Quo Vadis Euro?
European Journal of Finance, Vol. 8, No. 4, December 2002
Posted: 20 Jul 2003
This paper attempts to measure the degree of misalignment of the euro - in particular against the dollar - by estimating equilibrium exchange rates for the euro and the rest of G-7 currencies. Building on the methodology of Alberola et al. (1999), we show that the stock of net foreign assets and the evolution of productivity can be considered relevant fundamentals underlying the behavior of the real exchange rate. Panel cointegration techniques allow for the extraction, using an unobserved components methodology, of a time-varying equilibrium real exchange rate, and deviations from this equilibrium provide an estimate of the degree of multilateral misalignment. Finally, an algebraic transformation converts these multilateral equilibrium real rates into bilateral equilibrium nominal rates.
The results uncover that the euro is the only currency that shows a substantial undervaluation (around 12 percent), largely accounted for by the overvaluation of the dollar (about 8 percent) and the pound (about 12 percent) by the end of 1999. The euro-$ estimated nominal equilibrium rate was 1.18 $/$ by then. Thus, the situation was then more a reflection of euro weakness than of dollar, yen or pound strength. More concretely, the euro is found to be slightly undervalued by the start of Stage III of EMU and that, despite a faint fall of its fundamentals since then, the slide during 1999 has widened the misalignment.
Since 1998, the equilibrium rate of the euro has reversed its long term appreciation trend and has depreciated around 1.5 percent, while in parallel the dollar equilibrium rate has initiated an upward swing, reflecting its strong relative growth in productivity. In any case, fundamentals do partially justify the weakness of the euro in the last year but cannot account for all of its downward movement. An overreaction of the markets to the current decline in fundamentals or to the expectation that this decline will be permanent rather than transitory may have been influential.
Note: This is a description of the paper and not the actual abstract.
Keywords: Equilibrium Exchange Rates, Panel Cointegration
JEL Classification: F31, F41, C23
Suggested Citation: Suggested Citation