Why the Euro Hasn't Depreciated

Recently, The Economist had an article where it intended to explain why the Euro had not depreciated by as much as most believed, given the developments in Eurozone (Greek/Spanish/Irish bailouts, too much Italian debt, the Cyprus haircut, and so on). Without trying to come off as critical, the article did not really explain much about the Euro's endurance in the markets. In fact, the article did not really mention that in most cases not only the euro hasn't been depreciating, but appreciating for more than a year, with a slight fall in March 2013 (Cyprus haircut anyone?). Have a look at the following 2-year courses of the Euro compared to other currencies (Source: Yahoo!Finance):

USD/EUR

EUR/Canadian Dollar

EUR/Swiss Franc

EUR/Sterling Pound

In every one of the above charts the Euro has been appreciating from a low just before September 2012 (for what you see in the USD/EUR graph think of the reverse). Thus the question is what happened in September 2012? The answer is not something most would really believe: the Outright Monetary Transactions (OMT) scheme. This was presented by the ECB in early September 2012, even though the decision was announced in August. As you may recall, there have been many critics of the ECB's stance on the subject (amongst them was Yanis Varoufakis), claiming that the "bazooka" could never be used and the threat was not credible. 

Yet, as stated at the time both the timing and the actions were much more than the markets anticipated; this showed clearly that the ECB was willing to take some action on the subject. The point of the policy was that it was better that it was never used since there could be potential caveats (Paul De Grauwe and Yuemei Ji have an excellent post on the subject). Still, just affirming that the ECB was willing to act like a real Central Bank and prevent a meltdown did the trick. 

Although the OMT could account for the spike in markets, it wouldn't be sufficient for the longer trend. There are two additional reasons why the euro has been appreciating over time:

1. Increased trade surpluses Eurozone countries have been running for the past year

2. Very low inflation

The first reason is as obvious as it can get: when a country has massive exports then its currency appreciates. As the trade surplus has been on the rise, led by Germany and following by almost every other country in the EZ wishing to gain from exports or reduce their deficit, the Euro has been steadily increasing in value relative to other currencies.

The second reason is again obvious: the higher the inflation rate, the lower the deterioration of a currency's value. Thus, as inflation falls, as the next graph (originally posted on BritMouse's blog) shows, the value of the currency increases.

The trend is obvious as inflation has been steadily falling since 2012, but the interesting question here is why. The answer lies to something rather simple: bank loans. As banks have been deleveraging over the past year, the amount of money in the system is decreased, making inflation fall with it. The extend of this decrease in loans can be seen in the following graph (Hat Tip to the brilliant Frances Coppola for bringing it to my attention)

If the former graph is not descriptive enough, then the next, showing the M3 evolution over time in the Eurozone, will almost certainly be sufficient to convince most of those who are unwilling to believe that banks assist in inflation:

In essence, the Euro appreciation can be summarized in three simple points: commitment to "do what it takes" (raises trust and causes the original spike), a decrease in trade deficit and its conversion to trade surplus within a year (inflow of cash increases the value of the currency) and a fall in the inflation rate caused by bank deleveraging (makes the currency more valuable). Add to this the instability of several of the Eurozone's countrerparties (the UK and US for example) and the whole "mystery" of the appreciation is unveiled.

Is the Euro appreciation a good thing? Not really to be honest. First of all, the Eurozone needs inflation, for reasons explained in other posts. To get that, we need good banks. We do not have them at the moment. Thus, the whole appreciation issue masks the main problem the Eurozone is trying to hide at the moment, something which is even more important than the sovereign debt issues; the banking crisis. Why is it more important than sovereigns? Simply put, it's because sovereigns cannot issue money. Only the ECB can, and the banks are the only others which can increase that quantity.

Thus, their significance in a region which shares the same currency cannot be overstated. The banking system really requires reforms; yet, these should not come at the cost of growth. It makes no sense to start combing your hair before you can even stand on your feet.

Foreign Currency Loans in Europe: Slovenia

A policy usually followed by many banks, especially those in countries belonging to the emerging or developing group, is lending on a foreign currency. This practice has been extremely popular during the 2000's, where in Europe developing countries witnessed foreign currency loans in excess of 50% of total loans (see graph below). The practice does not just take place in  developing countries; borrowers in countries with a relatively stable currency or one which is appreciating pursue such strategies in order to minimize the amount of funds they have to return in terms of local currency.

Source: Foreign Currency Loans and Systemic Risk in Europe

Interestingly, most Central Banks appear to be approving of such behaviour since foreign currency loans are usually a strong growth driver. According to a recent paper, Turkey witnessed a significant increase in growth since forex loans expanded, although restrictions (which were later eased) on household loans were imposed in 2009. Economic theory, and more specifically the currency substitution view, states that high inflation drives high forex lending as people mistrust their domestic currency. Conversely, as inflation falls and domestic currency appreciates, demand for loans is reduced (see graph below). The rationale behind this idea is simple: if domestic currency rises, then I have to pay less in terms of domestic currency than I have borrowed. If, for example, I got a $1 million loan and the rate with my domestic currency currency was 2 units I would get 2 million units of domestic currency. If domestic currency rose to 1.5 unit per $1, then I would have to repay just 1.5 million units of domestic currency. The more stable the currency is, the less the probability that an appreciation will cause the value of the loan to fall, thus the incentive for foreign borrowing is reduced. In addition, this type of strategy works well for both the lender and the borrower.

A more interesting question is why high inflation leads to higher foreign currency borrowing. The reason is that as people see the value of their currency reduced by tremendous inflationary pressures, they tend to switch to something more stable, in most cases the US dollar. This was something evident in other cases of hyperinflations where the domestic currency was discarded by the residents and something else was used in transactions. Yet, what the theory cannot explain is why people choose to borrow in foreign currency when borrowing in domestic currency is something they could have done to reduce the value of their loans. The only possible explanation from my point of view is that when people see a very high rate of inflation (although not as high as to discard the currency) , they expect it will fall sooner or later so they decide to gamble with foreign currencies to win the difference. Such a practice would have been extremely successful had it been followed in Turkey since the late 1990's or early 2000.

What one should note here is the dangers such practices pose for the banks themselves: if the currency depreciates significantly, they are in grave danger of never seeing their loans repaid. Thus, it is essential for the banks to hedge their foreign currency loans if they wish to minimize the exchange rate risk; risk arises from the banks' unwillingness to do so. In the Fed article cited above, Yesin calculates something very interesting: the foreign currency mismatch index, which is a measure of net unhedged foreign liabilities (foreign liabilities minus foreign assets minus loans in foreign currency) over total assets. This indicates the indirect exchange rate risk that banks assume when they lend to unhedged borrowers as derived from the probability of a joint failure of households and nonfinancial corporations to service their foreign currency loans as a result of a foreign currency appreciation (or domestic currency depreciation). The results presented are quite interesting:

As we can see, most of the non-EZ countries have a significant exposure to foreign exchange risk. Interestingly, if these countries face a currency depreciation, and bank need to be bailed out, the excess funds needed to bail the country out will further depreciate the currency; this will mean that the cost of repaying the funds will be further increased, thus promoting more failures and bad debts. Nevertheless, given that most of these countries are not yet caught up in the recessionary spiral the whole of the EZ has been in (with the exception of Croatia which is the only case which needs to be further examined), the probability of such a thing occurring is low. 

Slovenia on the other hand is a very different story. With recent developments stating that Slovenia is one of the most likely candidate for the next EU bail-out, given the similarities the country poses with Cyprus, and the fact that it has been in recession for at least the last year, it is interesting to note that a depreciation of the euro could deeply impact the country and have severe consequences for the country's already wounded banks. The problem with Slovenia lies not just with the euro depreciating but with other currencies appreciating as well. Slovenia's bank have given out many loans in Swiss Francs over the past 5 years; if the CHF appreciates more than the euro does then consequences could be devastating for households and corporations which borrowed in the currency. While 4% of total assets may not appear to be much, for banks which are heavily depended on regulatory requirements to lend even a change of 1% could wreck havoc; especially if we are talking about a bank with very low capital requirements.

It is not that banks can be destroyed with a 1% loss. It is that banks with trust issues cannot sustain the consequences of such actions: people lose confidence in the banks, they withdraw money thus reducing liquidity; their fear causes consumption to fall, which means that investment also falls. These, in addition to higher unemployment, make non-performing loans increase, which brings banks a step closer to collapsing.

Is this as bad as it sounds? Unfortunately, I cannot predict the future paths of neither the CHF nor the Euro. The Euro has been appreciating with regards to the CHF over the past year, yet, given the instability of the region, large movements in both currencies cannot be discarded. This puts Slovenia's banks at the mercy of both currency speculators and the ECB; unfortunately for the country they cannot distinguish which represents the lesser evil. As Slovenia sees its growth potential reduced it would be a good time to impose restrictions on the banks' lending on foreign currency, either by forcing hedging or by restricting further lending in other currencies in general.

Skeptics might say that it would put too much emphasis on the euro and the success of the Eurozone. This might be true, but whether we like it or not this is our domestic currency and it is probably the best hedge ailing banks like the ones in Slovenia can do at the moment.

Investor Pessimism

Lately, I have been reading a lot about investors, banks and nations preparing for the worst case scenario. It seems that the definition for "worst case scenario" differs from time to time: a Greek exit, a Euro collapse, a banking collapse, a Eurozone collapse and so on. Obviously one has to prepare for such events. What I always thought to be weird is that people always prepare for "worst case scenarios" only after recessions or severe economic blows occur. One should never be worried by pessimism or optimism in the markets. Although they may last long in many cases, they are always alternating. They are both outcomes of human nature, a sort of behaviour that was the same throughout the years.

All of the great investors throughout history understood this. People are always prone to good or bad feelings. A bear market (e.g. a falling index in the stock exchange) occurs when people feel overly pessimistic about the present and the future and a bull market (the exact opposite, a rising index) occurs when people feel overly optimistic about it.

A great example of this is the banking situation nowadays. Banking institutions after expanding rapidly in the last decade (overly optimistic) are now contracting their business operations to operating only at the local level (overly pessimistic). Cross-border lending is steadily declining in the EU reaching 2007 levels in last June. Otmar Issing, a former ECB chief economist states: "Over the long term, the monetary union can't be maintained without private investors,because it would only be artificially kept alive." While this is true and many feel that getting rid of their assets in euros and buying gold or real estate is a great idea, others have gone even further by removing themselves from the monetary zone. 

Many investors are even betting against the euro surviving. John Paulson, who made billions shorting (i.e. selling something now - e.g. a stock or a currency - in hope of buying it later at a lower price and thus profiting with the difference) during the sub-prime lending crisis in the US and the now retired George Soros stated that they are betting against the common currency. 

As for me, I wouldn't worry about bank contraction. Both economies and firms contract and expand as they react to the general feelings of threat or hope for the future. A crisis is a good opportunity for people, firms, economies and states to learn from their mistakes. What I hope is that politicians and policymakers will realize the need for action. Even late action is better than no action, however too late would mean the end of the euro as many investors prophesied.