Forecasting future trends in financial markets is best left to fortune tellers armed with a crystal ball as professional analysts are continuously proved wrong with their economic predictions. Foreign exchange traders, for instance, just a few weeks were predicting a steady fall in the strength of the euro in 2014. Yet the euro’s rise remains relentless.

There are various very logical reasons why this is happening. The price dynamics of any market should be the interplay between supply and demand. In foreign exchange markets, predicting supply and demand has become that much more difficult because global trade is no longer the only factor affecting exchange rates.

While analysts were predicting that in 2014 the US economic recovery would leave the eurozone trailing, putting upward pressure on the dollarthis has not really happened. EU countries, especially Germany, continue to register current account surpluses thereby increasing investor confidence in the eurozone economies.

At the same time emerging economies in the Far East as well as South America are underperforming and capital has been seeking safer havens. With US equities looking expensive, the next viable option was investment in eurozone equities. While equity markets are still quite volatile, there has not been the significant loss in value that one would have expected.

The political problems in the Ukraine have affected the euro’s value as many consider the common currency as a safe bet in troubled times.

Other factors affecting the euro’s appreciation is the long-term policy of China to diversify its reserves away from dollars to the euro. With China’s ever increasing reserves being invested in the euro, it is inevitable that the European currency will continue to gain strength against the dollar.

Now the ECB is beginning to worry about the strength of the dollar. The main concern relates to the risk of deflation that will stifle any chance of robust economic growth in the eurozone.

Mario Draghi, the ECB president, is worried “over the impact that the euro’s strength has had on inflation in the currency bloc, which at 0.8 per cent is less than half the ECB’s target of less than two per cent”.

Markets, however, do not seem very impressed with Draghi’s attempt to talk down the euro. Chris Turner, an ING Bank strategist, said: “Markets react more to deeds than words, and we doubt that ECB rhetoric will be enough to weaken the euro.”

While the Federal Reserve has clearly indicated that it will eventually stop buying government bonds to help liquidity in the US economy, the ECB has committed itself to holding interest rates at a low level and to continue buying sovereign debt to improve the chances of a robust economic growth in the eurozone.

The main concern relates to the risk of deflation that will stifle any chance of robust economic growth in the eurozone

What does all this mean for Malta’s economy? One positive effect of the euro’s strength is that inflation is at last well under control. This will encourage more consumer spending as imported goods priced in dollars or sterling will seem less expensive. Increasing expenditure on consumption was in fact one of the reasons for the robust economic growth registered in 2013.

But the opposite effect is experienced by manufacturing industry exporting their goods to non-eurozone countries. While the costs of these industries are mainly incurred in euros, their invoices are paid by buyers who have to pay more in their local currency to pay their euro debts.

Perhaps the most negative effect of the euro’s relentless strengthening is the loss of competitiveness that will result when the prices of our goods and services are compared to those of our competitors whose costs are denominated in a weaker currency.

With such an open economy, we will be significantly affected by this phenomenon.

Mario Draghi cannot forever rely on talking the common currency down by resorting to more ‘forward guidance’. The ECB may well decide in the near future to impose negative interest rates on bank funds parked with it overnight’ This would normally put downward pressure on the value of a currency – a remedy that many analysts argue is now badly needed for the euro.

The strength of the euro is just one element that needs to be managed well to give eurozone economies a better chance of economic growth. Reforms in labour markets and taxation levels on businesses are other areas that need to be addressed by political leaders.

While politicians can do little to affect exchange rates, they can certainly be more effective in fiscal and labour market management.


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