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Fall of euro and the economic-history factors

R. Parthasarathy

EURO, the common currency of the 11 countries of the European Monetary Union (EMU), has been in the news recently because of its steep slide vis-a-vis the dollar. Its value in relation to the dollar fell as low as $0.8917 on May 9, whi ch is within a cent of its earlier record low. The euro's fortunes have been fluctuating since its inception on January 1, 1999. The present fall came immediately after the meeting of the Eurozone Finance Ministers which did not make any spectacula r move for its recovery.

Currency traders in Europe were still hopeful that the European Central Bank would intervene if there is no improvement. In the last couple of days, there has been some recovery amidst rumours of some kind of an intervention which restored market confide nce in the currency. For a better understanding of the euro's problems, the historical and economic factors that underlie its origin and performance muse be looked at.

The euro came into being more than 15 months back under mixed and complicated set of conditions. On the one hand, convergence efforts to create the EMU, particularly in the fiscal area, had helped to lower inflation in the 11 EMU-states and interest rate s to historically low levels. On the negative side, the growth in the region, which had just started to recover after several years of disappointing performance, slowed down as a result of the emerging market crisis of 1998, particularly in South-East As ia, which hit Europe more than the US. Moreover, the impact of this crisis, as also the general economic conditions, was not uniform among the EMU countries.

However, thanks to the liberal monetary policy and the fiscal consolidation of 1999, domestic demand picked up, limiting the extent of deceleration. With the improvement in the external environment in 1999 second half, growth started picking up in Europe . As the Organisation of Economic Cooperation and Development (OECD), in its February 2000 policy paper, put it, ``the new regime's debut is commendable, especially when recalling the gloomy predictions of some sceptics and taking into account that the f irst year has been a year of learning-by-doing for all agents. The policy trade-offs facing the European policy-makers are harsher in some important ways than those confronting their counterparts across the Atlantic, because of the deeply ingrained labou r and product market rigidities.'' Further, the fact that the euro is not the currency of a single nation, but commonly accepted for the 11 EMU-states, each with its own sovereign rights and obligations and different levels of economic performance, bring s its own set of problems. In a nutshell, the strength of a currency depends on the economy of the region and there has also to be a period of harmonisation of economic policies to restore confidence in the euro.

Economic performance

For the reason's mentioned above, the Euro was born under the most sluggish economic performance in the winter of 1998. However, this was offset by a pick-up in the domestic demand and easy credit conditions in mid-1999. Lower interest rate spurred investment activity in 1999 and despite the occasionally worsening business confidence, the investment remained steady in the whole of Europe. A depreciating euro also had its beneficial effects in that exports picked up. The real GDP growth expanded towards the third quarter of last year. A real problem in assessing the trends is the relative dearth and uneven quality of euro area data and the tardy progress towards implementing the superior system of national accounts which involves considerable revisions of the key macroeconomic series. The EU has to overcome the teething problems of this transition in measurement. Unlike the US or the UK, which have uniformity as single states, the effort at bringing about uniformity in concepts, measurement and reporting of statistical entities among the eurozone countries is fraught with difficulties.

In contrast, employment measurement in the region per unit of output growth has improved in the recent past -- a sign that labour markets are becoming less rigid with flexible forms of work contracts emerging, improved coverage of employment in th e hidden economy and short-run impact of government-funded programmes. As a result. unemployment now stands at around 9 per cent compared to the high of 11.5 per cent five years ago.

However, it is also true that the labour market performance remains uneven among the countries of the region mainly as a consequence of the variation in the progress of reforms. Starting from the launch of the euro, price inflation remained below one per cent for several months with major country-wise differences in high energy and food prices, while competition kept prices down in the telecommunication area. Asset prices, notably stock market prices and real-estate, rose in the prosperous countries.

Effect of monetary policy

The way the euro is the functioning, national currencies of member-countries are apparently different denominations of the euro. There has been spectacular progress in the use of the euro in the European bond markets, even rivalling the dollar. The same cannot be said of the equity market transactions or the bank lending market. Further, capital market integration and improvement in allocative efficiencies, still an area needing attention, will help the harmonisation effort. Acco rding to Pedro Selbes Mira, Member of the Commission for Economic and Monetary Affairs: ``The way the monetary policy was run during the first year of the existence of the monetary union was also a genuine success. We should attach greater impor tance to these factors of the euro's introduction and use than to short-term fluctuations in the currency's exchange rates. The external value of currencies depends on the range of economic factors and the expectations of dealers concerni ng changes in those factors.

``In the case of the euro, its depreciation since the beginning of the year merely reflects a shift in the expectations of the market. The economic situation in Europe and the US has been different from that expected before January 1, 1999. The important factor to bear in mind is that these movements in the exchange rate of the euro are not linked in any way to the problems in economic policy. On the contrary, the credibility of the euro is underpinned by the existence of a balanced policy mix in the eu ro zone.''

As worries about inflation gave way to deflation fears, to counter the slowdown in growth, the credit policy was accommodative with cuts in refinancing rates in the first half of 1999. As an OECD analysis states, ``the strategy has been relatively eclect ic and has been applied rather pragmatically.'' The conduct of the policy was less focussed on monetary aggregates alone but took note of other indicators.

One must also realise that there are unique and unavoidable complexities of the institutional set-up which cannot be compared to the Bank of England or the US Federal Reserve, which themselves have their own differences. Even so, there are attempts withi n the eurozone to move towards a harmonised policy objective, say, of defining a range for money growth and more symmetric inflation target; possibly around one to two per cent. It is expected that at some stage, not too far in the future, the European C entral Bank might publish macrocconomic models and

ideas on monetary transmission. Again, as the OECD analysis indicates, ``The new regime is in its infancy, and some acid tests still he ahead, including when headline inflation approaches or exceeds the 2 per cent mark.'' Another feature is that whereas the monetary policy is centralised, the banking operations and supervision are still a matter of state control and, thus, remain decentralised. Supervision standards and practices vary widely though some harmonisation has taken place in this area.

Fiscal policy

Fiscal policy remains a national prerogative, even more so than the monetary policy, where one can say that some measure of harmonisation has been attempted. However, multilateral surveillance has been enhanced as per the Stability and Growth Pact (SGP), which requires the Eurozone countries to achieve fiscal balance in the medium term. Some of the hopeful expectations of the OECD analysis are: ``The deficit and debt projections of the euro area as a whole are broadly in line with those in the initial programmes, consolidation is projected to continue, with the deficit shrinking to 0.8 per cent in 2001 and the debt ratio declining to just over 70 per cent. This would bring the deficit to levels last witnessed in the 1960s, but accompanied by a much higher debt ratio. The tax reforms under way in several countries would contribute to easing tax pressure...``Public expenditure would decline more rapidly and would end up 5 percentage points below its 19 93 peak, which constitutes welcome progress. While the modest pace of underlying consolidation may partly reflect `Maastricht fatigue', as well as concern in some cases to support aggregate demand, several countries remain uncomfortably close to 3 per cent deficit ceiling and quite vulnerable to adverse interest rate or other shock.''

Innovative methods of containing fiscal deficit within the mandatory three per cent level continues to occupy the attention of national governments. Using gold and foreign exchange reserves of central banks to public spending and further privatisation ef fort might help reduce public debt and deficits.

Reasons for Europe's poor performance

Why has the Eurozone performed poorly? It is believed that European living standards slowed down over the past three decades compared to the US. Moreover, in the light of product and labour market differences, certain reforms were felt necessary, if productivity levels were to go up and growth impulses strengthened. Microeconomic and structural rigidities that prevent better performance need to be addressed. According to an EMU survey, institutional reforms are necessary. Out-of-work benefits are generous vis-a-vis in-work income. Competition policies, wage bargaining arrangements against productivity gains, tax and benefit systems could influence favourably the overall degree of market flexibility and play a ke y role in improving economic performance. Differences in productivity and labour and product markets among euro-member countries need to be reduced and the process of harmonisation speeded up.

Nonetheless, one ought to recognise that there is a certain degree of dissimilarity in comparing euro region's economic performance with those of the US or the UK which are single sovereign nations subject to fairly uniform policy regimes. The first year of the euro has also been a year of high expectations which subjected the Eurosystem's performance to closer scrutiny than any policy of national central bank. This is particularly true when it comes to the exchange rate with the well-established dollar against which the euro was to compete for global supremacy!

The decline in recent weeks in the exchange value of the euro on a rational analysis, does not appear to be anything to do with economic fundamentals, even with adverse exogenous conditions, but it is rather a market sentiment. After all, one cannot forg et that in the early 1970s, when the fortunes of the dollar fluctuated in the face of large trade and fiscal deficits in the US economy, special efforts were mounted to restore its strength from outside, especially through support by pound-sterling contr oversies about overvaluation of the Deutschmark or, more recently, of the Japanese yen. For a new currency, such as the euro, the experience has not been disastrous to foreclose its success in world money markets.

There are methods by which confidence can be restored and the euro brought back to the normal level of exchange. One could be the European Central Bank reportedly considering a switch to a variable rate liquidity tender from its fixed rate regime. This c ould be an extreme remedy but one hopes that the present fluctuation in euro's exchange rate will be a short-term phenomenon that would correct itself once the market psyche settles down. The well-known money illusion in Keynes' terminology masks the eco nomic reality.

Implications for India

Notwithstanding the present crisis, the euro has emerged as the second-most important currency in international financial marketsafter the US dollar and ahead of the yen. In mid-1999, 48 per cent of international financial transactions was settled in US dollars, and 27 per cent in the euro. Only 10 per cent of the international obligations was settled in the yen. The euro has a higher share than the total volume in terms of the ECU -- its predecessor unit of settlement -- a nd even the national currencies of the 11 euro countries put together.

The European Union is India's important trading partner with close to 30 per cent of the trade being with this region. The EU has a combined population of 300 millions with the region's GDP being about $6 trillions. In terms of external economic interact ion of India, a third is with the EU, of which a major part is with the Eurozone. Apart from savings in intra-eurozone transaction costs, which a common currency bestows, it gives access to the region more easily than otherwise. Its stability is of prime interest to us for trade and financial transactions. It is, however, a long way for the euro to become a reserve currency, although that prospect cannot be ruled out in future.

The European Commission has brought out an informative booklet Your Business and the Euro: A Strategic Guide, giving country-specific case studies of impact assessment among the euro countries. It may be well worth the effort of corporates in India, havi ng substantial business interest with the Euro region, to conduct such euro impact assessment studies to prepare themselves for the fallout of currency fluctuations.

(The author is a New Delhi-based management and financial consultant.)