Analysts have described 2022 as “the worst year in the euro’s history”. However, the euro’s relevance has been in decline for the last two decades. Its share of global official holdings of foreign exchange reserves was 20.6% at the end of 2021, down from around 25% in 2003.
The euro has lost 16% of its value against the dollar over the past year and is trading at the lowest since December 2002.
The single currency is currently 20% lower than its average since 1999.
The strength of the European monetary union would come under more pressure if the inflationary crisis were to result in a protracted economic recession. During periods of rising inflation and shrinking household incomes, the widening of political divides among member countries may also contribute to the rise of populism and jeopardise the Union’s stability.
To prevent the euro from collapsing, the authority in charge of controlling inflation, the European Central Bank, must bring inflation expectations back under control, which requires hiking interest rates decisively.
It is a bitter but necessary pill to swallow in order to avoid further negative outcomes for the euro.
Depreciation in 2022
One of the key drivers of the euro’s depreciation against the dollar in 2022 has been the widening of the monetary policy gap between the Federal Reserve and the ECB.
The Federal Reserve started hiking interest rates in March; this was followed by further, faster hikes. The ECB, however, was slower to act, only announcing its first rate-hike in July 2022.
However, the euro’s decline against the dollar is not solely attributable to widening interest rate differentials. The conflict between Russia and Ukraine has had significant negative effects on the Eurozone’s macro fundamentals, weighing on external accounts and the confidence of households, businesses, and foreign investors.
Consumer confidence in the Eurozone is now at an all-time low. The ZEW Indicator of Economic Sentiment (a sentiment indicator created from the monthly ZEW Financial Market Survey) is at its lowest level since the sovereign debt crisis of 2011; the trade deficit is at an all-time high; the Purchasing Managers Indices (PMIs) for both service and manufacturing activity have already entered contraction territory in July.
Soaring natural gas prices in Europe were another major factor that caused the euro to fall below parity with the dollar over the summer. In particular, the wholesale gas benchmark in Europe (Dutch TTF) is currently eight times higher than US domestic natural gas prices, giving European companies and consumers a big competitive disadvantage compared to those in the US.
The record-high inflation and the bleak outlook for economic growth may still weigh on the euro’s performance in the coming months.
Growing pessimism has already resulted in a significant depreciation of the single currency (-16% in the past year), and it is hard to identify catalysts that could reverse the euro’s course.
Despite the ECB starting its hiking cycle later, it is not entirely clear that it can raise rates faster or for longer than the Fed. This means the euro may continue to struggle against the dollar. The possibility of a further devaluation is real – in a scenario where the euro falls well below parity if energy and inflationary problems persist over the winter.
According to a recent International Monetary Fund (IMF) study, the German economy, the engine of the Eurozone, could see a GDP decline relative to baseline levels of approximately 1.5% in 2022, 2.7% in 2023, and 0.4% in 2024, with no gains in subsequent years from deferred economic activity. This could have a domino effect on the other Eurozone members, which are inextricably linked to Germany’s economy.
By announcing the Transmission Protection Instrument (TPI) in July, the ECB has temporarily curbed the risks of a new sovereign debt crisis in the Eurozone. Rising government deficits as a result of the gas crisis, however, alongside political elections in Italy are risks that could bring sovereign spreads back into focus in the coming months.
What does a crash mean in real terms?
If we examine the REER (Real Effective Exchange Rate) of the euro – a measure of the value of the single currency against a weighted average basket of foreign currencies after adjusting for relative price indices – it is already approximately 7% below its long-term mean.
The euro has historically undergone two significant episodes of real devaluation. The first occurred between November 2009 and July 2012; it was precipitated by the Great Financial Crisis and worsened by the Eurozone debt crisis. The euro’s real effective exchange rate (REER) fell roughly 17%, from 110 to 92 levels.
The second happened between March 2014 and April 2015. The European Central Bank (ECB) announced an extensive quantitative easing programme while the Federal Reserve was pursuing differing and more restrictive monetary policies. The euro’s REER fell by about 14%.
If we are confronted with another major real shock of the euro, like those already mentioned, we could still experience an 8-9% decline in real terms.
Given that we are already in an inflationary period, further euro depreciation could result in higher inflation, with dire economic consequences.
The capacity for response
Following the 2008 Great Financial Crisis, the ECB had ample room to lower interest rates because the Eurozone was in a deflationary phase. This recession might be different, as it is likely to be marked by persistently high inflation due to the gas crisis, which prevents the ECB from using monetary stimulus to revive the economy.
A further depreciation of the euro cannot be easily avoided given the macro-outlook, but the ECB has the tools to mitigate the speed of the decline. For this to occur, the ECB must implement outsized and quicker interest rate hikes.
With inflation at record highs, the ECB cannot afford to be complacent. The risk of escalating market inflation expectations and the failure of the euro to find a floor could have more damaging consequences than a recession.
With fewer monetary weapons now available, the Eurozone’s future economic recovery may need to go through a new phase of reforms and productivity growth, driven by the ambitious Recovery Fund’s commitment to promote the green transition and the digitalization of the economy. Even if this were to be completely successful, however, there’s a long and winding road ahead.
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