Submitted by: ANUBHAV KATHURIA

Student at IBS BANGALORE, 2011

Future of Dollar and Euro

Introduction – The analysis of US Dollar and Euro currency is based on the economic and non-
economic indicators, trade theories applicable and various factors which are believed to drive
Forex market like Interest Rates, Economic Growth, Geo-Politics, Trade & Capital Flows and
Merger & Acquisition Activity.

The U.S. dollar is the currency most used in international transactions and is one of the world's
reserve currencies. Several countries use it as their official currency, in many others it is the de
facto currency (unit of money that is not legal tender in a country but is treated as such by
majority of the population). Like Lebanon, Zimbabwe, Iraq use US ($) and Andorra, Kosovo use
Euro (€).

The euro is the second largest reserve currency as well as the second most traded currency in the
world after the U.S. dollar. As of June 2010, with more than €800 billion in circulation, the euro
is the currency with the highest combined value of banknotes and coins in circulation in the
world, having surpassed the U.S. dollar.

Factors deciding the Future of Dollar and Euro:

1. Exchange Rate Mechanism: US follow a free float in which the movements are totally
determined by the market. One more factor that comes into play is de facto currency, so the
demand is not limited to US only rather there are other countries mentioned above, so it
generally has a higher demand than supply.

The EU has also liberalized its capital markets, and as the European Central Bank has chosen
monetary autonomy, the exchange rate regime of the euro is floating. In EU, there are 16
member nations out of 27 total members share euro as their common currency, also known as
Monetary Union or Optimal Currency Area. There were some pre requisites like a budget deficit
of less than 3% of their GDP, debt ratio of less than 60% of GDP, low inflation, and interest rates
have to be close to the EU average. But many of the nations were allowed to follow euro without
scrutinizing the above norms.

The recent Euro Sovereign Debt Crisis was due to the rising public debt in PIIGS (Portugal,
Ireland, Italy, Greece and Spain) and Greece finally defaulting. The disadvantages with such
system is they cannot devalue their currency, lower interest rates or print money so the option
was only bailout which was opposed by Germany. Due to obvious reason PIIGS supported the
bailout altogether. This crisis has created gaps between the member nations.

A euro seems to have a dismal future in short term, the average debt-to-GDP ratio hides very
large differences between countries and the region doesn’t have a mechanism to deal with these
differences. Debt Concerns, Regional Divergences are some other factors which make us ponder
over the future of Euro.

2. Interest Rates: The stronger the economy, the greater the possibility that the central bank will
raise its interest rates to tame the growth of inflation and the higher a country's interest rates, the
bigger the likelihood that foreign investors will invest in a country's financial markets. More
foreign investors mean a greater demand for the country's currency. A greater demand results in
an increase in a currency's value. The Interest rates forecasted for US T-bills are expected to
fluctuate on higher side a bit but Euro zone for the last sixteen consecutive months had the same
interest rates stagnant at 1 % and is expected to maintain the same. If the Interest Rate Parity
condition holds true, then the Dollar will appreciate and Euro will depreciate.

3. Economic growth: Economic growth inspires higher interest rates inspires more foreign
investment inspires greater currency demand which inspires an increase in the currency's
value. The United States and Euro zone represent two of the most prosperous regions in the
world with GDPs running at $14.62 trillion and $13 trillion respectively. Thus, the Euro zone is
lagging significantly behind the United States in economic growth, 1.7% rate at the end of June
while the US expanded at a healthy 2.9% rate. Consequently, investment capital flowed from
Europe to the US and the EUR/USD dropped by nearly 2,000 basis points from 1.3468 to
1.2271.
4. Geo politics: The currency market is the only market in the world that can be successfully
traded on political news as well as economic releases. Because currencies represent countries
rather than companies, they are political as well as economic assets and are therefore very
responsive to any of the disturbances.

The key to understanding speculative behavior with respect to any geopolitics is that whenever
investors fear any threat to their capital, they will quickly retreat to the sidelines until they are
certain that the political risk has disappeared. Therefore, the general rule of thumb in the
currency market is that politics almost always trumps economics. The history of Forex is filled
with examples of political trades.

The Political Theatre in Euro Zone as mentioned above due to worsening of relationships is
relatively unstable than US, where President Barrack Obama is introducing newer reforms for
betterment and saving its party in upcoming elections. Hence, dollar is expected to appreciate in
this regard as well.

5. Trade and Capital Flows: Trade flow refers to how much income a country earns through
trade. Capital flow refers to how much investment a country attracts from abroad. Some
countries are sensitive to trade flows, while others are far more dependent on capital flows. If the
focus is on growth, it is apparent that the severe slow-down is seen in U.S. shores, while the Euro
Zone continue to post positive key economic data after quarter ending June. This could cause
investors to begin questioning the need to hold U.S. Dollars, and can result in very large move
against the Dollar in the near-term but at the same time the view that the Euro Zone may face
another round of major sovereign debt concerns.

To Sum Up: There are various factors which play a major role in Forex market and determine
the exchange rates apart from the import and exports data, the importance of interest rates,
economic growth, trade and capital flows, geo politics and the inter relationships between the
states and member countries, well balanced and stable political and economical status also helps
in understanding the movement of exchange rates. When applied to Dollar and Euro, it shows
Dollar will continue to appreciate in the near future till Euro zone restores and recovers from
sovereign debt crisis. But in the long run, the picture may change.