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| The contradictory nature of policy statements on the euro has sometimes left the markets confused. Dominick Sutton places the blame on the low degree of transparency within the ECB. |
In establishing the European Economic and Monetary Union on midnight January 1st 1999 the eleven participant countries embarked on a novel and risky venture. In the succeeding nineteen months the Single Currency project has both fulfilled and disappointed expectations.
It has exceeded expectations in the success and ease of the adoption of the banking and wholesale payments systems to the new unified currency. Indeed, virtually none of the predicted business disruption occurred in what must be acknowledged as a credit to European business adaptation. With the conversion of retail payment systems and the introduction of coins and notes now less than a year and a half away, the new currency faces its biggest test yet on the political arena. However, as a trading unit it has already proved a success.
However, the Single Currency has not proved to be the solid international currency expected by its architects. In this it has responded to economic rather than political forces (although the two are intimately linked). Nonetheless, the weaknesses of the system have been cruelly exposed and these remain significant challenges for EMU and the political space within which it operates.
One major concern for the financial markets has been the low degree of transparency in the European Central Bank’s operations. Not only does it not release minutes of its bi-weekly policy meetings, but it has yet to release its economic forecasts. Clearly, part of this opacity has to do with national voting patterns and the desire to prevent political pressure being brought to bear on the national members of the ECB Council. Nonetheless, the very lack of transparency has had a serious impact on the credibility of the organisation in the eyes of the financial markets and this has shown up in the trading performance of the euro.
Another problem is the lack of consistency in statements from representatives of the ECB. Indeed, on occasions the statements can be totally contradictory, such as at times of strain in the foreign exchange markets when very different views of the likelihood of ECB intervention can all carry the stamp of a senior ECB official.
In part this all stems from the very youth and disparate origins of the organisation and its constituent parts. However, over time this lack of transparency and statement co-ordination must be addressed if the ECB is to perform at its optimum.
It is in explaining interest rate decisions that the aforementioned lack of transparency and track record is particularly onerous. This had left the market uncertain about ECB decision making algorithms, the data set used in those decisions and the influence of political factors on the decision making process.
One of the most visible results has been the almost constant depreciation of the euro in the foreign exchange markets. This has been seen by many (often hostile) commentators as a sign of weakness in the overall project. It also has provoked divisions within the ECB, national central banks and different national administrations regarding its desirability, durability, causes and the appropriate response. The statements from monetary officials in both the ECB and national central banks have often been confusing and sometimes directly contradictorily. On occasions the various statements have implied that the ECB views the euro exchange rate weakness as a serious concern but at the same time as not one of great interest, that intervention is a viable prospect but also that it does not even merit discussion.
Confused? So was the market and this is one of the reasons that the euro fared so poorly even in the light of a clear recovery in euro Zone economic activity, particularly in Germany. This, in turn, is also an aspect of the aforementioned transparency problem. Without a clear view of where the ECB stands on such matters as the importance of the exchange rate, how the spot exchange rate compares to the forecasted rate used in policy decision, and the implication of any difference, the market is forced to treat all such policy statements with scepticism. This is aggravated by the array of views on display that all purport to be official ECB policy.
The depreciation of the euro in the first year of its life can be seen as a response to two factors. Principally, it has acted as would be expected by most mainstream currency economic theories. In a state where an economy is operating below capacity, exchange rate depreciation can be expected to occur in order to reduce economic imbalances. In terms of the ‘sticky price’ model the exchange rate will overcompensate for the sluggishness of adjustment in the real economy.
Given the slowness of adaptation of the European economy on the basis of this model the euro could be expected to undershoot to help stimulate an economic recovery. This, indeed, appears to have been the case. Now that the European economy is moving to a higher growth rate the need for this additional exchange rate stimulus will progressively diminish. It is this theoretical model that forms the basis for so many forecasts of euro appreciation in the medium term.
Another issue is the impact of the euro on the currency markets in general, EMU created a currency for an economic block of similar dimensions to the US. This provoked speculation that it would dilute the importance of the dollar by virtue of being a viable alternative for international transactions by other countries. In addition, it also generated discussion concerning the replacement of US dollars by Euros in national central bank reserve holdings. Both of these are likely developments in response to a successful Single Currency over time. To date, though, their impact is not obvious in the foreign exchange markets.
The bigger question, though, is how the euro will fare once the temporary overshoot is corrected. This will be a function of the underlying economic trend performance relative to the other major economic areas. The euro Zone is currently seen as an area that will produce lower growth in economic activity compared to its main rivals. This is a reflection of relative levels of liberalisation in labour, business regulation and corporate control markets. Indeed, the realisation of these gaps, particularly in the ‘new technology industries, was behind the recent Lisbon Summit and the proposed reforms to boost activity in those areas. Given the current state of affairs and the aspirational nature of the proposed European reforms it is difficult to see a strong and sustained euro rally succeeding the more immediate reversal of the current euro undershoot.
Dominick Sutton is chief economist with Investec Gandon. |
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| Article appeared in the September 2000 issue.
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