Currencies
Why Is the EUR So Strong: A New Hypothesis
April 07, 2008

By Stephen Jen | London

Summary and Conclusions

EUR/USD is grossly over-valued, according to our valuation model and common sense.  There are many reasons that have been offered to help explain this rising trend in EUR/USD in the past six years.  But none of these factors convincingly explains why the EUR is so over-valued, i.e., why its level is so extraordinarily high.  In this note, we propose a new hypothesis. 

In recent years, US real money investors have aggressively diversified out of USD assets.  Most of the rest of the world have also been reducing their financial ‘home bias’ by diversifying out of their own domestic asset markets.  However, European investment funds (IFs) have diversified more within the Eurozone than outside the Eurozone, i.e., they diversified out of their own countries but into other EMU member countries, and not out of the Eurozone.  The EUR, therefore, should be strong if everyone else in the world is diversifying while the Europeans are not. 

One perverse implication is that, when the Eurozone economies finally achieve economic convergence, the benefits of diversifying within the zone should decline and European IFs will need to diversify more outside the Eurozone than within the zone.  In our view, that will be one powerful structural factor weighing on the EUR, unwinding a major distortion in the currency markets in the next few years.

US Real Money Investors Are the Biggest USD Diversifiers

We have argued in the past (see The Biggest Dollar Diversifiers Are American, July 19, 2007) that the US real money accounts – which include mutual funds, life insurance companies and public and private pension funds – have been the single-biggest USD diversifiers in the world.  Controlling assets totaling some US$22.0 trillion, these real money accounts have been aggressively diversifying out of the USD since 2003.  For US mutual funds, for example, their exposure to non-US equities has risen from 13% then to around 23% now.  With a combined portfolio of this size, the negative impact on the USD from this process has been quite material.  Despite the media and investor focus on currency diversification by central banks, whose reserves total ‘only’ US$6.4 trillion – small in comparison to the AUM of the US real money accounts, we believe that diversification by the US private sector has been a much more important driver for the dollar.  This process, we have argued previously, need not necessarily reflect a bearish view on USD assets by all US real money investors.  Rather, an important part of the reason has been the desire to capture the benefits of globalisation by reducing the financial ‘home bias’. 

Similarly, we have seen the beginning of the process of a decline in financial ‘home bias’ in Japan and other Asian countries, as private sector capital outflows have increased to allow private investors to build a collective financial portfolio that has a higher exposure to foreign assets.  The JPY has, as a result, remained mostly under-valued, as have most of the other Asian currencies. 

Euroland Institutional Investors Have Not Diversified!

Euroland’s financial home bias has actually increased since the launch of the euro.  While European IFs have been diversifying out of their own countries, they have invested more in other EMU member countries than in countries outside the Eurozone, e.g., French investors raising their exposure to Germany rather than non-EMU markets.  (For bonds, the financial home bias increased sharply between 1998 and 2005, before flattening out in recent years.  There has been a slight decline in the last three years, but the size is very modest.) 

We highlight several points: 

•           Point 1.  A steady and significant rise in the financial ‘home bias’ since the launch of the euro in 1999.  The overall investment posture for the European real money accounts – with mutual funds having €5.9 trillion in assets under management  – has exhibited greater ‘home bias’ since 1998, with the overall ‘home bias’ ratio across equities and bonds having risen from 21% in 1998 to 34% at end-2007.  In other words, at end-1998, European IFs were already very diversified, as their investments in each other’s markets were 21% of their investments in non-EMU markets.  But this ratio has risen substantially since then.  This upward trend has been particularly powerful for bonds, as the investment ratio – defined above – has risen from 23% in 1998 to 44% in 2007, after reaching a peak of 47% in 2005.  At the same time, while the levels of the ratio have been lower for equities, the upward trend in the investment ratio is steadier for equities – rising from 16% to 25% during this period. 

•           Point 2.  Diversification across countries, not across currencies.  The lack of economic convergence within the Eurozone may explain this rather curious trend, that the European IFs have been diversifying out of their own countries, but not out of the Eurozone, as they find it sufficient to achieve their diversification objectives without being exposed to currency risks.  With the introduction of the EUR, bonds, equities and other securities in Euroland all became denominated in one currency.  The concomitant enhancement in liquidity and reduction in currency risk may have encouraged intra-EMU portfolio investments and diversification, not only because the cost of doing so is cheaper, but also due to a lack of economic convergence.   

•           Point 3.  But virtually every other country has seen a decline in the financial ‘home bias’.  What has happened in Euroland in terms of the peculiar pattern of portfolio diversification by IFs is rather unique in the world.  In this period of financial globalisation, virtually every other country has been reducing its financial ‘home bias’.  The EMU is the only economic bloc not diversifying, financially.  It should not be a surprise that the EUR is overshooting. 

•           Point 4.  We’ve seen a different version of this movie before.  In the first year of the launch of the euro, EUR/USD collapsed from the ‘IPO’ rate of 1.17 to 0.82.  This steep fall in EUR/USD surprised many back then.  In our view, that EUR sell-off was, like now, related to portfolio shifts.  Replacing the legacy currencies, the EUR offered better liquidity and thus became a major currency in which debt could be issued.  In fact, new debt issued by entities within and outside the Eurozone increased sharply after 1999.  However, though the supply of EUR-denominated securities increased, the demand for them declined, particularly within the Eurozone in the first year of the EMU, from the central banks of the Eurosystem (see Why Has the Euro Been So Weak? by Guy Meredith, 2001, IMF, and The Impact of the Euro on Europe’s Financial Markets, by Galati and Tsatsaronis, 2001, BIS).  Since the reserve holdings of the European central banks held in legacy currencies were no longer ‘foreign’ assets, a one-off conversion from EUR into USD by European central banks may have weighed down EUR/USD. 

The EUR Is Over-valued and Over-rated

Relative to most currencies outside Europe, the EUR is grossly over-valued.  The likes of GBP and SEK are also ‘guilty by association’.  The relative stability of their cross-rates with the EUR in recent years has made them over-valued as well.  The ECB likes to point to the fact that the EUR TWI (trade-weighted index) is not that high.  But this is misleading, because a great portion of the TWI basket includes other European currencies that move with the EUR.  Unless European companies see other European companies as their biggest export competitors, policymakers will need to pay more attention to the EUR/USD and EUR/JPY cross rates. 

What this hypothesis we propose in this note suggests is that, all along, capital flows were probably the dominant force propelling the EUR higher, out of line with the underlying real economic fundamentals.  Only seven years ago the EUR was ridiculed by investors.  Economic fundamentals don’t change so drastically in a short seven years.  European cyclical fundamentals may be superior to those of the US, but the EUR’s structural superiority is highly debatable.  Certainly, EUR/USD at 1.60 cannot be justified, in our view.  To think that the EUR could overtake the USD as the dominant international reserve currency, with Europe’s dormant structural problems, is quite disturbing to us.  

Rather perversely, our hypothesis implies that when there is greater economic convergence within Euroland, the EUR will weaken as European IFs need to go beyond the EMU to attain the desired level of diversification.

Bottom Line

Since 1999, while virtually every country in the world has exhibited a trend reduction in the financial ‘home bias’, Euroland’s financial ‘home bias’ actually increased significantly.  We believe that this has been a key distortion in the international financial markets and a main reason behind the EUR’s over-valuation. 

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Currencies
Difficult Times Ahead
April 07, 2008

By Carlos Caceres | London

Economic Deceleration Set to Continue…

As we have mentioned in recent reports, the economic slowdown in Spain is already a reality. Real GDP growth has been decelerating since 1Q07, while at the same time unemployment has been on the rise. We believe that this deceleration in activity is likely to continue this year, and in our forecasts we see GDP growth (on a year-on-year basis) starting to recover again only by mid-2009.

…and Construction Is Set to Be the Weakest Link

The construction sector, which accounts for almost 18% of Spanish GDP (residential construction investment represents about half of that amount) and around 13% of employment, is the main factor behind the economic slowdown. The downward correction in the construction sector has already started, and the outlook regarding activity in that sector remains bleak. Our construction activity synthetic index – which depends on demand, current production, but also output expectations – is already pointing at below-trend growth since October 2007, and is showing signs of a rapid deterioration.

House Prices Are Entering Negative Territory

Real house price growth has been continuously decelerating since it peaked in 1Q04 (when house price growth reached almost 16%Y) and came virtually to a standstill by the end of last year, recording a mere 0.8%Y growth in 4Q07. Following this (very clear and persistent) trend, real house prices are likely to fall throughout 2008. In fact, demand for houses is likely to decelerate due to both cyclical (e.g., lower disposable income growth, possible immigration flow reversals) and structural factors (e.g., the effect from the 1960/70s baby boomers coming to an end). This is likely to weaken the already fragile construction sector further.

The Bulk of the Slowdown Is to Come in 2009

We have revised down our growth forecasts for the next two years in Spain. Contrary to our previous forecasts, where we saw the economy recovering by the end of this year, we now believe that the economy is likely to slow further through 1H09. In our main case scenario, this still leaves GDP growth at around 2.5% in 2008, while growth in 2009 is revised to 1.7% (compared to 2.5% in our previous forecast). This is partly due to two main factors – the general outlook for the global economy (and for the euro area in particular), and the specific internal characteristics of the Spanish economy, notably the housing sector and the current fiscal stance.

How Bad Can it Get?

Clearly, GDP growth in Spain is likely to be dragged down by the correction in the construction sector in the near term (the next four quarters or so). Nevertheless, not all the news is bad in Spain. In particular, a sound fiscal position should help to moderate – albeit not to stop – this economic slowdown. In what follows, we present our main case scenario (together with alternative scenarios) and, more importantly, the main variables and assumptions that are likely to shape the outlook for the Spanish economy in the next couple of years.

Using the Fiscal Muscle to Stimulate the Economy

Spain enjoys a very sound fiscal stance. The general government fiscal balance recorded almost 2.0% of GDP in 2007. Certainly, part of this surplus is likely to be automatically eroded by the slowdown; we estimate that under a neutral fiscal policy (i.e., neither contractionary nor expansionary) and with GDP slowing to 2.5%, the fiscal surplus would be at slightly above 1.2% of GDP in 2008. This would still leave enough room for the authorities to employ counter-cyclical fiscal measures.

The Timing and Composition of the Stimulus Matter

Even before winning the elections in March, the Partido Socialista Obrero Español (PSOE) already promised – in its political platform – to resort to tax cuts in an attempt to boost the economy. One of the main measures proposed was to return €400 to each taxpayer. The cost of such a measure is estimated to be approximately 0.5% of GDP. We believe that this could be actionable as soon as the new government is formed (within the next month or so), and thus we think that the main effect of this stimulus would come in 3Q08. The tax cuts would likely support consumer spending in that quarter. However, if the former were to be discontinued – quite likely in our main case scenario – this would have a negative effect on the rate of GDP growth in 4Q08.

Phase II of the Fiscal Stimulus: Capital Expenditure

Given the significant expected deceleration in the (private) construction sector, the remaining fiscal stimulus is likely to come in the form of infrastructure expenditure – e.g., building new networks of high-speed rails and highways. We believe that this second measure is more adequate, in the sense that it targets more directly the sector in difficulty – sustaining activity and employment in the construction sector. In addition, as is the case with other types of capital expenditures, this is likely to have an impact on the long-term productivity of Spain. Thus far, we believe that the government will try to maintain the fiscal balance in positive territory – at least in the next couple of years. If this is the case, the second phase of the fiscal stimulus is likely to amount to another 0.5% of GDP.

This is likely to have a positive effect on GDP growth, but only with a relative time lag. For instance, the construction of a building is only included in the national accounts once the building has been finished, even though the spending has already been taken into account. In this sense, this ‘second phase’ of the fiscal stimulus is likely to become noticeable only from 2010 onwards. Given the importance of the authorities’ fiscal reaction for the overall economic outlook, this is indeed one of the reasons behind the downward revision to our growth forecasts for 2009.

High Risk Provisions Turned Out to Be Good for Spain...

The relatively low level of involvement in Spain with ‘sophisticated’ financial instruments combined with high risk provisions demanded by the Bank of Spain has turned out to be a good thing for the Spanish economy. Sub-prime lending as such does not really exist in Spain (it is actually illegal), and off-balance-sheet securitisation is tiny, both due to the small demand for these products and a short supply (related to the relatively high cost of securitisation in Spain). Since the manager of a mortgage loan is also its originator – basically, credit entities, which are regulated by the Bank of Spain – they have fewer incentives to supply high-risk loans, as they are likely to bear the bulk of the risk and a sizeable amount of the losses. Moreover, Spanish delinquency rates are relatively low, and are likely to remain so, in particular given the very small probability of the ECB hiking rates significantly in the near future.

…although Size and Strategy Matter for Banks

The banking sector in Spain contains several dis-symmetries, and the difference in performance among the various Spanish banks is likely to become more evident with the construction-led slowdown. In fact, the biggest banks have a significant amount of their stakes outside the Spanish domestic economy, in particular emerging markets in Latin America (e.g., Brazil). This is crucial, as some of these regions or countries are likely to weather this global slowdown better than the Spanish economy. Nevertheless, smaller banks – which have financed the bulk of the construction boom – are likely to suffer disproportionately from the weakness of the domestic economy.

SpainExposed to Credit Conditions

Both households and non-financial corporations exhibit relatively high levels of indebtedness, with the former reaching 83% of GDP by the end of 2007, and corporate debt reaching 115% of GDP at the same time. We believe that a tightening of credit conditions is very likely to hit corporate investment (i.e., capex), given excessive debt levels and the high rate of internal investment financing. We see investment plummeting from a solid 6.3% growth in 2007 to just over 2% in 2008, and coming to a virtual halt (i.e., close to zero growth) in 2009. This is even more striking when we consider construction investment, which is likely to grow by just over 1% this year, and likely to turn negative in 2009.

Private Consumption Should Remain Afloat

Another important characteristic of the Spanish economy is that home equity loans are not that common (compared, for example, with the ‘Anglo-Saxon’ economies). Thus, a fall in house prices should have a lesser effect on the amount of credit borrowed for consumption purposes. Further, real wages have been growing faster in Spain than the euro area average for almost two years now, and this trend is likely to continue this year. However, with rising inflation and nominal wages indexed ex-ante, we cannot completely exclude the possibility of a downward surprise in real wages as happened in early 2006. In combination with the fiscal stimulus, all this should help to maintain consumer spending above 2.0% in both 2008 and 2009.

Immigration Remains the Uncertain Element of the Mix

The labour force in Spain has been increasing significantly in recent years, and the strength of recent immigration flows had played a key role in this phenomenon. Labour force growth moved from an average of around 1.4% in the 1990s to over 3.6%Y for 2000-07. Foreign nationals have arrived in increasing numbers in Spain (estimated to be around 3 million in the period 2000-06), encouraged by not only the income differentials that persist between their country of origin and that of Spain, but also by the strong employment creation that we have witnessed in Spain after it joined the monetary union. In fact, Spain accounted for almost half of all job creation in the euro area in recent years. Apart from being a particularly delicate political issue, immigration is a relatively recent phenomenon in Spain, and thus historical evidence regarding immigration flows is scarce. However, a significant reversal of the current migration patterns could have serious consequences for growth, competitiveness (immigration has to some extent helped to keep labour costs relatively low) and the housing sector (through lower demand for houses, exacerbating the fall in house prices).

Is There a Rainbow at the End of the Horizon?

Spain is likely to experience a significant deceleration this year, and even throughout 1H09. However, we believe that Spanish economic fundamentals are generally sound and, more importantly, they seem to be improving. In this sense, we welcome the continued increase in spending on higher education and R&D.  Indeed, the share of the population holding a tertiary education degree has increased from around 10% to over a third in one generation; the current level in Spain is similar to that of France, and well above that of Italy (around 15%). Expenditure in R&D (as a percentage of GDP) has been growing faster than in most countries in the euro area over the last decade, and this trend is likely to continue in the medium term. Labour productivity is also higher than most people believe – in fact, the regularisation and incorporation of labour previously working in the informal economy (‘black market’) in the national accounts has ‘artificially’ reduced the measure of labour productivity in Spain. In fact, Spanish exports have increased in line with euro area exports, suggesting that factors other than price competitiveness are working in Spain’s favour. Overall, on our forecasts, we see the Spanish economy starting to recover in 2H09, and we believe that the economy is likely to grow at around 2.5% from 2010 onwards, which is still above the potential growth for the euro area as a whole (estimated to be just over 2.0%).

 

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