Weak Currencies are Europe's Best Economic Hope

Over the past decade, little, if any, positive economic news has come out of Europe, as most of Europe’s leading economies have either bounced from crisis to crisis, or have managed to record relatively anemic growth during this period.  However, some glimmers of hope have emerged in recent months, raising the possibility that many of Europe’s leading economies will find themselves on firmer footing in the coming months.  Sure, the imminent withdrawal of the United Kingdom (one of Europe’s better-performing economies) has the potential to destabilize many of the economies in the region.  However, growth rates across Europe have been steady, if unspectacular, over the past two years and much of this has to do with the fact that the region’s leading currencies have all weakened during this period.  Furthermore, it appears that the euro, the pound and other currencies in Europe will remain relatively weak over the coming year. 

While some of Europe’s currencies have rebounded slightly in recent weeks, most European currencies are trading at levels well below where they were a few years ago.  For example, the euro, the region’s largest currency, has lost 20% of its value against the US dollar over the past three years, providing a huge boost for European exporters, particularly those exporting to the US.  The British pound has experienced an even larger decline (23.6%) against the US dollar during this period, with much of this depreciation taking place in the wake of the British vote to leave the European Union. 

In fact, with the exception of the Swiss franc, all European currencies have trended sharply downwards against the US dollar in recent years.  Not only have these currencies weakened against the world’s leading currency, but they have also depreciated against the Chinese yuan, the country that has become one of the leading competitors for European exporters around the world. 

For years, we were arguing that the Euro and most other European currencies were dramatically overvalued and this was preventing Europe from achieving more stable rates of economic growth.  In fact, we compared this situation to that of Japan in the 1990s and the 2000s, when a combination of a declining domestic market and an over-valued currency combined to lead to 25 years of economic stagnation. 

For Europe, the need for a weaker currency is clear.  First, nearly all of Europe’s leading domestic markets are stagnant or shrinking, due in large part to the region’s demographic decline.  The decline of Europe’s domestic markets is adding to the region’s dependency on export growth to generate any economic growth, and the success of Europe’s exporters depends upon the region’s export competitiveness.  One aspect of this are relative cost levels, and thus a weaker currency vis-à-vis Europe’s main exporting rivals in places such as the United States and China help to boost the region’s level of export competitiveness.  Furthermore, a weaker currency helps to make Europe more attractive to foreign investors after a long period in which many European countries struggled to attract foreign investment.  If Europe can boost its export competitiveness in the coming years, then perhaps it can avoid the type of stagnation that has bedeviled Japan since the early 1990s.

As we look ahead, it is expected that most European currencies will remain weak, at least through 2018.  With three interest rate hikes forecast for the United States this year, and with the yuan unlikely to experience a sharp depreciation, European currencies will face more downwards pressure in the months ahead.  Undoubtedly, this is a positive development for Europe’s leading economies, as long as inflationary pressures do not rise too far.  Nevertheless, European economic growth levels will be held down by a number of significant risks facing the region. 

For example, few regions are as exposed to the threat of rising protectionism as Europe, due to its dependency upon exports for much of its growth.  In addition, the process of the British withdrawal from the European Union will undoubtedly slow growth in what had been one of Europe’s fastest-growing economies, and this will have ramifications across the entire region.  Furthermore, domestic demand levels will suffer not only from the demographic situation in Europe, but also from the new threat emerging in the form of higher inflation rates.  Nevertheless, the need to improve the region’s export competitiveness offsets these threats, and thus the weakening of Europe’s major currencies is a welcome development for a region in need of positive economic news.