As Croatia became the 20th member of the euro, it ought to have been a day of joy.
The single currency, however, slid towards a less welcome milestone: parity with the U.S. dollar, as finance ministers were welcoming the newest member of their club.
In light of worries that the euro’s sharp decline this year may worsen the hardship caused by rising living costs for hundreds of millions of Europeans, analysts are now speculating as to how low the single currency can go.
There may ultimately be a political cost as rising energy prices and inflation reduce living standards.
Robin Brooks, the chief economist at the Institute for International Finance, tweeted on Sunday that there is still much room for the euro to fall. “We’ve only just begun.”
For the first time in 20 years, the euro and the dollar briefly reached parity on Tuesday. The last time the euro was less valuable than the dollar was in 2002, when only 12 member states were using euro money at the time.
Since the beginning of the year, the value of the euro against the US dollar has decreased by more than 10%.
A worsening outlook for growth in the euro area as a result of Russia’s invasion of Ukraine and increased demand for the dollar as a safe haven currency both contributed to the rapid decline.
Not everyone will consider it to be bad news, as usual. A falling currency has benefits, such as making exports more affordable and desirable. However, Paolo Gentiloni, the European Commissioner for the Economy, cautioned that it would be “a mistake” to interpret the euro’s decline in these terms.
At a press conference on Monday, he said, “Of course it is encouraging the export capacity, but we have to look also to the negative side of this coin.
Import costs increase due to a weaker euro, increasing inflationary pressures.
Francois Villeroy de Galhau, a member of the ECB Governing Council, is one of the decision-makers who has cautioned against this risk. The central bank “will carefully monitor developments in the effective exchange rate, as a significant driver of imported inflation,” he warned earlier this year.
“A too-weak euro would go against our goal of price stability,” he continued.
A 2020 ECB paper cited models that predicted a 1% decline in the value of the euro relative to a basket of currencies could increase inflation by up to 0.11 percentage points in a year and 0.25 percentage points over three years.
still no bottom?
Given the ongoing dangers that a Russian gas cutoff could plunge the region into a severe recession, analysts caution that the euro may not have reached its low point.
In the unlikely but not impossible scenario that Russia does not restart the Nord Stream 1 gas pipeline, some analysts predicted that the price of one euro could drop as low as 90 U.S. cents.
In turn, this scenario might severely limit the ECB’s ability to raise interest rates, which it hasn’t yet done. When it holds its next policy meeting on July 21, it is anticipated to raise benchmark rates by 25 basis points and possibly announce a larger increase in September.
In contrast, the U.S. Federal Reserve has moved quickly, supercharging the dollar with larger interest rate increases.
According to UniCredit foreign exchange strategist Roberto Mialich, “the Fed is still seen as having more room to hike rates going forward, also on the back of the strong U.S. jobs report for June.” “On the other hand, given the greater direct exposure their respective economies have to the gas and energy crisis, other central banks, such as the ECB and the [Bank of England], might be forced to become more prudent.”
The dollar is also gaining from safe-haven flows, as investors flock to buy US government bonds as a hedge against political and economic unpredictability.
According to ING economist Chris Turner, if the euro keeps falling, “no doubt [the ECB] will be quite concerned by the move — especially if it develops into a “sell the eurozone” mentality.” The ECB may not be able to threaten more aggressive rate hikes to defend the euro because of the pro-cyclical nature of the euro and the looming risk of recession.
On the day that Croatia received final approval from the EU’s finance ministers to join the eurozone and start using the common currency in January 2023, worries about the euro surfaced.
According to Zdravko Mari, Croatia’s departing finance minister, “the fact that Croatia will become the 20th member of the European Monetary Union area is also a clear signal that European integration is continuing despite all the challenges that we are facing.”
The formalities on Tuesday bring to an end the lengthy accession process, which has involved many requirements that countries must meet, including price, exchange rate, and interest rate stability as well as budgetary restraint and a ban on monetary financing.
Additionally, Croatia will be given a seat at the Governing Council of the European Central Bank, first as an observer beginning in September and then as a full member beginning in January.
ECB President Christine Lagarde said that joining the club requires dedication and adherence to the rules, adding that it is a wonderful club to be a member of.