An evaluation of the equilibrium value of the euro, its predecessors and their constituent currencies based on economic fundamentals

ABSTRACT

This study presents constructed equilibrium exchange rates (EERs) of the euro and its predecessors the European Unit of Account and the European Currency Unit, as well as the euro’s member states using a relative version of purchasing power parity (PPP) equilibrium. The revealed patterns of over- and undervaluation demonstrate how well suited the northern member states, in contrast to the southern states, were for the monetary union. Moreover, a relative persistent overvaluation for Greece and Portugal suggests that their ambition to join the euro reduced their competitiveness. The constructed EERs of the euro suggest the European Commission was able to set the initial value of the euro with a high degree of accuracy. Furthermore, the EERs indicate a successive strengthening of the fundamental value of the euro versus the U.S. dollar from 1999 to 2015. The analysis shows a close correlation between the deviations from equilibrium and the events of Greece’s sovereign debt crisis. In addition, the presented graphs show strong support for the PPP hypothesis. The results are robust to different constructed EERs and offer a guide to international market participants interested in the general equilibrium path of the euro and its predecessors.

KEYWORDS:

• Relative purchasing power parity
• equilibrium exchange rate
• over- and undervaluation
• euro
• European sovereign debt crisis

JEL CLASSIFICATION:

• F31
• F40

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ Cohen (2003), Bergsten (2002), Kenen (2002), and Hartmann and Issing (2002) provide a detailed discussion on the potential rivalry between the euro and the U.S. dollar.

² For example, before the euro introduction, due to these costs 15 franc were lost for every 1,000 francs in foreign trade (Sinn 2014).

³ For a detailed discussion on the issue see Sinn (2014).

⁴ For a detailed discussion of the cause as well as the response to the European sovereign debt crisis see, for example, Howarth and Quaglia (2015).

⁵ Besides the positive impact on exchange rate risk, the literature provides evidence for an immediate effect of the euro introduction on the Eurozone interest rates and fixed income markets (Adjaouté and Danthine 2003; Hartmann, Maddaloni, and Manganelli 2003; Rajan and Zingales 20033), an increase in competitiveness among Eurozone firms (Ottaviano, Taglioni, and Di Mauro 2009), more trade within the Eurozone countries and with outside countries (Micco, Stein, and Ordoñez 2003; Barr et al. 2003), more stock market integration (Fratzscher 2002; Askari and Chatterjee 2005; Kim, Moshirian, and Wu 2005; Leon, Nave, and Rubio 2007; Bartram, Taylor, and Wang 2007; and Bley 2009), and less market risk exposure for international companies (Bartram and Karolyi 2006). However, there is also some evidence that the euro has decrease stock market integration (Holmes 2003; Bley 2009).

⁶ The seven countries are excluded due to data unavailability. Moreover, those countries combined account for only a very minor composition of the euro. For example, in January 2015 they account for less than 1.8% of the total GDP of the euro member countries. Where possible, we also calculated the equilibrium exchange rates (EERs) of the euro including the seven countries that joined the euro in recent years; however, the inclusion of the countries in the construction of the euro EERs had a very minor impact on the presented results. Hence, the findings are not presented to preserve space, but available from the authors upon request.

⁷ Kim (1990) illustrates that with respect to the real exchange rate the purchasing power parity (PPP) hypothesis holds better when using PPI instead of consumer price indexes (CPI). Xu (2003) provides even stronger evidence in favour of the PPP hypothesis when using traded goods price indexes (TPIs) instead of whole price indexes or CPI.

⁸ Most studies find empirical support that the PPP hypothesis holds in the case of developed countries in the long run; while the evidence with respect to developing countries is rater mix. For example, Karabulut, Bilgin, and Gozgor (2013) find no evidence of a mean reverting behaviour with respect to the currencies’ of the Czech Republic and the Poland but limited evidence with respect to Hungary.

⁹ Hakkio (1992) assumes that the world economy was in equilibrium during that period. The period from 1980 to 1982 coincides with the beginning of the Reagan administration, which initially did not intervene in foreign exchange rate markets.

¹⁰ The country with higher productivity in the tradable goods sector experiences a real appreciation. If productivity in the tradable sector exceeds the productivity in the non-tradable sector, wage equalization between the two sectors will cause relative prices to increase in the tradable sector. This, in turn, will cause aggregate price levels to increase in the country with higher productivity in the tradable sector.

¹¹ Alquist and Chinn (2002) find that productivity differentials between the U.S. and the euro area are related to a real appreciation of the U.S. dollar/euro exchange rate. On the other hand, Schnatz, Vijselaar, and Osbat (2004) find that productivity differentials only explain a small portion of U.S. dollar/euro exchange rate movements.

¹² Following De Grauwe and Verfaille (1988), we assume a proportion equal to 0.7 for the share of tradable goods in consumption basket of developed countries. We also used different values for ɑ, which, however, did not alter our results.

¹³ While the literature provides overwhelming evidence rejecting the PPP and UIP hypotheses (Isard 1978; Mussa 1979; and, Frenkel 1981), Johansen and Juselius (1992) find support for a combined PPP and UIP model.

¹⁴ We construct EERs using short-term as well as long-term interest rates.

¹⁵ Note that we account only for the Balassa–Samuelson effect when using CPI to measure inflation rate differentials.

¹⁶ For example, Morey and Simpson (2001a, b); Simpson (2004); and Grossmann, Simpson, and Brown (2009).

¹⁷ When referring to euro EERs, we mean the European Unit of Account (EUA) before March 1979 and the European Currency Unit (ECU) before January 1999.

¹⁸ On 17 September 1984, the Greek drachma joined the ECU and on 22 September 1989, the Spanish peseta and the Portuguese escudo joined as well.

¹⁹ The weights based on the exports, imports and real GDP are not provided but available from the authors upon request.

²⁰ From 1981 to 1985, the U.S. dollar appreciated by around 50% against the four major currencies at the time (the Japanese yen, Deutsche mark, French franc, and British pound) challenging the exporting industries in the U.S.

²¹ On 22 September 1985, the finance ministers of West Germany, France, the U.S., the U.K., and Japan signed an agreement at the Plaza Hotel in New York to intervene in the foreign exchange rate markets to bring down the highly overvalued U.S. dollar.

²² The graphs are not presented to preserve space but available from the authors upon request.

²³ This may be seen as additional evidence that the period from 1980 to 1982 was indeed a period of equilibrium, as the EERs based on the rolling based period from 1974 to 1998 are similar to those solely based on the 3-year period from 1980 to 1982. Moreover, it is in line with previous studies, which demonstrate similar results using different base periods.

²⁴ We also generated the PPI and TPI EERs using the base period from 1980 to 1982, which did not alter the patterns in comparison to the graphs based on the rolling base period. The graphs are available from the authors upon request.

²⁵ For a detailed discussion of the Irish banking crisis see, for example, Fitzgerald (2013).

²⁶ The graphs are not presented to preserve space, but are available from the authors upon request.

²⁷ We also constructed PPI- and TPI-based euro EERs adjusted by long- and short-term interest rate differentials, which, however, did not change our main results. The graphs are not presented to preserve space but available from the authors upon request.

²⁸ Table A4 covers the pre- and the post-GFC period. The first five rows show the percentages for the CPI-based EERs using the rolling base period as well as all five different weighting schemes. The remaining rows show the percentages for selected other constructed euro EERs using the final ECU weights and GDP weights. The results based on the EERs not presented in Table A4 are available from the authors upon request.

²⁹ The committee consisting of the European Commission (euro group), the European Central Bank, and the International Monetary Fund, which organized loans to the governments of Greece, Ireland, Portugal, and Cyprus.

³⁰ In the spirit of the classical PPP hypothesis, it is assumed that the price indexes of equation $e{x}_{i(t)}^{PPP}=p_{i(t)}-p_{us(t)}+c$ represent traded goods.

³¹ For example, Edison (1986) states: ‘The respective shares, or weights, are determined not only by reference to each country’s gross national product, but also with reference to its participation in the Community’s external trade and its quotas under the short-term monetary support system’.

³² See also ‘The Unit of Account as a Factor of Integration. Information’ [Economy and Finance] 87/75. [EU Commission – Brochure] http://aei.pitt.edu/7861/1/31735055281731_1.pdf

³³ Belgium and Luxembourg had established a currency union; hence, the ECU basket shows only the combined weights under the Belgian franc until 21 September 1989.

³⁴ On 17 September 1984, the Greek drachma joined the ECU and on 22 September 1989, the Spanish peseta and the Portuguese escudo joined as well.

³⁵ The press release, which explained how the conversion rates would be determined, can be found under: https://www.ecb.europa.eu/press/pr/date/1998/html/pr980502.en.html.

³⁶ The difference between the actual irrevocable conversion rates and the ones calculated in this article has a mean squared error of less than 0.01%.