Cold reception for a strong currency

Cold reception for a strong currency

By Frank Vinke

This is the first of a two-part article looking at the fate of
the euro and its prospects.

JAKARTA (JP): On Jan. 1 1999, 11 member countries of the
European Union merged their currencies to form a brand new
monetary unit, the euro. This created a single currency zone
stretching across Europe, covering a market comparable to that of
the United States. The transition is not yet complete.

At present, the euro exists only in bank accounts. Euro coins
and notes will be put in circulation in January 2002. Until then,
participating currencies like the German Mark or the French Franc
continue to exist, freely convertible to the euro at a fixed
exchange rate. So, after 30 years of discussion and preparation
the euro is in place. How has it fared so far and what is its
outlook?

Let us first look at the European economy. Economic growth in
the euro-zone is expected to be 3.4 percent in 2000, the highest
level in 10 years. Unemployment has been declining for the past 5
years and has dropped to below 10 percent this year.

Euro-zone government debt, now at 72 percent of gross domestic
product, is declining steadily by 1 percent to 2 percent points a
year. Trade is buoyant, investment robust and consumer confidence
at the highest levels in years. Looking at all these data, one
can only conclude that the euro-zone economic credentials are
about as good as they get.

On the monetary front the picture is similar. The transition
of financial markets to the euro at the start of 1999 has been
almost flawless.

Banks, markets and regulators prepared in an exemplary fashion
to achieve the smooth transition. Annual inflation in April stood
at 1.9 percent. This is both historically very low and right on
target.

The European Central Bank's (ECB) prime objective is to keep
inflation at 2 percent in the medium term. The inflation outlook,
unlike in the United States, is favorable too, as two main
threats to price stability, overspending by governments and
excessive wage increases, are successfully being kept at bay.

Can it get any better? Or should the question should be: can
it get any worse? Beneath the surface of the bright economic
picture, a disquieting situation has developed.

The euro has seen a steady and altogether quite radical
decline compared to the US dollar. The ECB has been accused of
applying misconceived monetary policies, of not being transparent
enough, of being receptive to political pressure.

Citizens of the euro-zone have become disillusioned: their
high expectations have vanished and many feel that they exchanged
something good for something bad.

The chief of the ECB made a public broadcast to assure the
citizens that their money was safe. He was accused of causing
panic instead of calm. Meanwhile, euro-zone politicians are
struggling and confused.

Political leaders are claiming that the weak euro is in fact a
blessing in disguise because it helps exporters. Others have
called for immediate action by the ECB to lift the currency.
Central bankers instead call on politicians to do their job by
making the European economy more flexible.

Euro-skeptics are having a ball. They see in the euro's
decline the final proof that the euro was stillborn from the
outset.

What has gone wrong? Why this steady decline of the euro? Just
days after its start at US$1.16, the euro started to go downhill.
The drop coincided with a superior US economic performance
compared to the stalling EU economy. Many feel that the euro's
decline during most of 1999 was no more and no less than a
cyclical reaction, based on the differences in economic outlook
at the time.

Growth rates indeed diverged throughout much of 1999. But that
is no longer the case. The outlook on the euro-zone economy has
been upgraded several times since late 1999 and is now the
brightest in 10 years.

Recent data on the US, in contrast, point to a declining
growth rate. After recent worrying inflation data and a strong
increase in the interest rate, there is little doubt that US
growth will decline. The question is rather whether a hard
landing can be prevented and instead a gentle move towards a new,
sustainable level of about 3.5 percent to 4 percent can be
achieved.

So, there is a clear pattern: first, diverging growth rates,
second, converging growth rates. Now, the outlook in both
economies is at roughly comparable levels again. During this
whole period, the euro has steadily declined. So we can safely
discard the notion that the decline of the euro since late 1999
has been driven by the growth differential between the two
economies.

Another argument is that interest rate increases cause a
currency to appreciate. Don't believe this either. When US
interest rates are raised, such as happened on May 17, the dollar
indeed appreciates against almost every currency in the world.
But when the interest rate in the euro-zone is raised, most
recently on March 31, the euro fails to appreciate and instead
devalues further.

There is more to the euro's exchange rate than rational
arguments can explain. A European central banker recently called
the euro value "ridiculous". Markets agree. George Soros, a
renowned player on the currency markets, recently stated that
there is a "clear overshoot" in the $-value against the euro.

The author is an economist at the Delegation of the European
Commission in Jakarta. The opinions expressed in this article are
entirely his own.