More to euro than domestic politics
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Euroland should be looking stateside if it really wants to judge possible
future trends, writes Geraldine Concagh. |
A part from a brief rally immediately following its launch in January, the euro has spent much of its time trading well below its opening levels against the dollar and sterling. All indications are that the euro will maintain this weak trend for the foreseeable future. The factors determining its direction include the relative performance of the euro economy, the policy position adopted by the ECB and the appetite of financial investors for the new currency. However, even for well-established currencies, foreign exchange forecasting is far from an exact science. The euro is only it in infancy and one should be cautious about drawing long-term conclusions from its initial performance.
Together Germany and Italy account for about 50 per cent of euro GDP. Persistently poor data from these two economies has hampered the euro over the course of the last three months. Boosted by falling prices and historically low interest rates, consumer spending within Europe has remained relatively strong. Industrial activity, however, has fallen back with output, employment and orders all falling in line with a downturn in global demand. Given their traditionally close correlation, there is a very real danger that poor business sentiment will eventually spill over to the consumer sector. Disputes between politicians and the European Central Bank over the appropriate level for euro interest rates have not helped the euro either. Politicians, in particular those from Germany, feel that current conditions warrant a rate reduction. The central bank on the other hand sees the high unemployment/poor growth scenario as a structural problem, which cannot be remedied by a marginal change in monetary policy.
However, there is more to euro weakness than poor domestic conditions and political wrangling. One of the key risks to the euro at the moment is the comparative strength of the US economy. Enjoying its eight-year of economic expansion, the US is showing little sign of the slowdown predicted as a result of last autumn’s global turbulence. It had been expected that lower interest rates in Europe would be accompanied by a weaker performance from the US economy. This would have supported the euro over the longer term. Instead, however, underpinned by a buoyant labour market and a roaring stock market, US consumer confidence remains at all time highs and the economy grew by over 6 per cent in the final quarter of last year.
Initial forecasts had put US growth for this year at about 1.5 per cent. Analysts are now speculating that the economy could expand by as much as 4 per cent in 1999. In contrast, the eurozone is only expected to grow by 2 per cent. At this stage, the risks attached to this forecast are nearly all on the downside. There is a danger that the slowdown could be more deeply rooted than originally anticipated and that consumer confidence will wane. At 10.8 per cent, the rate of unemployment in the eurozone remains a serious problem. Despite its policy stance to date, the ECB may have little option but to reduce rates. The opposite may to be true in the case of the US.
For now, these factors will continue to hamper the euro and the greater probability is that the USD/EUR rate will remain in a $1.05-1.15 range over the course of the next six months or so with the bias definitely to the downside. This implies a $1.33-$1.46 trading range for the USD/IEP rate. The longer-term outlook for the euro is more uncertain and will primarily depend on a more favourable performance by the euro economy. Some other factors however, could have
a positive influence.
Prior to its launch, portfolio flows were cited as one of the factors that would result in a strong euro. However, this significant movement in funds has been slow to materialise and under current conditions the more liberal markets of the US and indeed the UK still offer a more attractive alternative to investors. There is also some evidence to suggest that portfolio shifts took place prior to the euro launch with investors anticipating future euro requirements and buying into EMU legacy currencies. The relative size of the euro economy compared to the US means that the euro should be in a position to challenge the dollar as the dominant world currency. The eurozone is only 8 per cent smaller than the US in GDP terms. If the four EU countries remaining outside were to join it would exceed the size of the US. However, this will not happen until the euro has established itself as a viable international currency backed up by an independently credible central bank.
The euro should also take some comfort from that fact that the euro economy is carrying a sizeable current account surplus. The US on the other hand has a widening external deficit, which could become an increasingly negative factor for the dollar. However, it will take some narrowing of the existing US-euro growth dividend to guarantee any significant appreciation in the euro over the course of 1999. |
Geraldine Concagh is an economist with AIB Group Treasury.
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| Article appeared in the April 1999 issue.
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