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New phase in euro-dollar exchange rate

Sluggish progress in carrying out structural economic reforms at home and the torrid growth rate registered by the US, even defying IMF forecasts, perpetuated the euro's weakness. Europe's tendency to exercise monetary authority reluctantly and erratical ly, further undermined the euro's credibility, says D. Sambandhan

EVER SINCE it was launched 17 months ago, the euro -- the currency of the 11-member European Union (EU) -- has lurched from crisis to crisis. The carefully-crafted myth that it would emerge as a powerful key currency and serve as a credible alternative t o the dollar, has remained just that: A myth. The bitter truth is that its weakness and continued vulnerability against the US dollar became apparent when its alleged magic failed -- it fell more than 22 per cent against the dollar.

It is unfortunate that Europe's continual search for a new world role, by building partnerships and bridges with other parts of the world commensurate with its unquestionable economic power, is not adequately matched by its currency value.

Fall and fall of euro

Despite strong economic fundamentals, a satisfactory inflation performance and a reasonable degree of political stability, euro enthusiasts are visibly disappointed to find their fledging key currency faltering at every stage and having none of the quali ties being attributed to it at the time of its birth.

Aspiring to become a strong key currency is no easy task. With South-East Asian currencies getting repaired and the dominant world currency -- the US dollar -- perched at the top for too long, Europe has been struggling to stem the tide against the euro.

But despite recent setbacks, it would be wrong to assume that the young euro is losing its relevance. If anything, European nations need the common currency more than ever to tackle a host of new challenges. But to reap the advantage of European currency unification, both from within and outside, the authorities need to reconstruct the euro, by correcting passive central bank intervention.

Experiments with floating, in general, and the more recent euro experience, in particular, do abundantly suggest that domestic price stability is no guarantee for the stability of exchange rate when extraneous/exogenous shocks and disturbances continuall y disturb fragile currencies. Who cares whether the PPP theory relation will hold good in the long term when today's exchange rate is bombarded by speculative capital and ``the expectation of tomorrow's tomorrow,'' to use Tobin's expression.

Central bankers' dilemma

In the operationally relevant short-term, there is no such thing as an ideal equilibrium rate commensurate with goods market/real sector performance. There are only different perceptions from the market shaped by the current and expected images of econom ic variables. Under the circumstances, it is definitely the central bankers' right and discretion to choose from a particular economic and political context which they respond to. Even while the central bankers are committed to maintaining what they feel is an orderly movement in exchange rate, they have been swayed by violent and vicious currents in the forex market. Exchange rate overshooting arising out of asset market perspective becomes common place and something Central bankers find difficult to m anage through intervention.

The euro began well with a lot of goodwill. The US made a gesture of support generously noting that Europe and the world would largely benefit from it. There was also a fond hope and conviction that the European Central Bank, modelled on the German Bunde sbank, would follow a sensible and responsible monetary policy and, hence, there was nothing to disturb the price stability goal of the euro.

But, then, what has gone wrong with the euro? Early on, it was apparent to the authorities, as also the market participation, that Europe, battling massive unemployment and not having made an adequate recovery from recession, could not opt for a strong e uro and higher level of interest rate. This would logically imply that in its onward journey as a fledgling key currency, the euro would be allowed to depreciate moderately to deepen and strengthen the process of economic recovery.

There was nothing wrong in choosing this Keynesian route to buy more employment and make economic growth take roots. This also proved to be a sensible and inevitable measure considering that the dollar began rising. However, with the euro's depreciation, the logic of the Keynesian route became flawed and was exploited by the market. Though there was no explicit talking down of the euro, a passive central bank and its apparent insensitivity to the continual euro slide did give an impression that the weak euro was preferred by the authorities. Thus, a fertile climate was created for one-way profitable speculation. The strong perception that the euro would be a candidate for depreciation, facilitated speculative activity at discrete time intervals. There was always some `news' to press the panic button.

Sluggish progress in carrying out structural economic reforms at home and the torrid growth rate registered by the US, even defying IMF forecasts, perpetuated the euro's weakness. Europe's tendency to exercise monetary authority reluctantly and erratical ly further undermined the euro's credibility.

The US factor in reverse gear

Finally, the expected inflation threat for the US overheated economy came when the continued strong growth of the US, along with matching success at containing inflation was threatened, the low interest rate scene in the US began to change. It all starte d with the announcement of a higher inflation figure than that anticipated by the market. This information became the immediate cause for pulling down the overheated stock market and pricking speculative bubbles built around IT-based stocks.

The Fed's attempt to hike interest rate to adjust with high US growth, and tackle inflation, could not be faulted. The US knew well that fresh inflationary pressures could pose greater trouble, eroding competitiveness in world trade and putting an end to the dollar's ascendancy.

One can cite an interesting parallel currency experience involving the Exchange Rate Mechanism (ERM) in September 1992. England, a late entrant into ERM then, recession-racked, but keen to remain within the ERM asked Germany for an easing of monetary pol icy. But Germany, confronted with inflation, refused to accommodate. It instead tightened it, forcing a heavy devaluation on the pound, and its exit from the ERM. History seems to have repeated itself with the euro. In recent months, the euro (which does not contain the pound) became the victim of monetary austerity in the US. The evident tension surrounding the euro during April-May was understandable and self-explanatory.

Reconstruction must begin

The euro's reconstruction by the European Central Bank can only begin when the sense of disillusionment and disenchantment with it ends. The euro's recent and startling recovery (May 31, 2000), putting an end to its 17-month downtrend, raises hopes that the market has realised that the euro is grossly undervalued and needs correction. Expectations are now ripe that the European Central Bank will hike interest rates to keep pace with increased money supply growth at home and also respond to the US ratche t effect on interest rate.

Regardless of the existence and operation of the US factor in compounding the euro's troubles, the meaning of the euro's tumble must be made clear to the authorities. The message: Traders and investors already hold more euros than they want to, and the m arket expects somebody else to do the buying - the European Central Bank.

In the 1980s, when the EMU was designed, conservative leaders were determined to solve the problem of stagflation even at the cost of high unemployment. It was also in conformity with the spirit of the 1980s -- disinflation. By contrast, the predominantl y Centre-Left European governments that now direct the EMU emphasise economic growth and reducing unemployment. Europe has honeymooned with radical domestic politics which represents another political landmine for the euro.

In the present context, the European Central Bank can ill afford an easy monetary policy. Realistic market expectations of a hike in interest rate by the European Central Bank must see the euro as a `come-back kid' in the hands of a highly capable specul ators.

The European Central Bank must make a supreme effort to win the confidence of this group by playing a closer role in forex market, so that it can take over the task of mopping up excess euros, in view of the future gains involved.

Will the euro magic finally click and its enthusiasts heave a sigh of relief? It appears that the worst is over, but so long as the dollar enjoys a competitive edge, thanks to the great `digital divide' and `Viagra growth', the euro will keep even the op timist guessing. The restoration of near euro-dollar parity in a graduated fashion will provide a platform for a return to world economic growth.

(The author teaches international economics at the School of International Studies, Pondicherry University.)