ECB sends markets a salutary reminder

Date: 28/09/00

The euro's collapse last week prompted G7 intervention to bolster its value on world markets. But this was no ordinary currency crisis. Tim Jones explains why

THE world's most powerful monetary authorities threw up to €7 billion at the foreign-exchange markets last Friday and added a cent to the international price of the euro.

If driving the euro up to parity versus the dollar was the European Central Bank's aim, then this smacks of fictional anti-hero Edmund Blackadder's quip that the Battle of the Somme was "yet another gargantuan effort by Field Marshall Haig to move his drinks cabinet six inches closer to Berlin".

Fortunately, the European Central Bank and its allies are not that stupid. They learned back in 1992-93 that the currency markets - now averaging a daily turnover of €1.7 trillion- cannot be bucked by central bank intervention.

The best that can be hoped for is a tug on the markets' lead; a reminder that if dealers 'short' the euro - sell euro they do not yet have in the hope of buying them more cheaply in a couple of days time - they will get their fingers burnt.

That was the motivation last Friday when ECB President Wim Duisenberg and his operations chiefs convened an early morning conference call with the US Federal Reserve, the Bank of Japan and the remaining Group of Seven central banks.

The first G7-coordinated intervention since 1995 went through the markets like a jolt, driving the euro up from 87 US cents to 90 cents before settling at 88.20 at the end of the day. "It was 'textbook' in that the intervention was heavy, caught the market by surprise, it was coordinated and it was public," says Kathryn Dominguez, professor of public policy at the University of Michigan and co-author of Does Foreign Exchange Intervention Work?. "Still, I am surprised they waited as long as they did."

That the ECB simply sat and watched the collapse in the euro's value abroad for as long as it did is a mystery to many.

French officials have been clamouring for months for the bank to unleash some of the €245 billion at its disposal to buy euro and sell dollars. Their motivation is hard to fathom, but the French seem to believe that strengthening the euro would take pressure off the ECB to raise interest rates.

The obstacles came from elsewhere: from the reluctance of new US Treasury Secretary Larry Summers to sanction intervention which would drive down the dollar just weeks before a presidential election, and internal ECB analysis suggesting that buying euro in bulk would be futile.

On top of this was a prevailing view at the highest levels of government, up to and including German Chancellor Gerhard Schröder, that the euro was simply doing what it had been designed to do: gyrate with very little impact on the 11-nation economy.

The Organisation for Economic Cooperation and Development (OECD) has calculated that a sustained 10% fall in the external value of the euro would accelerate inflation in the single currency area by 0.6 of a percentage point without any interest-rate increase to quell it.

This is why this supposedly classical currency crisis was nothing of the kind. Even as the currency was 'falling through the floor' last Thursday, the Bank of France managed to offload €3.5 billion in euro-denominated debt to hungry investors. And the price of holding onto this debt for up to five years at the risk of massive currency losses and inflation? A mere 5.2% - just 0.7 of a percentage point above current base interest rates. Currency crises do not look like that.

Still, while traders thrive on volatility, central bankers hate it; a strong or a weak exchange rate makes interest-rate management unnecessarily difficult. And for most politicians, the economist's argument that a falling exchange rate can be a good thing is impossible to sell to the public, even to those whose jobs have been saved by their firm's improved export performance over the past year.

Add to this the clincher for the Americans - a stock market downturn as chipmaker Intel reported that a European sales slowdown would chip 5% off this quarter's revenue growth - and the combination of political necessity and economic management needs did the trick.

The markets were impressed; traders love 'rambos'. But the battle is far from over and it may even be unwinnable.

A new study by Jesper Dannesboe, chief currency strategist at Dresdner Kleinwort Benson Research, suggests that nobody is speculating against the euro by 'shorting' it. An analysis of speculative positions on the Chicago Mercantile Exchange reveals that investors are not borrowing to finance short-selling the euro. "Indeed, most of these non-commercial accounts were long euro and actually helped brake the speed of the euro's fall," says Dannesboe.

Instead, as economist Patrick Artus at CDC Marches has long argued, the key factor driving the euro's 25% decline against the dollar is the trend in foreign direct investment (FDI) by European, American, Japanese and British multinationals. "Companies are not concentrating on foreign exchange as their criterion for expanding into the US," says Jonathan Isaacs, editor of merger industry magazine Acquisitions Monthly. "The fact is that Europe is still seen as a fragmented market and chief executive officers wanting to go global are attracted by the returns from US and its corporate culture."

There must come a point at which companies in the single currency area become so cheap that US firms will be falling over themselves to snap them up. But, even then, hurdles litter the road.

To begin with, many euro-zone corporate gems are still untouchable. Take-overs of Deutsche Telekom, France Télécom, KPN or Electricité de France would be impossible without a huge political fight. UBS Warburg estimates that the value of EU unprivatised telecoms stock alone comes to more than €250 billion.

Secondly, as Dannesboe points out, even if the FDI tide does start to turn it may not drive up the value of the euro as much as it could. "For some reason, when a German company buys a US firm, they pay in cash," he says. "When a US company buys in the euro-zone, it often does it with shares. Euro-zone investors are reluctant to accept euro-zone shares."

Which brings the argument back to the oft-stated demand that the euro zone must undergo thoroughgoing 'structural reform' to boost the currency's exchange rate. In Prague, Summers called for "continuing structural reforms in Europe to increase the productive potential and to raise the incentives for job-creating capital investments in the continent".

Neither the Americans nor the ECB will be willing to carry on spending their reserves on an operation to support the euro without concrete action from governments to make their markets more attractive to foreign capital.

But all the signs are that little more will happen until the end of 2002. Schröder has used up all his political capital driving tax reforms through the upper house of the German parliament, Jospin showed only recently how little appetite he has for a scrap with organised opposition, and Giuliano Amato is just keeping the Italian premier's seat warm.

Europeans may just have to start listening to the economist's argument, and learn to love a weak euro. Either that or welcome deep-seated reforms to tax, pensions, and state-owned sectors without taking to the streets.

Major analysis. The euro's recent collapse prompted G7 intervention to bolster its value on world markets. But this was no ordinary currency crisis.