Sunday, November 7, 2010

Is euro overvalued?

“There is only one route for the euro, towards 1.08 in the US dollars by the end of this year and towards the eventual parity in 2011”, forecast an expert in a TV interview during the heydays of the euro crisis in the beginning of June 2010. The actual exchange rate was then 1.20 US dollars per euro.

Only two years before, in May 2008, when the euro hovered at 1.55, another currency strategist forecast: “there is only one route for the US dollar, towards 1.70 by the year end”. Incidentally, the euro touched 1.25 half a year later – and 1.50 in subsequent November in 2009.

Forex-strategists may in passing mention purchasing power parity (PPP), but most often emphasize short-term trends that may not at all be based on a convergence towards PPP but on recognition by technical analysts, that is, by those who try to find out recurring patterns in the historical data. PPP is a theory of the intrinsic value of a currency: the equilibrium exchange rate equates the cost of an average goods basket in the two currency areas. When PPP holds true, a dollar or a euro buys the same basket irrespective of the country where it is expended.

The best available estimate for the correct long-term value of the euro in the US dollars is based on the average goods basket of the OECD countries as calculated by the Ifo Institute in Munich, Germany, the most recent value of 1.17 being published in CESifo Forum 3/2010, p. 39. Were the US basket the reference the parity of the two currencies would roughly represent the PPP indeed. And in respect of the German basket, the PPP value is not far from the current exchange rate of 1.40.

The euro zone contains countries with a lower level of general prices than in Germany. Hence the rise of the euro to 1.55 in 2008 may not have represented any drastic overvaluation in terms of the euro-zone basket of goods. In fact, during the Carter administration the US dollar was much weaker, about 1.70 dollars per euro.

The preferred OECD purchasing power parity of 1.17 in contrast to the current exchange rate of 1.40 implies about a 10 per cent overvaluation of the euro. But, how quickly does the exchange rate of a currency converge to its PPP value?

The established robust econometric result during my life-time of teaching was that any discrepancy from the PPP would be halved over the medium term which most researchers interpreted as anything from one and half years to three years. From this perspective the forecast for the dollar exchange rate of the euro for November 2011 is that the euro would slightly depreciate against the US dollar. – And experience shows that we will experience much wider fluctuations.

This leaves ample room for the real actors in the currency (forex) markets: find a trend, trade the trend, and ride the trend. For a forex trader a trend in an exchange rate is like bureaucracy: it does not pay to fight against it.

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