hand firms can also absorb part of the effects of appreciations through incomplete pass-through, i.e. by cutting their margins in order to stabilize the price in foreign currency. A large literature find evidence of a widespread use of this strategy by European firms.  

Too little, or what are the other channels that do make an exchange rate appreciation costly

  1. Price competitiveness is only a limited part of the story. Also relevant is the loss in terms of cost-competitiveness: when converted in a common currency, the unit costs (not due to imported inputs) of EA firms rise with respect to competitors with a depreciating currency. Whereas price competitiveness can be protected from the exchange rate as explained above, relative costs cannot.  Firms can then use different strategies: i) completely pass-through the exchange rate appreciation into export prices, thus facing a potential reduction in foreign demand; ii) compress its margins in order to absorb part of  the exchange rate movement, thus stabilizing export prices; iii) seek to reduce costs in order to compensate the unfavourable effect of the appreciation: this entails for instance the re-localization of production, which is further facilitated by a strong currency.
  2. Market penetration by foreign firms is easier: appreciation of the euro reduces their costs relative to EA firms, hence it increases their price-cost margins. This gives foreign firms more latitude to pay the sunk fixed entry-costs to penetrate EA markets. Therefore, not only exporting firms are damaged by an appreciating euro, but also firms only serving local demand will now face an increased competition.
  3. By the same token, foreign market penetration by EA firms is more difficult, although it reduces the cost of acquisitions and FDI.  A simple glance at the data tells us that between 1999 and 2002 –when the euro was depreciating against the dollar and other currencies- the number of exporters grew by 7% in Italy and 3% in France. On the contrary, between 2002 and 2005 their number went down by 1% and 8% respectively. A similar trend is even more apparent in France where the number of manufacturing firms with more than 20 employees that is engaged in export activities has reduced by 10% between 1999 and 2005. Sure, correlation is not causality, but an econometric study confirms that the propensity to become a first-time exporter is significantly affected by the level of the exchange rate in the case of French firms.[3]
  4. Non-price competitiveness becomes very important in these circumstances. But as appreciation persists, it can damage EA firms from this side because  cuts in margins and pressure from domestic costs jeopardize future investments that build future non-price competitiveness.

To sum up.

  • The public debate over the threats of the strong euro should be brought back to a more balanced and careful consideration of all various elements at work. Money and its value are terribly serious and dangerous arguments that should be kept out of reach of populists and lobbies. We all remember the symmetric complaints for the weak euro soon after its birth.
  • The balance between real and imagined threaths of the euro in the light of available evidence is, to say the least, uncertain. Overall, the macroeconomic evidence against the strong euro is flimsy to date[4]. The ECB Montly Bullettin of December 2007 reports export and import volumes growing at a year rate of 6% and 3.5% respectively, substantially in line with previous years. As a result, the trade balance of goods and services remains positive in a string of six consecutive years. If serious threaths may jeopardize growth prospects, almost unanimously these come from commodity prices and financial turmoils much more than from the euro exchange rate.  At the micro level, the evidence is more mixed and subtle, as we have explained above. If we look at the world trade shares country-by-country or industry-by-industry, we can find a EA economy like Italy (until 2006) among loosers, but also another EA economy among winners, Germany. This fact suggests that the strong euro cannot be the single explanation of poor export performance at the country or industry level, though it may still be true that  less of a rampant currency might have helped everyone and the EA as a whole to get a larger slice of the world trade pie.
  • Finally, currency appreciation brings not only costs but also benefits. The latter are often hidden from view or cursorily mentioned. We shall return to them as they deserve more attention and consideration.

[1] Cf. D. Schwarzer: http://www.roubini.com/euro-blog/2007/10/19/german-industry-finally-joins-europeans-in-concern-over-strong-euro/

[2] Further downward correction is due to the share of extra-EA trade going to the New Accession Countries and other East European Countries whose currencies are pegged to the euro.

[3] See Guillou S. « Exports and exchange rate: a firm-level investigation », OFCE WP Series, forthcoming.