A Clever Way Of Valuing The Euro: How Would Things Look If Each Member Still Had Its Own Currency?

From Morgan Stanley’s Stephen Hull, some interesting thoughts on the euro, and how things might look if each eurozone member were still on its own currency.

We have taken a different approach this time and instead of
assuming that the European crosses were fairly valued in
1999, we have estimated long-run equilibrium exchange rate
models for the USD against individual currencies within the
Eurozone, assuming that the euro doesn’t exist. As we
mention above, of course productivity and inflation in Greece,
for example, might have been different had they still been
using the GRD but we cannot correct for that. We have
estimated a simple purchasing power parity model adjusting
for productivity differentials. The rationale and theory behind
this is explained in the appendix but essentially exchange rate
theory suggests that countries with high labour productivity
growth and low inflation should have strong currencies. The
relentless decline in USD/JPY and USD/DEM in the 1970s
and early 1980s is perhaps the best example of such models
working well.

The results of our analysis are shown below. We find that
historically, for all exchange rates, productivity is mostly
significant and has the right sign (productivity has been less
significant in FRF, GRD and ITL). The most interesting result
is that we find that USD/DEM and USD/FRF are fairly valued
at current exchange rates. If the euro were comprised of only
those two countries fair value would be 1.32.

Likewise if the euro comprised only Greece, Spain, Portugal
and Italy its fair value would be around 1.10.

Here would be the relevant over and under-valuation of the various individual currencies, were they around today:

chart

Photo: Morgan Stanley

And here’s how the trend would have looked over time:

chart

Photo: Morgan Stanley

And finally, if the euro were a true blend of its individual members, weighted by GDP:

chart

Photo: Morgan Stanley

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