Euro’s fall is sign of greater ills

Date: 18/03/1999

The fluctuations in the value of the euro which followed the resignation of Oskar Lafontaine give a hint of the problems affecting the single currency's state of health. Tim Jones reports

AS EVERYONE now knows, the euro soared last week after the mercurial Oskar Lafontaine stormed out of the German finance ministry.

The mystery of the falling euro was over, it seemed, since all the new currency needed was the constructive dismissal of Lafontaine.

Well, no actually. What everyone does not know, because it was much less interesting to newspapers than the euro's post-Oskar rise, was that all the currency's gains were erased the following day.

The reason for this is simple: since Lafontaine was the not the reason for the euro's weakness, why should his departure be the reason for its rally? Admittedly, he was politically erratic and he did call loudly and often on the European Central Bank to cut its interest rates, but there is pretty telling evidence that it was not listening.

Moreover, his greatest fiscal legacy - the 'anti-business' tax reform package - is set to pass through the upper house tomorrow (19 March) unamended and it is still far from certain that a new bill to cut corporate taxes will be introduced later in the year.

Even sillier is some of the talk, originating from the German chancellery, that the euro would weaken if EU heads of state and government failed to put together a new seven-year budget deal for the Union at their summit in Berlin next week.

This idea is so outlandish that it can only be hoped that it is purely rhetorical and designed to bring more intransigent prime ministers into line in time for Berlin. If any politicians actually believe it, then it is no wonder that the ECB is running intellectual rings around its governmental counterparts.

The euro has weakened because, while financial market participants may be fickle minute-by-minute, they are not stupid. As the fictional Wall Street corporate raider Gordon Gekko said: "Never get emotional about stock and, if you want a friend, get a dog."

Fund managers and investment bankers make and lose their reputations, as well as their astronomical bonuses, on one basis only: the return they can achieve on their investors' capital. If they made irrational decisions based on their feelings towards a single finance minister, they would soon be on the streets.

The euro is trading close to $1.1 rather than the $1.18 level at which it began life nearly three months ago because, at the moment, it is a far less attractive prospect than its toughest international rival, the US dollar.

Euro-zone gross domestic product shrank in the final three months of last year compared with the previous quarter, manufacturers are scaling back use of their plants' full capacity, unemployment rates have hardly been dented and industrial confidence continues to erode.

Across the pond, the US economy continues to power ahead with no discernible signs of inflation emerging. Only last week, the US labour department revealed that the economy generated another 275,000 jobs in February.

Investors anticipate that the next move in short-term interest rates in the US will be up and the next move in euroland will be down. This makes holding dollars more attractive. With more immediate prospects for economic growth, US firms' equity also seems to be a surer bet.

The nature of the euro's fall late last week told a story all on its own. The consensus in the London and New York foreign exchange markets is that the euro will fall still further and remain stuck at between $1.05 and $1.08 until June at the earliest.

For this reason, on Thursday afternoon, many market participants had 'gone short' euro - meaning that they had sold euro they did not yet have, expecting that they would soon be able to buy the euro they needed to meet their order more cheaply.

When the Lafontaine bombshell dropped late in the day, these people scrambled to get hold of the euro they needed for fear that others would do the same. The euro surged over $1.1 but, by Friday, realising nothing had really changed to make the currency worth holding in bulk, traders opted to go into the weekend with their positions squared up. This meant selling euro again.

London traders think the currency will, in the short term, remain somewhere between $1.08 - the level at which investors have placed a large number of automatic bids - and just below $1.10 - where they trigger sell orders.

There could be more to the phenomenon of the recent weakness of the euro; a factor which the ECB is investigating. When the 17-member governing council last met two weeks ago, the bank's economists said they were puzzled by two elements in the data.

Firstly, at a time of falling business confidence, there had been a huge increase of more than 9% in credit to the private sector. Secondly, the 12-month growth rate of M3 'broad' money - banknotes and coins in circulation with the public and easily-withdrawn deposits - had surged to 5.7% in January from 4.5% in December.

The ECB aims to keep this 'aggregate' close to 4.5% and wild swings away from this reference rate could presage inflation. But, on this occasion, the bank's economists pointed out that the increase was entirely due to an upsurge in overnight deposits, which account for one-third of M3.

Thirdly, they noticed that the 'yield curve', which maps official interest rates all the way from overnight deposits to ten-year government bonds, had steepened. Short-term rates had dipped while bond yields had edged up.

ECB President Wim Duisenberg has a possible explanation. "The very strong increase in credit to the private sector has partly led to, or has been used to buy US dollar-denominated assets, attracted by the higher interest rates to be earned in the United States," he said. "That by itself could have, let's say, financed the weakening of the euro or the strength of the dollar."

Economists are looking into this possibility, focusing on capital flow data and analysing where this private-sector credit is going. It is a fascinating insight into the mechanics of a marketplace. If the data bear out Duisenberg's suspicion, euro-zone investors are effectively borrowing money at attractively low interest rates in Europe to finance a higher return in the US markets and, by doing so, are driving the euro down.

Duisenberg seems untroubled by the phenomenon. With business confidence weak, there is little prospect that the fall in the value of the euro will turn into imported inflation. His calls for perspective could easily be aimed at those for whom the euro was meant to be a symbol of economic virility.

" If you look at the level which the euro has now reached ... this is more or less the level which the deutschemark had during most of last year," he said. "The strength with which the euro started life was more the exception than the rule."

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