5 May 2017

Group 201A
Dirk F. Damsma
Academic year 2016/2017
International Money Semester 2, Period 5

The French Elections of 2017 and the Possible Effect of a Frexit on the Exchange Rate

Rebecca Belochi 11084499

Lena Arndt 11103124
Noortje Bleeker 11064439

The rise of far right parties all over Europe and the changing international scene have led to increased
uncertainty about political stability in Europe and across the world. While many researches have been
done on how economic status can affect agents expectations, few have underlined the effect of
expectations on the economy.

This paper aims to analyze the repercussion of political expectations on the economy. More
specifically, we will take the case of Frances ongoing presidential elections to assess how political
expectations and outcomes can affect the fluctuations of the euro.

Our explanations will be supported by a theoretical framework composed of the Uncovered

Interest Parity model to help underscore how expectations are formed and the IS-LM model. We will start
our analysis with a short introduction to the political climate in France and how the outcome of the
elections will determine the future stability of Europe. We then proceed with the analysis of expectations
and their consequence on the euro. Finally, we will provide our prediction of the final outcome of the
presidential elections and how it will influence the euro.

To start our analysis of agents expectations, we need to lay down the basics of these elections, how they
affect the European Union (EU) and result in changes in the value of the euro. Four main candidacies are
important to understand the oppositions (Ferdinand, 2017). Franois Fillon, candidate of the right party
Les Rpublicains, and Emmanuel Macron, head of En Marche!, support the EU and want to reinforce
it. On the other side, Marine Le Pen, from far right the Front National and Jean-Luc Mlanchon from far
left La France Insoumise, depict a Union that needs to be exited, working for Frances sovereignty and
1
freedom. Girard, in his recent intervention at Room for Discussion (2017), underlines the tension before
the first round. The outcome of the first round was unclear with equal chances of candidates supporting or
opposing the EU. Official results give Macron and Le Pen 24.01% and 21.3% of votes, respectively
(Conseil constitutionnel). We will focus our analysis on these two last candidates. We consider that their
convictions and campaigns regarding the EU embody the opposition before the first round. As one of the
six founding countries, France holds a key position in the European Union both symbolically and
politically.
France is the third best performing country, its exit would be accompanied by a 30% decrease of
the EUs GDP (Xavier, 2017). The recent case of the Brexit has already questioned the legitimacy of the
EU, and a Frexit would have damaging effects on both economies and EUs currency, also because other
members may follow (Duval, 2016).
With this uncertain climate, the outcome of French elections has become an international focus
point to determine the future of the European Union. As Chen and Chou have demonstrated, agents
expectations do have an impact on the economy and consecutively, the value of the euro (2012).

For the analysis of the effect of political expectations on the euro exchange rate, we decided to use the
dollar as reference currency. Eichengreen (2005) supports the status of the dollar as reserve and dominant
trading currency, allowing for an unbiased result. The euro exchange rate fluctuations against other
currencies such as the Swiss franc or yen show similar tendencies, as can be seen in appendix 1.
Furthermore, the UIP framework will be utilized to explain the fluctuations in the euro/usd
exchange rate. Conceptually, UIP states the expected rate of depreciation of one currency against another
to be equal to the interest rate differential of the two countries bonds (Pilbeam, 1992, p. 150). Working
from the EMUs goal of a constant inflation level of around 2%, the expected future exchange rate should
remain constant accordingly. Exchange rate fluctuations should then give a development closer along with
the events of the elections.
As analyzed previously, Le Pens victory would be a threat to stability of the European Union,
leading to higher investment risk. Since this risk is not compensated for, investors prefer to hold safer
currency. This would lead to a capital outflow and an excess supply of the euro on the foreign exchange
market, causing it to depreciate. Further depreciation is caused by inflation in the Eurozone, since prices
rise as the currency devaluates. Using the IS-LM model (Pilbeam, 1992, p. 73), it can be observed that
interest rates fall while prices increase, making investments abroad more profitable. According to the UIP
model, the euro continues to depreciate due to the capital outflow, which in return causes the spot rate to
rise more than the long term rate. Further, an equilibrium can only be restored once the euro is so cheap
that it is expected to appreciate in the future.

2
 On the other hand, a victorious Macron can influence the exchange rate in the opposite way. His
support of the European Union would reassure and stabilize expectations. Therefore, there would be no
capital outflow shock, as investors do not see an increased risk in owning the euro. However, a capital
inflow could be expected, due to the removal of election uncertainty and the repronounced support of the
euro by one of its most thriving members. This would lead to an increase of euro demand, falling prices
and increased interest rates. The UIP model then predicts that there will be an appreciation of the domestic
currency and a falling spot exchange rate. An equilibrium is reached once the euro is too expensive to
yield a profitable investment.
As shown above, the euro will be affected by the predictions for the presidential elections. Until
the first election round on Sunday April 23, we see an unstable exchange rate in figure 1. Three time
series, indicated by red and green lines, will be dealt with in greater detail. The red time series presents the
polls expectations of the first round results. The green time series shows the predictions and results of the
first round.
The red time series shows an appreciation of the euro in figure 1. If we compare this to the first
rounds poll statuses presented in appendix 3, we see that in this period, Le Pen is starting to lose predicted
votes-percentages compared to Macron, reassuring the stability of the EU. The drop in exchange rate that
we see in the time period between red and green, can be explained through the predicted votes gain in
appendix 3 for Melenchon. He advocates the same Frexit policy as Le Pen (Mowet, 2017), and by
gaining 7.3% between March 20 and April 21, hence taking away possible votes for Macron, this
increased the uncertainty. The week before the first election round on April 23, we see the exchange rate
climb again, until it reaches the green time series, as the polls predict more certainty of Macron winning
the first round. Friday April 21, when the markets close, the exchange rate makes a jump from 1.0715 to
1.0874 on Monday April 24. Macrons win translates into a sharp fall of the VIX volatility rate and a 4.5%
increase of the French CAC40, among other indices, as can be found in appendix 4. A nine-year high since
2008 (Wearden, Fletcher, 24 April).

3
Figure 1 EUR/USD exchange rate from Feb 24 '17 - Apr 27 '17. Second green line indicates first round of French elections.
Red time series: 15/03/2017 - 28/03/2017. Green time series: 21/04/2017 24/04/2017.

The increased probability of Macron becoming the next President of France as presented in the
second graph in appendix 3, combined with the relieved pressure of two possible candidates advocating
the leaving camp, we expect the euro to attain a stronger position and predict an appreciation from the
more certain and stable status of the EU. However, the question remains whether the Euro can survive a
Frexit and stabilize if the tables turn when Le Pen takes Presidency.

We can now state that political expectations and outcome of the French elections do have an effect on the
fluctuations of the euro. A limitation of our analysis would be the restriction of comparing the euros
strength against the dollar, when that rate could fluctuate reflecting upon other events. To extend the reach
of our topic, one could research whether expectations are rational and always accurate or if they originate
from pure speculation. It is here assumed the EU losing another member would hurt its future and
stability, but the predicted devaluation of the euro could turn into an advantage, therefore showing a one
sided view of the elections outcome.

(1179)

4
Bibliography

Chen, S. S., & Chou, Y. H. (2012). Rational expectations, changing monetary policy rules, and real
exchange rate dynamics. Journal of Banking & Finance, 36(10), 2824-2836.

Conseil Constitutionnel. Annonce Des Rsultats Officiels Du Premier Tour De L'lection Prsidentielle.
Paris: Journal Officiel, 2017. Retrieved from: http://www.conseil-constitutionnel.fr/conseil-
constitutionnel/francais/publications/contributions-et-discours/2017/annonce-des-resultats-officiels-du-
premier-tour-de-l-election-presidentielle.148936.htm.

Cunningham, T. (2017, April 21). Euro under pressure amid French election fears, as FTSE 100 suffers
worst week since November. Retrieved from http://www.telegraph.co.uk/business/2017/04/21/euro-slips-
three-week-high-amid-french-election-fears/

Duval, G. (2016, october 7). Quelles seraient les consquences dun Frexit?. Alternatives Economiques.
Retrieved from: http://www.alternatives-economiques.fr/seraient-consequences-dun-frexit/00012328.

Eichengreen, B. (2005). Sterling's past, dollar's future: Historical perspectives on reserve currency
competition (No. w11336). National Bureau of Economic Research.

Ferdinand, O. (2017, april 22). Prsidentschaftswahl in Frankreich. Zeit Online. Retrieved from:
http://www.zeit.de/politik/ausland/2017-04/praesidentschaftswahl-frankreich-kandidaten-erste-runde-
szenarien.

Kirk, A., Scott, P. (2017, May 4). French Election: Latest polls and odds tracker. Retrieved from
http://www.telegraph.co.uk/news/0/french-election-latest-polls-odds-tracker/

LeMonde Journal. (2017, April 24). Resultats presidentielle 2017 France. Retrieved from:
http://www.lemonde.fr/data/france/presidentielle-2017/

Mowet, L. (2017, April 15). Worst nightmare for EU as French election could be between two candidates
wanting FREXIT. Retrieved from: http://www.express.co.uk/news/world/791408/French-election-
European-Union-nightmare-two-candidates-want-Frexit

5
Pilbeam, K. (1992) International Finance. New York, N.Y: Palgrave Macmillan.

Room for Discussion. (2017, may 3). Journalist interview. Retrieved from:
https://www.youtube.com/watch?v=cM7SJBJKAWg&t=2075s.

Wearden, G., Fletcher, N. (2017, April 24). Frances stock market hits nine-year high in election relief
rally as it happened. Retrieved from https://www.theguardian.com/business/live/2017/apr/24/euro-
rallies-shares-market-france-election-macron-eurozone-business-live

Xavier. (2017, april 17). Quelles seraient les consquences si la France quitte lUnion Europenne?.
Dmocratie lectronique. Retrieved from: http://www.democratie-electronique.fr/seraient-consequences-
france-quitte-lunion-europeenne/.

Yahoo Finance. (last checked: May 4, 2017). Retrieved from: https://finance.yahoo.com/quote/EURUSD

%3DX?p=EURUSD%3DX

6
Appendix 1
Euro exchange rates with USD, CHF and JPY source: YahooFinance.com
Exchange rates, overview of one
month preceding may 4th, 2017.

7
Appendix 2
French 2017 election results, all candidates, round 1 source: LeMonde Journal

8
9
Appendix 3
Construction of results round 1 and poll predictions for results of round 2 of French Elections 2017
Source:

http://www.telegraph.co.uk/news/0/french-election-latest-polls-odds-tracker/

23 Apr 2017

10
11
Appendix 4

Source: https://www.theguardian.com/business/live/2017/apr/24/euro-rallies-shares-market-france-
election-macron-eurozone-business-live

Figure 2 Volatility Index 20/04/2017 - 24/04/2017

Figure 3 Europe Indexes

12