Sunday, November 21, 2004

European finance ministers at the G-20 meeting which opened Saturday, November 20th, are expected to discuss the current exchange rate of the euro vs. the dollar. The euro is currently trading high against the dollar, so that it takes around $1.34 (as of December 4, 2004) to buy one euro. This has the effect of making exports from Europe to the USA more expensive, increasing the likelihood that US consumers will buy from a non-EU country. The exchange rate is set by the currency markets, although it is heavily influenced by the current account status (ie. the balance of trade between countries).

Some European leaders want the United States to take action to increase the value of its exchange rate. The US though is seen as not wanting to do this, for two reasons:

  1. A low dollar relative the euro means that all exports from the US to Europe are cheaper for Europeans to buy, increasing the likelihood that Europeans will buy US items and thus helping the US economy
  2. Many actions which governments have done in the past to bolster unnaturally their currency have been fought by the market, and the market won. The most famous example is George Soros’ “breaking of the Bank of England”

One side-issue that this discussion might evoke is that of the exchange rate between the dollar and the Chinese yuan, which is fixed by China. Studies of this exchange rate using the concept of purchasing power parity (ensuring that a dollar traded to Chinese yuan will still buy roughly the same amount in China) show that the Chinese yuan has been around 50% undervalued for the past two years. This makes things from China on average 50% cheaper for a US consumer than they should be. US officials have throughout 2004 repeatedly called for China to end this practice. Normally it would end itself, i.e. even with a fixed exchange rate this process could only go on for so long before the entire Chinese market becomes valued differently. But since the Chinese central bank has been constantly lending money to the United States government (via the purchasing of US treasury bonds), that effect is mitigated.

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