The euro's depreciation is not only due to the war in Ukraine

Why the euro has fallen so much while the US dollar has strengthened, who benefits - these and other questions were researched by the Deutsche Welle (DW) multimedia portal www.dw.com.

The short answer is that the fall in the euro's exchange rate is being influenced by three things - the war in Ukraine provoked by Russia, investors' reactions to the benchmark interest rates set by the US and European Union (EU) central financial institutions, and energy shortages.

The depreciation of the euro is also a concern for a large part of the Latvian population, but detailed explanations of what is happening in the public sphere are not particularly available in the media or on the Bank of Latvia's website.

Base interest rates are most affected

As you know, on July 8 this year the euro and the US dollar were equal at 1:1. The last time the euro was this low was in autumn 2002.

In 2008, when the financial crisis hit the US, one euro could be exchanged for USD 1.60.

According to the DW study, the sharp depreciation of the euro in recent months may give the impression that the Russian aggression in Ukraine is the main reason for what has happened. The war in Europe has made many international investors cautious, who are now taking their assets out to the dollar zone. EU sanctions against Russia, unprecedented in scale, are also creating an energy crisis, in particular a gas supply crisis which, according to DW analysts, threatens to plunge EU countries into recession.

However, as the study underlines, central banks and sovereign bond yields play a key role in currency markets. " However, if you look at the chart of quotations of the euro-dollar currency pair for a slightly longer period, it is clearly visible that the consecutive decline began as early as the first half of 2021, when the rate was still higher than 1.22. The reason for this trend (the high value of the euro) was the expectation of global financial market participants that global inflation, which is increasing due to the consequences of the pandemic, will force the US Federal Reserve System (the Fed, an institution with similar functions to the European Central Bank) to raise interest rates earlier, faster and more radically than the European Central Bank (ECB) is willing to do. And the increase of the base rates by the central banks leads to an increase in the yield of government bonds. The US, with its huge national debt, issues a large number of such securities, and they are considered the world’s most reliable investment asset. While the Fed pursued a policy of ultra-cheap money with a virtually zero base rate in the past years, US government bonds had low yields and were not very attractive to investors. Therefore, many of them, in search of more profitable assets, converted dollars into other currencies. The prospect of a rate hike caused capital to flow back into the dollar space, and this process intensified and accelerated from the fall of 2021 as it became clear that, due to accelerating inflation, the base interest rate in the US would have to be increased much more decisively than one could have thought a year ago," writes www.dw.com.

As the study explains, the predictions came true in real life, as the base rate was already raised by 0.25 percentage points in March 2022, for the first time since 2018, and by 0.5 percentage points in May. On June 15, the base rate rose by up to 0.75 percentage points for the first time since 1994. The survey forecasts that the rise in base rates will continue in the coming months. It highlights that, at the same time, the ECB only started to move away from zero interest rates in July, starting to do so in small 0.25 percentage point steps.

As Michael Heise, Chief Economist at German investment firm HQTrust, explained to DW, the difference between base rates and yields on government bonds is the main reason for the euro's depreciation. The war in Ukraine and its consequences on the European economy are only intensifying this process.

It is important to note, however, that according to Reuters, it is not only the euro that is falling at the moment. The Japanese yen has also fallen to a 24-year low against the US dollar.

Who benefits from a strong US dollar?

"The fear of recession is increasing in Europe", according to the latest analytical financial report of the German commercial bank Commerzbank. As DW explains, at such times international investors, especially in the US, prefer to keep their money in the US.

The DW study acknowledges that the euro's fall has benefited stock market speculators, who "saw the euro falling and decided to profit, and they really did, but they are not the only players to gain or suffer from currency fluctuations".

The study explains that high exchange rates favor countries whose economies are dominated by large imports of goods. For example, a high dollar is good for the US because it cheapens goods imported there from Europe, China, Japan and elsewhere and helps to fight inflation, which is now almost the main macroeconomic problem in the US. At the same time, however, the strong dollar is destroying domestic producers of US goods because of cheap foreign products. In addition, the high exchange rate is detrimental to the interests of US exporters, as it makes their products more expensive on world markets and thus reduces their international competitiveness. It is a blow to cars, computers, microchips, food and other goods labelled “Made in USA”. "As a result, US goods are starting to lose ground to EU-made cars and Asian-made semiconductors," the study concludes.

The euro will make energy even more expensive

As www.dw.com points out, there is another important aspect to the dollar's rise: "The dollar's excessive strength is reversing years of efforts by several Washington administrations to balance the US's one-sided foreign trade balance. The US imports more than it exports, which has a major impact on the development of the US industry. Accordingly, the low euro exchange rate is very favorable for exporters in Germany, France, Italy and other euro area countries. However, all this is with a big caveat: Europeans must produce their products only in their own countries, that is to say, in the EU, and must use only EU-made parts or raw materials. As Sonja Marten, currency analyst at German commercial bank DZ-Bank, explained to DW, "if manufacturers buy their components from outside the EU, they will lose all profitability from the current situation". The analyst explains that the situation is similar for energy-intensive EU plants, as oil, coal and liquefied petroleum gas are traded globally for dollars. From this point of view, according to Marten, the devaluation of the euro took place now at a very unfavorable moment for the EU. Europe, she said, is facing a shortage of energy carriers and their extreme cost, and these energy carriers will become even more expensive as a result of the low euro exchange rate.