The American Dollar Against The Euro Finance Essay - Free Essay Example

The Euro was launched on January 1, 1999, when 11 countries (Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxemburg, The Netherlands, Portugal, and Spain) came together as one European Economic and Monetary Union (EMU) with a common currency Euro. After two years Greece joined EU. A common currency and monetary policy direct was created by the European Central Bank (ECU) after which all members of European Union fixed their currency in a specific rate against the  euro. During the first few years of Euro existence, it was depreciating against USD, and from 2001 for a significant period the euro began to appreciate, and only interrupted in 2005 for a short period, and reached it record level in April 2008. Various schools of thoughts have offered differing explanations for the fluctuation of euro and dollar exchange rate trend. Before the euro had been introduced United States experienced structural improvements in productivity, which is affected by the high rate of return on capital. With the higher rate of return, foreign direct investments (FDI) flowed to the United States (see appendix, figure.1), which might explain 1990s appreciation of the US dollar by almost 40% over the euro (Schnatz et. Al., 2004). In fact, the dollar appreciated and reached 0.852 dollar per 1 euro in October 2000 (Chen et. Al., 2006). Neck (2001) explains depreciation of the euro at the first stages against the US dollar. He explains that the depreciation was due to the fact that euro introduced as a cash and coins only in the beginning of 2002, the demand of the investors portfolio for the euro was low due to lack of transparency of the new currency. Moreover, many other studies believe that appreciation of the dollar in 1999-2002 happened due to other factors. Meredith (2001) poised that as equity price increased in United States, the overall market capitalization reached its highest level. This has an effect on investment and consumption boost. He thinks as demand shock exists it causes long-term interest rates to increase, which is an effect on capital inflow, for this reason, appreciation of the US dollar. Many economists believe that strong oil price rebound effected on appreciation of the US dollar against the Euro. However, Meredith (2001) argues this approach, in his research shows that the oil price change has only minor effects on exchange rate fluctuation. He proved his approach by carrying out a research based on past experience of oi l price changes. His study shows that oil price volatility does not show high changes in fluctuation of the Euro Dollar trend movements as seen in 1999-2000. However, in mid 2001, euro started to rebound against the dollar and reached a historical highest point of 1.31 dollar per 1 euro in January 2005 (Sapir, 2005). The appreciation of the euro or depreciation of the dollar can be explained by the fact that from 2001 United States experienced a current account deficit (see appendix, figure.2), which reached 5.5 percent in 2004 (Sapir, 2005). Sapir (2005) explains that economists believe that the US deficit is a product of high level of US public and private consumption, which is financed by high public borrowing and low private saving, and reached 3 percent of GDP in 2005. The appreciation of the euro against the US dollar can be also explained by increasing Euro market share in total world export of goods (see appendix, figure.3), which are 16% and significantly higher that Uni ted States and Japan market shares (Shams, 2005). During the 1990s United States owned 12% of total world export of goods and decreased up to 9.7% in 2003 (Shams, 2005). In late 2001 companies such as Enron, World Com, Tycon and many others were involved in accounting scandals (Paul, et. al., 2003). Negative signaling news affected on falling investors confidence in US stock market, mutual fund market, and bond market, which has had an impact on the depreciation of the US dollar. Stage 2: 2002 2005 3 As the Euro became a denomination currency in 2002, it started appreciating for the next 2 years. Furthermore, US were making an attempt to curtail its international trade deficit by increasing exports thus leading to depreciation of its currency (Shams, 2005). During 2003 US dollar continued experiencing depreciation against the euro, many experts explain this down movement due to Iraqs war, which negatively affected investors confidence on holding  Dollars (Dougherty, 2004). In 2004 the dollar strengthened for the first few months. However towards September, the Dollar reversed course quickly. This reversal was caused by continued spikes in the cost of oil and Lack of confidence in the US economy which was aggregated by its heavy long term borrowing lead to the depreciation of the Dollar (Dougherty, 2004). Stage 3: 2005 2006 4 During 2005 USD/EUR trend is showing positive increase, appreciation of the dollar after four years of continues depreciation against the euro. There are many issues explaining the reason of dollar appreciation, but the main explanation of this issue is that interest rate in United States expected to grow continually. During the year interest rate increased from 2.25% until 4.25% (see appendix, figure.4). US economy was starting to show positive signs of economic growth leading to appreciation of the Dollar.  [5]  Due to high yield and growing economy, foreign direct investments increased proportionally. Stage 4: 2006 2008 6 However, in August 2006 US government combined with Federal Reserve agency stopped raising interest rate while in EU the interest rate continued to raise (Le, 2006). For international traders this decision was the perfect opportunity to sell off dollars and buy out euro, which soon affected depreciation of the US dollar and appreciation of the euro (Le, 2006).  In 2007 US dollar depreciated at a record level against the euro and reached the maximum low position. Depreciation happened due to US credit-market loss, in other words, Subprime crisis, and speculative attacks due to Federal Reserves prompted to cut interest rate (Bloomberg, 2007). Macdonald (2007) ascribes the weakness of the dollar in 2007 due to continued spending of the Unites States government on combat operations in Afghanistan and Iraq, and according to the Congressional Budget Office for the June 2007 US spent around 500 billion US dollars. Stage 5: 2008 2009 7 Appreciation of the euro against the dollar continued until year 2008 reaching the record peak 1.6037 dollar per 1 euro. The rapidly increasing oil price since the end of 2007 until beginning of 2008 is the reason behind strong depreciation of US dollar over the year (see appendix, figure.5). According to Bjorland (2008) oil importing countries exchange rates are negatively related to oil price shock. Higher oil price reduces the total usage of energy in production, because it becomes more costly for the company. Hence, the net quantity produced by the company decreases, which affects net revenue and this, is followed by reduction in consumption and investment spending. However, in the late 2008 dollar started to appreciate rapidly against the euro. One of the reasons of such movement is decreasing oil price until February 2009, as oil price and exchange rate is negatively related in oil importing countries. Economists also explain these changes as highly increased demand for US Tr easury bills as it is safety investment during the crisis period (McCauley, 2009). Furthermore US banks offered the highest yield, stimulating capital inflow and appreciating the local currency (McCauley, 2009). Stage 6: 2009 2010 8 After one year of appreciation of the dollar against the euro, dollar suddenly down turned against the euro in 2009. One of the reasons for continues depreciation of the dollar in 2009 is the hiked up price for gold (see appendix, figure.6). In 2009 gold price reached its record level of 1227.50 dollars per ounce (Gold Investing, 2010). As the dollar continued to depreciate and price for the gold increase, investors switched to safer alternative investments such as gold, this affected on continues pressure on dollar depreciation (Gold Investing, 2010). Stage 7: January 2010 February 2010 9 In February 2010, EU experienced economic downturn, as Greece suffered economic troubles (see appendix, figure.7). The European Central Bank announced that Greece experienced twin deficits and lost its export competitiveness, this also affected overall European export performance. Over the year European export decreased by $ 109.1 billion. This economic shock negatively affected exchange rate and the Euro depreciated against the US dollars. (Arestis, et. al., 2010). In conclusion, since 2001, the US dollar depreciated almost by 30% against major international currencies, and one of them is Euro. After launching on January 1, 1999, the overall trend Euro against US dollar is appreciating. However, from the chart it is possible to detect that US dollar is appreciated against Euro in some time period. On De Grauwe (2000) research paper explains a change in exchange rate fluctuation is due to news in the fundamental. Hence, appreciation and depreciation of the dollar or the euro lea d to positive or negative news. For example, when Federal Reserve announced that it wants to increase its interest rate, such news is a positive signal for the investors, and action is taken immediately, as seen later dollar appreciated against the euro in  2005. Apart from investor speculation, other major factors contributed to the exchange rate volatility. These factors include introduction of Euro cash and coins, US deficit, war in Afghanistan and Iraq, oil price shocks and current financial crisis. From a long-term view, dollar is losing its position against the Euro, and Euro is promising great potential in near future. Word count: 1,592 2. Hong Kong should dismantle its fixed exchange rate peg with US dollar. Instead it should peg its currency with the Chinese Renminbe (CNY) or allow its currency to float freely. In 1983 Hong Kong exchange rate system moved from a conventional floating rate to an unconventional fixed rate linked to the US dollar (Lui, et. al., 1989). New changes in exchange rate system attracted international interest, because Hong Kong has become one of the developed and largest financial centers in the world. There exists a continuous debate on whether Hong Kong should shift to a floating exchange rate regime or continue with its fixed peg to the US dollar. We show the pros and cons of both regimes using Hong Kong and Singapore as examples. The cause for the East Asia economic crisis is currency crisis. In mid 1997 the Thai baht was experiencing heavy pressure, this instability spread to the other East Asia country currencies, the Malaysia ringgit, the Indonesian rupiah, the Philippine peso, and even to Singapore dollar. In October 1997, economic crisis reached Hong Kong, Taiwan, Japan, South Korea, and affected countries even outside Asia. (Tsang, et. al., 1999). During the Asian crisis in 1997-1998, the Hong Kong dollar, which is pegged to US dollar, survived from speculative attacks by international hedge funds. This proved that Hong Kongs exchange rate regime struggled positively to the negative turmoil. However, many economists are doubtful whether the current exchange rate regime will prevent Hong Kong dollar from cyclical speculative attacks. (Lu, et. al., 1999) After the economic crisis in East Asia, Singapore experienced fast economic and financial growth. Economists explain this success due to managed floating exchange rate regime of Singapore, and offer a valuable lesson for Hong Kong exchange rate regime. (Lu, et. al., 1999) Hong Kong and Singapores economies and the way they are developing are close to each other in the East Asia area. Both economies are small and open, both were under British Empire and applied British common law regime, and in both economies domestic private sector and public services are well functioni ng. (Rajan et. al., 2002) However, during the Asian economic crisis, the Hong Kong exchange rate regime showed its vulnerability to negative shocks. Both Singapore and Hong Kong were affected by the crisis, but in different ways.  (Cheung et. al., 2002). Singapores economy was affected mainly because half of Singapores external trade is dealing with Southeast Asia countries such as: Malaysia, Thailand, Japan, Hong Kong, South Korea and Indonesia. After July 1997 all these countries suffered from economic distress. In contrast, Hong Kongs external trade involves dealing with countries such as: Taiwan, China, United States and Europe, countries not suffered from Asian economic crisis. As Honk Kong dollar was highly used in the Asian region and as other currencies fall all over Asia, Hong Kongs dollar was viewed as unsustainable. During the Asian crisis, Hong Kongs economy experienced difficult days, because of its local currency which was pegged to US dollar, and several speculative attacks on the HK dollar. In comparison with Singapore, Hong Kongs economy went into recession half year earlier, and experienced slower recovery rate. Even though, Hong Kong government continues to peg its currency to US dollar, and local business community supports this exchange rate regime. There are two beliefs why government and business community supports fixed rate. (Lu, et. al., 1999). Firstly, Hong Kong government believes that there exist long-term benefits from pegging Honk Kong dollar to US dollar. Government and business communities believe that current system was working well and can work now, during bad times any type of regime can be negatively affected by any crisis, and changing in the exchange rate regime would destabilize the economy and create panic. (Lu, et. al., 1999). Secondly Honk Kong government and business community worry about losing leading position of being the international financial center in East Asia.   They think, if Hong Kong dollar was not fixed to a strong currency like the US dollar, the unstable and weak Hong Kong dollar would discourage investors. Hong Kong may experience a capital outflow as they have an open economy. However, experience of Singapore and Taiwan is illustrative of expose above believes.   In 1997 Taiwan changed its exchange rate regime to floating; this did not discourage investors confidence in the economy, no capital outflow, and the economy became the most flexible in the Southeast Asia region during the Asian crisis. During the crisis, Singapores dollars depreciated more that 15% against the US dollar. These changes in the economy did not discourage investors confidence, continued to be a leader on regional financial center with future potentials.  These experiences show that floating exchange rate regime can protect itself from speculative currency attack. (Lu, et. al., 1999). By analyzing economic backgrounds of both Hong Kong and Singapore countries, bot h economies were the healthiest among other East Asian countries during the East Asia crisis. To be well performed for such a negative shock, government collected enormous fiscal reserves. Both economies have been lowest regional outperforming loan ratios, largest reserve funds and highest capital sufficient ratios. During the Asian crisis, Hong Kong and Singapore showed great flexibility in quick adjustments of labor market and property price volatility control. (Cheung et. al., 2002). If Hong Kong applied Singapores exchange rate system, it would be easier to defend the own currency from speculative attack, because for speculators it would be riskier to speculate on none preannounce exchange rate.   Under the floating exchange rate regime, the speculators would not have prior knowledge on how monetary authorities will respond on volatility of its own currency.  Having a strong reserve, the monetary authorities can easily minimize losses from speculative attacks, a nd Singapore exchange rate policy and speculative attacks on Singapores dollars in 1985 is a good example. (Lu, et. al., 1999). Changing from fixed up the floating exchange rate regime, Hong Kong should considerably boost business and investors confidence in the economy. As Singapore is almost similar as Hong Kong economy, it should be enough to convince Hong Kong to adopt a floating exchange rate regime, as did Singapore in 1973 and successfully experiencing economic growth. At the end of the last century Singapores currency moved from the position to be fixed on the pound Sterling and US dollar to floating, and now Singapore is a regional financial leader.  The Singapore case shows that, by having strong economic fundamentals, sufficient reserves and strong political objectives, moving from fixed up floating regime push the economy more forward, to more efficient way and safer position from speculative attacks. In present days, Hong Kong has the better position than Singapore in 1970s; hence changing exchange rate regime would be easier and safer. (Lu, et. al., 1999). Nevertheless, ignoring the factor that Hong Kong belongs to China and at the same time being one of the important trading partners, would be inappropriate. Due to cheaper land rent and cheaper employment availability, a large proportion of Hong Kong export manufacturing industries had set up their plants in China. China being one of the biggest and fast growing economies in present days, being an important trade partner, having lots of Hong Kong manufacturing industries, question arise here should have a Hong Kong repeg exchange rate regime from US dollar to Chinese Yuan? During the Asian crisis China protected Hong Kong from heavy crisis impact by having massive foreign exchange reserve of the HK dollar, and by subsidizing Hong Kong export manufacturing industries with credit supply and VAT repayments (Kueh et. al., 2002). Therefore, analysts are suggesting repegging to Chine se Yuan in order to gain economic and political advantages. Regardless of the high trade and economic relations between China and Hong Kong, Hong Kong government is not planning to repeg to Chinese Yuan. They are supporting their decision arguing that Chinese Yuan itself is de facto fixed to US dollar with similar objectives in order to maximize export earnings from United States and other foreign markets (Kueh et. al., 2002). However, according to Yues (2008) research re-pegging HK Dollar to Chinese Yuan is impractical due to the fact that HK Dollar is a fully convertible currency where as Chinese Yuan has yet to become a fully convertible currency. Furthermore, during the crisis Hong Kong dollar showed that it is very vulnerable to economic shocks and this instability may harm economic condition itself (Kueh et. al., 2002). In conclusion, changing Hong Kong regime from being fixed to US dollar to Chinese Yuan is inappropriate, as Chinese Renminbi itself fixed to US doll ar and pursuing similar objectives as Hong Kong economy. Another reason against pegging to Chinese Renminbi is that Chineses economy is not highly developed as Hong Kong economy, hence pegging to Chinese Renminbi will push back Hong Kongs economy. However, the stability of the Chinese economy and government decision made on not to devaluate the Renminbi, have attracted attention (Wei, et. al., 2000). Singapores case showed that floating exchange rate regime is more flexible during economic shocks as currency speculative attacks are less comparing with currency under fixed exchange regime. However, during the economic boom, both regimes show good performance and high future potentials. Suggesting changing exchange rate regime to new one or remaining with the current regime is an unclear, but floating exchange rate regime more promising. Word count: 1,518 References Altman, D., 2003. Dollar faces path of deeper slide. New York Times. Arestis, P., and Pelagidis, T., 2010. Greeces economic problems and euro threats are exaggerated. Guardian. 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