LONDON, 14 February 2005 — The theoretical evidence suggests that the euro is slightly overvalued at current levels against the dollar. If the US increases the domestic savings rate and there is Asian currency appreciation, there would be little justification for further significant dollar depreciation against the euro and the US currency could certainly avoid a fresh record low this year.
If, however, US and Asian politicians fail to make the necessary policy adjustments and the markets lose confidence in a gradual US adjustment, the euro is likely to be subjected to further upward pressure, potentially pushing it to at least EUR1.50/$ within 12 months.
Estimates of Fair Value
The US current account deficit, at over 6 percent of GDP, will remain a very important currency-market focus and the relationship between the deficit and the dollar will also be crucial during 2005. The dollar has recovered from a record low against the euro of 1.3660 at the end of 2004 to stand at close to 1.28 and there is uncertainty over near-term direction. In the near-term, there will be a conflict between interest rate factors and structural issues. An important question, therefore, is whether the dollar is still overvalued or now undervalued against the euro.
The latest purchasing power parity (PPP) estimates from the OECD suggest that the PPP rate for the dollar against the euro was around 1.12 in 2003 and the theoretical PPP rate will still be close to this level. This implies that the euro is overvalued by around 12.5 percent at current levels.
The latest index on fast-food prices also pointed to the euro being overvalued, this time by around 25 percent. The service sector is not, however, exposed to international competition and there will, therefore, be a distorting effect as the industrial sector is forced to be more competitive in order to compete within international markets.
Without getting bogged down in complicated econometric models, the evidence suggests that the euro is overvalued on a pure price basis by around 10-15 percent at current levels.
Dollar Needs to Be Weak
The dollar will, however, need to be weaker than an equilibrium level as a period of undervaluation is needed to help correct the trade imbalance and compensate for the overvaluation seen between 1999-2002. A sustainable US current account deficit is likely to be in the region of 3.0 percent of GDP and a weaker dollar will be part of the mechanism to lower the current account deficit. An equilibrium value would be in the region of EUR1.20-1.25/$.
As far as the trade data is concerned, the US monthly trade deficit with the euro zone amounted to $7.6 billion in December and there was a 2004 deficit of $82.9 billion.
The trade deficit figures will, however, have to be cyclically adjusted given that US spending growth is faster than in the euro zone. Strong US demand will push up imports into the US and will inflate the trade deficit even if there is no valuation disparity. A cyclically-adjusted deficit would suggest that dollar levels around current levels would be enough to control the trade gap with Europe.
Political Action Remains Crucial
This does, however, assume that the US also closes the domestic savings gap. The problem is that the US is running a structural rather than a cyclical savings gap.
If the US does not narrow the structural savings shortfall, then the trade deficit is very unlikely to narrow no matter how far the dollar depreciates. In this context, promotion of a weaker dollar to close the trade gap would be ineffective at best.
Asian currency policies will also remain important given that the bulk of the US trade deficit is with Asia. If Asia continues to resist currency appreciation, the burden of adjustment will continue to fall on Europe and the euro. (Investica Ltd.)
