Behind the Gyrations of Euro/Dollar Exchange Rate
Chih Kwan Chen
(January 15, 2004)
The merchandise trade balance between USA and Western Europe is shown to be determined by
the exchange rate between US Dollar and Euro and its predecessor currency. The ups and downs
of the exchange rate is then analysed and traced back to various economic, financial and political
reasones. This analysis allows us to project the future course of the exchange rate.
In the eighties and nineties,
the major part of the globalization era, Euro region has just stood at
the side line and watched the other two major economic blocks of the world,
USA and Asia Pacific region led by Japan, danced into the death spiral
of tremendous trade imbalance; the trade imbalance is first induced by
wanton spending policy of Reagan era and then intensified by the persistent
currency market manipulation of Japan, under the nod of US government,
in Clinton era(Ref. 1).
During that period the major trend of the core currency of euro region, German Mark, can be summarised in one sentence, "follow Japanese Yen". However, near the end of the 20 th century, German Mark and then Euro has started to diverge from Yen, and has attained its own life vs. Dollar. The substantially weak Euro in the stretch of 1998 to 2000 has pushed US trade deficit with Europe to about 1 % of US GDP and ranked US trade deficit with Europe the second largest trade deficit of US with a specific region just after China. It becomes necessary to study the behavior of Euro/Dollar rate and the trade pattern between US and Europe independently in order to fully understand the current Dollar and trade deficit crisis of USA.
In Section 2, it will be shown
that the trade balance between US and Europe is determined by Euro/Dollar
exchange rate with the rate enjoying at least one and one-half years
of leading time, that is, the trade balance with Europe at the end of 2003
is determined by the Euro/Dollar exchange rate at the summer of 2002 or
earlier. In Section 3 not only the major trend of Euro/Dollar rate, but
the noticeable secondary fluctuations of the exchange rate since 1980 are
explained from economic, financial, and political factors. The last section
is for discussions where Euro/Dollar rate and US-Europe trade balance are
2. Euro/Dollar Rate Determines US-Europe Trade Balance
It is first shown that the trade balance between US and W. Europe(Ref. 2) is determined by the exchange rate of Euro/Dollar(Ref. 3). Euro is introduced at the beginning of year 2000. Before that time, German Mark, the core currency of Euro region, is multiplied by a factor 1.95583 and is considered as the surrogate of Euro. The pattern of trade balance of US with more narrowly defined Euro region has turned out to be almost exactly the same as that of W. Europe, so the trade balance with W. Europe is used here. In Fig. 1, the exchange rate of Euro/Dollar is plotted in quarterly interval as the black curve, and the ratio between the trade balance with W. Europe and the nominal GDP of USA, expressed in percentage, is also plotted in quarterly interval as the red curve.
The time scale of the exchange rate curve is shifted toward right by
one and one-half years compared to the time scale of the red trade balance
curve. The major trend of the exchange rate curve indicated by the peaks
and valleys, A, B, and C coincides reasonably well with the peaks and valleys
of the red curve. This implies that the exchange rate leads the actual
trade balance by about one and one-half years to two years, that is, US
- W. Europe trade balance in the first half of 2004 is determined roughly
by the exchange rate of Euro/Dollar at the first half of 2003.
3. Reasons Behind the Gyrations of Euro/Dollar Rate
In the previous section we have
shown that US - W. Europe trade balance is determined by Euro/Dollar exchange
rate. The next question is what determines the exchange rate? When the
major trend of trade balance changes, it in turn will influence the exchange
rate. However, there are also many other financial, economic, and political
factors which also will influence the exchange rate. To study not only
the major trend but all the visible secondary ups and downs of the exchange
rate, two curves in Fig. 1 are replotted in Fig. 2, but this time the time
scale of Euro/Dollar rate is synchronized to that of the trade balance
curve. Major peaks and valleys on the curve of Euro/Dollar rate which we
will discuss are marked from "a" to "k" in Fig. 2.
The exchange rate curve, the black one in Fig. 2, raises from the leftmost point to point "a", indicating the weakening of German Mark against US Dollar from 1980 to 1985. This weakening of German Mark is due to the persistently high real interest rate in USA than that of Europe during that period. The high real interest rate of USA was the consquence of huge Federal Government budget deficit and the policy to finance the deficit with the issuance of treasury debt instruments, instead of just printing money as done in Carter administration that fueled high inflation of late 1970's. The persistent weakening of German Mark and Japanese Yen under the influence of high real interest rate of USA had made US trade deficit explode; by 1985 US trade deficit with W. Europe approached 0.5% of US GDP and US trade deficit with Japan reached 1% of US GDP. The exploding trade deficit imposed heavy financial burden on US heavy industries which competes with the counter parts of Europe and Japan. With general election looming in 1986 and under strong pressure from domestic heavy industry to do something about this first phase of run away trade deficit, Reagan adminstration in 1985 consulted with leading industrial nations and decided to sharply upward revaluate Japanese Yen; this decision was carried out by verbal and coordinated currency market internventions, causing Japanese Yen to move from near 250 Yen/Dollar to around 125 Yen/Dollar by the latter half of 1987. West Germany and Japan have been two economic miracles during the recovery phase after the World War II, and German marks and Japanese Yen were always grouped together and pitched against US Dollar as the barometer of the currency market. Thus the sharp upward revaluation of Yen from 1985 to 1987 also prompted strong upward revaluation of German Mark throughout the time period, as can be seen on the exchange rate curve of Fig.2 from point "a" to point "b".
The sharp upward revaluations of Japanese Yen and German Mark against US Dollar, started in 1985 finally curbed the exploding US trade deficit. From the red curve of Fig. 2 we can see the US trade deficit against W. Europe peaked in 1986 and dropped sharply near the end of 1987, and US economy entered the phase of slower and slower growth. Sensing this sea change in economic condition, US stock market crashed in October of 1987 (see Ref. 1 for detailed discussions of US economic booms and busts). The currency market hailed the demise of US trade deficit and immediately started to weaken both Yen and Mark, thus the uptrend of the exchange rate curve marked from "b" to "c". In 1989, Soviet Union started to crumble, and that was a trenmendous boost for Western Europe in general, and Germany in particular, so German Mark staged a quick strengthening as shown on the black curve of Fig. 2 from "c" to "d". However, in 1991 first West Germany overpaid East Germany in the monetary reunion, causing the cave in of East German industries and huge unemployment in the east, and then Russia, following bad economic advises, sank into economic chaos. Realizing that the collapse of the communist block may cause substantial uncertainty in Europe, German Mark started to weaken again as the section from "d" to "e" testifies.
The fluctuations from "c" to "e" in the exchange rate curve of Fig. 2 is due to special factors of Europe, and is absent in the exchange rate curve of Yen/Dollar (see Fig. 3 of Ref. 1). Yen rather continued to strengthen against Dollar until 1995. During that period, US corporations restructured extensively to export manufacturing jobs to Asian countries like Taiwan whose currencies are fixed against Dollar. Thus despite steadily strengthening Yen, US trade deficit started to expand from 1992. Eventually German Mark had no choice but to reflect the strengthening Yen and expanding US trade deficit and started to strengthen too, as displayed by the section of the exchange rate curve of Fig. 2 from "e" to "f". Then as the first Gulf War concluded successfully, US Dollar enjoyed a brief period of strength (from "f" to "g") against German Mark, but eventually steadily increasing US trade deficit pulled German Mark up along the continuingly strengthening Yen as indicated by the section of "g" to "h".
In 1995 Japan made a drastic change in its monetary and Yen-Dollar policy. It pushed Japanese interest rate toward zero and started massive currency market manipulation to artificially destroy the value of Yen against Dollar. With many industrial products still competing with Japan, German Mark could only tag to Yen and became weaker against Dollar as well, as depicted in the section from "h" to "i"; the artificial weakening of Yen from 1995 to 1998 was done with the encouragement of Clinton administration under the name of "strong Dollar policy". This currency market manipulation of Japan induced the 1997 Asian economic crisis, has pushed Japan into the chronical recession from which it has not recovered even today, and the ripple effect finally reached Mexico and Russia by 1998. Japan and US were forced to reverse the artificial weak Yen- strong Dollar policy and made coordinated internvention to weaken Dollar, causing the sharp drop of Dollar vs. Yen. This sharp drop of Dollar is also reflected on German Mark as can be seen in the section "i" to "j" of the exchange rate curve of Fig. 2. The detailed description of the disastrous effect of Japan's currency manipulation can be found in Ref. 4, and how the drop of Dollar in 1998 caused the shrinkage of US trade deficit, the burst of dotcom bubble and ushered in an economic recession in the time span of 2000 to 2001 is explained in Ref. 1.
From 1998, another unique European
factor has set in, that is, the scheduled inaugulation of Euro. Euro is
an artificially created currency by combining strong German Mark with several
weak European currencies. Thus it is equivalent to the transfer of wealth
from Germany to other countries. The natural result of such a combination
is for the strong currency to fall, as shown in the portion from "j" to
"k"; after the inaugulation of Euro at the beginning of 2000, the uncertainty
of the new Euro market prompted Euro to continue to fall against Dollar.
However, steadily weakening Euro has pushed US trade deficit with Europe
to very high level. The natural mechanism of a free curreny market then
demands Euro to strengthen in order to reduce the run away US - Europe
trade imbalance. Thus at point "k", Euro has started to bottom out and
eventually turned to sharply stronger as US trade deficit with Europe approached
1% of US GDP. In recent months the trend of the strengthening Euro is further
accelerated by the failure of Euro Central Bank to match very low interest
rate in US.
4. Conclusions and Projections
With sharply stronger Euro from 2002 and on, it is a matter of time that US trade deficit with Europe will shrink and then Euro will weaken against Dollar. This turn around will occure at latest by the second half of 2004. If Euro Central Bank lowers interest rate before that time, then the turning point will come sooner.
It is always difficult to estimate how strong Euro will be at its peak. One way is to use some technical analysis and view the strongest point, "h", on the exchange rate curve of Fig. 2 as the land mark. That point corresponds to 0.72 Euro/Dollar, or 1.39 Dollar/Euro based on quarterly average. Thus translated into daily trading, Dollar/Euro may be higher than 1.39 at the peak. If European interest rate is lowered, not only the peak of Euro will come sooner, but its peak value will also be lower than the land mark value discussed here.
Though there is no explicit central
bank internvention in Euro, it still can not escape the currency manipulation
effect of Yen/Dollar. However, compared to Japanese Yen, Euro is already
substantially free from artificial manipulation. Thus to some limited degree
the free Euro/Dollar market is allowed to selfcorrecting the imbalances
of trades between USA and Europe. The Euro Central Bank should learn
the serious mistake of Japanese Government of manipulating the currency
market and refrain from direct internvention of the currency market to
weaken Euro. If it feels that Euro has risen enough, then it can always
lower European interest rate. Actually Euro Central Bank is too concerned
about the phantom of inflation. With the rise of Euro in recent months,
Euro region's trade balance will soon shift toward deficit, imports will
flood European market, and it will be "disinflation", not "inflation" that
will be the norm for Europe in coming years, just as USA has expeienced
during the years of trade deficit explosions; this will leave plenty of
room for Euro Central Bank to lower European interest rates.
1. Yen/Dollar, Trade Deficits, and Recent Boom Bust Cycles of USA by Chih Kwan Chen (Aug. 2003).
2. From data compiled by Bureau of Economic Analysis .
3. From quarterly data compiled by United States of America Federal Reserve System.
4. The Super Low Interest Rates
of Japan, and The Anomalies of World Economy, by Chih Kwan Chen (Dec.,