Recently, there was a significant event in the global financial sector: The Euro and the U.S. dollar achieving parity. This indicates that one could exchange one dollar for one euro in the foreign exchange market. Since the year’s start, the euro has seen a depreciation of approximately 12% against the U.S. dollar, a trend expected to continue into the future.
The Dynamics of Currency Exchange Rates
The price of any currency in a market economy is primarily determined by supply and demand factors. The supply of a country’s currency is influenced by various elements such as local demand for imports and foreign assets, central bank policies, and more. Conversely, the demand for a country’s currency is driven by factors like foreign demand for exports and domestic assets.
Causes behind the Euro’s Fall
The main reason behind the euro depreciating against the U.S. dollar is the divergence in the monetary policies of the U.S. Federal Reserve and the European Central Bank. In June 2022, inflation in the U.S. hit a high of 9.1%, the highest it’s been in four decades, while inflation in the Eurozone matched its record high at 8.6%. The U.S. Federal Reserve has consequently raised the interest rates to slow down the money supply growth in reaction to the rising prices. In contrast, the ECB has been less aggressive with their policy tightening, leading to a devaluation of the euro against the dollar. This contrasts in policies have been causing traders to expect an increase in the euro supply in the market compared to the dollar.
Impact of Global Events on the Value of Euro
Russia’s invasion of Ukraine and subsequent actions against Russia led to uncertainty in energy supplies, which, in turn, impacted the value of the euro. As a result, Europe had to expend more euros to import limited energy supplies, leading to a further decrease in the value of the euro against the U.S. dollar.
Effects of Euro-Dollar Parity on Economy
The fall in the euro’s value has repercussions for businesses and economies alike. For European companies that export outside the Euro area, the lower euro value is beneficial as it means their prices are more competitive when converted into dollars. However, the reverse is true for companies that import from outside the Euro area as they now have to pay more euros for imports. Local firms dependent on raw materials and energy but who export little face potentially steep cost increases due to the weakened euro.
Impacts on Growth and Debt
As the euro falls in value, goods and services from the single currency Eurozone become more competitively priced on the global market, theoretically encouraging exports. Conversely, rising commodity prices – particularly influenced by Ukraine’s war – could offset these benefits. For nations with dollar-denominated debt, the declining euro value drives up debt repayment costs.
The Role of Central Banks
The euro’s fall could spur the European Central Bank to accelerate interest rate hikes, thereby fuelling inflation. The bank is looking at tightening borrowing costs for the first time since 2011, set for July 2022.
Question of Discussion
For deeper understanding: Which one of the following groups of items is included in India’s foreign-exchange reserves? (2013) (a) Foreign-currency assets, Special Drawing Rights (SDRs) and loans from foreign countries (b) Foreign-currency assets, gold holdings of the RBI and SDRs (c) Foreign-currency assets, loans from the World Bank and SDRs (d) Foreign-currency assets, gold holdings of the RBI and loans from the World Bank. The correct answer is (b): Foreign Exchange Reserves are assets kept in reserve by a central bank in foreign currencies. According to RBI, Foreign Exchange Reserve in India includes: Foreign Currency Assets, Gold, SDRs, and Reserve Tranche Position with IMF.