Why is the Euro so strong, given problems with the Olive branch?

Planning a trip to France or Spain this Summer? Ever wondered why the Euro is so strong against Sterling. With a spot rate around 1.12, one hundred pounds would buy around one hundred and five euros. Living on a fixed pension in Spain, the weakness represents a drop in income of thirty six per cent over ten years. Why is Sterling so weak against the Euro?

According to some the Euro is near collapse with reluctant Franco German support for the Olive branch of the Euro. The currency caution is “Beware of Greeks needing bailouts”, for they will soon be followed by the others in the PIG pen. Portugal, Italy, Greece, Spain are queuing at the trough, the system will collapse say some. From a macro economic and political risk perspective, a strong Euro doesn’t make sense. 

Monetary considerations offer some support given the interest rate disparity between the 50 basis points available in London compared to the 50 basis points deposit facility and a 1.25% available for main refinancing operations available in Euroland. Think of the 2% marginal lending facility from the middle of April and the capital pull makes some sense. 

But the fall in Sterling began long before the interest rate spreads opened up. The Sterling effective exchange rate has fallen by almost 25% since 2008. Examine the charts and the fall in Sterling is not universal. A cable rate (Dollar Sterling) of 1.62 isn’t that bad in 2011. It was actually 1.60 eleven years ago. 

A rate of 1.12 against the Euro is really mis priced. The problem is not Sterling against the Euro, it is the Euro rate against the Dollar. Compare the weakness of the Dollar. It has fallen from 1.18 to around 0.70. A decline of forty per cent. Against the yen, the fall has been almost sixty per cent.  

To understand, look back, in history to the dilemma of the Bank of France at the end of the 1920s. This was the “end of era” phase of Sterling as the world reserve and the last flap for Gold. France with significant sterling holdings had to divest but in a way which didn’t overly damage the exit price. 

Consider China with some $3 trillion of reserves. The Middle Kingdom has to diversify away from the imperilled dollar. The dollar is an end of era reserve currency. Hence the quest for a hybrid option in Special Drawing Rights, SDRs or a return of Keynesian Bancor from the Asean block.

It is estimated that already over 20% of China’s reserves are in the Euro. China has built the longest bridge in the world, not the Qingdao bridge, [pictured] but the financial bridge from Beijing to Berlin. China needs a strong Euro to delay the day when the renmimbi will rule. Hence the offer from Chinese premier Wen Jiabao to buy Euro bonds and landmarks in Greece. Parthenon not the Pound.

The strength of the Euro is a challenge to holiday makers, but it is the weakness of the dollar which is the challenge to policy makers. It is the strength of the Asian economies and China specifically that pose the real policy dilemma for the UK. A sterling recovery may take longer than we think. 

An extract from China - Return of the Middle Kingdom - The impact of China on the world economy. John Ashcroft 2011.

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The views expressed are my own and in no way reflect pro.manchester policy. In no way should the comments be considered as investment advice or guidelines or reflect political bias. UK Economics news and analysis : no politics, no dogma, no polemics, just facts. JKA is a visiting professor at MMU Business School, an economist and specialist in Corporate Strategy, educated at LSE, London Business School with a PhD from Manchester Metropolitan University.

 

Comments

[MadNumismatist]

A very interesting post, it shows exactly how FUBAR sterling is. We must be really screwed to fall against the euro. The fact is all traditional correlations are out of the window. Everything is up- except the pound.

[תת פעילו בלוטת התריס]

There is the challenge for policy makers. It is the strength of Asian economies and China in particular, it is true policy dilemma for the United Kingdom. Sterling recovery may take longer than think.

[Nike Air Jordan]

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