THE IMPACT OF THE GLOBAL FINANCIAL CRISIS ON EURO-DOLLAR EXCHANGE RATE

Abstract

Financial crises are often associated with surprising exchange rate evolutions. The exchange rate evolution can be explained with the help of fundamentals, but during financial turmoil, their analysis became irrelevant as the markets turned extremely volatile. This paper attempts to show that there is no correlation between macroeconomic fundamentals and euro-dollar exchange rate, at least not during periods of crisis. In analyzing the euro-dollar relationship, we identified some factors that influenced the exchange rate evolution since the beginning of the crisis, such as a repatriation of capital to the US by US investors in euro area, a fight-to-safety phenomenon by US and euro area investors and an increased need for US dollar liquidity by European banks. The current economic and political situation in Eurozone posed additional pressure on the exchange rate, threatening the very existence of the single currency.

Key words: exchange rate, euro, dollar, financial crisis, Eurozone

JEL classification: G01, F31, F33, G15

1. Introduction

Financial crises can bring surprising exchange rate evolutions, which reflect investors` increased aversion to risk, but also a change in their preference to invest in certain currencies. The current financial crisis determined significant modifications of the exchange rates between the main international currencies. Before the outburst of the crisis, the vast majority of the scholars believed that current account disequilibrium will cause a significant depreciation of the dollar. This argument was sustained by the necessity of improving Unites States` competitiveness while reducing its unsustainable deficit (see Obsfeld et al. (2005) and Krugman (2007)).

Briefly, the depreciation of the dollar was expected to lead to a global adjustment process in the currency market. However, one of the most striking characteristics of the current financial crisis was the appreciation, instead of the depreciation, of the American currency against almost all important currencies, including the euro. This fact is even more remarkable as the United States is considered to be at the origin of the crisis while the European economy did not seem particularly affected by the crisis initially. The purpose of this paper is to analyze the euro-dollar exchange rate evolution since the beginning of the global financial crisis and to determine the factors that influenced the relationship between the two currencies under its impact. We will also try to assess the economic and political perspectives of a weak euro and the possible evolution of the euro-dollar exchange rate under the influence of Eurozone sovereign debt crisis.

The paper is organized as follows. In the following section we study the relationship between exchange rate evolution and fundamentals between 2007 and 2012, showing that under stress conditions, macroeconomic fundamentals are of little help in forecasting the exchange rate. Section 3 deals with the factors that actually influenced exchange rate evolution during the recent financial crisis. Section 4 sketches the perspectives of the single currency and forecasts the evolution of euro-dollar exchange rate in the coming years,

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describing attentively the ongoing Eurozone crisis. Section 5 presents the concluding remarks.

2. The role of fundamentals in the exchange rate evolution

The relationship between the exchange rate evolution and fundamentals is an extremely popular and controversial issue in international economics. Since the adoption of the floating exchange rate regimes by almost all leading industrialized countries in the 1970s, scholars believed that a change in certain fundamental variables between two countries will lead to a modification in the exchange rates between their currencies. Henceforth, the vast majority of the studies in the 1970s concentrated on developing econometric models of estimating exchange rates using fundamentals. Models such as the flexible price monetary model developed by the economists from Chicago school (Frenkel, 1976; Musa, 1976 and Bilson, 1979), the sticky-price model developed by Rudiger Dornbusch (1976) or the portfolio balance model1 were considered revolutionary at that time. They sustained that the fundamentals that influence exchange rates are variables such as relative money stock, relative national income (or relative output level), real interest rate differentials, expected rate of inflation differentials or current account position.2

However, in the beginning of the 1980s, the assumed success of these models had been contradicted by the poor empirical results. In their famous paper, Meese et al. (1983) demonstrated that macroeconomic fundamentals are of little help in forecasting the exchange rate, suggesting that fundamental-based models could not outperform a simple „random-walk” model. Since then, an important number of such models have been developed. Although they performed reasonably well over a long period, those trying to explain short- and medium-term movements had only limited success.

The consensus among economists is that the main reasons for the bad performance of these models are a small sample bias and the lack of quality data (see, for example, Sarno et al (2003) or MacDonald (2006)), but also irrational behavior of the market participants, speculative bubbles and other elements extremely difficult to be incorporated in an econometric model.

In the next sub-sections, we will not attempt to prove, but rather to illustrate the correlation (if there is any) between some macroeconomic fundamentals from the American and European economies and their exchange rate during the crisis.

Figure 1 illustrates the unexpected evolution of the euro-dollar exchange rate (during the crisis). Even if in the beginning of the crisis the dollar depreciated, plummeting to a record low of almost 1.6 dollars for a euro, it suddenly started to appreciate in the second part of 2008, immediately after the collapse of Lehman Brothers. There is also a sharp appreciation of the dollar since the end of 2009, and especially in the beginning of 2010, as the euro debt crisis emerged. Surprisingly, the dollar depreciated in the second semester of 2010 and first semester of 2011, although extremely negative news was coming from the PIGS3 economies.

Before the financial crisis, a negative US shock led to a depreciation of the dollar against foreign currencies, including the euro. However, during the financial crisis this response pattern changed - a negative US shock during the financial crisis since July 2008 (e.g. Lehman Brothers collapse) has induced an appreciation of the dollar. As Fratzscher (2009) noticed, there are two possible arguments for this evolution: either that bad news for US economy means worse news for the rest of the world, or the financial turmoil led to repatriation of funds from the financial markets that determined an appreciation.

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Figure 1 – Spot euro-dollar exchange rate during current financial crisis

Source: Federal Reserve, monthly values

Figure 2 and Figure 3 illustrate the short-term and long-term nominal interest rates in the United States and Eurozone. If we analyze the long-term interest rates, represented by 10-year Government bond yield, we can easily observe that the euro yields were above the US yields, except for the year 2007 and the first semester of 2010. In theory, the interest parity relation states that interest differential between two countries should equal the expected exchange rate change, especially in the long run. Instead, if we look at the euro-dollar exchange rate, we notice that it is disconnected from this fundamental variable. Even if the dollar interest rates were higher than the euro rate in 2007, the dollar systematically depreciated during 2007 and first semester of 2008. In August 2008, the dollar started to appreciate steadily while interest differentials (a higher interest rate in Eurozone compared with the US interest rate) were announcing a depreciation of the dollar. As the gap between the two interest rates widened to 1.5 percentage points during 2009, the dollar started again to depreciate, apparently as a result of interest rates evolution. For 2010 and first semester of 2011, the interest differential was close to 0, which also does not explain the euro appreciation from 1.22$ to 1,44$. There is also a clear disconnection between the dollar appreciation in the second semester of 2011 and 2012 and the higher interest rate in Eurozone. To conclude, there is no correlation between long-term nominal interest rate differentials and euro-dollar exchange rate during the actual financial crisis.

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Figure 2 – 10-year Government bond yields*

*US: Yields on actively traded non-inflation-indexed issues adjusted to constant maturities;monthly rates; end of period; rates in percentages per annum; Eurozone: AAA-rated euro-area central government bonds; monthly rates; end of period; rates in percentages per annum;Source: ECB Monthly Bulletin, December 2008,2009,2010,2011 and 2012; Federal Reserve, Economic Research and Data

If we look at the short-term interest rate differentials, represented by 3-months LIBOR and EURIBOR in Figure 3, the evidence of a total disconnection is even more pronounced. Except for the year 2007, EURIBOR was constantly over LIBOR, even if there were periods of differentials close to 0 while the exchange rate had large fluctuations. This determines us to state that the nominal short-run interest rate differential is not an indicator of exchange rate evolution during financial turmoil. Instead, a “near-zero” interest rate policy adopted by Federal Reserve since June 2009 is extremely helpful for the US government, which has the world`s largest deficits and debt, and could be interpreted as “good news”, driving the dollar up. Moreover, this combined with Eurozone`s sovereign debt crisis, determined the “safe haven” effect, driving the 10-year US governments bonds` yield to the lowest level since the `60s.

Figure 3 – Money market interest rates*, 2007-2012

*US: 3-months deposit (LIBOR); percentages per annum; period averages. Eurozone: 3-months deposit (EURIBOR); percentages per annum; period averages.Source: ECB Monthly Bulletin, December 2008,2009,2010,2011 and 2012

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Analyzing real interest rates offers us an intriguing perspective. The US real long-term interest rate (Figure 4) plummeted below 0 for the first three quarters of 2008 and then again since May 2011, mostly due to an accelerated inflation level (see Figure 6). Interestingly, the dollar appreciated during these periods, revealing the lack of any correlation between real interest rates and exchange rate. The case of real short-term interest rates (Figure 5) is even more striking as the US interest rate was constantly below 0, except for a short period in 2009.

Figure 4 – Real 10-year Government Benchmark bond yields*, 2007-2012

* US: real 3-months LIBOR; percentages per annum; period averages. Eurozone: real 3-months EURIBOR; percentages per annum; period averages.Source: European Central Bank

Figure 5 – Real money market interest rates*, 2007-2012

Source: European Central Bank

Figure 6 shows the rate of inflation. In theory, the purchasing power parity rule states “the nominal exchange rate between two currencies should be equal to the ratio of aggregate price levels between the two countries, so that a unit of currency of one country will have the same purchasing power in a foreign country” (Taylor et al., 2004). A rigorous data analysis reveals that, throughout the financial crisis, there was some evidence of correlation between interest rates differentials and euro-dollar exchange rate (e.g. In 2007 and the first part of 2008, US experienced a higher level of inflation, which lead to a depreciation of the dollar). Still, for most of the examined period, the exchange rate evolution could not be explained using inflation differentials (the negative inflation in 2009, associated primarily to lower oil prices compared with the previous period, determined a depreciation of the dollar).

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Figure 6 – Inflation rate, annual rate of change, 2007-2012

Source: European Central Bank; authors` calculation using the Current Consumer Price Index published monthly by the Bureau of Labor Statistics

Until now we have examined data referring to the financial and monetary sector. Another set of variable fundamentals, which are considered relevant in the exchange rate determination, are the ones referring to real economic activity. The current account balance, for instance, is considered a key variable in explaining exchange rate movements, conventional wisdom claiming that a current account deficit will cause a depreciation of the dollar.

However, a close look at the US and Eurozone`s data forces us to state that there is no clear relationship between the two variables. During the last five years, the dollar depreciated three times and appreciated three times while the US maintained a constant, even though shrinking, deficit.

Still, large and persistent current account deficits can affect a country`s financial stability, as it causes trade tensions, which may lead to trade war and protectionist policies. For instance, businessmen and policymakers in US are blaming the Chinese government of discriminatory practices, especially on manipulating yuan-dollar exchange rate. In fact, the reality is that the US runs multilateral deficits. A study made by Cooper (2005) shows that China`s surplus accounts for only a sixth of America`s deficit. Moreover, even if China adjusted its exchange rate as suggested by US government, it would reduce US current account deficit by only 10%. Even though these global imbalances are not sustainable in the long run, it is difficult to estimate when they will be corrected or what will be their impact on the exchange rate.

Figure 7 – Current account balance* (% of GDP), 2007-2012

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*quarterly dataSource: ECB Statistical Warehouse; OECD Stat Extracts

Real GDP growth is another measure of real economic activity. As a general rule, a country with a strong economic activity (relative to the rest of the world) will have a strong, appreciating currency, all others conditions being equal. Because the economic environment is more attractive, investors will become interested in the country`s currency, as they will expect higher yields. As noticed in Figure 8, Eurozone had a better performance in 2007 and 2008, although the gap narrowed in 2008. With all this, the dollar started to appreciate abruptly since August 2008 until the end of the year. Instead, since 2009, US economy had a higher, even though negative growth than Eurozone`s economy. What draws the attention is the 2012 evolution as the gap between the two economies` growth rate widened to over 2 points. US economy had a real growth rate of over 2% while the Eurozone could not even achieve a positive growth. While the US data seems to announce an economic recovery, a closer look at the sources of growth shows us a different situation. The main driver of the US growth was represented by real government expenditures and investment, which increased 9.5 percent in the third quarter, in contrast to a decrease of 0.2 percent in the second. Moreover, national defense spending alone increased by 12.9 percent, in contrast to a drop of 0.2 percent (BEA News Release, 2012). Unfortunately, government spending does not generate sustainable economic expansion because it does not create real wealth. To conclude, the GDP increase signals an economic expansion that is more apparent than real: if the government slows the rate of spending, the economic reality will be revealed.

Figure 8 – Real GDP growth*

*Growth rate compared to the same quarter of the previous year, seasonally adjustedSource: OECD Stat Extracts

3. The impact of the current crisis on euro-dollar exchange rates

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In general, it is considered that the exchange rate evolution can be explained with the use of fundamentals, such as consumer price index, interest rate or balance of payments. However, during financial turmoil, the analysis of fundamentals becomes irrelevant as the markets become extremely volatile and, therefore, unpredictable. In analyzing the euro-dollar relationship, we identified some factors that influenced the exchange rate evolution since the beginning of the crisis

3.1 Safe haven currencies and risk

During periods of high volatility and risk aversion investors tend to seek certain types of currencies, known in the economic literature as “safe haven” currencies. There is no accepted definition for “safe haven”, but generally in recent research papers it is referred to as an asset with low risk and high liquidity, an asset that investors buy in uncertain times, a hedge asset, one with a return unrelated (or negatively related) to that of the reference portfolio or a rainy day asset, one that performs well when the reference portfolio suffers significant losses (McCauley et al., 2009). Financial investors traditionally regard the Japanese yen, the Swiss franc and to some extent the US dollar as safe haven currencies, as they are low-yield currencies that typically appreciate during times of global financial stress.

The existing literature on exchange rate movements during crisis underlines one puzzling aspect of the current financial crisis: the dollar was regarded as a safe haven currency and appreciated against almost all currencies exactly at the time when the crisis intensified, after the Lehman Brothers collapse (see McCauley et al., 2009; Kholer ,2010). Figure 9 illustrates the situation: as the crisis spread after 21 August 2008, foreign investors sold their portfolios in other currencies against the dollar. According to McCauley et all (2009), investors took refuge in US Treasury bonds while they massively sold asset-backed securities and mortgage-backed bonds.

However, the observation does not apply when talking about US international position with respect to Euro area. Euro area investors did not increase their assets in the US during the most severe part of the crisis (from Q3 2008 to Q2 2009), as noticed from Figure 10. Instead, another financial phenomenon, called repatriation of funds, can be observed during this period. US investors were the ones that panicked and sold their foreign assets (euro assets) since the second quarter of 2008, in order to invest in the home market. Still, a flight to the dollar can be observed since the beginning of the Eurozone crisis in the first quarter of 2010. Only when the risk of a sovereign debt crisis developed among investors` perception, as a result of the rising government debt levels in the euro area, the dollar turned into a safe haven currency for the European investors.

Figure 9 – US international position with the world (millions of dollars)

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Source: US Bureau of Economic Analysis

Figure 10 - US international position with Euro area (millions of dollars)

Source: US Bureau of Economic Analysis

3.2 Dollar shortage

Prior to the financial crisis, foreign banks, mostly from Europe, systematically increased their dollar denominated assets. The growth in dollar assets can be attributed partly to the increased globalization of capital markets during this period, as well as to the international role of the dollar as a medium of exchange, which has contributed to the dollar exposure of non-U.S. banks as European institutions made dollar-denominated loans to support international transactions. The vast majority of the European banks accomplished their dollar needs by issuing dollar denominated debt (certificates of deposit and commercial paper). As shown by McGuire et al. (2009), key sources of funds were money market funds ($600 billion to $1 trillion), the monetary authorities ($500 billion), and the foreign exchange swap market ($700 billion). As this funding model is considered appropriate during normal times, it attracts a huge amount of pressure and uncertainty during crisis. The main reason is that the vast majority of funding is represented by short-term, uninsured debt, which means that debt holders become exposed during periods of economic crisis (Miu et al, 2012). US money market funds are especially prone to withdraw funding once financial conditions begin to deteriorate. As shown in Figure 11, this situation occurred during the subprime crisis in the US and reoccurred more severely during the Eurozone debt crisis. The

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exposure of US money market funds shrank from a high 55.2 % in the second part of 2009 to only % in June 2012.

Figure 11 – US Money Market Fund exposure to banks in Europe

Source: Fitch Ratings, 2013

Under these circumstances, pressures in the money market pushed up LIBOR (London Interbank Offered Rates - is the interest rate at which banks borrow unsecured funds from other banks in the London wholesale money market), as banks became reluctant to lend to each other. Moreover, the spread between LIBOR and the OIS (Overnight Index Swap Rates- refers to future expected policy rates, i.e. Federal Funds rates), a barometer of distress in the money market, reached historically wide levels after the Lehman Brother collapse, as noticed in Figure 12.

Throughout the crisis, but particularly after September 2008, many banks, especially from Europe, faced serious difficulties securing short-term US dollar funding. At the same time, US financial institutions appeared to become significantly more cautious about lending USD liquidity to other institutions in the interbank markets. After the Lehman Brother collapse, hoarding behavior of US financial institutions regarding liquidity risk led to a dollar shortage problem, which determined three episodes of dollar appreciation.

In response, central banks around the world adopted extraordinary policy measures, including international swap arrangements with the US Federal Reserve, in order to enable them to provide US dollars to commercial banks. Although swap line arrangements between Federal Reserve and ECB existed since December 2007, on 13th October, 2008, they became unlimited to accommodate any quantity of US dollar funding demanded (McGuire et all, 2009). In May 2010, the central bank liquidity swaps were reintroduced in response to the reemergence of strains in the short-term dollar funding markets. However banks made little use of the facility compared with earlier periods, possibly because the cost of borrowing from the swap facility exceeded the cost of borrowing dollars by way of the FX swap market for most banks ((Miu et al., 2012). These actions turned Federal Reserve into an international lender of last resort, revealing the fact that the euro is far from being a true international currency. The dollar swap lines also had the effect of highlighting the dollar's continued dominance, which seemed threatened before and in the beginning of the international financial crisis.

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Figure 12 – US LIBOR – OIS Spread

Source: Picture taken from http://www.globicus.com/globicus2/index.php?option=com _content&view=article&id=3056:us-libor-ois-spread&catid=37:us-fixed-income&Itemid=66

4. Challenges and perspectives on euro-dollar exchange rate in the context of the Eurozone crisis

The current economic and political situation in Eurozone is seen by many economists as a predictor of a future euro collapse, even to the “worst case” scenario of 1 euro buying only 0.82 cents as it happened more than a decade ago (Mistral, 2010). However, since the beginning of the floating exchange regimes in 1973, volatility between the two currencies gradually increased. Looking back, we can observe that the dollar actually depreciated with more than 90% since its peak value in October 26, 2000, reaching the lowest level in July 15, 2008, at a value of 1.59 dollars for an euro.4 Is it possible to see a reverse of trend in the future, and if so, what are the consequences?

4.1 Economic perspectives

Imports and exports. From an economic point of view, the depreciation of the single currency would not be such a negative event. Because a depreciating euro improves the price competitiveness of euro exports in foreign markets and deteriorates the price competitiveness of foreign goods in the euro area markets, it will tend to reduce the euro area trade deficit. A smaller trade deficit is likely to have two favorable effects on the Eurozone economy: first, it will subtract less from demand in the economy, providing a boost to employment; and second, it will slow the growth of the euro area foreign indebtedness. European exporters have been already severely affected from an overvalued euro. At a more balanced level of 1.2-1.3 dollar/euro, German cars, French wines or Greek holidays become cheaper, accelerating the euro area economic recovery. Since the beginning of the euro debt crisis at the end of 2009, the euro lost almost 13% of its value. Still, the Big Mac Index, an estimation of the exchange rate based on purchasing power parity, suggests that the euro is still overvalued with 11.7% According to The Economist, the appropriate exchange rate would be around 1.17 dollar for 1 euro.5 On the other hand, the depreciation of the euro has a serious impact on American exporters because the most important export market becomes more expensive. The imports become cheaper, but taking

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into consideration the fact that an important share of US imports comes from China6, the advantage seems somewhat diminished. US were counting on exports in order to boost employment and stimulate economic recovery, but in this situation, American goods will be less competitive on the European markets. A decline in exports will also involve an increase in the historical trade deficit.

Oil and commodity prices. Commodity prices and the US dollar exchange rate tend to move together, although the cause of this apparent connection is extremely debated. Depending on the channel highlighted by the corresponding theory, the link might either be positive or negative, or might vary from one period to the other (Cuaresma et al., 2008). The general consensus in the existing literature states that, as oil and other commodity are priced in dollars on international financial markets, when the US dollar appreciates, oil becomes more expensive, in terms of local currency, for consumers in non-dollar countries.7

This could reduce their demand for oil, which in turn could lead to lower oil and commodity prices in the long run. This channel provides an intuitive explanation for the negative relationship between oil prices and the dollar observed in recent years.

Analyzing the evolution of euro-dollar exchange rate and the price of oil8 (Figure 13), it is easy to spot the negative correlation: the upward revision of oil price during 2007 and the first semester of 2008 can be linked with the massive depreciation of the dollar. As the dollar started to rise in the second part of the year 2008, the oil price plummeted from over 130$/barrel to 40$/barrel in only 6 months. Interestingly, since 2011, the oil price stabilized between 100-120$/barrel while euro-dollar exchange rate reached its pre-crisis rate (around 1.3$/euro).

In conclusion, a weak euro would translate into lower prices for oil and commodity in Eurozone, although, in the past 2 years, the price remained high, probably due to a decrease in supply.

Figure 13 – Oil price and euro-dollar exchange rate

Source: Federal Reserve, US Energy Information Administration

4.2 Political perspectives

The future of the Eurozone`s economy and its fiscal governance are one of the most disputed issues among economists, researchers and policy makers in recent years. Although increasing efforts are made by European institutions, there are more and more rumors on a future collapse of the euro area`s financial system. The current financial crisis has brought a serious economic and social divide among member states, which is considered that it cannot be sustained within a monetary union for a long time. A recent forecast provided by European Commission reveals a worrying situation: unemployment rates close to or above

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5% in Austria, Germany, and the Netherlands in 2013, but above 25% in Greece and Spain; real GDP increase of 3% in Estonia, around 0% in Germany, France, Austria, Luxemburg and Finland, but under -3% in Greece and Cyprus (European Commission, 2013). In this situation, the same monetary policy cannot possibly fit the needs of a country that is in depression and another that is at or close to full employment. For this reason, it is particularly often brought into discussion the “reconstruction” of the Eurozone, either by excluding Greece (Roubini, 2012) and other states from the periphery, or by Germany`s exit (Soros, 2012). In this case, what will happen with the single currency? Is it possible for a currency to survive without political support? To answer these questions, we have to focus first on the convergence criteria.

Convergence criteria. As the Eurozone was modeled after Bundesbank and German mark, all the countries aspiring to join the monetary union were rigorously bound to fulfill the convergence criteria, which were projected to synchronize European economies to that of Germany. After the outburst of the financial crisis, it became clear that these criteria were not able to overcome divergent history, geography and economic models. Moreover, looking at the data, we can easily notice that almost all member states – including France and Germany, which elaborated the criteria – contravened the rules from the beginning.

If we consider, for example, the available data for public debt, we can observe that, although the Maastricht Treaty stipulates a reference value of 60% of GDP, 7 out of 12 countries were not fitting the criteria in 1999. This means that countries like Belgium, Germany, Italy or Greece were not prepared to enter a monetary union. In the context of the current financial crisis, the situation deteriorated even further, with only 2 countries (Luxembourg and Finland) fulfilling the criteria.

Table 14 – Government debt in Eurozone`s initial member states (plus Greece), selected years

Note: For Greece, the value from 1999 refers to 2001Source: Eurostat

In the case of government deficits, the data looks much better. Only Greece exceeded the reference value of 3% of GDP at the accession in 2001. Still, the real problem is that national governments are suspected of manipulating the data. For Greece, it was a case of proved fraud (Castle et al., 2010) while for countries such as Belgium, France, Italy “creative accounting” was often used to hide government debt levels (de Grawe, 2009).

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Table 15 – Government deficit in Eurozone`s initial member states (plus Greece), selected years

Source: Eurostat

In other words, the Maastricht convergence criteria were not respected even before the accession to Eurozone, nor sanctions have been applied so far. In fact, they are more a political instrument built to achieve political objectives, rather than an indicator of economic performance. In the past, they were used as a justification for creating a monetary union while nowadays it is a tool for controlling the rapid enlargement of the euro area. The question that arises is what will happen if there is no political consensus among member states? What is the future of the euro?

Possible scenarios of euro`s future. Before the current financial crisis, the idea of a breakup in Eurozone was unthinkable. However, in the wake of the European debt crisis, economists and researchers started to question whether the euro could survive. A lot of possible scenarios about the future of the euro area were launched.

One of the possible scenarios is the rescue of the euro area. The single currency is now facing a “turning point”, and its evolution depends on political will. European leaders should make serious efforts to build a more closely integrated union, and also to implement sound fiscal policy coordination, so as to bring deficits to reasonable values.

A more widely spread scenario is the exclusion of Greece (and possibly other states of the “periphery”) from Eurozone. Although there is no provision in the Maastricht Treaty for such a move, political leaders are definitely considering the possibility. Greece was benefiting from its membership in Eurozone by receiving transfers from other countries and financial assistance from international organizations, but the price to pay was a huge unemployment and social unrest. Abandoning the euro would be efficient for Greece, because a new drachma would allow currency devaluation while euro would remain strong. However, the strategy is extremely risky as no one will buy a currency which is doomed to depreciate from the beginning. Moreover, the strategy can prove to be risky even for the “core” members as there is a high probability of default in these countries, which will not be able to pay their debt.

By contrast, a compelling alternative to the conventional wisdom is Germany leaving Eurozone. Technically, the reintroduction of German mark will not determine adverse reactions from the financial markets, nor capital flight.  In this case, the euro would be the

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currency that falls in value, relative to Germany’s new national currency and also to the dollar. The weaker European countries would get to keep the euro but still get the devaluation they need. Still, this strategy would be extremely risky for Germany, due to its massive exposure to PIIGS countries, but also to the loss of labor competitiveness.

However, despite the tensions around the single currency, we believe the perspective of a break up in Eurozone is highly improbable. The cost of breaking up the single currency would be enormous. In the ensuing chaos, the survival of the EU and its single market would be in jeopardy. Given the likely and devastating chaos, it would be a mistake for a country to choose to leave. However, mistakes occur in times of crisis. That is why maybe we should begin to contemplate the unthinkable.

4.3 Currency outlook

In this context, trying to forecast exchange rates or even to understand past behavior can be challenging. With the crisis still in the process and the role of fundamentals still irrelevant, it is difficult to make predictions whether all this abrupt fluctuations are going to reoccur once the crisis ends. What is obvious is that all those who predicted the depreciation of the dollar turned out to be mistaken.

The euro-dollar exchange rate has been extremely volatile during the last semester of 2012, reflecting alternating periods of optimism and pessimism among investors regarding the prospects for resolution of the Euro Area debt crisis, fiscal and monetary policy actions in Euro Area, United States and uncertainty regarding the sustainability of recovery in the two economies. The ECB’s bond purchase program announced on September 6 contributed to the strong 8.6 percent appreciation of the euro against the US dollar between July 26 and December 31 2012 (see Figure 1). The euro appreciation intensified especially in late November and early December after Greece exit fears receded following a debt deal in November to reduce the interest rate on official loans to Greece, extend the maturity of loans from the European Financial Stability Facility (EFSF) from 15 to 30 years, and grant a 10-year interest repayment deferral on those loans (World Bank, 2013).

However, the euro could be overvalued, so we could expect a further depreciation if the internal political and economic situation in Euro land worsens. According to Bloomberg (2012), the dollar`s weakness in late 2012 is temporary and is related to recent developments in the euro area. So it is expected an euro depreciation from 1.31 $ in December 2012 to an average of 1.25$ in 2013 and 2014, as estimated by Bloomberg (2012) and OECD (December 2012).

Concluding remarks

The financial crisis has triggered sharp and unexpected currency movements, with the US dollar appreciating significantly against the euro, especially since the intensification of the crisis in 2008. The paper attempted to show that there is no correlation between macroeconomic fundamentals and euro-dollar exchange rate, at least not during periods of crisis. Before the financial crisis, a negative US shock led to the depreciation of the dollar against foreign currencies, including the euro. However, during the financial crisis this response pattern changed, triggering a strengthening of the US dollar.

Instead, a repatriation of capital to the US by US investors in the euro area, a fight-to-safety phenomenon by US and euro area investors and an increased need for US dollar liquidity by European banks, all have played a decisive role in the euro-dollar exchange rate trend after the Lehman Brothers collapse. The current economic and political situation in

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Eurozone posed additional pressure on the exchange rate, threatening the sheer existence of the single currency.

A weaker euro is not necessarily a negative phenomenon as it improves the price competitiveness of euro exports. Moreover, the price of oil and other commodities will fall in the long run, as a consequence of a negative correlation between the price of commodities and the price of the dollar. Still, the intensification of the Euro sovereign debt crisis determined inconsistency in political and economic support over the Eurozone, which proved that convergence criteria were unable to overcome divergent historical and geographical issues. Greece was blamed as it severely violated regulations, but in the end all Eurozone nations – including France and Germany, broke the rules. All over Europe there is an intense debate about the “reconstruction” of the Eurozone. A lot of scenarios have been made regarding certain members leaving the Euro area; we believe the prospect of a break up in Eurozone is highly improbable as the cost of breaking up the single currency would be enormous.

In this situation, trying to forecast exchange rates can be challenging. However, the rescue of the euro area with a slightly depreciated euro seems the most plausible alternative.

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Notes1. The portfolio balance model has its origins and development in research conducted by

McKinnon and Oates (1966), Branson (1968) and McKinnon (1969).2. For more details see Copeland (2008); MacDonald (2006); Sarno and Taylor (2003)3. Portugal, Italy, Greece and Spain4. European Central Bank5. The Economist, Interactive currency-comparison tool, available at

http://www.economist.com/content/big-mac-index6. According to US International Trade Organization, the share of Chinese imports in US was

around 19%, while the share of the 6 euro area countries in top 30 importers (which represents 89% of US imports) was only 10%.

7. See, for example, Cuaresma and Breitenfellner, 2008; Brown et al., 2008; Lizardo and Mollick, 2010.

8. Brent crude oil

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