Determining the “pain threshold” beyond which the euro appreciation would significantly impair the recovery is crucial at this juncture. Deutsche Bank's quantification of this “pain threshold”, is not fixed but depends critically on the pace of global growth. If world demand accelerates from a current pace of 1.3% YoY to 4.2% YoY by Q3 2013 (30% below trend), as per OECD forecasts, the EURUSD exchange rate which would be consistent with maintained competitiveness would stand at 1.37 (not far from where we are).
However, if growth is lower (as we humbly suspect) the threshold for currency strength to hamper growth is considerably below current levels. What is more concerning, as a dysfunctional union of economies might be suspected of, is the divergences between member states and their pain thresholds.
Crucially, the fact that Italy and France are already facing problems as the current EURUSD rate is well above their pain threshold, while Germany remains below (despite its protestations) may be fuel for more Franco-German instability as the push-pull of easier monetary policy places Draghi between a rock of core stability and a hard place of depression.
EURUSD at 12-month highs...
Via Deutsche Bank, Euro appreciation: the moving pain threshold
Exchange rate issues have made a spectacular come-back in European policy debate this week, on the back of speculations on “currency wars” emanating from emerging economies and Japan. While market sentiment towards the Euro area and specifically on the periphery has improved significantly over the last few months, a higher euro is seen as a potential “spanner in the works” which could rekindle doubts surrounding debt sustainability there, if the expected export led recovery is postponed by several quarters by a loss in competitiveness.
When controlling for the pace of world demand and when looking at the Euro area as an aggregate, we are according to our estimates currently in or near the “danger zone” where the exchange rate is effectively undermining competitiveness.
We apply our model to the four largest economies of the Euro area. We find that while the pain threshold for Germany, and probably more counter-intuitively for Spain, now stands higher than any level ever reached since the beginning of monetary union, it is actually quite low for France (1.24) and Italy (1.17), for a world demand pace of 4.2%.
It is therefore surprising, at first glance, to observe that most of the recent flurry of comments on exchange rate issues came from Germany. We suggest that the German concerns over currency wars do not primarily stem from a fear of the consequence for German exporters, but rather from the fact that further euro appreciation could unduly delay the normalization of the ECB monetary policy framework.
What these comments from Germany reflect in our view is a concern that currency wars ultimately generate global inflation which the ECB could not easily resist given the persistent fragility of the periphery.
It follows from these considerations that on balance further euro appreciation is the likeliest path, short of a rapid relapse in widespread doubts in the periphery’s sustainability (which would be likely if the Euro area “misses the recovery” in 1H 2013. This means that France and Italy must make rapid progress on productivity and flexibility (as well as possibly off-shoring) to enhance their resilience to currency appreciation.