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Forex

Everybody wants to buy the euro

Why the dollar is the real question mark heading into 2017

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ECB President Mario Draghi, right, and Vice President Vitor Constancio meet the press in Frankfurt on Dec. 8.   © Reuters

With the U.S. Federal Reserve raising interest rates, and European Central Bank President Mario Draghi seemingly unable to break his addiction to quantitative easing, many investors are questioning who would want to buy the euro. The answer is simple. The whole world is eager to buy the euro. The problem in 2017 is more likely to be finding anyone who wants to buy the dollar.

The Middle East is a good example of a region of avid euro buyers. Even with the recent oil price rally, most Middle Eastern countries are expected to run sizable fiscal deficits. The International Monetary Fund expects Saudi Arabia to run a fiscal deficit of almost 10% of gross domestic product next year. To fund their budget deficits, the Gulf countries are selling central bank reserves and pools of assets held by their sovereign wealth funds.

Imagine Saudi Arabia sells U.S. Treasurys, and uses the dollars it receives to pay its civil servants. Then imagine that a Saudi Arabian civil servant uses the money to buy a BMW in euros. What is happening? Saudi Arabia is selling dollars and buying euros. It does not matter that there is an asset on one side of the transaction and a BMW on the other side -- the foreign exchange market implication is the same whether it is bonds or BMWs that are bought.

When the Middle East buys assets, it likes them to be made in America: Central banks buy roughly twice as many U.S. assets as other assets. If the Middle East buys products and services, it likes them to be made in Europe: The region buys twice as much from Europe as from the U.S. Thus, if the Middle East sells assets to buy goods, it sells dollars to buy euros.

So why is the euro not stronger with all this enthusiastic buying of BMWs and other European goods? In 2016, the U.S. basically pleaded with the rest of the world to lend it money. U.S. interest rates are above those of the euro area, where they are negative. U.S. bond yields are above those of the euro area, where many are negative. U.S. equities have outperformed those of the euro area by about 15%, and euro area equity performance is negative this year.

The U.S. did just about everything it could to persuade investors to buy dollars -- and at the end of all of that effort, the euro still trades within 4% of where it traded against the dollar at the start of the year.

The challenge for the U.S. is that it needs foreigners to buy dollars every day to stop the greenback from falling. In the first nine months of 2016, foreigners had to purchase $2.7 billion every day. That is more than the daily GDP of the Netherlands. Any day that foreigners were not inclined to buy $2.7 billion, the dollar would weaken.

This is important. If foreigners decide that they want to "wait and see" what President-elect Donald Trump's policies are like before committing to buying more dollars, then the dollar will fall. "Wait and see" is not good enough for the U.S.

Therefore, the question is not who wants to buy euros -- the whole world wants to buy euros because the whole world wants to buy European products. The question for 2017 is, in the new abnormal of the U.S., who can be persuaded to buy dollars?

Paul Donovan is the global chief economist at UBS Wealth Management and the author of "The Truth About Inflation," published in 2015. Read more at www.ubs.com/pauldonovan.

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