Euro remains undervalued against US dollar

THE US dollar has lost considerable ground against the euro over the past 12 months with a move from about $0.86 in February 2002 to around $1.075 today.

This 25% rise in the euro has contributed to an increase of 11% in the overall trade-weighted value of the euro. Over the same period, the euro rose by almost 12% against sterling and by over 15% against the yen.

At a current trading range of $1.06-$1.09, the euro remains undervalued against the US dollar. European Central Bank officials have generally spoken favourably about the rise in the value of the euro, seeing the appreciation as a vindication of the sound underlying performance of the eurozone economy and the ECB’s stewardship of monetary policy. However, there must be some concern that the dollar could continue to decline, jeopardising the contribution of the foreign trade balance to the eurozone’s modest growth performance. Based on the burdens facing the US economy, Europeans would be justified in worrying about the prospects for the US dollar. The US faces the burden of its war on terror and the risks to the economy of the geopolitical risks associated with its determination to disarm Iraq. Apart from the Iraqi crisis, there are other political hotspots around the world that are likely to weigh on the outlook for the US economy.

A second burden for the US economy is the emergence of a growing budget deficit which is heading for 3% of GDP. There are doubts about the positive contribution that the Bush tax plan will make to the economy in 2003. Most of the impact will be delayed until 2004. There is a more general concern, however, that efforts to use fiscal policy as a means of stimulating the economy at a time of heightened economic uncertainty could fail to produce that spark which brings the private sector back into the picture. Think of the failure of successive fiscal packages in Japan to restart that economy.

The US now faces the re-emergence of a significant twin deficit problem with the growing external current deficit on top of the fiscal deficit. The latest US trade data for December last showed a monthly deficit of $44.2 billion, up from $40 billion in November. For 2002, as a whole, the US trade deficit amounted to $435 billion or 4.2% of GDP. This was up from $358 billion or 3.6% of GDP in 2001. These latest figures suggest that the current account deficit for 2002 is likely to reach 5% of GDP. Countries reaching current account deficits of this order of magnitude in the past have often experienced financial market turbulence with downward pressure on their exchange rates. In the case of the US, the deficit appears to be on a rising trend. The options for reversing this mounting deficit are limited. The deterioration on the trade account is coming from two sides. On the export side, the US has lost competitiveness due to the overvalued level of the US dollar. Furthermore, export markets for US goods are weak. On the import side, the US faces growing import penetration due to globalisation and the strong growth in US domestic demand relative to other countries. The latest figures for December 2002 showed that exports rose by 4.8% in value terms on a year-on-year basis but the corresponding rise in imports was 19.7%.

Looking ahead, it is unlikely that US import demand will slow significantly relative to the growth in US exports. European and Japanese demand for US exports will remain limited due to the sluggish nature of economic growth in these economies. It is also unlikely that the US terms of trade will improve sufficiently to reduce the trade deficit in nominal terms.

With a deficit on trade in goods and the emergence of a deficit on investment income, the US current account deficit could rise to 6% of GDP by 2004 with further deterioration towards 10% of GDP over the medium term.

John Beggs, Chief Economist, AIB Global Treasury.