Putting a price on euro's head presents poser
Monday 16 December 1996
When valuing a currency, it is useful to proceed in three logical steps, taking in order the following: its fundamental equilibrium valuation; then the level of real interest rates; and finally the risk premium which the markets demand to hold it. Of course, it is not easy to produce equilibrium estimates for a currency that does not exist. Even now, we do not know what internal cross-rates (Fr/DM, etc) will be used to create the euro, and even if we did we could not conduct an accurate experiment in which we pretended that the euro had existed in the past, since everything else (especially European inflation) would have been very different if the single currency had been around for 25 years. Goldman Sachs has attempted to get round these problems simply by estimating the fundamental valuation of each of the constituent national currencies which are likely to form the euro, and then weighting these together to assess the putative value of the euro itself.
The answer derived from these calculations is that the euro is not at present overvalued against the dollar or sterling, and is around 4-6 per cent undervalued against the yen. Thus, there seem to be no grounds for expecting the euro to sink in the markets on a long-term basis. But of course, the euro could be driven away from these fair-value estimates according to the behaviour of real long-term interest rates.
At present, the yield in the US is 3.7 per cent while that on the core euro is 4 per cent. (These figures are derived by taking today's nominal bond yields, and subtracting the inflation forecast for 12 months ahead, using the GDP deflator as the relevant inflation measure). Since the real bond yield on the core euro is very close to that on the US dollar at the moment, there is no particular reason from this source either for the euro to trade any great distance away from its fundamental value.
Of course, when EMU is launched in 1999, the relative real interest rates in the US and the EMU bloc may have changed, in which case the implied value of the euro may also change over the next two years. The likelihood is that the European economy will be in a cyclical upswing between now and 1999, while the US economy may embark on a cyclical downswing in the latter part of that period. This would tend to be a factor increasing real bond yields in Europe relative to those in the US, which would tend in turn to push the euro up against the US dollar.
On the other hand, it could be argued that the fiscal tightening being planned under the EU Stability Pact will tend to have the opposite effect. Under the likely provisions of the pact, budget deficits in the EMU countries are likely to need to fall to around 0-1 per cent of GDP over the medium- term, compared to a probable out-turn of around 3.4 per cent for the budget deficit in core EMU next year. As a broad rule of thumb, it may therefore be necessary to reduce the core EMU budget deficit by about 3 per cent of GDP over (say) 5 years, some of which would be accomplished by the upswing in the economic cycle.
The conclusion from this is that the stance of budgetary policy in core EMU would tighten by only around 0.5 per cent of GDP per annum at most, even if the requirements of the Stability Pact are adhered to. This may be a little larger than the likely tightening in budgetary policy in the US, but the difference would not be very large - especially if the US President and Congress could agree to a balanced budget objective by 2002, which is the currently stated intention.
Consequently, I am not very inclined at present to place much weight on the argument that a sharp tightening in the relative stance of fiscal policy in the EU compared to the US will reduce European bond yields compared to those in the US, and thereby depress the value of the euro.
Finally, we need to consider the behaviour of underlying risk premia when assessing where the euro might trade relative to its fundamental fair value. One of the factors which has tended historically to reduce the spot price of the US dollar is that the combination of a large current account deficit in the US, along with a more recent desire on the part of US asset holders to diversify their portfolios overseas, has produced a big deficit on the US basic balance of payments. As a result of this, there has usually been a risk premium required to hold dollar assets - ie investors have needed to expect an excess total return from holding US dollar assets, compared to holding European assets, to clear the market. On average in recent years, this risk premium on the dollar seems to have averaged about 3-4 per cent against European currencies.
There is no good reason to expect this situation to change once the euro has come into existence. The US balance of payment deficit shows no real sign of improving, either on the current account or capital account side, and meanwhile the current account balance for core EMU members remains healthy at a surplus of just under 1 per cent of GDP. Based on these figures, there seems little reason to expect the dollar risk premium to decline from present levels, once EMU has taken place.
Of course, it is possible that a new risk premium may develop on the euro to reflect the fact that the European central bank (ECB) will not have the same degree of monetary credibility as the Bundesbank has built up. But remember that we are talking here not simply about the Bundesbank, but about the combined monetary credibility of all the national central banks which will comprise the future euro, including potentially some of the southern European states if these are expected to get in to the single currency eventually.
It is not obvious why the future ECB should have less monetary credibility than the overall average of all the national European central banks in the past. In fact, the opposite may be the case.
So while the French may fervently hope that the euro becomes a weak currency, it is not clear that it will be easy to bring this about.
Fundamental valuation of the euro1
(Euro overvaluation shown as positive numbers)
% Core euro2 Wider euro3
Against dollar -0.2 -2.1
Against yen -4.1 -5.9
Against sterling +0.3 -1.5
1Valuation relative to GSDEER (Goldman Sachs dynamic equilibrium exchange rate)
2Likely first-round members of the single currency
3Likely second-round members
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