An exchange rate is a ratio of two currencies whose movement primarily reflects changes in both countries that issue those currencies. In my international trade and international economies courses, I add that the current account can be approximated by the difference between national saving (private + government savings) – investment. If national saving exceeds investment, then there will be a surplus in the current account of the country whose exchange is of interest. If national saving falls blow investment, then there will be a deficit in the current account of that country.
In euro-zone, national saving exceeds investment, which means that the euro countries are experiencing a surplus in their current account as a whole. Obviously the protracted sovereign debt crisis has hurt investment in that area and contributed to the surplus in the current account. On the other hand, the injection of liquidity by the European Central Bank and later the use of quantitative easing have added to the weakness of the euro which has depreciated by 22 percent in the last year or so.
If we combine negative interest rates in the euro-zone, which mean financial institutions are chewing part of the savings, with the increasing savings in that area, the result is an atmosphere unsympathetic to keeping the euro money in the euro-zone thereby caused the exodus of the euro from the euro-zone. When a domestic currency crosses its country’s boundaries to other markets, it means an increase in the supply of that currency abroad, resulting in the depreciation of the flying currency as is the case of the euro and the euro-zone. The exchange rate I have in mind is the U.S. dollar price of the euro, which is defined as the U.S. dollar over the euro.
In the United States, the Federal Reserve is diverging from the other central banks. Foreign central banks are decreasing their short-term interest rate and pursuing easy monetary policy, while the Fed is getting ready to go the other way. On one hand, the European Central Bank, the People’s Bank of China, the Bank of Japan, the Bank of Korea and the Bank of Thailand, among others, have eased. On the other hand, the Fed has stopped its third QE last December and is now trying to shift gear to increase its short-term interest rate. Add the strengthening of the U.S. economy relative to the euro-zone’s economy and we get the 22 percent drop in the U.S. dollar/euro exchange rate, with the dollar getting stronger and the euro is getting weaker.
The decline in the world’s total foreign currency reserve is also emblematic of the strength of the dollar as the undisputed and dominant global currency. Total global foreign currency reserves dropped from $12.03 trillion to $11.60 trillion. With a drop in the supply of the U.S. dollars abroad, the dollar gains strength along with increases in U.S. short-term interest rates by damping the world’s demand for U.S. Treasury bonds. This bodes ill for the euro, which has benefited from central banks using part of the increases in their reserves to buy this currency.
The rapid appreciation of the dollar could be a problem for the Fed and the Obama administration. The Fed is groping the data to figure out what to do, and it does not seem to have clear thinking of what to do next. The strengthening of the dollar is deflationary and this does not help the Fed meet its 2 percent inflation mandate.
Moreover, we are having both a current account deficit and an appreciating currency, which usually do not go together. Finally, the Fed may be concerned with the contracting impact of the appreciating dollar on economic growth, carry trade and interest rate spreads at the time when it is considering making the first increase in short-term interest rates in more than seven years. The Obama administration is reaching out across the Atlantic and proposing the Transatlantic Trade and Investment Partnership agreement, which can be complicated by the rapidly strengthening dollar.
In major oil-exporting countries, there is an effective beg to the dollar, whether unilaterally or through heavy weighting in a currency basket. This means we should experience an appreciation of the riyal, dinar, and dirham, etc., which are the currencies of Saudi Arabia, Kuwait and Bahrain, and United Arab Emirates, among others. Moreover, since those countries do not have their independent monetary policy, we can also expect an increase in their domestic short-term interest rates. On top of that, the world demand for oil should go down with the appreciation of the U.S. dollar. The first loser in this case is the euro.
There is however a silver lining in the appreciation of the dollar. It should bring lower imports inflation to the oil exporters. But the United States is suffering from an inflation rate that is significantly below the target making it difficult for its monetary policy to harden.
The euro is going in the direction of having a parity with the dollar and is likely that one dollar will even buy more than one euro before the end of this summer. Concurrently, the oil price, which moves in the opposite direction to the dollar, should continue to head down towards $40 a barrel.