Euro v Dollar – 4800 words

   INTRODUCTION

 

Will the Euro rule over the Dollar as a leading international currency?

This question was even discussed ten years ago when the dollar was the uncontested leading currency in the world. In the aftermath of World War II, the dollar emerged as a leading international currency and economists believed this had a historic significance. During 1899 the share of the pound in foreign exchange market holdings had been twice greater that of its nearest rival competitors. Even the franc and the mark were greater than the dollar. Lending of US and UK borrowings to fight World War I resulted in the fall of the pound and the subsequent rise of the dollar. The decline in the pound was also due to the UK losing its economic dominance, colonies, and military power. This reversal procedure indicated the changing trends in economic fundamentals, which were already taking since the late 19th century. During 1872 the US economy started surpassing the UK economy but its exports did not move ahead of the UK until 1915 due to the non-establishment of a central bank, which was founded in 1913.

 

In the 1990’s economists questioned whether the dollar was on its way of losing its status of international currency as had happened with the pound after World War II. The yen and the mark were rising steadily during the 1970s and1980s as their shares in the central bank’s holding of foreign exchange were rising steadily. Moreover, the fundamentals of the Japanese and German economies in terms of low inflation rate and their current account surplus attributed various factors.  The fact was the Japanese and German economies and their currencies were far behind the United States and the dollar. Actually throughout the 1990s the dollar’s share in reserves rose tremendously and also was much in demand in Latin America and in the rest of world because people had lost faith in their currencies. Again now, it is being questioned, whether the dollar is losing its role of international currency. The present circumstances predict the answer ‘yes’. Due to reason the euro standing as a greater potential threat than the mark and the yen were. Other factors such as chronic current account deficits in the last 25 years of US history and the depreciation trend of dollar are also influencing over euro.

 

 

Before the economic crisis hit financial markets, the US dollar was lying low and an upward trend was shortly expected. Difficulties in credit conditions in world financial markets and difficulties in receiving money resulted in the value of the dollar going up. The pound also weakened against both the dollar and euro as it is entered in a period of devaluation.  The recent performance of the pound against the euro is causing some consternation to UK – as will its fate in 2008. For exporting UK businesses however, the recent weakening of sterling is a welcome respite. On the foreign exchanges the pound is now worth €1.344, having tumbled steadily from €1.525 in January last year. The pound has been worth more than €1.45, give or take the odd week, since January 2004. A pound now buys only €1.255 at the High Street bureau de change.

 

The pound has weakened sharply against the euro and dollar in recent months but many economists believed this is an overdue correction to an overvalued currency. So what are the factors that determine a currency’s exchange rate and why do currencies get over or undervalued? A currency’s exchange rate is its price in terms of another currency. Most major currencies – the pound, dollar, euro and yen for instance – are ‘freely floating’. This means their exchange rate is determined by market forces, by the levels of supply and demand on the internationalmarkets.
There are several factors affecting this. A higher interest rate means a better return on bonds, gilts and other Government securities and will tend to attract financial capital from overseas. So if UK interest rates go up the pound will be strengthend against other currencies, and vice versa.  Institutions tend to move investments out of weakening economies and into ones perceived to be strengthening. So an economy whose indicators like growth, inflation and debt burden are positive trends will see more demand for its currency and see its exchange rate strengthen. The pound has generally seen itself rated strongly against both the dollar and the euro in recent years, as its economy has done relatively well. Other countries must buy sterling in order to buy UK goods, so if there is a high demand for British exports, the pound will tend to strengthen. Large trade deficits as the UK has run in recent years will tend to depress a currency. But it is a circular relationship: the exchange rate will also affect levels of imports and exports. If the pound is strong, UK exports become less attractive, and foreign imports more so.

Official interventions.

Governments or central banks could intervene to prop up a currency for political or economic reasons by buying it on the international markets, or by raising interest rates. The John Major government in 1992 controversially raised interest rates by five percentage points and spent billions in a doomed attempt to keep sterling in the European exchange rate mechanism (ERM).

 

Stocks and speculations.

     Markets don’t like unexpected news and because currency markets are very ‘liquid’ (shortages of a currency are very rare), exchange rates are prone to move quickly in response to surprises. Currencies are also traded as speculative investments in their own right, and expert brokers trade them according to how they think the market will move. But these trades in themselves will affect exchange rates.

A lot of reasons can influence fluctuating market and currency rates, and not one or two can be blamed for any sort of rise or fall in them. Although it is not advisable to say that the financial market business is more or less based on these fluctuations only. Traders trade in this market, purchase and sell various currencies with the expectation of making gains if the value of the exchange moves in their favor. Now this sudden movement in the market can be caused by either market news or current events all over the world, which have an effect on the demand and supply of these currencies.

This law of demand and supply is what works well in this financial market too. When the demand of a particular currency goes up, its market price also escalates as compared to the other currencies in the market.

Similarly, if the demand of a particular currency goes down, traders are no longer interested in holding it back with them, and so the market price of the currency also decreases.

Economic development

It is quiet obvious that the traders trading in currencies and interested in exchange markets, will be equally keen and interested in knowing about the overall economic development of the countries whose currencies they hold, or are interested in buying. Every trader wants to be convinced that they economy they are about to invest in is developing with a solid and steady growth, which can be known by studying various factors such as unemployment, import and export, and the GDP statistics of a particular country.

Rise in Unemployment experienced by any particular country is considered as a negative factor, whereas a fall in Unemployment is always measured as a positive aspect.

Similarly, an increase in the GDP figures of a particular country is considered as a positive feature, whereas a decrease in GDP figures is always measured as a negative aspect.
Also, a mount in the Exports numbers of a particular country are always considered as a positive trait as compared to the decrease in Exports numbers which is looked upon as a negative aspect.

 

 

Political strength

Lots of factors are responsible for determining the political stability of a particular country. These factors can be any kinds of alterations in government or by the government, rising unemployment rates, elections or international and political conflicts.
Every investor is cautious enough and considers all these factors in his mind before going in for investing in a particular economy.

Any kind of Political conflicts, natural calamity or terrorism attacks or wars are major contributors in making or marring the economy of a country

When and Why a Currency is described as Weak or Strong.

This is the tricky question. After all, one could argue that the market price is the right price, and therefore it’s never too high or too low. But markets aren’t perfect. Exchange rates are sometime perceived as being unrealistically high or low. For instance, it is widely asserted that sterling has in recent years been strong (or ‘overvalued’) against the dollar, and perhaps even the euro. Much of this is intuitive: if US goods seem unnaturally cheap, and US importers shun UK goods as too expensive, and the British trade deficit is widening, then the suspicion arises that the pound is too strong.

CONSUMER:
Can a sort of ‘average rate’ be discerned over the long-term? Not really: changes in countries’ real economic conditions mean that an historical ‘fair value’ for the pound against the dollar doesn’t really exist. Sterling nearly hit the $1 dollar mark in 1985, but had been as high as $2.44 five years previously. That doesn’t mean however that a fair value can’t be estimated at any one time, or over the medium term. The best-known method of measuring what it might be is purchasing power parity. This takes as its basis the cost of living, and asks: what is the exchange rate that would make one’s money go exactly as far in one country as the other? The most basic versions are the measures that use one product. For instance, a 4GB iPod Nano costs £99 in the UK and $149 in the US – direct from the Apple Store in both cases. This makes the PPP exchange rate just over $1.50 to the pound.

The Economist magazine runs its Big Mac index, which surveys the price of the burger around the world. In 2007, a Big Mac was priced at £1.99 in the UK, and $4.01 in the US: this means the PPP exchange rate is $1.71.

Obviously, these are slightly unscientific measures. There could be specific local reasons why I Pods or Big Macs are priced differently, and most people’s cost of living is not restricted to consumer electronics and fast food. So more advanced PPP measures take a basket of goods and looks at how much it costs in the US in dollars versus how much it costs in the UK in pounds. The World Bank undertakes this laborious process for every country in the world in its International Comparison Program. In 2006, its report put the PPP exchange rate at $1.66 to the pound.

So in this sense the feeling that sterling has in recent years been overvalued against the dollar is justified.

 

The Forecast Global Currencies of World Markets-2009.

The year 2008 has brought to investors many surprises. So, the second half-year in the international currency market became most fluctuating in comparison to the period for last years. The main background of “development” of financial markets, certainly, became global financial crisis, causing transformation in general economic recession. Investors began to leave from financial platforms, deducing the means from all without analysis of tools, thus aggravating a collapse of the share markets. Participants have preferred flight in so-called “quality”, on behalf of the American dollar and exchequer bonds the USA, as the most reliable, in their opinion, actives in modern conditions.

Dynamics of rates of exchange in 2008.

For these reasons, only during the period from the middle of July on the end of November the American dollar has become stronger to uniform European currency on 20 %, having reached on pair EUR/USD of a level 1,25 (whereas in July the pair was on a mark 1,59).

Schedule 1. EUR/USD 2008

 

 

 

 

 

 

 

 

 

 

 

 

 

The pound sterling, in March costing more than two dollars (2,01), by the end of year is at a level 1,5. Thus, from levels of the maximal value the British currency has lost more than 25 %.

Schedule 2. GBP/USD of 2008

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Change of tendencies

In the beginning of December in international currency market, of the tendency have exchanged. Participants at last have reflected on, whether so the national currency the USA and state debt papers denominated in it as it is considered to be is reliable and safe. Especially in conditions when the Exchequer and the Central Bank of the United States unpunished maintain a press on full capacity. In a result less than for a month the European currency managed to win back at dollar more than 12 % of the cost lost for last quarter. And pair EUR/USD has all chances to close year near to a mark 1,40.

All these enormous fluctuations in the international currency market were accompanied by repeated ineffective attempts of financial authorities of the key countries though somehow to stop the type revolution total economic recession. Practically at each session the Central Banks of the leading states of the world softened the monetary and credit policy. In a result by the end of year key rates in these countries have achieved long-term minima . Thus many Central Banks have actually deprived with themselves an opportunity of use of such traditional tool of monetary regulation, as change of interest rates. The given circumstance is still the big uncertainty of consciousness of investors.

 

 

Forecast Exchange Rate of 2009.

Proceeding from all above-stated, we expect easing of dollar to the basic currencies in coming year. And if in the first half-year 2009 it is possible to predict some lateral movement in key pairs in the currency market, in second half of year (in process of stabilization of economic) descending dynamics of dollar will most precisely be expressed. The measures accepted by financial authorities the USA on stimulation of economy and overcoming overhauling of processes, all undermine trust of investors to American to ” paper values » more.

In a result – our forecast on EUR/USD in the first half-year 2009 assumes movement of currency pair in a range 1,30-1,55 with the subsequent easing dollar in second half of year up to values 1,55-1,75. Thus, in case of development of the most pessimistic scripts, we do not exclude an opportunity to see in coming year currency tandem EUR/USD on a mark 2 dollars for one euro

 

 Forecast EUR/USD of 2009.

 

The British pound also, in our opinion, will seriously win back a part of the lost cost in pair GBP/USD. The target range on the given currency tandem will be established the next year at a level 1,40-1,90.

 

 Forecast GBP/USD 2009

 

The important macroeconomic indicators leaving in 2009 (it is especial in I-II quarters), will have generally pessimistic character, confirming the fact of the further recession, both in industrial sector, and in sphere of services. The published data on a rate of unemployment still will testify to serious problems on a labour market. Indicators of business activity the most part of year will stay on minimum levels. Volumes of consumer crediting and personal charges will make also rather modest values.

Decrease in rates of gross national product of the majority of the countries of the world, amplifying deflationary processes in economically advanced states, the further mitigation of a monetary and credit policy there where it is still possible (the Euro zone and the Great Britain) – on a background of these events will “develop” market FOREX in new 2009.

 

To determine the basic trends of movement of the main currency pairs the next year, consider the current fundamental preconditions, capable to render the greatest influence on movement of a rate of the American dollar in the foreseeable future At the end of 2008 in America the data on a condition of the federal budget the USA for November have been published. As it became known from the release promulgated by the Ministry of Finance, deficiency of the budget of the country this month has made 164,4 billion dollars. In a result for first two months 2009 (we shall remind, fiscal year in the USA begins in October) the American treasury has increased up to 401,6 billion dollars. For comparison, for all last fiscal year deficiency of the budget has made 454,8 billion dollars. Thus, if to assume, that the current tendency of increase in deficiency will proceed, let even not such prompt rates by the end of this fiscal year the United States can receive “hole” in the federal budget in area of one and a half billions dollars (at the budget in 3,1 bln. dollars). And more than it is enough bases for such assumptions. Accepted measures on stimulation of a national economy result in huge budgetary charges.

In such conditions the destiny of the American dollar in the future is unenviable. Growth of cost of dollar at such huge blank in the budget will have fatal consequences for economic system of the country. In particular because it will create unreasonable debt loading on “sick” economy, which and so every year all is more difficult to serve the obligations. Therefore the States, most likely, will not allow increase in a rate of national currency.

 

Forecast of Possible Trend of Currencies in Coming period.

The British Pound Sterling has suffered more from the financial crisis and recession than any other major currency. From its high point of just over 2.1100 in November 2007 to its Friday close at 1.3812 the Sterling has lost 35% of its worth against the US Dollar. It has sustained similar losses against the Yen, 51%, the Euro 44%, and the Swiss Franc 36%.

In comparison the Euro has declined only 19% against the Dollar, 32.1% versus the Japanese Yen, and 11% against the Swiss Franc; the Australian Dollar has lost 33% against the US dollar, and 46% against the Yen; the Canadian Dollar has fallen 26% against the American Dollar and 43% against the Yen but gained 9% against the Euro; and the Swiss Franc has dropped 20% against the US Dollar and 27% against the Yen while gaining the above 11% against the Euro. With the exception of the Yen crosses which were the beneficiary of the funding based carry trade and whose destruction in a welter of deliberating, repatriation and capital flight is a story apart from the general market, the Sterling has forfeited more value than any other industrial world currency.

The immediate economic and interest rate prospects can account for a large part of the market disenchantment with the Pound. But there are also secondary concerns, the British sovereign debt outlook, the health of the banking system, the pending election and even the trading history of the Pound, which although not as quantifiable as interest rates or GDP add considerably to a Sterling trader’s worries. Unfortunately for the British public and the government not one major criterion is positive for the Pound.

Gross National Product in the United Kingdom plunged 1.5% in the last three months of 2008. It was the largest economic contraction since 1980. The British housing market has experienced a credit fueled real estate boom like the US and is mired in oversupply, falling prices and bankrupt mortgage lenders. Unemployment is at 6.1% the highest since 1997, claims jumped 77,900 in December and consumer spending and confidence are sinking. Industrial and manufacturing outputs were down 6.9% and 7.4% respectively on the year in November.

Posited Scenarios

Various experiments so far concluded have proved similar results Two of them produced the result that the euro would gradually gain on the dollar, and sometime early in the 2020s the system would reach a tipping point, a fast reversal in which the euro would surpass the dollar, which would then settle in at the number 2 slot. The first scenario was that EU countries that are not currently in EMU, of which Great Britain is by far the most important for these purposes, would join by 2020. Even three years ago prevailing conditions were all together different and today as UK economy performed well since the start of EMU. The major factors coming up seemed to be small EU members joined the euro countries. Under these conditions the dollar continued to lose value in the future at the same rate that it had in the past. This scenario produced a flipping of roles between the dollar and euro taking place around 2022.

On the one hand, we can argue that this scenario was too pessimistic for the dollar in two respects: first, the 2001–04 rate of dollar depreciation that we used was more rapid than the longer-term historical average, and, second, the scenario did not allow for likely more rapid economic growth in the United States than among European countries. On the other hand, one could argue that the scenario has proven to be too optimistic in three respects. First, the dollar has actually depreciated since 2004 at a more rapid rate rather than a slower rate. Second, European growth prospects now appear not that bad after all, in light of a modest recovery of productivity growth in the meantime in Western Europe and in light of the continuing gradual process of accession by countries that, although small in GDP per capita, loom larger in terms of both population and growth prospects.

The third point is potentially the most important by far. The measure of financial development that has been analyzed until now financial turnover in Frankfurt versus New York understates the progress of the euro. We also find that the liquidity and breadth of euro financial markets are fast approaching those of dollar markets, and as a result the euro is eroding some of the advantages that historically supported the pre-eminence of the US dollar as a reserve currency’. Three years ago we had taken for granted that the euro would benefit from the depth and liquidity of London financial markets if and only if the United Kingdom were to join euro land, which is sighted as an unlikely prospect.

(In this we shared the assumption by British policy makers, for whom staying out of the euro was presumed to run the danger of substantial negative effects on London as a financial center.) Frankfurt remains far less developed as a financial center than London or New York, which in the earlier scenarios was perhaps the clearest drag on the euros progress as an international currency. But as of today, it appears that London has managed in many respects to become the financial center for the euro even while the United Kingdom remains outside EMU.

We now drop from the scenario the idea that the United Kingdom, Denmark and Sweden join the euro area anytime soon. We also drop the assumptions that the dollar continues to depreciate indefinitely at the 2001–04 rate (let alone the rate of 2004–07).

Our second scenario is the most conservative case: the dollar in the future depreciates only at the rate experienced on average over the 20 years up to end-2007, and only the new accession countries join the monetary union. Using the actual market GDP levels, exchange rate volatility and trading volumes recorded in 2007, we obtain the predictions for the dollar versus the euro. In this case, the dollar retains its primacy, even as the euro narrows the gap to a 40–60 difference.

As noted above, the issue of financial depth is important. Our third scenario implements the idea that London, not Frankfurt, is in some sense the true financial center of the euro. It seems implausible, however, to assert that London is entirely devoted to providing the liquidity for the euro area. We chose to allocate 20% of London financial trading to the euro area. Applying this measure of financial depth, the euro overtakes the dollar sometime around 2015.

These simulations illustrate what sort of combinations of assumptions can drive the tipping

Points.

Conclusion

Although our econometric analysis pertains only to the reserve currency role, we believe that similar conclusions apply to other criteria of international currency status. For one thing, similar considerations of country size, financial depth and rates of return also have direct effects on decisions by private citizens regarding what currencies they hold for transactions and as a store of value. For another thing, each international currency function has important influences on the others. If central banks hold more of their reserves in the form of euros, they are more likely to want to undertake foreign exchange transactions in terms of euros. Thus the euro could come to be used more as a vehicle currency in the foreign exchange market. But if it becomes easier to transact in terms of euros in the foreign exchange market, without having to go through dollars, then private firms are more likely to invoice trade in euros and keep transactions balances in euros. If they invoice trade in euros and keep transactions balances in euros, then they are more likely to want to borrow in terms of euros. And so forth. Consequently, if the dollar were to overtake the euro as a reserve currency, it is natural to conjecture that the international usage of the dollar might also be eclipsed by the euro along these other dimensions as well.

Summary of Conclusions.

Predictions about various factors under which the euro might in the future rival or surpass the dollar as the world’s leading international reserve currency are the major pay-off of this paper. Several years ago, we examined closely the conditions that would produce a reversal of roles within the subsequent two decades were along the lines of either a scenario under which the United Kingdom joined EMU, which seems unlikely, or one in which the dollar continues to depreciate at the same rate as it had over 2001–04 (4% per year, trade-weighted), presumably because US macroeconomic policies eventually undermine confidence in the value of the dollar. Now, even with the United Kingdom out of EMU, if a fraction of London’s financial markets is counted as the home for euro transactions then, we find that the euro could overtake the dollar as early as 2015.

If the dollar does indeed lose its role as leading international currency, the cost to the United States would probably extend beyond the simple loss of seigniorage narrowly defined. We would lose the exorbitant privilege of playing banker to the world, accepting short-term deposits at low interest rates in return for long-term investments at high average rates of return. When combined with other political developments, it might even spell the end of economic and political hegemony. These are century-long advantages that are not to be cast away lightly.

Most recent assessments of the sustainability and adjustment of the US current account feature substantial depreciation of the dollar in the future, whether adjustment then operates via expenditure switching or a valuation effect. Our results suggest that such dollar depreciation would be no free lunch, and could have profound consequences for the international monetary system. These consequences include the loss of the exorbitant privilege of easy financing of large US deficits, both government and national. The political influence that American policy makers have internationally, including in international institutions, could also be diminished.

If the euro were to overtake the dollar in a few decades, it would be a once-in-a-century event. But it happened to the pound in the last century, so who is to say it could not happen to the dollar in this?

 

 

 

 

 

 

 

 

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