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Weakening currency = good for exports?

Euro weakness has been the dominant theme on the currency markets in 2010.  In trade-weighted terms (i.e. its average performance against its main trading partners), the single currency has fallen by 10% this year, with the total decline from its recent high in October 2009 now standing at some 13%.

The euro’s declines have been importantly linked to investor concerns about the public finance crisis in Greece, with its change of trajectory late last year coinciding with the intensification of pressure on the Greek sovereign bond market evident in the major widening out of Greek bond spreads (the cost of borrowing for the Greek government relative to Germany) since last November.

Major deficiencies

In particular, the crisis has exposed major deficiencies in the way that the single currency area is set up and managed.  In many ways the origins of the current public finance crisis can be traced back to the lack of effective fiscal rules for member states.  The Stability and Growth pact has clearly failed to deliver a sound and sustainable budgetary environment for the euro zone and events of the past few months have laid bare the problems inherent in running a monetary union made of up questionably compatible members in the absence of a centralised fiscal policy. 

Also, the fact that the policy response from the European authorities has at times looked haphazard, tardy and uncoordinated has contributed to an erosion in investor sentiment towards the single currency.  For example, it took EU policy makers several months to decide upon and agree an aid package for Greece, a process that was bedevilled by political squabbling over both the principles underpinning and implementation detail of the support mechanism.

Dollar benefits from Euro’s Woes

A notable strengthening of the US economy in recent months has left the dollar well-placed to benefit from the euro’s woes.  US GDP growth has exceeded that in the euro zone for each of the past three quarters and the result has been a sizeable move lower in Eur/USD which fell to a 4-year low of below $1.19 earlier this month – corresponding to a 21% decline from a late November 2009 high of $1.515.

Some 20% of all Irish goods exports are destined for the US, so this move provides a very welcome boost for the Irish export sector as it reverses what was some very painful prior euro strength, in the process boosting the euro value of dollar trade receipts.

Sterling hasn’t quite managed the same kind of gains as the dollar, a theme that has reflected quite a bit of uncertainty in the UK political environment in recent months as doubt about the outcome of the UK general election gave investors very little visibility on how the troublesome double-digit budget deficit was going to be tackled.  However, the newly-formed Conservative / Lib Dem coalition has made deficit reduction a top policy priority and an emergency budget on June 22nd is set to unveil additional detail on the new fiscal strategy – developments which have fostered a more positive view on both UK Inc. in general and sterling in particular lately.

Importance of UK market

And the euro is now also falling against sterling, news that is of much greater significance from the point of view of the Irish SME sector than the decline in the Eur/USD rate.  Looking at Ireland’s overall export numbers reveals that about 19% of total goods exports are destined for the UK.  But this greatly underestimates the true importance of the UK market for Irish-owned firms.  For example, almost 50% of the exports of Irish-owned manufacturing firms are headed to the UK.  So clearly, the UK retains a particularly important status for Irish business. In this context, the decline in the euro’s value from as high as 94p last October to as low as 82p earlier this month represents a particularly welcome development. 

Despite some quite hysterical commentary referring to a ‘collapse’ in the euro, recent moves in both Eur/Stg and Eur/USD have, in our view, merely reduced the amount by which the euro was overvalued to begin with.  Estimating a currency’s fair value is far from a precise science, but commonly cited figures put in a $1.10-1.20 range for Eur/USD and 75-80p for Eur/Stg.  At time of writing (mid-June) the euro was worth $1.23 and 84p respectively and we think the rationale for the euro to trade at a premium to fair value, as is still the case despite recent moves, is weak in the current environment.  Thus, we anticipate further declines in the period ahead.  We have year-end targets of $1.12 vs. the dollar and 78p vs. sterling, equivalent to declines of some 9% and 6% respectively from current levels.

Indeed, we are conscious of the possibility that the euro could undershoot in the period ahead in the event of another major negative shock to the euro zone.  This is a scenario that could see a return to parity or below in Eur/USD, or to say around 70p vs. sterling, though we are inclined to treat this as a risk to the forecast rather than incorporate it into our baseline view.

Winners and losers

While euro weakness likely comes as very welcome news indeed from the point of view of Irish exporters who enjoy a timely boost to their competitiveness, recent moves do exert upward pressure on the euro price of dollar- and sterling-invoiced imports of course.  Over 30% of our goods exports come from the UK, for example, and there are signs beginning to come through that currency moves are starting to push up on import costs.  There are always going to be winners and losers across the economy as economic variables such as exchange rates change.  However, our overall view is that the net impact of a weaker euro should be helpful from the point of view of the Irish economy as a whole as it will make a very important contribution to improving the country’s competitiveness – a vital component of the transition back to a more sustainable, export-led growth model.

To conclude with a more general point, the speed and scale of recent moves highlights how volatile the currency markets can be and underscores how important it is for firms in the SME sector to take an active approach to the management of all foreign-exchange exposure.  Pro-active hedging of such exposure can play a critically important role in dampening the impact of currency market volatility on company cash flow.

Simon Barry, Chief Economist, Ulster Bank Capital Markets