The euro - return of the zombie

Its resurgence is good news for Indian firms

The award for the biggest surprise in the currency markets this year must surely go to the euro. It has gained by a hefty 6.9 per cent against the dollar since the beginning of 2017, effectively silencing the tribe of sceptics who, temporarily dazzled by the intensity of the pro-dollar Trump trade, had (yet again) predicted a precipitous fall in the currency.

Two things are happening with the euro that needs to be appreciated. First, the last few so-called “risk-off” phases (driven by say a fresh leak on the US administration’s alleged collusion with Russia), the euro has emerged as a “safe haven”. This is in contrast to the last few years when the slightest whiff or risk sent market players scurrying to the American dollar. Second, while there has been considerable evidence of growing strength in the euro region for a while now, the robustness in the currency is finally highlighting the underlying fundamental strength of Europe. Indian exporters and importers for that matter are taking note. We can think of a number of export companies who are contemplating a ramp-up in their business links with Europe. Forecasters are beginning to push up their numbers for the current year from 1.7 per cent earlier to a healthy two per cent and building in further traction in 2018.

The political situation has, of course, played ball. The victory of the pro-euro candidates in the Dutch and French elections has effectively laid fears of a domino effect of Brexit on continental Europe to rest. It has also ushered in the prospect of market-oriented reform to drive growth instead of insular protectionist regimes. The new French president Emmanuel Macron is considering a serious revamp of France’s labour laws that have for years affected its competitiveness. Other economies that have high rates of unemployment could follow.

How much further could it gain against the dollar? Therein lies the rub. While it is possible that its economic fundamentals get stronger by the day and perhaps even give the US (that has led the global recovery) a run for its money, the European Central Bank’s (ECB) monetary policy stance could rein in the exchange rate. Euro bulls and indeed some of the region’s policy bosses were more than a tad disappointed when Mario Draghi, the ECB president, announced recently that the eurozone still needed considerable monetary stimulus. This set to rest expectations of a more hawkish policy stance in the monetary policy due on the 8th of this month. If the US central bank hikes rates as the markets expect and Europe stays pat, more attractive interest rates in the US vis-a-vis Europe could dull the euro’s edge a little.

Draghi does have his reasons. Inflation remains subdued, with core inflation in the region printing at around 1.2 per cent year-on-year for April. Much of the softness has to do with the unemployment rate that’s still uncomfortably high at 9.5 per cent. Besides, there is a large pool of unemployed workers who are too discouraged to look for work or are underemployed. Estimates by Capital economics, a well-known think tank put “labour market slack” at a hefty 18 per cent of the workforce.

The problem with Europe of course is the huge variation in economic performance. The German economy is operating close to full capacity and thus it wants Draghi to tighten soon. Countries on the periphery such as Spain have considerable excess capacity and would want the super loose monetary policy to continue. Thus, Germany could see inflation pressures build up and that could impinge on its export competitiveness. Berlin is likely to be unhappy with this but differential inflation across the region could check some of the internal imbalances (a massive German trade surplus that had built up in the late 2000s) that had ultimately driven the great European crisis of 2010-11

A resurgent Europe and euro is good news for Indian companies. Europe is one of our top export destinations and a source of foreign direct investments. If it sustains its momentum it could counter some of the problems created by a protectionist US and soft-landing China.

Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is chief economist, CII