Collapsing value of Euro against the dollar: A forerunner to Quantitative Easing By Dr. Bobby Srinivasan and Dr. Sudhakar Balachandran

January 7, 2015 | Posted by bobbysrinivasan << back to blog

This is the ongoing conversation between a student and his finance professor.

Student: Professor, I read in the newspaper that the Euro currency has hit a four year low against the dollar. Can you tell me as to why it is happening?

Professor: I will try. The Euro currency is on a yoyo trip. On Jan 1, 2010, it cost US $ 1.43 to buy one Euro. But by June 2010 it dropped to 1.19 to a dollar. Today on Jan 6, 2015 it has touched 1.19. Many currency analysts believe the when the euro zone quantitative easing, which is widely expected, is implemented it could push the euro to new lows. If such a thing happens, the euro as a currency may not exist.

Student: Professor, why is this happening?

Professor: There are several possible reasons. I will try to enumerate them for you.

The rapid drop in the value of crude oil has literally pushed the euro zone into deflation.
There is a national election happening in Greece on Jan 25, 2015. Opinion polls suggest that the anti-establishment party, Syria could win the election. If it happens, there is a possibility that Greece may decide to pull out from the euro zone.
The euro zone has entered into a deep deflationary cycle like Japan and no one can predict as to when it will come out of it.

Student: Are steps taken to revive the euro zone economies?

Professor: Yes of course. The same solution the US and Japan adapted namely use quantitative easing to pump in large amounts of liquidity in the economy. This may result in a possible revival of economic activities which hitherto has been suffering for want of money.

Student: Professor how does it work?

Professor: Here is how it works. Mario Draghi, the ECB president has indicated that he is getting ready to buy the sovereign bonds of Italy, Spain and German. When and if these bonds are bought an equivalent amount of money to the value of the bonds will be pumped into their respective economies. This will hopefully revive their economies.

Student: With this announcement to purchase the sovereign bonds, what effect would it have on the yield of the bonds?

Professor: Good question. In the last few days, for the government bonds of Italy, Spain, Portugese, the yields have dropped pushing up their prices. For example, the yield on 5 years German government debt turned negative for the first time. This amounts to investors paying to lend money to Berlin. This indeed is a strange situation.

Student: Professor, I am getting confused in understanding this. Can you help me?

Professor: For sure, a few days back the Italy 10-year government bond fell 11 basis points to yield 1.75 percent. The Spain 10-year government bond fell 9 basis points to yield 1.5 percent. Similarly Portugal government bond dropped 21 basis points to yield 2.4 percent. These are record lows and suggesting a deep recession.

Student: In summary, what do you think is going to happen to the euro zone?

Professor: Slowly, deflation is setting its foot prints in the euro zone. They are going to be stuck in this situation for a long time. This will be very similar to what has happened in Japan. Honestly, if you ask me, I feel that there is a high probability that the entire world may go into a serious recession. In fact our RBI governor has already expressed his concern in this regard.

Student: Professor you scare me.

Professor: Let us look at facts. It makes no sense to get scared. Prices of all major industrial commodities have fallen between 30 to 50 percent. For example, Iron ore price has dropped by more than 50 percent in the last one year. Crude oil prices have dropped below US $ 50 dollar for the first time in 9 years. All the major commodities, save a few are currently dropping in value. This implies that the demand is falling rapidly. At the moment there is no possibility of revival in the near term.

Student: How about India?

Professor: Our government just announced that tax collection for FY 2014-15 have fallen way below target, which implies that corporate tax, Custom Duty, Excise Duty along with the Personal Income Tax collected is significantly lower than what is expected. Modis “Make in India Policy” may have to wait a couple of years before anything can happen. Besides, both gross domestic savings rate and the gross capital formation are heading lower. In this environment, if we achieve 5 percent growth it can be considered a miracle.

Student: Professor I will come back to you later with more questions. In the meanwhile thank you for your time.

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