When Does It Hurt?

By: Ansgar Belke

“I’m not worried about a strong euro. I love a strong euro” –
Peer Steinbrueck, former German finance minister, July 2007

European politicians and business persons are frequently concerned with the European currency. The  $/€-exchange rate is still one of the most closely watched exchange rates in the world (much as the DM/dollar rate was in the past). Its gyrations, which are at times difficult to understand on purely economic grounds, are often perceived to be politically costly. It has often even argued by Mundell and others in the past that movements of the $/€-exchange rate comparable to those of the mark-dollar rate since 1971 would break Euroland apart.

Episodes of $/€ exchange rate “pain thresholds”

Every time this exchange rate climbed new peaks in the past, the German export industry and its lobbyists regularly raised the pronounced call that the exchange rate threshold had been passed. This has also been the case some days ago when $/€-exchange rate temporarily exceeded its threshold of 1.50.[1] However, laments appeared to be quite contained these days until very recently - most probably not because this critical level of the exchange rate is not regarded as harmful (during recent peaks in 2004 and 2007/08 even lower levels such as 1.16 (the starting value of the euro at its birth date), 1.30 and 1.40 have been called “pain thresholds”)[2] but because the awareness of appreciation of the euro has simply been overlaid and dominated by the public reception of the economic and financial crisis. In a recent study, we show that this time exporters and their lobbies do not appear to be too wrong with their assessment, making use of an econometric model which takes into account the price elasticity and the path-dependence of exports.

Hysteresis in German exports – estimating the “pain threshold”

The main aim of our study is to identify “pain thresholds” for German exporters. We rely on a non-linear model according to which suddenly strong spurts of exports occur when changes of the exchange rate go beyond a kind of “play” area (analogous to a mechanical play). Starting from the former, we are able to show that the frequently mentioned notion of an exactly identified unique “pain threshold” of the $/€ exchange rate which is constant over time simply does not exist.

At the end of our estimation period (which is based on quarterly data ranging from 1995 to 2008), our estimation results imply a “pain threshold“ of 1.55 $/€ which continued to hold in October 2009. In a sense, the main reason for this pattern is that no comparable exchange rate maximum which could have shifted the play area and thus the “pain threshold” has occurred in the meantime from January to October 2009. Compared to the more recent laments of business German business representatives and also to the more recent implicit assessment by the ECB this threshold is slightly but not substantially higher. On October 22nd, 2009, the dollar hit the 1.50 level which implies that we have recently been not too far away from this threshold – especially if we take into account that macroeconomic uncertainty as measured by the VDAX and/or the volatility of the S&P100 has shrunk slightly but steadily since the turn-of-the-year 2008/09. Hence, firms tend to have less and less call to wait with using their option to exit from US export markets.

Our results turn out to be valid independent on whether we focus on total German exports to the US or on specific sectors such as “machinery and transport equipment” and “road vehicles” which dominate German exports to the US. Since these two sectors represent about three quarters of the German exports to the US, it turns out that the “play” of both groups of goods taken together nearly completely drives the “play” for the exports. Due to high market-entry cost prevailing within the machinery and automobile branches, it is not surprising that we could find the best fit of our model, i.e. for the play-spurt dynamics, especially for these branches.

Significance of a strong euro for the German industry

It has become a stylized fact that different sectors of the economy are to a different degree sensitive to exchange rate movements, depending on their export shares and shares of imported raw materials and intermediates. The public laments raised in recent episodes when the exchange rate reached local peaks suggest that the exchange rate threshold has been steadily increasing in the recent years.

Where does all this lead us? If, as a result of global imbalances, the external value of the euro increases even further, the demand for German exports will fall dramatically and (units of) German firms reduce or even stop trading internationally, then re-entrance into international trade will be severely hampered, even if the euro will devaluate again in the future. So, once there will be a zero entry in any export good category, the concern is that it is going to be hard for exporters in this goods category to re-establish their export nodes and get back in. A German firm may even be likely to decide not to re-establish global trading networks again, or, at a minimum, it might take some time before it well be capable of doing so. Hence, the “ever rising euro” may have consequences that go well beyond the prediction of any standard economic model when the presence of sunk costs of for German exporters, as for instance, those of information gathering on the new market (costs for market research), setting up new foreign distribution networks, marketing and possibly repackaging of the product to appeal to new consumers, paying for lawyers versed in the law of the foreign country, is acknowledged.[3]

Forex market interventions versus coordinated exit

But as in recent episodes of local maxima of the $/€ exchange rate, also the ECB is also now apparently becoming increasingly aware that a stronger euro must absolutely be avoided. Further euro strengthening in the remainder of the year will have a significant impact on 2010 economic growth, for instance, in export dependent Germany, and make the ECB’s own pessimistic forecasts for this year even more probable. Hence, this may become a new era of the ECB’s rhetoric on exchange rates because (i) it will be the euro area which will have to bear the burden of the global adjustment and (ii) voting majorities in the ECB Council have changed in the meantime to the benefit of former weak currency countries which are inclined to enact central bank interventions in the FX markets in order to weaken their home currencies.

While we repeatedly advised against forex market interventions elsewhere and at earlier occasions[4], it would currently be clearly desirable if, instead, a clear price stability orientation of the ECB would also induce the Fed to enact a timely exit from its strongly expansionary macro policies (for instance, because the US are not willing to give up the status of the dollar as a world reserve currency). Such kind of a monetary policy somersault would take significant pressure from European exports and wages since the very low US money market rates are generally considered as the main reason for the decline of the dollar. This would correspond with a return of the world to more monetary stability and growth, while preserving the status quo regarding the world reserve currency. Anyway and also with an eye on the huge amounts of liquidity vagabonding around the globe, a coordination of the exit from unorthodox monetary policies on both sides of the Atlantic is highly indicated. The alternative would be that the doubts about the stability of the dollar would increase even more.

 

Reference

Belke, Ansgar, Göcke, MATTHIAS, GUENTHER, MARTIN (2009): When Does It Hurt? The Exchange Rate “Pain Threshold” for German Exports, DIW Discussion Paper no. 943/2009, Deutsches Institut für Wirtschaftsforschung, Berlin, October. LINK: www.diw.de/documents/publikationen/73/diw_01.c.342531.de/dp943.pdf.

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