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What holds the euro down?

G. Srinivasan,

recently in Brussels

THE Economic and Monetary Union (EMU) became a reality with the formal launching of the euro currency on January 1, 1999, when the central banks of 11 of the 15 participating countries adopted the single monetary unit. The euro was designed to be at leas t as stable as any of the former national currencies in the Euro zone as it co-exists with the currencies of the 11 countries, including Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland. These co untries are collectively and commonly called the Euro area; four EU members -- the UK, Denmark, Greece and Sweden -- have not accepted the euro.

Even as the euro is about to complete its second year of existence by the end of this month, preparations to meet the January 1, 2002 deadline, when member- States would ensure that the bulk of cash transactions could be made in the euro, seem to be in f ull swing all across Europe.

A group of journalists from South Asia, covering India, Pakistan, Bangladesh and Nepal, was exposed to a series of disquisitions on euro by the Amsterdam-based European Journalism Centre at Brussels, where the EU is headquartered, and in Frankfurt, where the European Central Bank is headquartered, in early November, precisely at a time when the embattled euro was losing heavily against the US dollar, and the ECB had to intervene four times in less than a fortnight to shore it up.

Currency market experts contend that though the Euro area does not suffer the same imbalance as low savings and wide current account deficit as the US, it lacks `New Economy' productivity growth. Deeper integration of product and financial markets, regul atory reform and accelerating use of new technology should buttress investment, but the risk is that the overall demand remains below potential because of labour market and other administrative constraints.

The authorities in the countries participating in the euro have waxed eloquent over the so-called single-currency for almost 300 million European citizens, which provides tremendous benefits for both consumers and businesses. It enables the trading of go ods and services among the participating countries, thus bolstering the single market in the EU.

For exporting and importing companies in the Euro area, the risk of fluctuating exchange rate is circumscribed to trade with countries outside the Euro area. After the advent of euro bank notes and coins in 2002, people criss-crossing the Euro area would have little need to change money or pay exchange fees. What is more, the wider use of the same currency in 11 countries would render prices across the Euro area directly comparable, resulting in cross-border competition.

Little wonder then that in the first annual report released this year, the ECB President, Mr. Willem F. Duisenberg, claimed that the ECB conducted only one fine-tuning operation in early 2000 to mop up some excess liquidity after the successful transitio n to 2000. While the euro immediately became the second-most important currency at the global level after the US dollar, given the former's economic weight in the world (more than one-fifth in terms of GDP), the ECB chief feels that the impact of the eur o would increase in the years to come.

Despite the hiccups the euro suffered in the wake of wild spurt in crude oil prices since July till mid-November, financial pundits characterised the November intervention by the ECB in the currency market ``as a doctor administering a tonic to an invali d. The patient showed brief signs of recovery but soon relapsed to his former poorly state.'' The perception that economic policy-making in the single currency area is chaotic is seen as one of the cardinal reasons for the collapse of the euro to a new l ow of 82 US cents -- 28 per cent below its launch rate on January 1, 1999.

It is not that the euro fell because of policy chaos as there were positive signs towards progress too. Thus, last year, the public deficit for the Euro area stood at 1.2 per cent of GDP, down from the 2 per cent recorded in 1998 and the 2.6 per cent in 1997. The public deficit for the EU as a whole was 0.7 per cent, according to Eurostat, the EU's statistical office.

The public debt came to 72.2 per cent of GDP in the Euro area last year and to 68.1 per cent in the EU as a whole. In its report on the implementation of the 1999 Broad Economic Policy Guidelines (BEPGS), the European Commission commended the member-Stat es for implementing the BEPGS in an encouraging manner.

Considering that countries willing to adopt the single currency must meet a set of economic criteria such as low inflation, sound public finances, low interest rates and stable exchange rates with the additional onus to ensure the political independence of their national central banks, the `encouraging' fulfillment of these convergence criteria -- known as the Maastricht criteria -- must be a good augury for the success of a common monetary policy.

It is against this setting that the continued weaknesses of the euro was viewed with concern and last month the ECB authorities intervened a few times to shore up the currency to demonstrate to the outside world that the ECB would not budge from buttress ing its currency value. EU officials feel that while evaluating the relative merits of the euro and the dollar, the economic strengths of the US are pitted against all of the Euro areas' inherent infirmities, such as the discouraging features of the labo ur and product market rigidities of Europe. They say that with the biggest current account deficit, a negative personal savings rate, record borrowing by firms and households and a perilously overvalued stock market, the US had such a strong currency.

Even as the growth gap between the US and the euro is being narrowed, the euro, by fostering a single, more liquid capital market, has goaded corporate restructuring across Europe. The end to currency risk means that investment no longer needs to occur w ithin national boundaries, which contributed to heightened efficiency in the markets and a cut in the cost of capital. This has also led to a surge of mergers and acquisitions (M&As) across Europe with distinctly cross-border deals between companies from different euro-zone member-countries becoming quite common.

According to a leading international financial daily, many European companies are fostering global ambitions and this has led to a huge outward flow of capital, especially to the US. It is not speculation that is holding down the euro but intense corpora te activity -- cross-border and cross-continent -- and this is borne out by the fact that in August alone there was a net outflow of direct investment from the Euro area of 46 billion euro.

It is against this backdrop that economists at the European Commission say with candour that though intervention coupled with higher economic growth and feel-good factors might stem the euro's erosion, the currency is not likely to gain in value unless c apital flows become balanced. This could happen if foreign companies decide that the Euro area is a lucrative hub to sink money. No doubt, it is scarcely likely that the EU governments would let the EMU flounder, but the next 13 months, prior to the intr oduction of euro notes and coins and in the run-up to elections in Germany and France, could witness the query posed with more frequency, unless the euro recovers in the interregnum.

That is why directors at the IMF Executive Board, while discussing the Monetary and Exchange Rate Policies of the Euro area last month, urged the EU policy-makers to adhere closely to the key requirements of safeguarding price stability, establishing str ucturally balanced fiscal positions and avoiding procyclical fiscal policies, thereafter, and strengthening the supply side through a balanced and proactive strategy of tax, expenditure and structural reforms.

The IMF projected the Euro area's real GDP growth at about 3.50 per cent for 2000 in a setting of broad price stability. Regional divergences in growth and inflation rates, reflecting in part the catching-up process in many EMU countries, are likely to c ontinue, though narrowing somewhat.

In fine, mandarins at the European Commission are quite sanguine that in the long run, the medley of single market, structural reforms and single currency ought to raise Euroland's potential growth rate, leading to a significantly stronger euro. The euro strength, in turn, should set off a virtuous cycle of low inflation and interest rates, prolonging the economic upswing to be evident in the short run.