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Pimco: The Euro Tug-of-War


The eurozone could end up with problems similar to Japan's: a too-strong, overvalued exchange rate, weak growth, very low overall inflation, and deflationary tendencies.

Figure 4 below highlights this positive current account development and the historical relationship with the direction of the euro. The trend points to a stronger trade-weighted euro exchange rate in the months ahead. A positive relationship between the current account developments and the exchange rate makes intuitive sense. Given the current 2% surplus relative to GDP, more than €200 billion of capital would need to leave the eurozone every year in order for the currency to depreciate against key trading partners. Every euro less will support a rise in the euro exchange rate.
Euro rise as an indicator of political confidence

However, Figure 4 also illustrates that the state of health of the current account balance is only one side of the coin. In today's world of high capital mobility, the balance of capital flows is the other – at least as important – determinant for the direction of an exchange rate. And there is the rub for the euro.

We recently celebrated the first anniversary of European Central Bank (ECB) President Mario Draghi's "All it takes" speech at the Global Investment Conference on 26 July 2012. At that time, investor confidence in the institutional setup of the eurozone had become so fragile and undermined that the region was just one step away from facing a classical capital flight crisis. A capital jog from the eurozone was already happening and the euro was in a steep decline, despite the ongoing improvement in the current account balance. Mr. Draghi's courageous step and subsequent ECB announcement of the Outright Monetary Transactions (OMT) program on September 6, 2012 helped prevent a financial panic and stabilize the euro exchange rate. Since then, capital has been flowing back into the periphery and into the eurozone as a whole. In that sense the appreciation of the euro over recent months can be seen as a rising vote of confidence for the region by global investors.
Europe's risk: Strong euro, weak growth

The only fly in the ointment is that a rising euro exchange rate has the potential to undo much of the eurozone periphery's hard-won international competitiveness and undermine the fragile social consensus to continue with the necessary structural and fiscal reforms. The more capital the eurozone is able to crowd-in from abroad, the higher the probability that these capital flows eventually become self-destructive as they increasingly undermine the ability of the peripheral countries to perform successful structural transformations of their respective economies.

According to ECB estimates, a permanent 10% rise in the euro's real effective exchange rate results in a cumulative reduction in GDP between 0.6% (Global Vector Auto & Regression model) and 0.9% (Automated Valuation Model model) over three years relative to the baseline growth scenario. Given our subdued growth outlook for the eurozone over the next three to five years, another significant rise in the euro exchange rate could therefore make the critical difference between low, but positive, growth and an outright recession.

Where does this all leave investors?
Considering the ongoing improvement of the eurozone current account surplus in combination with rising net capital inflows – primarily driven by portfolio flows – there is a rising non-trivial probability that the euro will continue to appreciate against the currencies of its main trading partners in the weeks and months ahead. Europe could end up with problems similar to Japan's: a too-strong, overvalued exchange rate; weak growth; very low overall inflation and deflationary tendencies (at least in some parts of the eurozone).

Unless the ECB shifts gears, its conservative and reactive policy stance only adds to the odds of a "Japanization" of Europe.

This article originally appeared on Pimco.
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