I. Introduction
The euro’s depreciation since its inception in 1999 has been a notable economic puzzle, especially considering initial expectations of its strength. This article delves into the reasons behind this decline, particularly focusing on the exchange rate between 155 Euros To Dollars and the broader euro to dollar dynamic. Understanding why 155 euros might convert to fewer dollars than anticipated requires examining the underlying economic forces at play.
Initially, the euro’s weakness was dismissed as a minor correction. However, as the euro continued to fall, deeper explanations were sought. This analysis evaluates various theories attempting to explain euro weakness, primarily against the backdrop of the U.S. dollar. This comparison is crucial because the euro-dollar exchange rate movement has been significant, driven by both euro depreciation and dollar appreciation against other global currencies. Furthermore, discussions often contrast the economic structures and performances of the Eurozone and the United States to rationalize these exchange rate shifts.
In essence, a significant portion of the euro’s weakness stems from the dollar’s overall strength, a trend that predates the euro itself. This dollar strength can be linked to the substantial growth in U.S. equity prices since the mid-1990s, creating a demand surge that disproportionately benefited the U.S. economy. Model simulations suggest this factor accounts for roughly half of the euro’s effective value decline. The remaining euro weakness can be attributed to an imbalance in the supply and demand for euro-denominated assets following the currency’s creation in 1999. This imbalance arose from increased euro-denominated debt issuance by non-Eurozone entities and Eurozone borrowers replacing foreign debt with euro debt. Simultaneously, Eurozone lenders diversified into non-euro assets. These shifts increased the supply of euro assets relative to demand, putting downward pressure on the exchange rate.
While the U.S. equity market surge has partially corrected, creating potential for euro recovery, future equity market trends remain uncertain. Similarly, the portfolio shifts’ impact is expected to diminish as asset holdings and interest rate differentials adjust. However, in the short term, market volatility could be amplified by uncertainties surrounding the fundamental factors influencing currency values, making conversions of amounts like 155 euros to dollars subject to fluctuation.
This article will first review the euro’s movements and equilibrium level estimations. It will then present a framework for analyzing currency fluctuations, followed by a critical review of various euro weakness explanations. Finally, it will focus on two primary hypotheses: the impact of U.S. equity valuations and portfolio shifts within the Eurozone, concluding with key observations.
II. Examining Euro Exchange Rate Trends
Figure 1 illustrates the nominal and real euro/dollar exchange rates since 1979. Before 1999, these figures are based on weighted averages of legacy currency rates against the dollar. The close alignment between nominal and real rates indicates a consistent inflation differential. The euro’s decline from early 1999 is a continuation of a trend starting in 1995. Since then, the euro has depreciated approximately 35 percent against the dollar. The euro’s strength in late 1998 appears as a brief deviation within this larger trend.
Figure 1. Nominal and Real Euro Rates Versus U.S. Dollar
Euro exchange rates against the US dollar, showing both nominal and real values over time.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Source: INS.
Looking back further, the euro’s 1995 value was slightly above its 10-year average but not significantly. Compared to the early 1980s, the 1995 euro appears more appreciated, but the early 1980s dollar overvaluation distorts this comparison. The euro’s 1984 low against the dollar was almost 20 percent weaker than mid-2001 rates, suggesting recent fluctuations are not historically unprecedented.
Figure 2 presents the euro’s real effective value, both overall and excluding the U.S. dollar and pound sterling. In real effective terms, the euro has depreciated about 20 percent since 1995, roughly half the decline of the euro/dollar rate. This smaller effective index movement reflects the dollar’s strength against other currencies, particularly the yen. Excluding the dollar and sterling, the euro’s real effective value remained relatively stable from 1995 to 1998, with significant depreciation starting only with the euro’s introduction in 1999. Since 1995, this narrower effective rate measure has fallen about 10 percent. This suggests that of the 20 percent overall depreciation since 1995, half is due to dollar strength, and half is specific to euro weakness.
Figure 2. Euro Real Effective Exchange Rate Measures
Real effective exchange rate of the Euro, showing measures both including and excluding the US dollar and Pound Sterling.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Source: INS.
Compared to the 1984 low, the euro’s real effective value in mid-2001 is slightly higher, but the difference is less than for the euro/dollar rate. Both measures indicate the euro is below normal historical levels, although not as drastically as in 1984.
Table 1 summarizes euro weakness in historical context.
Table 1. Euro Weakness in Historical Terms (percent change to first half of 2001)
| Real euro/dollar | Real effective (CPI) | |
|---|---|---|
| 1984 low | +17% | +6% |
| 1986-95 average | -28% | -16% |
| 1995 | -34% | -19% |
| 1999 (January) | -23% | -14% |
Note: 2001 H1 average euro/dollar rate = 0.873.
Most studies on the euro’s equilibrium level suggest it is significantly undervalued in the medium term. Equilibrium estimates against the dollar center around $1.15-1.20 per euro, similar to its introduction rate. While estimates vary, a broad consensus exists that at $0.85, the euro was undervalued against the dollar by 25-30 percent. IMF staff calculations using a medium-term macroeconomic balance approach support this, judging the euro undervalued by over 25 percent against the dollar in mid-2001. This means that an amount like 155 euros, at an equilibrium rate, should be worth considerably more dollars than at the undervalued rate.
In summary:
- Euro weakening against the dollar began in 1995 from a seemingly not overvalued level.
- The euro remained stable against non-dollar/sterling currencies during 1995-98.
- Since 1999, the euro has declined against most currencies, including the dollar.
- Of the 20 percent real effective euro depreciation since 1995, half reflects dollar appreciation, and half is euro-specific weakness.
III. Understanding Exchange Rate Dynamics
Analyzing exchange rate movements is complex due to the intricate economic roles they play. Exchange rates influence the relative prices of domestic and foreign goods, impacting trade competitiveness. They are also driven by capital flows. Both trade and capital flows are linked to inter-temporal factors, including real interest rates. Real interest rates across countries reflect, among other factors, expected real exchange rate fluctuations. Consequently, the determination of real exchange rates, real interest rates, and trade and capital flows is interconnected and heavily relies on future expectations. These expectations are inherently subjective, making exchange rate determinants equally so. The challenge lies in assessing the plausibility of expectations associated with a given exchange rate level.
This can be illustrated by an equation linking expected exchange rate changes to interest rate differentials and expected excess returns on domestic assets:
er t , t + 1 e − er t = − ( i t − i t * ) + ε tHere, er represents the foreign-currency price of domestic currency (appreciation with increase), i is the domestic asset interest rate, i* is the foreign asset rate, and ε is the expected excess return on domestic assets. This equation is an identity assuming covered interest parity. It can be expressed in nominal or real terms by subtracting expected inflation. We will generally consider it in real terms.
Analyzing current exchange rate determinants using this equation is challenging as it includes future expectations. These expectations are closely linked to the current rate and influenced by similar factors. However, iterative substitution allows expressing the initial exchange rate (period 0) as a function of initial interest differentials and expected excess yield, the sum of their future values up to a distant point T, and the exchange rate at that time:
er 0 = ( i 0 − i 0 * ) − ε 0 + ∑ j = 1 T ( i j e − i j * e ) − ∑ j = 1 T ε j e + er T eThis approach is advantageous because the expected exchange rate at time T can be plausibly assumed independent of cyclical and temporary influences, especially in real terms.
Looking at this equation, the difficulty in understanding exchange rate behavior becomes apparent. The only directly observable factor is the current interest differential. Other variables are unobservable and often exert a far greater influence. Simplifying assumptions, such as long-term interest rates reflecting expected future short rates, can collapse the short-term differential into the current long-term differential:
er 0 = ( il 0 − il 0 * ) − ε 0 − ∑ j = 1 T ε j e + er T eHere, il is the long-term rate on assets of duration T.
This equation suggests a “capital-flows-centric” view of exchange rates, where asset yields are key determinants. However, it is not immediately clear how trade considerations fit in. To complete the framework, we need relationships linking long-term interest rates to exchange rates and determining the “terminal” exchange rate at time T. These can be represented as:
y − y ¯ = f ( er ( − ) , il ( − ) , y f ( + ) − y ¯ , z )
il = g ( y − ( + ) y ¯ )Here, y is economy-wide output, y¯ is potential output, *y*f is foreign output, and z represents other demand-influencing factors. These relationships are shown for the domestic economy, with similar relationships applying abroad. Output is negatively related to the exchange rate and long-term interest rate, while the long-term rate rises with output above potential.
Trade flows impact exchange rates in the short and medium term by affecting output and thus interest rates. In the long run, when output returns to potential and long-term interest rates equalize, the exchange rate is determined by solving the first equation when y−y¯ is zero. Demand factors (z) directly affect activity, influencing interest differentials and then exchange rates. “Portfolio effects,” or differences in expected currency yields, are captured by the ε terms. Long-term fundamentals are reflected in erTe, representing the long-run solution to the first equation.
The common view that real growth rate differences drive exchange rates can be reconciled within this framework. Faster growth from a positive demand shock (z) boosts output, raising real interest rates. Higher rates attract foreign capital, appreciating the exchange rate. Faster growth from potential growth shocks (Δy¯) can also increase demand through investment and consumption, similarly impacting interest rates and exchange rates. However, sustained potential output growth could have the opposite long-run effect: a higher y¯ relative to *y*f might require exchange rate depreciation to balance global demand and supply for domestic output.
The expected excess yield, ε, warrants further discussion. Differences in expected asset yields can stem from imperfect asset substitutability and/or investor risk aversion, often termed “portfolio effects.” These can create an inverse relationship between interest rates and exchange rates. For example, an increase in ε depreciates the exchange rate, boosting domestic activity and interest rates – causing simultaneous exchange rate depreciation and interest rate increases. Such portfolio effects are difficult to observe directly due to unknown market expectations. Their role in explaining exchange rate movements is therefore inferred. Increased supply of domestic currency assets, for instance, raises ε and depreciates the exchange rate if home and foreign currency assets are imperfect substitutes. Increased exchange rate volatility also affects ρ if investors are risk-averse, though the effect’s direction is uncertain. Generally, risk premiums rise on currencies where international investors have net long positions, as they reduce currency fluctuation exposure.
In summary, this framework connects current exchange rates to current and expected future interest rates, exchange risk premiums, and long-run equilibrium exchange rates. It highlights the difficulty in pinpointing exchange rate movement causes due to the largely unobservable nature of these factors. Nevertheless, the framework provides valuable structure by identifying channels through which various factors operate. The empirical validity of explanations can then be assessed through these structural linkages and their consistency with broader macroeconomic phenomena.
IV. Exploring Explanations for Euro Weakness
Numerous explanations have been proposed for euro weakness, categorized here broadly:
- Eurozone initial conditions (e.g., labor market inflexibilities).
- Political factors (e.g., Danish referendum).
- Global oil price shocks.
- ECB policies (uncertainties, anti-growth bias).
- Contrast with the U.S. “new economy” (e.g., productivity growth).
- Portfolio shifts (e.g., increased euro-denominated bond issuance).
- Non-fundamental market dynamics (e.g., herd behavior).
A. Initial Eurozone Economic Conditions
Eurozone structural weaknesses are often cited as undermining the euro. Examples include labor market rigidities, large welfare states, and fiscal policy challenges. However, these issues are long-standing. To explain recent euro weakness, one must argue for recent unfavorable surprises causing increased market pessimism. Yet, the general trend has been continued structural reform progress in the Eurozone, at a pace comparable to historical experience. Thus, aligning euro weakness timing with these factors is difficult.
A more provocative hypothesis suggests structural reforms are detrimental to the euro. In theory, supply-driven growth might depreciate the currency long-term to facilitate exports. However, empirically, this is also implausible. Significant shifts in Eurozone productivity growth relative to other countries would be needed to explain currency movements based on structural reforms. No such marked productivity growth change has occurred.
Another initial condition is potential Deutsche Mark overvaluation when EU-11 currency conversion rates were set. Germany was experiencing reunification’s demand shock effects then. If the strong Deutsche Mark contributed to general euro overvaluation, subsequent euro weakness could reflect a misalignment correction. However, this contradicts evidence suggesting the synthetic euro was not overvalued in 1995 when it began weakening against the dollar. While the Deutsche Mark was strong, weakness in other Eurozone currencies after the 1992-93 ERM crisis offset this. Overall, the synthetic euro was broadly in line with historical values.
B. Political Influences
Some analysts attribute euro weakness to political events surrounding the Eurozone’s future, such as the Danish referendum “no” vote, the UK’s continued opt-out, and uncertainties about enlargement. The euro project is sometimes viewed as politically incomplete. However, there’s no inherent reason to expect these factors to weaken the currency. Region size doesn’t determine currency strength; small countries like Switzerland can have strong currencies, as can large ones like the U.S. Monetary policy implications of including more countries are also unclear – it could strengthen or weaken policies. While these political events coincided with euro decline, so did many other factors. Causation, if any, seems more likely in the direction of euro weakness reinforcing aversion to joining, rather than the reverse.
The Kosovo war and Balkan disturbances have also been cited as triggering a safe-haven flight from the euro. However, the Balkan situation has stabilized. More fundamentally, the Deutsche Mark is a traditional safe-haven currency in Eastern Europe. Regional political instability might plausibly boost demand for “hard” Deutsche Marks, thus strengthening the euro, not weakening it.
C. Impact of Oil Price Shocks
The euro’s effective value decline during 1999-2000 correlates with the surge in global oil prices. An inverse relationship is expected as the Eurozone is a net oil importer, and higher oil prices represent a negative terms of trade shock. However, model simulations suggest oil price shocks explain only a small portion of euro depreciation’s plausibility. Simulations of a 50% oil price increase show a real effective euro depreciation of less than 2 percent, and only 1 percent against the dollar. This small euro/dollar rate effect is not surprising, given that the Eurozone’s net oil imports were only slightly higher than the U.S.’s.
Another aspect involves asset market effects: oil exporters tend to recycle revenues into U.S. dollars, increasing dollar demand. However, direct evidence for this is lacking. Furthermore, historical oil price shocks don’t show the same currency movement patterns as 1999-2000.
D. ECB Policy and its Perceptions
Market perception of ECB policy opacity is often cited as undermining the euro. Unexpected policy changes and unclear explanations are seen as problematic. Policy uncertainty could theoretically increase financial variable volatility, including exchange and interest rates. Risk-averse investors might then adjust exchange market risk premiums. However, the level effect on exchange rates is ambiguous. Euro/dollar rate volatility creates uncertainty for both Eurozone and U.S. agents, potentially prompting them to reduce foreign-currency asset and liability exposure. The net exchange rate impact depends on initial (net) exposures. If the home country is a net foreign asset creditor, its currency might appreciate with increased uncertainty. Eurozone data suggests it’s a net international creditor, while the U.S. is a debtor. Assuming this holds bilaterally, increased uncertainty might cause Eurozone residents to reduce dollar assets and U.S. borrowers to reduce euro liabilities, appreciating the euro, contrary to the conventional view.
Pre-1999 experience also contradicts this view. The Bundesbank, guiding Eurozone monetary policy, was perceived as unpredictable, yet the Deutsche Mark was a “hard” currency. Similarly, yen/dollar rate uncertainty seems to strengthen the yen by encouraging Japanese investors to hold yen assets despite foreign currency interest rate advantages.
Another view is that ECB policy has been excessively tight, undermining future Eurozone growth and euro value. Conversely, Fed policy, by boosting U.S. growth through rate cuts, is seen as supporting the dollar. If true, Eurozone rate cuts could benefit inflation by appreciating the euro and lowering import prices.
However, this view is inconsistent with pre-euro experience. The Bundesbank’s perceived anti-inflationary bias didn’t weaken the Deutsche Mark. Conceptually, future growth itself doesn’t directly influence exchange rates; its impact is through long-term interest rate changes. Monetary easing boosting future growth would require simultaneous long-term real interest rate increases to appreciate the exchange rate, and vice versa for tightening – effects contrary to expected monetary policy impacts and standard model predictions.
Empirical evidence is also unsupportive. Ten ECB policy rate changes occurred from 1999 to August 2001. Regressing the effective exchange rate percentage change around these changes on the interest rate change yields a slope coefficient of 1.17 (t-statistic 1.6). This suggests a 1 percentage point rate increase is associated with slightly over 1 percent euro appreciation, marginally significant and consistent with conventional interest rate effect theories.
E. “New Economy” Influences
Economic developments since the mid-1990s are often attributed to a “new economy,” driven by productivity growth from information technology and structural changes like increased competition. The U.S.’s sustained GDP growth revisions and lower-than-expected inflation strengthened this view. The Eurozone, in contrast, is seen as lagging, explaining growth performance differences.
From an exchange rate perspective, a correlation exists between U.S.-Eurozone growth projection revisions and euro/dollar rate movements. This correlation could arise through interest rate channels. Faster productivity growth can increase aggregate demand via investment and consumption, raising real interest rates and appreciating the exchange rate in the faster-growing economy, at least short-term. Supporting this, long-term interest rate differentials between the U.S. and Eurozone widened. The U.S.-German bond yield gap shifted from -25 basis points in the early 1990s to over 100 by 2000. U.S. treasuries versus aggregate Eurozone bond yield spreads widened even more, although other factors like reduced currency risk in countries like Italy may contribute. Assuming relatively stable long-term inflation expectations, real interest differentials significantly shifted in favor of U.S. assets.
Figure 3. Projected GDP Growth Rate Differential and Euro/Dollar Exchange Rate
Correlation between projected GDP growth differences between the Eurozone and US, and the Euro to Dollar exchange rate.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
[1/]Cumulative difference between Consensus Forecast for real GDP growth in the euro area versus U.S., 1999-2002.Source: Consensus Economics, various issues, and INS.
Figure 4. Long-Term Government Bond Yield Differentials
Differentials in long-term government bond yields between the US and Germany, and the US and Eurozone average.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Source: WEFA and Bloomberg.
Concurrently, the U.S. current account deficit rose sharply relative to the Eurozone’s. This combination points to a significant positive aggregate demand shock in the U.S. relative to the Eurozone. U.S. inflation restraint despite accelerated output growth suggests this demand shock was accompanied by a positive supply shock, possibly from productivity growth or another factor boosting both demand and supply.
Figure 5. Current Account Balances (Excluding oil trade)
Comparison of current account balances between the US and Eurozone, excluding oil trade, showing a widening US deficit.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Source: WEO Database.
A different explanation links productivity growth to euro/dollar exchange rates through long-run supply effects. If faster productivity growth is concentrated in traded-goods sectors and these goods are perfect international substitutes, the faster-growing economy should experience long-run exchange rate appreciation (Balassa-Samuelson effect). Supporting this, a correlation exists since the early 1990s between lagged Eurozone-U.S. labor productivity growth differences and euro/dollar exchange rate changes.
Figure 6. Productivity Growth and Changes in the Euro
Relationship between productivity growth differential between the US and Eurozone, and changes in the Euro to Dollar exchange rate.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
1/ 12-month growth in manufacturing output per worker.Source: Datastream and INS.
However, the Balassa-Samuelson explanation has evidentiary issues. The required magnitude of the effect would be much larger than observed in other countries, with the euro/dollar rate moving over 3 times more than the productivity growth differential. Typical estimates suggest this ratio should be at most unity. Using this upper limit, the Balassa-Samuelson effect might account for about 1 percent annual euro depreciation against the dollar during the 1990s, cumulating to about 5 percent by decade’s end, far less than the actual 34 percent depreciation.
More fundamentally, the associated exchange rate appreciation should not undermine U.S. competitiveness. Yet, the U.S. current account deficit has ballooned since the mid-1990s, consistent with traditional trade relationships, and equilibrium estimates suggest dollar overvaluation. Finally, Balassa-Samuelson contradicts real interest rate developments. Expected real exchange rate appreciation should lower real interest rates in the appreciating country in a world of high capital mobility, but U.S. long-term interest rates rose substantially relative to Eurozone rates during this period.
F. Portfolio Reallocations
The euro’s introduction triggered widespread Eurozone capital market changes. Reduced cross-border financial transaction barriers created more liquid euro-denominated debt markets. This led to an explosion in euro-denominated corporate bond issuance by both Eurozone and non-Eurozone issuers. Eurozone institutions naturally shifted from legacy currency assets to euro assets. However, this shift may not have been one-for-one. Assets previously considered foreign in portfolios (legacy currency denominated) became domestic-currency assets under the euro. With unchanged domestic/foreign asset allocation guidelines, funds were “freed up” for foreign currency investment, like dollars. Furthermore, some Eurozone institutions (e.g., French pension funds) adjusted guidelines to allow increased foreign-currency asset allocation. Finally, foreign investors showed limited euro-denominated asset acquisition interest, contrasting with borrowers’ issuance appetite.
These portfolio shifts, in theory, could affect exchange rates through changes in the expected excess yield on euro-denominated assets. Increased euro borrowing demand relative to investor funds would raise excess yield and depreciate the euro. Anecdotal capital market behavior evidence aligns with multilateral euro depreciation coinciding with its introduction.
G. Non-Fundamental Market Dynamics
Euro weakness since 1999 can be attributed to market views on exchange rate drivers. Given equilibrium exchange rate uncertainty, short-run movements are often driven by technical and chartist analysis. Sustained directional movements then prompt searches for fundamental explanations. Analysts selectively find evidence to support these movements, creating a self-reinforcing process. In the euro’s case, this led to excessive focus on positive U.S. economic aspects, even if overall fundamentals didn’t fully support this view.
This narrative aligns with research on market dynamics diverging from rational views. Past instances (e.g., early 1980s dollar, 1995 yen) suggest markets can amplify exchange rate movements by extrapolating recent trends absent strong fundamental views. This serves as a “residual” explanation when other factors are exhausted. While fundamental reasons may explain much euro depreciation against the dollar, non-fundamental market dynamics could be a supporting factor, possibly becoming primary in later currency cycle stages. Persistent euro weakness through mid-2001, despite equity market correction, could be consistent with this phenomenon.
V. Equity Market Performance and the Euro/Dollar Rate
Macroeconomic trends since the mid-1990s point to positive demand and supply shocks in the U.S. relative to the Eurozone. The surge in U.S. equity prices since the mid-1990s, reaching unprecedented market capitalization-to-GDP levels, could explain these shocks. Higher equity prices would boost both consumption and investment (demand-side shock), and increased investment would raise capital stock and labor productivity (supply-side boost).
A counterargument is that the equity price surge wasn’t U.S.-specific; prices rose globally. However, several factors suggest a disproportionate U.S. impact: First, new-economy company price surges were larger in the U.S. Second, U.S. equity market capitalization relative to GDP is much larger than in most other economies (except the UK). U.S. market capitalization rose from 80 percent of GDP in 1994 to 180 percent in 1999, a 2.25x increase. Eurozone capitalization rose 3x, but from a lower base (30 percent to 90 percent of GDP), resulting in a smaller GDP share increase (40 percent less than the U.S.). Third, U.S. households have a higher propensity to consume out of equity wealth than those in most other countries, leading to a larger demand shock in the U.S. for a given equity wealth increase.
Figure 7. Equity Price Indexes
Comparison of equity price index growth in the US, Eurozone and Japan, showing stronger growth in the US.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Note: Observation for 2001 is the average value through August.Source: Primark Datastream.
Figure 8. Equity Market Capitalization Ratios
Equity market capitalization as a percentage of GDP in the US and Eurozone, illustrating higher ratios in the US.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Note: Observation for 2001 is the average value through August.Source: FIBV.
Figure 9. Differences in Equity Market Capitalization Ratios
Difference in equity market capitalization ratios between the US and Eurozone, highlighting the widening gap.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Note: Observation for 2001 is the average value through August.Source: FIBV.
To assess equity price impact on exchange rates, equity market shocks were introduced into a two-region model representing the U.S. and other industrialized economies. The model (described in Annex A) simulates the effects of equity premium shocks on market capitalization and exchange rates. It accounts for differences in region size, leverage ratios, and household consumption propensities out of wealth. The exchange rate is determined by uncovered interest parity.
Equity prices in the model reflect discounted future profits. Current profits per share (π) and the present value of discounted profits (PQ) are calculated using equations (6) and (7) from the original paper, incorporating a discount rate that includes a risk-free real interest rate and an equity premium (ρ). The equity premium, representing the excess rate investors discount future equity returns, is a subject of debate. Possible explanations for its historical size include risk compensation, market inefficiencies, or investor psychology.
For this analysis of past events, explaining the equity premium’s origin isn’t crucial. The model uses equity premium shocks to simulate observed market capitalization changes. However, the shock size needed to explain the 1990s valuation surge is large, partially offset by higher interest rates (due to demand boosts) and lower future profit growth per share (from capital deepening). Simulations required reducing equity premia in both regions from baseline values of slightly over 5 percentage points to negative 4 percentage points by 2000, a 9 percentage point swing.
Figure 10. Simulated Equity Premia
Simulated equity risk premia used in the model for both the US and Rest of World (ROW) regions, showing a significant decrease.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Source: Staff calculations.
The simulation results show the capitalization gap between the U.S. and ROW regions rising from 50 percent of GDP in 1994 to 90 percent in 2000, while the dollar appreciates 23 percent. This compares to a 29 percent dollar real effective value appreciation from 1994 to 2000. The exchange rate movement is contemporaneous with equity valuation changes, as future valuation effects are incorporated into the spot exchange rate. This differs from actual experience where exchange rate movements lagged equity valuation changes, possibly due to recognition lags not modeled.
Figure 11. Simulated Market Capitalization and Exchange Rate
Model simulation results showing the impact of equity premium shocks on market capitalization gap between US and ROW, and the Euro to Dollar exchange rate.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Source: Staff calculations.
Other simulation aspects align with stylized facts since the mid-1990s. The U.S. output gap rises, and actual output increases even more due to potential output boosts from higher capital stock. U.S. inflation is temporarily pushed down due to higher labor productivity and dollar strength lowering import prices. The trade deficit widens by 2.5 percent of GDP, while ROW records a surplus.
Figure 12. Simulated Output and Output Gaps
Simulated output and output gap changes in the US and ROW regions following equity premium shocks.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Source: Staff calculations.
Figure 13. Simulated Trend Labor Productivity Growth
Simulated trend labor productivity growth in the US and ROW regions, showing a temporary increase in the US.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Source: Staff calculations.
Figure 14. Simulated Inflation Rates
Simulated inflation rates in the US and ROW regions, showing a temporary decrease in US inflation.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Source: Staff calculations.
Figure 15. Simulated Trade Balances
Simulated trade balance changes in the US and ROW regions, showing a widening US trade deficit.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Source: Staff calculations.
U.S. short-term real interest rates rise only later in the decade, as output and inflation effects on monetary policy roughly offset. Long-term real rates rise sooner, reflecting anticipated future demand shock impacts. The long-term real interest rate differential between the two regions rises to almost 1 percentage point by 2000, consistent with evidence.
Figure 16. Simulated Real Interest Rates
Simulated real interest rate changes in the US and ROW regions, showing a widening differential favoring the US.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Source: Staff calculations.
Assuming equity valuations stabilize at 2000 levels, the exchange rate peaks in 2000 and gradually declines. The decline is gradual due to the interest rate differential, with the exchange rate not returning to its initial level until 2040 and then asymptoting to about 8 percent below baseline in the long run, reflecting increased U.S. output relative to ROW.
Figure 17. Simulated Market Capitalization and Exchange Rate: Permanent
Model simulation showing long-term effects on market capitalization and exchange rate, assuming equity premia remain permanently lower.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Source: Staff calculations.
The model was also used to test a productivity-based explanation for equity and dollar rises. Increasing U.S. trend productivity growth more than ROW growth led to dollar depreciation and lower relative U.S. equity capitalization, contradicting observations. Higher productivity growth, while boosting profit growth, doesn’t boost profit growth per share due to increased capital accumulation and financing needs. Discounted profits also decline due to higher real interest rates needed to equilibrate demand and supply.
Figure 18. Market Capitalization and Exchange Rate: Productivity Shock
Model simulation of market capitalization and exchange rate changes driven by a productivity shock, showing results contrary to equity-premium shock.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Source: Staff calculations.
Assuming equity premia return to zero in 2001, the equity capitalization gap drops to about 75 percent of GDP, similar to observed levels after price corrections. However, the exchange rate decline to about 10 percent above baseline contradicts the euro weakening further as equity prices fell. This discrepancy could be due to recognition lags or other factors influencing the exchange rate, such as portfolio shifts or market sentiment.
Figure 19. Simulated Market Capitalization and Exchange Rate: Zero Equity Premium in 2001
Model simulation assuming equity premia return to zero in 2001, showing the impact on market capitalization and exchange rate correction.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Source: Staff calculations.
The UK’s experience in the late 1990s, with similar equity market capitalization increases and exchange rate appreciation, strengthens the equity market story’s plausibility for major currencies. The yen’s fluctuations in the 1990s are less clearly linked to equity prices, potentially due to dominant shocks like financial sector problems and the Asian crisis.
VI. Effects of Portfolio Rebalancing
The euro’s introduction spurred significant regional financial market activity. Euro-denominated debt issuance rose sharply relative to predecessor currencies, driven by both resident and nonresident issuers. Resident issuers substituted from foreign-currency debt, and nonresidents sought to establish a presence in the new market. However, international investor interest in euro-denominated debt remained limited, with domestic investors absorbing most of the increased issuance.
Figure 20. New Issues of Euro-denominated Debt Securities
Trend in new issuance of Euro-denominated debt securities, showing a significant increase post-Euro introduction.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Source: BIS.
International euro-denominated debt issuance, specifically by non-Eurozone residents, also saw a share increase in the market during 1999, at the expense of both dollar and yen. This increase became more pronounced when adjusted for currency value movements and continued into 2000 and early 2001. Euro-denominated debt share rose to 27 percent (constant-currency basis) by early 2001 from about 17 percent pre-euro. Increased euro bond supply was primarily purchased by Eurozone residents, not international investors.
Increased euro-denominated debt issuance could be driven by supply or demand. Evidence suggests investor demand wasn’t the primary driver. Limited international investor uptake contrasted with borrowing-side activity. Domestic investors might have found the market more attractive due to increased homogeneity and liquidity of euro issues. However, portfolio allocation constraints, often limiting non-domestic currency shares to manage exchange rate risk, would have worked in the opposite direction. While intra-Eurozone currency risk declined pre-1999, portfolio constraints wouldn’t automatically relax without explicit limit redefinition. The euro’s introduction as a domestic currency automatically relaxed these constraints. For example, a French investor buying German bonds now counted as domestic-currency assets, “freeing up” assets for foreign currency investments.
Another factor potentially shifting funds out of euro-area currencies is the exchange of Deutsche Mark banknotes for dollars by Eastern European underground economy participants, avoiding conventional euro conversion channels. Estimated Deutsche Mark cash holdings outside Germany totaled €30 billion, a potentially significant exchange market shock. However, this is dwarfed by capital market effects. The increase in euro-denominated debt security share implies a rise of over €300 billion, ten times the estimated Deutsche Mark cash held by nonresidents. Nevertheless, this cash shift could have played a supporting role in euro depreciation.
Figure 21. Euro-denominated Share of International Debt Issues
Share of international debt issuance denominated in Euros, showing a significant increase after Euro introduction.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Source: Updated data from Detken and Hartmann (2000).
These portfolio effects – increased euro borrowing, reduced euro investment – would exert downward pressure on the euro. The euro’s value would fall until expected future appreciation offset the portfolio shift drivers. Over time, the exchange rate should revert towards its original level, with portfolio shift effects reflected in prices, asset stocks, and interest rates. Quantifying these effects precisely is challenging due to data limitations and structural shifts. Instead, a shock to the “excess yield” on euro assets in the model from Section V proxies for portfolio effects.
A 40 basis point cumulative shock to the euro asset excess yield in 1999-2000 was simulated. This could represent higher borrowing costs to offset euro issuance advantages and higher yields needed to retain euro lenders. This shock led to a 17 percent euro depreciation by 2000. Combined with the equity market shock, this accounts for a total euro/dollar shift of about 40 percent by 2000, similar to the actual experience.
Figure 22. Simulated Euro Exchange Rate: Shock to Excess Yield
Model simulation showing the impact of a shock to the excess yield on Euro-denominated assets on the Euro to Dollar exchange rate.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Source: Staff calculations.
Figure 23. Simulated Real Interest Rates: Shock to Euro Excess Yield
Model simulation showing the impact of a shock to the excess yield on Euro-denominated assets on real interest rates.
Citation: IMF Working Papers 2001, 155; 10.5089/9781451857313.001.A001
Source: Staff calculations.
VII. Concluding Thoughts
Numerous theories attempt to explain recent euro weakness. Some lack conceptual grounding, while others have been challenged by evolving evidence. It’s likely that multiple factors, specific to both the U.S. and Eurozone economies, contribute to major currency exchange rate movements.
This analysis highlights two factors consistent with observed exchange rate movements and associated macroeconomic effects: the global equity value surge disproportionately impacting the U.S. economy, and portfolio shifts accompanying the euro’s introduction. The dollar’s rise against most currencies and aspects of the “new economy” align with the equity market shock. Increased euro debt issuance and lender shifts towards non-euro assets, while difficult to precisely quantify, plausibly explain the euro weakness component coinciding with its launch.
Looking ahead, these factors are unlikely to intensify. Equity price corrections since 2000 should create some reversal of euro weakness. Portfolio effects from the euro’s introduction are likely strongest initially, diminishing as portfolio allocations and interest rate differentials adjust.
From a policy perspective, these explanations don’t suggest direct policy tools for euro correction. However, the weak euro has impacted Eurozone activity and prices, influencing policy formulation. If fundamental forces driving euro weakness are indeed reversing, a key factor behind Eurozone inflation shocks would subside, allowing for greater monetary easing.
Speculative market forces remain important, especially given large, unexpected currency movements. Market uncertainty about fundamentals can be amplified by past volatility. The drivers of equity price movements are also crucial. The extent to which equity price run-ups were driven by equilibrium yield shifts versus “irrational exuberance” about future earnings remains open. If market expectations are distorted, equity prices could face larger adjustments, significantly impacting exchange rates, potentially affecting the dollar value of amounts like 155 euros.
References
(References are identical to original article and are omitted here for brevity, but would be included in a full version)
ANNEX A
(Annex A: Description of Model is identical to original article and is omitted here for brevity, but would be included in a full version)
