It should have been a day of celebration as the euro welcomed Croatia as its 20th country. But as finance ministers backed the newest member of their club, the single currency fell towards a less welcome milestone: parity with the US dollar. Analysts are now asking how low the euro can go, amid concerns that the currency’s rapid decline this year could worsen cost-of-living misery for hundreds of millions of Europeans. Ultimately, as rising energy costs and inflation squeeze living standards, there may be a political price to pay. “The fall of the euro has much more room ahead,” Institute for International Economics chief economist Robin Brooks tweeted on Sunday. “We’re just getting started.” On Tuesday, the euro briefly hit parity against the US dollar for the first time in 20 years. The last time the euro was worth less than the dollar was in 2002, when the euro currency was in its infancy and shared by only 12 member states. The single currency has lost more than 10% of its value against the dollar since the start of the year. It was a rapid slide, driven in part by a worsening outlook for growth in the eurozone thanks to Russia’s invasion of Ukraine and stronger demand for the dollar as a safe haven currency.
As always, not everyone will see this as bad news. There are advantages to a falling currency, namely that exports become cheaper and more attractive. However, European Economic Commissioner Paolo Gentiloni warned that it would be a “mistake” to see the euro’s slide in these terms. “Of course it is encouraging for export capacity, but we also have to look at the negative side of this coin,” he told a press conference on Monday. A weak euro makes imports more expensive — adding to inflationary pressures. One of the policymakers who has warned of this risk is ECB Governing Council member Francois Villeroy de Galhau. He warned earlier this year that the central bank would “closely monitor developments in the real exchange rate, as an important driver of imported inflation”. “A euro that is too weak would be contrary to our objective of price stability,” he added. An ECB paper published in 2020 cited models estimating that a 1% depreciation of the euro against a basket of currencies could add up to 0.11 percentage points to inflation within a year — and 0.25 percentage points over three years.

No bottom yet?

The euro may well not have reached its threshold given persistent risks that a Russian gas cut could plunge the region into a deep recession, analysts warn. Some have suggested that one euro could fall as much as 90 US cents in the grim but not impossible event that Russia does not restart the Nord Stream 1 gas pipeline. This scenario could in turn significantly limit the ECB’s ability to raise interest rates, which it has not yet done. It is expected to raise benchmark rates by 25 basis points on July 21 when it holds its next policy meeting, and may announce a bigger increase in September. The Federal Reserve, by contrast, has gone ahead, overloading the dollar with larger interest rate hikes. “The Fed is still seen as having more room to raise rates going forward, also based on the strong US jobs report for June,” UniCredit foreign currency analyst Roberto Mialich explained in a research note. “On the other hand, other central banks, such as the ECB and [Bank of England]may be forced to become more prudent given the greater direct exposure of their respective economies to the gas and energy crisis.” At the same time, the dollar is benefiting from safe-haven flows, with investors rushing to US Treasuries as a hedge against economic and political uncertainty. If the euro continues to decline, “there is no doubt [the ECB] will be quite alarmed by the move — especially if it develops into a ‘sell the eurozone’ mentality,” said ING economist Chris Turner. “However, faced with the looming risk of recession – and the euro is a pro-cyclical currency – the ECB’s hands may be tied in its ability to threaten more aggressive rate hikes to defend the euro.” The concern over the euro came on the day EU finance ministers gave final approval for Croatia to join the eurozone, allowing it to adopt the single currency from January 2023. “The fact that Croatia will become the 20th member of the European Monetary Union is also a clear signal that European integration continues despite all the challenges we face,” said Zdravko Maric, Croatia’s outgoing finance minister. Tuesday’s formalities complete the multi-year membership process, which requires countries to comply with a number of criteria such as price, exchange rate and interest rate stability, as well as fiscal discipline and a ban on monetary financing. Croatia will also gain a seat at the European Central Bank’s Governing Council table — as an observer from September onwards, and as a full member in January. As she welcomed Croatia to the group, ECB President Christine Lagarde said membership required commitment and respect for the rules, adding: “It’s a great club to be a part of.” Tim Ross contributed reporting.