ANNUAL REPORT 2008 - Polymer Bank Notes of the World

sharp depreciation of the euro was associatedprimarily with a revision of market expectationsabout the euro area economic outlook – as thefinancial crisis continued to unfold and its globalreach gradually began to be realised – and tookplace within an environment of heightenedmarket uncertainty and global risk aversion.Towards the end of the year, the euro reboundedstrongly, reaching another historical peak on18 December 2008. By the end of 2008 theeuro was, in nominal effective terms, about2.5% higher than at the beginning of the yearand about 7% above the average level in 2007.Much of the nominal effective appreciationof the euro in 2008 can be accounted for byits sizeable strengthening against the poundsterling, which was only partly counterbalancedby the euro’s weakening against the US dollarand the Japanese yen.Against the US dollar, the euro underwent astrong appreciation in the first eight months ofthe year, peaking in mid-July at USD 1.60. Thisappreciation was driven largely by expectationsof a widening interest rate differential in favourof euro area assets, reflecting market beliefsthat the euro area was going to be affected bythe ongoing financial turmoil to a significantlylesser extent than the United States. From thatperiod on, however, data releases began to showthat the financial turmoil that originated in thesub-prime US mortgage market in August 2007was unfolding into a synchronous economicslowdown across all main economic areas. As aresult, the euro began to depreciate sharply againstthe US currency in August. In the course of theautumn, renewed strains in global money andcredit markets intensified the downward pressureon the euro, with the single currency reachingUSD 1.25 in October. This sizeable depreciationwas associated partly with a worldwide dollarliquidity shortage which commanded a sizeablerepatriation of foreign investments and concertedcentral bank policy actions. In this environment ofextremely heightened risk aversion and financialdeleveraging, the US dollar found support in itsinternational status. Other technical, and possiblytransitory, factors in foreign exchange marketsalso appear to have lent support to the US dollar,as can also be deduced from the weakening ofthe link between interest rate differentials andmovements in the EUR/USD exchange rateduring this period. In December, however, theeuro experienced a strong rebound as the strengthof the above-mentioned non-cyclical factors thatsupported the dollar in the autumn waned andforeign exchange markets refocused attention onthe growth outlook and interest rate differentialsacross major economic areas. On 31 Decemberthe euro was trading at USD 1.39, i.e. about 5%weaker than at the beginning of 2008 and about6% stronger than its 2007 average.Following a similar pattern to the EUR/USDexchange rate, the euro also fluctuated widelyagainst the Japanese yen in the course of 2008,trading within an unusually wide range ofJPY 115.75 and JPY 169.75. The volatilityin the EUR/JPY exchange rate seems to havereflected not only a changing market assessmentof relative economic prospects, but mostimportantly market expectations relating to assetprice volatility. As a consequence, the latter hadan impact on the expected profitability of carrytrades, i.e. trades that consist of borrowing ina low-yielding currency (such as the yen) andinvesting in a high-yielding currency. In general,an increase in the expected volatility of the yenreduces its attractiveness as a funding currencyfor carry trades, tending to put upward pressureon the yen and downward pressure on highyieldingcurrencies. Indeed, implied volatilityin the EUR/JPY exchange rate – as measuredthrough indicators based on option prices – sawwide gyrations in the course of 2008, peakingin October and subsiding thereafter. Theseextremely volatile conditions in the foreignexchange market accounted mostly for the initialappreciation and subsequent sharp depreciationof the euro against the yen in 2008. On31 December 2008 the euro traded at JPY 126.14,i.e. 23% weaker than at the beginning of the yearand about 22% lower than its 2007 average.The euro also continued to appreciate againstthe pound sterling in 2008, strengthening bya sizeable 28.5% by the end of the year, afterthe 9% appreciation witnessed in 2007. OnECBAnnual Report200879