Morgan Stanley: A New Hypothesis on the Euro's Strength

Stephen Jen and Luca Bindelli put forward a new hypothesis to explain why the euro has been so over-valued in Morgan Stanley's latest Global Economic Forum. It is based on a European tendency to diversify within the Eurozone, while U.S. and other real money investors increasingly diversify outside their own spheres. As Jen and Bindelli explain:

Most of the rest of the world have also been reducing their financial ‘home bias’ by diversifying out of their own domestic asset markets. However, European investment funds [IFs] have diversified more within the Eurozone than outside the Eurozone, i.e., they diversified out of their own countries but into other EMU member countries, and not out of the Eurozone. The EUR, therefore, should be strong if everyone else in the world is diversifying while the Europeans are not.

Diversification by the U.S. private sector, they note, has been significant: Controlling assets totaling some US$22.0 trillion, U.S. real money accounts have been aggressively diversifying out of the USD since 2003. In Japan and other Asian countries, private sector capital outflows have also reflected a portfolio strategy that increases exposure to foreign assets.

Jen and Bindelli make several points in their analysis of European IFs diversifying out of their own countries, but remaining within the EMU zone.

* A steady and significant rise in the financial ‘home bias’ since the launch of the euro in 1999. At the end of 1998, European IFs were already very diversified, and since then the ratio of investment in each other's markets (in relation to their total non-EMU investment) has substantially increased.

* Diversification across countries, not across currencies. This may be explained by the lack of economic convergence within the Eurozone, enabling the IFs to reach their diversification objectives by investing still within the Eurozone, while avoiding exposure to currency risk.

* Virtually every other country has seen a decline in the financial ‘home bias’. And yet, Jen and Bindelli report, the EMU is the only economic bloc not diversifying, financially, and so it comes as no surprise to them that the EUR is overshooting.

* A different version of this movie has run before. In the first year of the launch of the euro, EUR/USD collapsed from the ‘IPO’ rate of 1.17 to 0.82, but that was, according to Morgan Stanley, like now, related to portfolio shifts:

Replacing the legacy currencies, the EUR offered better liquidity and thus became a major currency in which debt could be issued. In fact, new debt issued by entities within and outside the Eurozone increased sharply after 1999. However, though the supply of EUR-denominated securities increased, the demand for them declined, particularly within the Eurozone in the first year of the EMU, from the central banks of the Eurosystem (see Why Has the Euro Been So Weak? by Guy Meredith, 2001, IMF, and The Impact of the Euro on Europe’s Financial Markets, by Galati and Tsatsaronis, 2001, BIS).

Jen and Bindelli propose in their hypothesis that capital flows have been the dominant force in driving the EUR higher, with little relation to the underlying economic fundamentals:

European cyclical fundamentals may be superior to those of the US, but the EUR’s structural superiority is highly debatable. Certainly, EUR/USD at 1.60 cannot be justified, in our view. To think that the EUR could overtake the USD as the dominant international reserve currency, with Europe’s dormant structural problems, is quite disturbing to us.

Rather perversely, our hypothesis implies that when there is greater economic convergence within Euroland, the EUR will weaken as European IFs need to go beyond the EMU to attain the desired level of diversification.

Comments

[fxtrader07]

very interesting thoughts. However, the folks at MS seem to think that economic fundamentals do not matter, only money flows do. well, i might ask, what does matter to the money flows (i.e. the guys deciding about allocation of funds?). So rather explaining currencies movements by money flows , it will fall back to fundamntals nonetheless. after all, in the end, of course money flows rule as currencies follow demand-supply considerations.
then, it may be noted that europe was quite well exposed to the usa as the us has been the dominant financial centre of the world for decades. since i do not believe that the world economy will gravitate to "another dollar" but rather, that a "reserve currency" will not exist in future or simply be a basket of major currencies, this diversification out of the dollar will probably be irreversible.
now, looking at the enormous debt and the still extremely high trade deficits of the usa and at the vast dollar-reserves with central banks allover the world i wonder how the folks at MS arrive at the conclusion that 1.60$ is §unjustified" for the euro. memo to ms: there is more flight from the dollar to come and regardless where it heads it will dirve the exchange rate of the dollar further down versus nearly every major currency.

[01GTvert]

The PTB will use the above mentioned examples of Euro "success" to introduce the Amero to the US to replace the USD...mark my words.

[sorgmot]

The Euro zone is huge in population and huge in investment opportunities. Why should Euro companies hold USA dollars investments as USA investments decline in USA dollar value due to lower USA price to earning ratio values? That is, USA dollar prices fall for USA real estate, USA bonds, USA stocks and etc.