- The euro has been very strong this year (appreciating over 10% YtD against the dollar)
- Fair value (measured using PPP) is 1.33, suggesting the EURUSD pair is still around 15% undervalued
- In this blog post we use a FEER (Fundamental Equilibrium Exchange Rate) framework to investigate what level exchange rate is consistent with a sustainable balance of payments. Our results are broadly consistent with PPP valuations, and suggest that there is a risk of further euro appreciation to come
The standout performer in the G10 currency universe in 2017 has been the euro. Against the dollar it has appreciated by more than 10%, supported by a strong macroeconomic backdrop and receding political risk. GDP growth is running at a healthy 2.3% YoY, supported by investment, consumption, and trade. Though slack remains in the labour market, unemployment has reached a six-year low. On the political front, though risks remain, the French election result was highly market-friendly. The election of centrist Emmanuel Macron and, more importantly, defeat for the Eurosceptic Marine Le Pen, has given the single currency a stay of execution and calmed investors enough for macroeconomic fundamentals to exert their influence.
Figure 1 shows this year’s euro move in context. In historical perspective, neither the euro’s appreciation nor its prior weakness is unprecedented. Euro strength could also have a long-way to go. In order to match its real-terms historical high, the euro would need to reach around 1.66 against the dollar. This analysis suggests further that in order to reach Purchasing Power Parity (the pair’s historical fair value anchor point), a further 15% appreciation would be required.
In this post, we seek to corroborate this analysis by examining the fundamentals of the Eurozone economy and how they relate to the currency.
The FEER framework
One way of estimating the fair value of a currency is the FEER (Fundamental Equilibrium Exchange Rate) framework. This focuses on the role of the exchange rate as a shock absorber for the economy over the medium-to-long run. Fluctuations of the real exchange rate are assumed to ensure a sustainable balance of payments. Thus, for example, if an economy is running an unsustainably large current account deficit, the currency must depreciate in order to boost net exports and foreign income and correct the imbalance. Similarly, an economy cannot run consistent current account surpluses, since at some point, its consumers and investors will no longer be willing to export enough capital to offset the inflows and will look to consume the wealth that they have earned. The currency will then appreciate, choking off the current account surplus.
Figure 2 shows the position of the Eurozone’s balance of payments. The current account stands at 3.12% of GDP, driven by its large surplus in goods. The economy’s large positive trade balance is well-known, but what is interesting is that it is only being sustained by significant capital outflows in the form of portfolio investment leaving the Eurozone (3.15% of GDP). In other words, the Eurozone’s entire current account surplus is being leaked overseas through the net selling of domestic securities and net purchasing of foreign ones. This is driven by two things: firstly, the Eurozone crisis, followed by political instability, spooked investors. Secondly, the advent of Quantitative Easing (QE) saw an increase in outflows, as investors driven out of domestic securities sought returns elsewhere. Clearly, this is an unsustainable situation and is supportive of further currency strength to come.
The FEER framework consists of two assumptions. The first is an assumption about the sustainable current account; the second is an estimate of how the current account responds to the currency. We use a regression model of the current account on the trade-weighted Euro to derive this estimate. The result suggests that a 1% appreciation of the currency eventually leads to a 0.22 reduction in the current account as a percentage of GDP.
Regarding the first, we make three alternative assumptions about the required current account. Firstly, we calculate the currency appreciation required to return the Eurozone’s current account to its post-crisis average; secondly, the appreciation required to balance the current account at zero.  Thirdly, referring again to Figure 2, we hypothesise that the sustainable current account is equal to outward FDI flows (which are more stable and less sentiment driven).
The results are given in Table 1. Because our regression model suggests that the exchange rate has a lagged effect on the current account, in all our calculations we assume that the current account would close even without currency appreciation. Indeed, our estimates suggest that the current account will return to its post-crisis average with very little further appreciation of the euro, due to pent-up pressure from its appreciation this year.
By and large, however, our modelling suggests that current account dynamics are supportive of further euro appreciation. In order for the Eurozone’s current account deficit to erode entirely, appreciation up to the level of PPP would be required. Furthermore, even a more conservative estimate based on the current account being equal to longer-term capital flows suggests significant appreciation to come.
Of course, a fair value estimate says nothing about how and when a currency can be expected to get there. The euro could have a bumpy ride in 2018 due to Italian elections, political shenanigans around the Catalonian crisis, and Brexit. The still-expansionary stance of ECB policy is also likely to weigh on the euro for some time to come. In the medium run, though, this analysis provides support for the idea that the euro remains significantly undervalued, and that the structure of the Eurozone economy supports further appreciation.
 The first is based on a theory that economies have a short-to-medium-run “fair value” current account; the second on the fact that economies cannot run deficits or surpluses indefinitely.