Parity worries hide real growth story

Date: 22/07/1999

By Tim Jones

MARKETS move so fast that by the time you read this sentence, the euro may well have struck parity with the US dollar.

This has got Eurosceptics excited and others, who finally felt they could walk tall in the world with a currency bigger and better than the Americans', very depressed.

Since its January launch, their strong, proud currency has looked limp and has embarrassed them in public.

Worse still for euro-enthusiasts, the currency's stumble since then - losing 15% against the dollar, 12% and 7% against the yen - has gone hand in hand with an equally calamitous drop in its popularity with the public.

The day parity comes - and it probably will, with the euro tottering for the past three weeks in $1.01-$1.03 territory - newspapers in Germany, the UK, Denmark and Sweden will have a field-day. The upshot will be a euro even less loved than it is today.

But, in reality, a one-for-one euro/dollar swap means nothing, except perhaps a great opportunity to lock rates and create a single western currency. As one 'spot' currency dealer at a London bank put it in a mad moment of frankness: "It is not very dramatic; traders just want to see parity on their screens."

Parity, like the 2-mark dollar or the $2 pound, is known in the financial markets as 'psychologically important', which usually means not very important at all. The European Central Bank and its national satellites know this.

"The euro is weak only in relation to the dollar," said Bundesbank council member Klaus-Dieter Kühbacher last week. "Within Europe it is exceptionally stable; we do not really need to care about external weakness."

The ECB's 17-strong governing council, which meets again in Frankfurt next Thursday (29 July), will be expected by the ill-informed to do Kühbacher's caring for him by sanctioning intervention in the foreign exchange markets or even raising the refinancing rate it cut to 2.5% three months ago. It will do none of this.

To see why, parity should be translated into national rates, such as 6.56 French francs, 1.96 marks or 1,936 lire: all places where the euro zone's three major currencies have been in the not-so-distant past.

Parity should not be fetishised, as German government adviser Horst Siebert said in a remark last week that he quickly lived to regret. "We should have enough imagination also to look at value below parity," he said, and promptly drove the euro down a half-cent to $1.0120.

But even looking at the equivalent national exchange rates fails to tell the whole story. "These rates have a different effect on euroland," says Commerzbank economist Bernhard Pfaff. "Germany would have imported inflation pretty quickly, but euroland does not because it is a huge and much more self-contained single market."

Nevertheless, it is certainly not immune to inflationary pressures - and this is where the real story of the moment comes in. While newspaper headlines have concentrated on the euro's daily 'lifetime lows', highly significant changes have been going on in euroland's debt markets; processes reflected in ECB President Wim Duisenberg's warning last week that the idea of raising interest rates is "gradually creeping into our considerations".

Until now, the euro has fallen against the dollar in tandem with a widening of the gap between euro-zone interest rates and those in the US. At the short end of the market - usually measured by the interest rates on debt to be repaid within three months - the US/euroland 'differential' widened to three percentage points. The ten-year bond spread hit historic highs of 1.7 points.

The US economy's phenomenal eight-year-long growth spurt - with some year-on-year increases of as much as 6%, the attractions of the deep, liquid and seemingly unstoppable New York stock market, and great returns on holding American state debt have sucked cash out of the euro area.

But, over the past month, this tide has started to turn. The US/euroland ten-year bond spread has narrowed from 1.7 to 1.2 points and interest rates on all debt maturities (the 'yield curve') has steepened, suggesting that investors are starting to believe that inflation could accelerate in the euro area.

This is not, it must be stressed, because the falling euro is importing heavy doses of foreign inflation. This month's ECB bulletin stressed that the 9% fall in the external value of the currency, measured against the currencies of the zone's major trading partners, had little effect either on import prices or on export growth.

Pundits have short memories. It is less than two years ago that the south-east Asian tigers crashed and took their currencies with them. A new Crédit Lyonnais study into the continuing impact of the Asian crisis on 37 French industrial and services sectors revealed that textiles and steel are still fire-fighting against cheap far-eastern imports.

If there are external inflationary pressures, they come from a significant pick-up in commodity prices across the board rather than the plunging euro. It is no longer just crude oil setting the pace; black gold has been joined now by copper and pulp.

The signs of future inflation, which are driving up bond yields in euroland, are in fact good news. They suggest that the long period of subdued euro-zone economic growth could finally be coming to an end, despite yet more evidence from Germany that industrial output had dipped 0.2% in the second quarter.

Euro-area business confidence has risen for two consecutive months, while a break-down of Germany's weak first-quarter gross domestic product data indicates that the pain was concentrated on net exports and the building up of stocks of manufactured goods. Domestic demand - measured as investment, consumer spending and government consumption - was fairly strong.

Commerzbank's Pfaff sees another euro-supporting phenomenon underway: the long-awaited reallocation of institutional investors' portfolios suggested by this month's poll of fund managers by US investment bank Merrill Lynch.

"A lot of investors looking at the US stock market in particular, but also improvements in Japanese equities, have bought heavily," says Pfaff. "But we could be looking at a turning point as international investors see that the share of European equities and fixed-income products in their portfolios is too low."

Observers had better enjoy parity when it comes. It promises to be as short-lived as the August eclipse of the sun.

Main refinancing rate: 2.5% (confirmed 15 July)

Deposit rate: 1.5%

Marginal lending rate: 3.5%