Expected Euro Appreciation

Since the beginning of 2018, the euro has depreciated against the dollar. At the beginning of June, the price for one euro rose again. Even if the euro lost value again in the last few days, a further appreciation of the euro is expected for the next 12 months (see, for example Michels 2019, page 3). This revaluation directly worsens the international competitiveness of the euro countries. In the medium and long term, however, the appreciation of the euro can also have positive effects on the competitiveness of companies in the euro zone.

Euro Appreciation and foreign trade

In the short term, a euro appreciation will worsen the export opportunities of European companies. Let us assume that the value of a euro rises from one dollar per euro to 1.10 dollars per euro. The price American consumers have to pay for a German car or for Italian shoes will rise by 10 percent. The demand of US consumers for these products is thus declining – and the exports of the euro member countries are shrinking. In the euro zone, production and employment are falling.

Productivity enhancing effects of a euro appreciation

In the medium and long term, however, the euro appreciation can also improve productivity in the euro zone. There are three central reasons for this.

#1 Appreciation as a productivity whip

A first productivity enhancing effect of an appreciation concerns the described deterioration of the competitiveness of domestic enterprises. In order to improve sales opportunities again, cost reductions are necessary. The use of appropriate production technologies increases the productivity of domestic companies. Seen in this light, the appreciation of one’s own currency has the effect of a productivity whip.

#2 Appreciation accelerates structural change

The already low productivity companies in particular are suffering from increased competitive pressure. With a permanently strong currency, they disappear from the market. This process of “creative destruction” accelerates structural change, which has a long-term positive effect on productivity.

#3 Appreciation cheapens imported capital goods

The mirror image of an appreciation of the euro is a devaluation of foreign currencies. This makes imported capital goods cheaper. Companies in the euro zone are therefore increasingly demanding these goods. The associated increase in investments increases productivity.

Productivity lowering effects of an appreciation

In addition to these three effects, which increase productivity, an appreciation can also result in a reduction in productivity. There are as well three central arguments for this.

#1 Appreciation as a productivity brake

The appreciation of one’s own currency does not have to be a competitive disadvantage for all companies. As mentioned above, an appreciation of the euro is the equivalent of a depreciation of the dollar. This is an advantage for European companies that purchase inputs from abroad: a ten percent devaluation of the dollar means that all inputs purchased from the dollar area – calculated in euros – become ten percent cheaper.

For a German company that buys many inputs from the dollar zone and sells its products in the euro zone, this is a reduction in production costs. The decreasing competitive pressure reduces the incentive to carry out technological innovations. In this case, the appreciation of the domestic currency acts as a brake on innovation and productivity.

#2 Decrease in production reduces productivity

An appreciation makes domestic products more expensive in the rest of the world. Domestic exports will thus fall. At the same time, imports are increasing because foreign products – again expressed in euros – are becoming cheaper. As a result, the demand for domestically produced goods and services decreases. Companies adapt to this and domestic production consequently declines.

At least the capital stock cannot be reduced at the same rate. If the output of the companies decreases, but the capital stock used remains more or less constant, the capital productivity decreases. The same applies to labor productivity if enterprises keep the redundant labor in the enterprise.

#3 Appreciation as a brake on investment

Whether companies can actually carry out necessary innovations – i.e. above all the associated research and development expenditure and investments – is also a question of financial capabilities. A central source of financing is corporate profits. If an export-oriented company suffers a decline in sales due to the appreciation of its domestic currency, this is to the detriment of profits. Lower profits reduce the ability to finance investment and R&D. The activities necessary to increase international competitiveness cannot be financed, which has a negative impact on productivity.

The recourse to credit-financed innovation activities may not be an alternative either. If banks discover that a company’s sales expectations are deteriorating, this will have a negative impact on the company’s creditworthiness.

Which effects predominate?

With so many impact channels, it is unpredictable what the net impact of a change in exchange rates will be on a country’s overall economic productivity. The overall effects are somewhat clearer if a distinction is made between the short and the long term:

• In the short term, the effects that slow down investment and productivity are of greater importance. If the domestic currency appreciates, these are above all the unused parts of the capital stock and the workforce in the event of falling production as well as the declining profits to finance productivity-increasing measures.
• In the long run, however, the productivity-enhancing effects gain in importance. The main factors here are the need to cut costs and the acceleration of structural change in the economy. Both developments are of a long-term nature and have a time lag before they take effect.

These considerations on the short- and long-term effects of a change in exchange rates are confirmed by two studies:

• The strong appreciation of the Swiss franc in 2015 reduced Swiss companies’ expenditure on investment, research and development in the short term and thus lowered their overall productivity (see research-collec-tion.ethz.ch).
• Richard Harris examined the impact of the devaluation of the Canadian dollar on productivity in the early 1990s. He explicitly examines the long-term effects and concludes that this devaluation had long-term negative effects on Canadian productivity growth (see bankofcanada.ca).

In the longer term, the appreciation of the euro could therefore have positive effects on productivity, growth and employment in Europe.

Literature: Michels, Jürgen: Perspektiven Juli 2019: Zinslose Zukunft, BayernLB Research, München.