The Euro: A cold reception for strong money

By Frank Vinke

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

JAKARTA (JP): What then has been the driving force behind the euro's decline? The answer is as simple as it is illusive: market sentiments. These have been positive towards the dollar and negative towards the euro.

Views on the dollar are linked to the United States economy, which has obtained the image of being like a super-economy. They are reinforced by the reputation of U.S. Federal Reserve, to which people have come to almost attribute a sense of magic in guiding the U.S. economy. Such beliefs will not stand the test of time, but they have provided a clear boost of the dollar's image and hence its exchange rate.

Sentiments towards the euro, in contrast, developed in a distinctly negative way. It may be difficult to capture the sentiments themselves, but it is possible to identify factors that help cause and sustain them.

Some factors are "transitory" and linked to the recent and incomplete introduction of the euro. Others have a "European" dimension and relate to the unique European context of the euro.

The euro is like a caterpillar at the stage before it becomes a butterfly. The euro is fully alive but the transition to its final stage of becoming a visible and tangible currency still lies about 19 months in the future.

During this time it will continue to lack a face and a sense of ownership by the inhabitants of the euro-zone. In other words: it will remain unloved. Apart from being incomplete, the euro simply is new and without a track record.

People and markets are still in the process of getting acquainted with it and with the new European Central Bank that governs it. All this novelty warrants more violent currency movements than one would normally see.

This does not mean that the euro was bound to go down, just that it could fall deeper than under normal circumstances. Which is exactly what happened. This is where the European factor comes in.

The euro's decline in the first few months of 1999 took European citizens and their political leaders by surprise. All the good news before and during its start had made them believe that the euro would rise like a star. The decline of the euro started to make people in and outside Europe think that something was wrong with it. Didn't the decline itself prove its weakness?

Meanwhile, Europeans started to increasingly become intimidated with the power of the U.S. economy that appeared leaner and better equipped to deal with the challenges of the New Economy of the Digital Age. Europe, the Old World, would be left behind with its obsolete and rigid economic structures.

Increasingly, people became concerned and critical noises could be heard. These found very receptive ears. The euro was launched at a time when the European Commission, the EU's executive body, experienced a deep crisis of confidence due to reports of corruption and mismanagement.

Public opinion, already highly skeptical and suspicious of European Institutions, reached new lows. Under this peculiar constellation the European Central Bank (ECB), rather than being somewhat elevated from the public domain, has found itself fighting battles for its credibility and being subjected to extensive, if not excessive, public scrutiny.

The ECB, like other EU institutions, has the natural disadvantage of being more complex than national institutions. Its policies touch the interests of 11 sovereign states. Once something goes wrong, the Pandora box opens.

Politicians and policy makers from all corners start making statements, often contradicting each other and causing confusion. That is Europe's irony; the more it unites, the more disunited it appears. The ECB has not yet succeeded in distancing itself from the European political arena.

All these factors have provided very bad public relations. The environment in Europe has worked like a resonance box of negative and confusing messages. This has allowed opinions on the euro to stray from the sensible and realistic.

They have created a perception of the euro as a weak, unguided currency. Currency markets have adopted this image and valued the euro accordingly.

What do all the above factors mean for the future of the euro?

The euro will rise in the future. The fundamental value of the euro, its purchasing power, is properly secured. The factors that have contributed to the euro's decline are transitory. People will get used to euro and policymakers and politicians will find ways to send more clear messages.

All the commotion surrounding the euro will in the end be short-lived. In the last 25 years, the euro -- or its predecessor, the ECU --has been trading typically at between US$1.10 and $1.30.

On one occasion during the mid-1980s the ECU dropped below parity with the dollar, but recovered later to its previous levels. One can safely assume the euro to move back to at least $1.10 in the years to come.

But that is of no interest to financial markets if the outlook for the next days or weeks is still negative. This is very much the case to date. Because of this, the euro could yet depreciate further.

One event that would change market perceptions is a deterioration of the economic conditions in the U.S.. Within the next few months it will be clear whether the U.S. economy is still going strong or not.

Look out for a steep appreciation of the euro in the event of a sudden decline of U.S. growth. Another possibility is that markets, driven by their keen profit-making instincts rediscover Europe for its own sake. Amidst the bad and mostly unjustified publicity, markets have so far turned a blind eye to the bright investment prospects in Europe.

The International Monetary Fund has estimated the undervaluation of the euro at 30 percent or more against the dollar. This situation may not be seen again in a lifetime. If you ever waited for the right moment to invest in Europe, you need wait no longer.

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