Pros and cons of the rise of the euro against the dollar

The euro continues to gain ground against the dollar, hitting one record high after the other, but the authorities and most people in Greece are more preoccupied with developments in the ruling conservative New Democracy party and the main opposition PASOK party. Looking at the growth of imports and exports, they may be right. But this is not the whole story. The euro rose to a record high against the dollar on Friday on expectations the Federal Reserve will cut interest rates this week to help the US economy weather the slump in housing. The markets bet with almost certainty that the Fed will reduce its funds rate to 4.50 percent from the present 4.75 percent as US consumer confidence has dropped to the lowest level since May 2006 and a sharper than expected decline in home sales last month. The euro has stabilized above the 1.43 level against the dollar, touching an all time high at 1.4395 last week. The single European currency has gained more than 7 percent against the greenback year-to-date while the US dollar has lost about the same against the currencies of its seven major trading partners. Yet, the strength of the euro against the dollar, the yen and other currencies does not seem to ring any alarm bells among Greek policy makers and the public in general. This, despite the fact that the strong euro has contributed somewhat to the widening of the country’s current account deficit, estimated at about 12 percent of GDP (gross domestic product) in 2007, up from 10.9 percent last year. The Greek current account deficit expanded by -4.2 billion in the January-July period compared to the same period last year, with increasing net interest payments and the widening of the non-oil trade deficit accounting for much of the difference. The fact that real export growth has picked up from 4 percent on average in 2005, to 5.3 percent in 2006 and a projected 8.0 percent in 2007 has overshadowed an average growth of 9.8 percent in imports in 2006 and a projected 8 percent this year after a drop of 2.1 percent in 2005. In this kind of environment, the issue of import penetration and its impact on sectors of local industry has taken a back seat in public debate and the priorities of policymakers. Also, with the Greek economy cruising at an annual growth rate of 4.4 percent in the first half of the year despite the drag from the external sector, the government does not feel any pressure to act immediately. On the contrary, policymakers and others take a different view of the issue by noting the favourable effects of the strong euro on inflation. Headline inflation is seen dropping to about 2.7 percent on average this year from 3.2 percent in 2006 and 3.5 percent in 2005. With EU average inflation estimated at about 2.0 percent in 2007, down from 2.2 percent in 2006, the gap between Greek and EU-wide consumer price inflation appears to be closing and this helps to improve things from the local point of view. The oil effect The government has another reason not to worry about the appreciation of the euro against the dollar and other currencies, namely skyrocketing oil prices. Since the price of oil is denominated in dollar, a stronger euro makes it easier for the eurozone consumer at the pump and the Greeks, citizens and policymakers alike, apparently know and appreciate it. It is a significant change given the negative opinion of Greeks and other Europeans about the effect of the introduction of the euro on national inflation rates. This is depicted and quantified in a study on the subject by EFG Eurobank. The study confirms the decline of inflationary expectations among Greeks and other citizens of eurozone member countries following the physical introduction of the euro which took place in Greece in 2002. One should not blame the government for the emphasis it places on the positive aspects of a strong euro for inflation. After all, even college students know that containing inflation is important in an economy growing above potential for a number of years. As for the negative effects of the strong euro on exports, one should note that about 70 percent of all Greek exports are destined for other EU countries and southeast European countries whose currencies are to some degree linked to the euro. So, the strong single European currency affects about 30 percent of Greek exports. And the latter have recorded double-digit growth in the last few years. Nevertheless, it would be a mistake to ignore the damaging effect of a super-strong euro on the eurozone economies. By contributing to the tightening of monetary conditions, the strong euro has the potential to clip a few points off economic growth. This in turn will have a negative impact on personal income and consequently Greek exports, although one may argue that a strong euro will force the ECB to give greater thought to raising interest rates. Still, the negative impacts should not be underestimated. They usually become manifest over the course of time, which can make it difficult to spot them and, more importantly, to feel their effect. The substitution of domestically produced products by imports takes time and the strengthening of the euro makes this easier. Greece has already felt the consequences in the textile industry where thousands of jobs were lost and many factories closed over the years, although this was due more to higher unit labor costs than anything else. In addition, those Greek companies which operate in or export to countries outside the eurozone find it more difficult to sustain higher earnings growth rates because their sales are hit when translated from these currencies and the dollar back into euro. All-in-all, the strong euro, especially if sustained for a long period of time, will have adverse effects on the Greek economy with lasting consequences. This is something Greek policymakers, not known for their long-term vision, should consider when they highlight the short-term benefits of the strong euro.