Euro is overvalued against the Dollar by at least 30% according to Bank of Ireland

Transfer of purchasing power from exporters to consumers. Rally in dollar expected by December 2008

The US dollar has rallied modestly in the past few weeks but its decline against the major currencies over the past twelve months is startling. It has fallen by 20% against the Swiss franc, by 18% against the yen and by 17% against the euro. The latter has risen by some 30% against the dollar over the past two years and by over 12% against a basket of the major currencies. Such moves may dampen Irish exports, currently 18% go the US, and squeeze export margins, but also increase Irish spending power in the US, be it for assets such as property or for consumer items. This essentially represents a transfer of purchasing power from exporters to consumers according to Bank of Ireland’s March Bulletin which was published today, 1 April 2008.

Author of the Bulletin, Dr. Dan McLaughlin, Group Chief Economist, Bank of Ireland said: “The fact that most Irish visitors to the US find shopping to be inexpensive implies that the dollar is now undervalued against the euro, at least on the basis of purchasing power parity (PPP). This theory, one of the oldest in economics, states that the same basket of goods in two countries should cost the same when converted into a common currency. Research also lends some support to the view that foreign exchange rates eventually return to PPP rates, which can be viewed as ‘fair value’ for a currency.

“Unfortunately, estimates of PPP differ but most studies put the euro’s PPP rate against the dollar in a relatively narrow range, between $1.10 and $1.20, which implies that the euro is currently at least 30% overvalued. If so, one might expect the euro to fall against the dollar. Again, things are not that simple as research shows that currencies can diverge from ‘fair value’ for years, so PPP is not very good as a short term forecasting tool.

“Nevertheless, it is noticeable that the consensus forecast is predicting a rally in the dollar this year, to $1.40 by end-December. We share that view, in directional terms at least, but there is a policy vacuum surrounding the dollar which poses further downside risks, in that policy makers on both sides of the Atlantic seem unconcerned about the value of the dollar. From the US perspective, a weak dollar has proven beneficial in that exports are the only major component of the US economy showing any serious growth. In Europe, the euro’s strength has proved beneficial from an ECB viewpoint, in that it has partially offset rising commodity prices and so helped to limit the recent rise in inflation. This leaves the fifteen respective member states of the euro, where opinions differ, and where there is no body to voice concern let alone actually intervene, even if there was a unanimous view that the euro is too strong. Contrast this with the situation in Asia, where many governments have bought dollars in recent years to prevent too rapid an appreciation of their own currencies”, added Dr. Dan McLaughlin.

Ends

1 April 2008

For reference:
Dr. Dan McLaughlin
Group Chief Economist
Bank of Ireland Global Markets
Tel: 01 609 3221

Anne Mathews
Media Relations Manager
Group Corporate Communications
Bank of Ireland
Tel: 01 604 3324 / 086 810 2807