Euro To Reach Parity To USD?

When should we plan to go to Europe? Now or later this year? I would say, wait for parity. There are two sides arguing about the direction of the Euro.

On news that China is to increase the flexibility in the yuan's fixed exchange rate, by mid-afternoon trading in New York the EUR had fallen 0.6% against the U.S. dollar to USD/EUR 1.2311 on June 21, 2010. The fall also followed news from ECB President Jean-Claude Trichet that governments in breach of European fiscal rules could face tougher punishment, such as the withdrawal of voter rights.

Despite a recent barrage of bad news regarding the European sovereign-debt crisis, the euro only fell 0.3% against the dollar on June 16, 2010, to US$1.2291. This is higher than both the recent low of US$1.1966 on June 4, 2010 and the euro's 10-year US$1.20 average. Analysts at Brown Brothers Harriman predict that if the euro stays above US$1.2220 then the recovery should hold, while Steve Barrow, a currency analyst at Standard Bank, believes there is more trouble is to come: "Even if the eurozone debt crisis is over the euro should still fall...the eurozone needs a weaker currency to allow it to cope with fiscal stringency."

The Peterson Institute for International Economics has calculated the fundamental equilibrium exchange rate (FEER) of the euro. The EUR was estimated to be undervalued by 0.6% against the U.S. dollar in May 2010. The FEER approach involves finding a set of exchange rates that simultaneously achieve internal and external balance in every country. Internal balance is defined as the state in which a country maintains full employment and price level stability (or zero inflation). External balance signifies a condition in which a country maintains a "sustainable" current account—a moderate deficit or surplus for a developing country and a surplus for a rich country (traditionally). The resulting rate provides an indication of how under- or overvalued a currency is, based on fundamental indicators.



It was reported that BNP expect the EUR to fall below U.S. dollar parity by the end of 2011. The forecast is based on the euro requiring a prolonged period of undervaluation to give the EMU the growth needed to escape the sovereign debt crisis. FX strategy analysts at BNP project the euro will reach parity at the end of Q1 2011 because "the Greek aid package has failed to stabilize markets." Also, there is a risk that the ECB will remove the unconventional monetary stimulus measures too rapidly, leaving the fragile eurozone recovery vulnerable.

On June 15, Danske Bank forecast EUR/USD bottoming out at 1.15 during the latter part of 2010, followed by a slow discovery to 1.27 by mid-2011. Despite current weak market sentiment for the euro, Danske analysts say, "if Europe manages to tackle its debt problems it will underline the fiscal challenges that lie ahead for the U.S. The dollar will also have to bear the burden from an unsustainably large and, not least, widening current account deficit, which is not the case for Euroland. Furthermore, the weaker euro also boosts European competitiveness relative to the U.S." Deutsche Bank forecast the euro strengthening to 1.35 USD/EUR by mid-2011. As of June 4, the euro was US$1.2 against the dollar.

Historical Records

• 2009 high: December 3, 2009, when EUR/USD rose to US$1.512.

• 2009 low: March 5, 2009, when EUR/USD fell to US$1.25 on European economic gloom, CEE exposure and the ECB rate cut.

• 2008 low: October 28, 2008, when EUR/USD hit US$1.2330.

• Steepest one-day drop ever: September 30, 2008, when EUR/USD fell 2.5% to US$1.4074.

• Steepest one-day rise ever: September 22, 2008, when EUR/USD rose to US$1.47 on news of the U.S. bailout plan.

• All-time low: October 25, 2000, when EUR/USD hit US$0.8248.

• All-time high: July 15, 2008, when EUR/USD hit US$1.6038 on the dovish testimony of Fed Chairman Ben Bernanke.

My view is that the Euro will try to breach parity sometime this year. It may not succeed though, but it should get very close 1.02-1.04 is likely. Hey, why all the fuss, when the Euro was enacted and blueprinted, it was supposed to trade 1-to-1 to the USD, so now we are just trying to get back to fair value.

Collectively, managing the Euroland crisis will be a lot tougher than managing the US subprime fallout. You can get the President, Bernanke, Geithner, and a few bank CEOs into one room and hash out a plan. You try to do that with the EU, you will have dissenting countries, some countries wanting different plans, some countries not putting in the money or do not have the resources to do so, some of the richer countries squabbling about why they have to shoulder the bulk of the burden, etc.

The strain will be so great that I suspect the EU may ask Greece and Hungary to step out of the EMU until they hit the fiscal restraint targets over the next 3 years. This way, the iffy countries such as Spain, Italy and Portugal may rein in their budget and fiscal problems more urgently.

Asia's Nervousness

For much of Asia, the last few months have been a bit nerve wrecking. While the dominos have been tumbling in US and Europe, Asians have been sitting nervously. The consensus was that this was the biggest global contagion since the 1929 Depression.

For almost everyone in Asia 30 years and above, we are sitting tight. Though the economic conditions in Asia are still relatively vibrant, at the back of our minds we cannot shake off the memories of 1997-2002 Asian financial implosion. No one dared to come out and say that Asia is different this time around.

Surely any substantive weakness in US and Europe will have its effects on most Asian economies. We have felt the tremors, but are still wary of a potential sledgehammer in the near future. Will it be coming down soon?

At the back of our minds, the balance sheet of most Asian economies have improved significantly since the 97 crisis. Is that sufficiently strong enough to weather the storm? Many Asian countries have the US as a major trading partner, surely that counts for something.

There are a few things which have evolved over the last 5 years. One, China's emergence as an economic power. Two, Asia's intra-trade have also grown substantially. Three, the US weakness is actually impacting less on the broader US economy and larely contained in property and financials.

The third point is very important. Many American companies are still seeing OK fundamentals because of globalisation (outsourcing) that has been taking place over the last 10 years, in particular over the last 5 years which has been at breakneck speed. Globalisation involves an increasing dependence on foreign markets. The outsourcing movement has also move a substantive part of manufacturing operations and processes in emerging countries.

There are many who incorrectly criticise China's stupendous trade surpluses. However, some 60%-70% of all China exports are actually manufactured by foreign companies and joint ventures operating in China back to other markets. They are not primarily China's own real exports that are home grown. China as a growing country have parlayed the buzzing economic activity to building infrastructure, thus its voracious appetite for commodities. China is at a stage where it can still ramp up infrastructure to sustain the economic growth.

Thus the ill effects on the broader American economy is not as bad as it appears. Most emerging markets, though affected, are not that dependent on America funding. Emerging markets' banks are relatively unscathed. While some weakness will be evident, it should not be paralysingly so.

Asians are scared to even dare mention that they are OK as they know how things were just a few years back. While its prudent to be cautious, we need not scare ourselves silly.

p/s photo: Dhini Amirnati Maulana