The euro has depreciated to its lowest level in nearly nine years when measured in trade-weighted terms. Common wisdom is to assume that this might trigger a GDP forecast upgrade for the common currency area. UBS says "no", while at first sight, this 'devaluation' should boost output, the exchange rate response is simply part of the bigger, well-known picture of economic stress in the common currency region. Simply put, the currency has depreciated on fear and risk aversion - and economic growth tends to suffer rather than flourish in that environment - and furthermore, the two structural measures that help determine the outlook for the currency - the internal balance (output gap) and the external balance (current account) - point to further weakness.
UBS: Euro depreciation: Implications for GDP
The euro has depreciated to its lowest level in nearly nine years when measured in trade-weighted terms. Clients have asked if this might trigger a GDP forecast upgrade for the common currency area. The short answer is no; the currency has depreciated on fear and risk aversion – and economic growth tends to suffer rather than flourish in that environment.
The euro has depreciated by 15% since its recent peak in October 2009. The depreciation is, in fact, exactly in line with our forecast, which is for the EURUSD to drop further to 1.15 by the end of this year and to 1.10 by the end of next year.
At first sight, this should boost output, but the exchange rate response is simply part of the bigger, well-known picture of economic stress in the common currency region. Our asset allocation team highlighted this point in their latest piece, with a compelling chart that shows a tight relationship between the value of the euro and the relative size of the ECB’s balance sheet (Chart 2). The ECB’s balance sheet has expanded much faster than the Fed’s, and this is simply because the eurozone economy and its banks remain troubled (sounds familiar).
This evaporation of confidence in parts of the European banking sector has a direct impact on the real economy, including through a higher cost of capital for companies and from tougher credit conditions for loans. The Spanish, Italian, Greek and Portuguese economies are in recession, and growth in the eurozone as a whole has ground to a halt.
To establish our point more explicitly, we have run a macro simulation on NiGEM, a large global macro model. We have specifically asked: what is the impact on the economy of the heightened fear that is reflected in wider risk premia? The calibration of the shock can vary depending on one’s judgements and on the time period under consideration, but the bottom line is that fear can drive the exchange rate lower – and economic growth.
What next for the exchange rate? The policy response to the crisis will remain an influence, but, as Chart 2 above shows, in essence it is the fundamentals that will be crucial for the long-term value of the currency.
The two structural measures that help us determine the outlook for the currency – the internal balance (output gap) and the external balance (current account) – point to further weakness. The charts below compare: (1) the euro area output gap with the weighted average output gap of its main trading partners; and (2) the euro area current account balance compared with that of its main trading partners. The charts essentially show that, although the current account is in balance, the euro area output gap is bigger than its trading partners’. If we think of the equilibrium exchange rate as one that restores internal and external balance, these charts suggest that there is scope for further depreciation in the euro.
To summarise, the euro has depreciated in response to broader concerns related to solvency and competitiveness in the single currency region. Although the weaker currency will help the troubled economies rebalance, the weakness is not a trigger for forecast revisions. Looking ahead, fundamentals continue to suggest that there is further scope for euro depreciation. We expect EURUSD at 1.15 by end-2012 and 1.10 by end-2013.