16 April 2011

EUR/USD, Big Mac and Money Supply

For quite some time EUR/USD exchange rate has been pretty volatile: in July 2008 we could get almost 1.6 US dollars for one euro, by the end of October 2008 this number was only around 1.25 (change: -21.9%), in the end of 2009 again close to 1.5 (change: +20%), and then in the middle of 2010 near 1.2 (change: -20%) while closing on last Friday (15 April 2011) at around 1.44 (change: +20%). According to The Economist’s Big Mac Index however, the  implied EUR/USD rate was 1.06 in 2008, 1.08 in 2009, 1.10 in 2010 and is 1.09 now. Thus, dollar seems to be constantly underestimated based on purchasing-power parity, i.e. the logic that a dollar should buy the same amount in all countries. Our task is to explore the issue from the perspective of money supply: the amount of dollars vs the amount of euros in circulation.

The logic goes: if the amount of US dollars compared to the respective amount of euros increases by x% then one euro should be worth x% more dollars. Of course it’s kind of short term approach which assumes no significant changes in more fundamental factors like relative production capacity of US vs Euro area or considerable enlargement of Euro area. Despite of the later addition of Greece (1 January 2001), Slovenia (1 January 2007), Cyprus (1 January 2008), Malta (1 January 2008), Slovakia (1 January 2009) and Estonia (1 January 2011) into the Euro area, we think that it still provides quite a good insight since the beginning of 1999 when Euro was introduced (in non-physical form for the first three years).

Anyway, the Figure below depicts the US money supply compared to the eurozone’s money supply. We see that in terms of Monetary Base there has been an explosion in the amount of US dollars relative to euros in autumn 2008 and another explosion is happening just now, in spring 2011. At the same time the story is quite different when broader classification of money, here shown as M2, is concerned: the ratio of US money supply and eurozone’s money supply has rather declined. This means that the newly “printed” US dollars hardly find their way out of the financial system and are not multiplied as in the normal course of money creation process. Or putting it otherwise: the printed dollars have only replaced money earlier created during the lending process and now ceased due to extensive write-offs and low new lending.  

Taking the beginning of 1999 as starting point, i.e. assuming that the euro was introduced at more-less appropriate exchange rate in relation to US dollar, and applying the above mentioned logic, we get that the current “right” EUR/USD exchange rate should be 1.10 (which happens to be even surprisingly similar to The Big Mac Index estimate of 1.09) instead of 1.44 based on M2. Everything else is attributable to speculations and expectations (and not unfounded, by the way) that at some point the huge amount of “printed” US dollars will flow into the economy and cause high inflation.

When we base our analysis to Monetary Base, i.e. assume that banks start usual lending again and FED will be unable or unwilling to call back the money that it has already issued, we get that the EUR/USD could move from 1.44 today to around 2.00! Two dollars per one euro!

No wonder that EUR/USD exchange rate is that volatile and forecasts not reliable when EUR/USD could range anywhere between 1.10 (without taking “what if” scenarios into account) and 2.00 (which includes the possible consequences of Federal Reserve’s “printing press” if financial system finally starts functioning as it is supposed to and Europe manages to solve its woes). This is good news for forex traders, yet not that good for businesses that need to hedge their FX risks.

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