More to euro’s fall than meets the eye

Date: 11/05/2000

Many analysts have suggested that when it comes to the euro, the financial markets are totally sentiment-driven. But there are concrete reasons for the decline in the value of Europe's fledgling currency - and they are relatively simple. Tim Jones reports

HIDDEN away in the countless words written about the euro's recent fall on the world currency markets, a genuine story is dying to get out.

Discussion about the euro in the UK has long been shrill and short on reason, but now the Germans are starting to match the British for logic-free debate, with Bundesbank council members criticising the tentative decision to let Greece into the single-currency area. Not only will Athens undermine the euro further, but the move will leave Tunisia as the only remaining cheap holiday spot for Hans and Heidi.

As the euro dropped below 89 US cents for the first time last week, even the normally level-headed European Central Bank President Wim Duisenberg felt the need to issue a misguided statement of reassurance to 'citizens'.

The extraordinary statement was counter-productive given the blood-lust in the media. Two columnists on the highly-respected Financial Times gave their considered explanation for the weakness of the 16-month-old currency. Market sentiment had turned, they said, and the euro was now seen as a "dog" - nay, a "toilet currency".

The use of such vocabulary pinpoints at once who the journalists had spoken to: City of London 'spot' currency dealers. These traders are at the front line of the €1-trillion-per-day market, buying and selling currency for their banks, clients and on their own account.

But traders is what they are. If you want the latest rate for depositing €1 million in a sterling account for 48 hours, the next 'chart point' at which euro-selling will accelerate, or a steer on who Chelsea football club should buy for next season, then call them. For guidance on what factors are driving down the value of the euro, the FT's alumni might as well have phoned an astrologer.

When it comes to the euro, the markets are, we are told endlessly, sentiment-driven. Apparently, there is no explanation for the fact that the currency is worth 80% of its kick-off value against the dollar. Investors just have a vague notion that Europe is badly run and that euro-zone politicians do not care about the currency's level.

This is just lazy thinking. The explanation for the fall in the euro's external value - and that is all it is, given that domestic inflation remains in check and long-term interest rates under wraps - is relatively simple.

For a start, as economist-turned-British Liberal Democrat MEP Christopher Huhne has pointed out, the euro "has become a victim of its own success in creating pan-European bond markets". Institutional investors who once scrupulously matched the ten independent euro-zone currencies' liabilities with those of their assets can now buy securities anywhere within the zone.

With interest rates so low - 4% for short-term borrowing and 5.5% for ten years - foreigners are piling into the market and using the cash raised to buy dollars and dollar-denominated company stock on Wall Street.

Imagine an investor with €100 million under management who is obliged, according to the terms of the fund, to place 40% in government bonds, 30% in stock and invest the remaining 30% at his discretion. With three-month deposits in the euro zone offering a 4.3% return while dollars and pounds yield 6.2%, he would be failing his fund contributors by sticking with the euro.

For the spot dealers, who like to talk about currencies like they talk about their women, the story is the same - except their horizons are even shorter.

If they take the view that the euro will fall further over the next few days - perhaps to the 85-cent threshold they are so keen to test - then they will sell euro they do not yet own for dollars. They will borrow money over 24-48 hours in the euro zone at 4%, use this to buy dollars and pick up the euro they promised to deliver at the lower rate they predicted. If the operation comes off, they will have made millions in a couple of days.

The EU politicians who are starting to sweat over the weakness of the euro - although less about its inflationary impact than about how powerless they appear to their electorates - would like to teach these dealers a lesson.

They have an influential spokesman in the form of Deutsche Bank's chief economist Norbert Walter. He wants the European System of Central Banks to deploy its fearsome arsenal of €275 billion in foreign-exchange reserves to intervene in support of the euro. Dealers who 'go short' - selling euro they do not have - would be forced to buy the currency as it rose to avoid incurring massive losses.

This approach was discussed at a meeting last week of top monetary officials on the EU's powerful Economic and Financial Committee (EFC), but there was little enthusiasm for it while the trend is against the euro. Finance ministers showed their willingness this week to accelerate a transfer of reserves to Frankfurt, but the majority are more worried about intervening and failing than about doing nothing at all.

Throwing hundreds of billions of euro at the markets might just be a waste of money because - and it is this which worries the EFC and the ECB most of all - the weakness of the currency could be part of a long-term trend.

The prodigious pace of US economic expansion over the past eight years has caused Americans to raid their savings for consumption. They cannot buy enough; a fact reflected in the country's €30-billion monthly deficit between the value of payments for imports and revenues from exports.

This current account shortfall has to be funded by somebody. With a current-account surplus and savers looking for more lucrative returns, the euro zone is only too delighted to oblige. The result: a huge capital outflow. It is no coincidence that the euro-zone surplus shrank from €85 billion in 1998 to €57 billion last year.

Patrick Artus, chief economist at Caisse des Dépots et Consignations in Paris, has looked into this phenomenon in detail and identified net annual long-term capital outflows from the single-currency area of €240 billion. Thirty per cent of all euro-zone business investment takes place abroad. While direct euro-zone business investment posts a negative balance of €130 billion every year due to high taxes, over-regulation and in search of growth in outlets, personal savers are also opting not to buy European.

A fast-greying EU population, with savings it can now invest internationally, is choosing instead to do just that. Artus estimates a net euro-area deficit of €110 billion in portfolio investment in stocks and bonds.

If this trend continues, it will lead to "a substantial difference between the potential growth rate in the US and in Europe - at least 4% and a little over 2% respectively", and interest rates will have to stay permanently higher in the States.

Instead of panicking about short-term dips in the euro exchange rate, which the ECB can and has offset with a 1 percentage-point rise in interest rates, Europe's politicians and opinion-formers should think about how to raise the euro zone's pitiful investment rates.

The cannier members of the ECB governing council can see the bones of a trade-off emerging. If finance ministers really want foreign-exchange intervention to support the euro, then they must offer the radical reforms of labour and services markets that the markets demand in return for repatriating their savings. "And that does not mean promises of structural reform," warns a senior monetary official. "It means bills going through parliament."

Major feature. Many analysts have suggested that when it comes to the euro, the financial markets are totally sentiment-driven. But there are concrete reasons for the decline in the value of Europe's fledgling currency and they are relatively simple.