Why Is the EUR So Strong: A New Hypothesis
April 07, 2008
By Stephen Jen and Luca Bindelli | London
Summary and Conclusions
"EUR/USD is grossly over-valued, according to our valuation model and common sense. There are many reasons that have been offered to help explain this rising trend in EUR/USD in the past six years. But none of these factors convincingly explains why the EUR is so over-valued, i.e., why its level is so extraordinarily high. In this note, we propose a new hypothesis.
In recent years, US real money investors have aggressively diversified out of USD assets. Most of the rest of the world have also been reducing their financial ‘home bias’ by diversifying out of their own domestic asset markets. However, European investment funds (IFs) have diversified more within the Eurozone than outside the Eurozone, i.e., they diversified out of their own countries but into other EMU member countries, and not out of the Eurozone. The EUR, therefore, should be strong if everyone else in the world is diversifying while the Europeans are not.
One perverse implication is that, when the Eurozone economies finally achieve economic convergence, the benefits of diversifying within the zone should decline and European IFs will need to diversify more outside the Eurozone than within the zone. In our view, that will be one powerful structural factor weighing on the EUR, unwinding a major distortion in the currency markets in the next few years.
US Real Money Investors Are the Biggest USD Diversifiers
We have argued in the past (see The Biggest Dollar Diversifiers Are American, July 19, 2007) that the US real money accounts – which include mutual funds, life insurance companies and public and private pension funds – have been the single-biggest USD diversifiers in the world. Controlling assets totaling some US$22.0 trillion, these real money accounts have been aggressively diversifying out of the USD since 2003. For US mutual funds, for example, their exposure to non-US equities has risen from 13% then to around 23% now. With a combined portfolio of this size, the negative impact on the USD from this process has been quite material. Despite the media and investor focus on currency diversification by central banks, whose reserves total ‘only’ US$6.4 trillion – small in comparison to the AUM of the US real money accounts, we believe that diversification by the US private sector has been a much more important driver for the dollar. This process, we have argued previously, need not necessarily reflect a bearish view on USD assets by all US real money investors. Rather, an important part of the reason has been the desire to capture the benefits of globalisation by reducing the financial ‘home bias’.
Similarly, we have seen the beginning of the process of a decline in financial ‘home bias’ in Japan and other Asian countries, as private sector capital outflows have increased to allow private investors to build a collective financial portfolio that has a higher exposure to foreign assets. The JPY has, as a result, remained mostly under-valued, as have most of the other Asian currencies.
Euroland Institutional Investors Have Not Diversified!
Euroland’s financial home bias has actually increased since the launch of the euro. While European IFs have been diversifying out of their own countries, they have invested more in other EMU member countries than in countries outside the Eurozone, e.g., French investors raising their exposure to Germany rather than non-EMU markets. (For bonds, the financial home bias increased sharply between 1998 and 2005, before flattening out in recent years. There has been a slight decline in the last three years, but the size is very modest.)
We highlight several points:
• Point 1. A steady and significant rise in the financial ‘home bias’ since the launch of the euro in 1999. The overall investment posture for the European real money accounts – with mutual funds having €5.9 trillion in assets under management – has exhibited greater ‘home bias’ since 1998, with the overall ‘home bias’ ratio across equities and bonds having risen from 21% in 1998 to 34% at end-2007. In other words, at end-1998, European IFs were already very diversified, as their investments in each other’s markets were 21% of their investments in non-EMU markets. But this ratio has risen substantially since then. This upward trend has been particularly powerful for bonds, as the investment ratio – defined above – has risen from 23% in 1998 to 44% in 2007, after reaching a peak of 47% in 2005. At the same time, while the levels of the ratio have been lower for equities, the upward trend in the investment ratio is steadier for equities – rising from 16% to 25% during this period.
• Point 2. Diversification across countries, not across currencies. The lack of economic convergence within the Eurozone may explain this rather curious trend, that the European IFs have been diversifying out of their own countries, but not out of the Eurozone, as they find it sufficient to achieve their diversification objectives without being exposed to currency risks. With the introduction of the EUR, bonds, equities and other securities in Euroland all became denominated in one currency. The concomitant enhancement in liquidity and reduction in currency risk may have encouraged intra-EMU portfolio investments and diversification, not only because the cost of doing so is cheaper, but also due to a lack of economic convergence.
• Point 3. But virtually every other country has seen a decline in the financial ‘home bias’. What has happened in Euroland in terms of the peculiar pattern of portfolio diversification by IFs is rather unique in the world. In this period of financial globalisation, virtually every other country has been reducing its financial ‘home bias’. The EMU is the only economic bloc not diversifying, financially. It should not be a surprise that the EUR is overshooting.
• Point 4. We’ve seen a different version of this movie before. In the first year of the launch of the euro, EUR/USD collapsed from the ‘IPO’ rate of 1.17 to 0.82. This steep fall in EUR/USD surprised many back then. In our view, that EUR sell-off was, like now, related to portfolio shifts. Replacing the legacy currencies, the EUR offered better liquidity and thus became a major currency in which debt could be issued. In fact, new debt issued by entities within and outside the Eurozone increased sharply after 1999. However, though the supply of EUR-denominated securities increased, the demand for them declined, particularly within the Eurozone in the first year of the EMU, from the central banks of the Eurosystem (see Why Has the Euro Been So Weak? by Guy Meredith, 2001, IMF, and The Impact of the Euro on Europe’s Financial Markets, by Galati and Tsatsaronis, 2001, BIS). Since the reserve holdings of the European central banks held in legacy currencies were no longer ‘foreign’ assets, a one-off conversion from EUR into USD by European central banks may have weighed down EUR/USD.
The EUR Is Over-valued and Over-rated
Relative to most currencies outside Europe, the EUR is grossly over-valued. The likes of GBP and SEK are also ‘guilty by association’. The relative stability of their cross-rates with the EUR in recent years has made them over-valued as well. The ECB likes to point to the fact that the EUR TWI (trade-weighted index) is not that high. But this is misleading, because a great portion of the TWI basket includes other European currencies that move with the EUR. Unless European companies see other European companies as their biggest export competitors, policymakers will need to pay more attention to the EUR/USD and EUR/JPY cross rates.
What this hypothesis we propose in this note suggests is that, all along, capital flows were probably the dominant force propelling the EUR higher, out of line with the underlying real economic fundamentals. Only seven years ago the EUR was ridiculed by investors. Economic fundamentals don’t change so drastically in a short seven years. European cyclical fundamentals may be superior to those of the US, but the EUR’s structural superiority is highly debatable. Certainly, EUR/USD at 1.60 cannot be justified, in our view. To think that the EUR could overtake the USD as the dominant international reserve currency, with Europe’s dormant structural problems, is quite disturbing to us.
Rather perversely, our hypothesis implies that when there is greater economic convergence within Euroland, the EUR will weaken as European IFs need to go beyond the EMU to attain the desired level of diversification.
Bottom Line
Since 1999, while virtually every country in the world has exhibited a trend reduction in the financial ‘home bias’, Euroland’s financial ‘home bias’ actually increased significantly. We believe that this has been a key distortion in the international financial markets and a main reason behind the EUR’s over-valuation."
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