Undeveloped African economies’ dollar trap offers opportunities for Europe

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by Enrico Colombatto

The US Federal Reserve’s remarks in March 2015 on potential interest rate rises took money markets by surprise. Nothing will happen in the short term. But the strong dollar could spell danger for undeveloped economies and Europe may be called on to help. This could offer an opportunity to build long-term economic and political ties.

Janet Yellen’s cautious message that the US Federal Reserve plans to raise interest rates to nip inflation in the bud – but it is in no hurry to do so – was probably the most important piece of news for the money markets in March 2015.

Ms Yellen, chairman of the Fed, surprised market operators with her announcement and they revised their expectations. Few observers believe interest rates in the US will rise before July, and the majority have doubts anything will happen before October 2015. As a result, investors have sold some of their dollars and bought euros, the exchange rate of which during the last two weeks of March moved from about 1.05 to almost 1.10 dollars per euro.

So what does the future of currency markets look like and how will Ms Yellen’s future decisions affect European economies? And, will there be further repercussions?

Bright spots

The last data about the American economy is not exciting. While annual growth was expected to be about three per cent, the last quarter of 2014 showed that annualised growth was just above two per cent. Data for the first quarter of 2015 is unlikely to be much better.

News on corporate profits, exports, investments and expenditure on durable goods is also disappointing. The only bright spots are the labour market with unemployment at 5.5 per cent and employment rising steadily, and the rate of inflation. This is currently about zero and might inch up a few decimal points by the end of the 2015, to the delight of central bankers and many traditional macroeconomists.

So, what should one make of this and should we worry about a possible slowdown of the US economy?

Americans do not seem overly concerned – and for good reason. The average person does not run after monthly and quarterly data, which is often inaccurate and tends to cloud the larger picture.

New opportunities

The big picture here is that the job market is in relatively good shape and new opportunities are opening up every day.

In contrast with continental Europe, losing your job in the US is not necessarily a catastrophe and the chances are that you can improve your position by looking around for new opportunities.

Americans have also seen the stock market reach all-time peaks with no signs of bearish behaviour, and the housing market is recovering. In other words, their wealth is not in jeopardy.

There are, of course, plenty of experts predicting forthcoming crises of all sorts. For example, the American public debt is above 100 per cent of GDP, and although the price/earnings ratios do not seem high by historic standards, some fear the stock market is actually betting on an unsustainable growth in profits.

Sound trend

According to this pessimistic view, a mini-crash will materialise when profit expectations prove overly optimistic and investors draw in their horns.

This is possible. However, consistent with our predictions during the past couple of years, we do not think it is very likely.

The American economy will not be growing at miraculous rates, but its fundamentals are solid. The economy may experience difficulties as companies adjust to the new market conditions – including a strong dollar and low oil prices – and possibly revise the timing of their investments. Yet, stagnation or financial disasters do not seem imminent. In particular, public-debt servicing is cheap and the refinancing of the debt about to expire is not problematic.

The same will be true even at higher interest rates. The stock exchange, likewise, will also feature fluctuations, but the long-run trend will remain sound, and be sustained by all those Americans who believe their retirement funds are better served by company equity than by low-yield government debt and corporate bonds.

Avoiding harm

We believe that not too much attention should be paid to the dynamics of interest rates.

It appears the American authorities are no longer using monetary policies to drive the economy towards a given goal, but rather to avoid causing harm. If this is correct, the Fed is likely to follow events and stay as neutral as possible for the next few months – if not for longer.

If the Fed continues to pursue a cautious monetary policy the value of the dollar will be driven by global politics – when tensions emerge, capital flows towards the dollar, which today is still considered the most reliable currency – and by what happens in the eurozone.

If the US economy continues growing at an annual rate above two per cent; if growth in the eurozone remains sluggish – the European Commission predicts a 1.3 per cent increase in GDP for 2015; and if the European programme of quantitative easing continues unabated, the exchange rate may hover around its current levels for a while, and then move towards the 1.05 territory or below.

Weak euro

European producers will benefit from the weakness of the euro compared with the dollar. However, a weak euro will not be enough to restore entrepreneurial confidence and boost output in the old continent.

Instead, producers will take advantage of the weak euro to increase their profits, which could possibly induce investors to buy stocks of those European companies exporting to dollar-denominated markets.

By contrast, countries which are heavy importers of dollar-denominated goods and are unable to adjust their production structure quickly enough, will suffer.

A weak domestic currency is welcome by import-competing firms, but may be ruinous for those industries which are heavily dependent on dollar-denominated imports, and fail to attract or awaken new business ventures.

Troubled countries

It could be fatal for countries indebted in dollars, and expected to pay heavy rates of interest. These are still modest – about six per cent on medium-term maturities – in politically fragile undeveloped countries, but could be rising fast.

In this light, it is telling that ratings agency Standard & Poor’s already considers the debt issued by most sub-Saharan countries as ‘junk’. Gambia, Uganda, Nigeria and Angola are perhaps the first group of countries which could experience trouble.

A number of countries, notably in Africa, could be falling victim to the strong-dollar trap. Their euro-denominated export markets have not expanded, while their dollar-priced supplies have become too expensive.

Should this scenario persist, and critical situations erupt or sharpen within and among undeveloped countries, the West will be required to make key political decisions, the consequences of which will be felt in the long term as well.

Undeveloped economies in trouble will ask for help eventually.

Political projects

Will European countries insist on the traditional approach – aid, International Monetary Fund-style technocratic advice and possibly some rescheduling of the debt?

Will Europe forget that crises also create opportunities? And will Europe fail to develop consistent, long-term foreign-policy visions, which would allow countries like China to gain further political and economic influence in key areas of the world?

Should European politics continue to be inward-looking and make use of resources to appease tensions which the European authorities themselves helped create? Or should European leaders put forward new political projects, following which the European Union could play a more effective role in a global context?

Potential crisis

The eventual deceleration of the American economy leaves the economic scenario in most developed countries unaltered.

The euro will hardly recover as long as growth in the eurozone remains weak. In fact, the euro could drop further during the rest of 2015. Likewise, the timing of the rise in American interest rates will have a limited impact.

But depreciation of the euro should not make us forget that many other currencies have followed the same fate and that these depreciations could provoke crises rather than enhanced competitiveness.

There is a big question-mark over whether our European leaders are prepared to deal with possible future instability in key undeveloped countries – and the requests for help which could flow from them.

Related GIS Articles:

• Matteo Renzi ignores Italy’s economic realities
• Germany emerges as power broker in Greek debt crisis
• Cheap oil and weak euro could drive Europe’s growth
• Weaker euro could provide European business with an edge
• Economic expectations for Europe and US differ widely in 2015

Source: Geopolitical Information Service