Little interest in propping up euro

Date: 10/06/1999

By Tim Jones

WHEN the euro falls, policy-makers are supposed to do something.

It seems that neglect of the external value of the five-month-old currency, whether benign or not, is unacceptable.

Hardly a day goes by without the euro falling to a new 'lifetime' low and commentators outside the financial markets calling for the European Central Bank, euro-zone finance ministers and even last week's Cologne summit to take action.

There are only four options available to monetary policy-makers when the currency they are tasked with protecting falls. They can do nothing because the currency weakness is actually helping exporters price their goods back into international markets; they can 'jaw-bone' or talk the currency up; or they can raise short-term interest rates to make the currency more attractive to global investors.

Finally, central banks can 'intervene'; selling a portion of their reserves of foreign exchange and precious metals and buying up the beleaguered currency. Since the same people who are calling for the ECB to 'do something' in defence of the euro also shouted the loudest for interest rates to be cut, option number three is ruled out.

Jaw-boning has conspicuously failed largely because currency dealers know that the ECB is not prepared to jack up interest rates to back up its tough talk. Short of the doing-nothing option, that leaves intervention as the commentators' favourite fire-fighting technique.

After all, the ECB has a fearsome stockpile of reserves worth €40 billion. If the executive board sanctions intervention, the ECB's dealers will get on the phone to their counterparts at the big commercial banks in Frankfurt, Paris and London, bid for euro at a set amount and keep bidding as the currency rises.

In a series of studies into the intervention policies of the US Federal Reserve, the Bundesbank and the Bank of Japan, University of Michigan economist Kathryn Dominguez found that central bank bidding had to start at about €100 million to be effective. "Once they go over that level, the size of the intervention matters less than the signal it sends to the market," she says.

" For example, if you are planning to tighten monetary policy but not right now or the government is pushing a tax cut or tax hike through parliament or Congress but it takes time to get politicians to agree, then coming into the market to buy the currency can send a strong signal that you are putting your money where your mouth is," she adds.

According to a former dealer at a Group of Seven central bank, intervention only works efficiently if it is used to back up a domestic policy change; whether this is an interest rate increase or a tightening of fiscal policy through tax increases or public spending cuts.

Otherwise, the effects of intervention will be short-lived. "You want to spook them," he says. "If you do it right, it doesn't even matter who it was who came into the market to buy the currency - the central bank or a big private buyer. You are trying to create a herd mentality so they all charge in the same direction."

This means the central bank dealing desk has to know its market intimately. "If the desk is good, they will have a feel for when the market is oversold," he says. This means that market dealers, anticipating that the currency will fall even further than it has already, will 'go short' or sell euro they do not yet have. To deliver on their deal, they are betting on being able to buy euro over the next couple of days at a cheaper rate and pocket the difference.

If the ECB placed orders for billions of euro when the market was short, the effects would in theory be sudden and brutal. Staring at their screens, the 'short' dealers would see the euro they expected to fall on the up and would scramble to cover their short positions, so pushing the currency up even further.

From her study with Harvard economist Jeffrey Sachs, Dominguez concluded that the most successful intervention was based on three pillars: surprise, coordination with other central banks and an unambiguous signal of future policy.

" This is the problem for the ECB," she says. "If they do want the euro to appreciate - which I doubt - then there is little they can do to convince the market that they will take further action to make it appreciate. If the markets were driving the currency away from its fundamental value, then it might work but there is little evidence that this is happening."

Currency economists have estimated that the 'fundamental value' of the euro, measured as the average exchange rate of the 11 constituent currencies over the past 20 years once inflation is stripped out of the calculation, is around $1.15. "That does not take into account the weakness of domestically generated inflation," says Michael Saunders of Salomon Smith Barney investment bank. "If the euro had stayed at $1.15, inflation in the euro zone would be next to nothing now."

The failure of the euro to respond to last week's tentative peace settlement in Kosovo suggests it is not fear of prolonged war or a lack of policy credibility in the single currency area which are driving it down. The euro is weak because the economy it represents is weak, particularly compared with its biggest alternative market for currency, bonds and equities - the US.

The interest rates on offer in the dollar market are just too good to refuse. Only two weeks ago, the difference between the yield on offer from ten-year US treasury bonds and their German counterparts widened to 1.54 percentage points; the biggest gap this decade and more than a point wider than last autumn. At the short end, rates diverge by more than 2 points.

If the euro collapses or stays below parity with the dollar for months, the ECB might consider spending its €40 billion. But, for now at least, they will keep it in the Eurotower vaults.

Sensitivity of the euro zone to:

Source: Organisation for Economic Cooperation and Development

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