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The waning euro and world economy

R. G. Bhatnagar

THE EURO, which lost sometime back nearly a quarter of its value since it was introduced in January 1999, further dropped to historic lows (within a fraction of a cent) against the dollar, following comments by the European Central Bank (ECB) presi dent, Mr Wim Duisenberg. The ECB boss said the bank would not intervene to support the euro if the crisis in East Asia caused the currency to weaken. Mr Duisenberg's comments -- reported in The Times -- immediately prompted traders to sell the currency. The euro quickly dropped to $0.8482 -- a third of a cent above its lifetime low of $0.8440.

The euro's decline is causing problems not only to central bankers and finance ministers across Europe but elsewhere too. Even the US, no advocate of euro, is viewing the development with considerable concern and is planning various steps to prop up the beleaguered currency.

The currency started its downward march against the dollar following the disturbing German business confidence reports indicating the prospect that the euro zone's largest economy may be slowing. This was followed by much less than expected growth in Ita ly's gross domestic product in the second quarter of the year and persistent forecasts of economic decline in other countries of the region. As if this were not enough, the Danes rejected the euro in referendum in the last week of September, voting decis ively to stay out of the European monetary union.

It may be recalled that the decline of the euro -- quoted at $1.17 when it was introduced in January 1999, and which had so far existed chiefly as an accounting unit -- could not be arrested despite five interest rates hikes this year by the ECB. T he euro was hammered in part because the booming US economy was seen as more attractive for investments though Europe's economy has generally been healthy. The rising oil prices have also contributed to the pressure on euro in no less measure. Analysts feel that rising oil costs may chip away at euro-zone growth forecasts if the prices do not decline appreciably in the near future, thereby increasing the pressure on currency still further, because EU governments' budgets were calculated with expectations of oil costing $26 per barrel. The attention-grabbing blockades in France, Germany and many other European countries demanding government action to lower gasoline prices, point to the mischief caused by the ri sing oil prices.

Though the euro's poor showing against the dollar has come as a welcome relief to critics and opponents of a common currency for Europe, especially Britain, its decline has a specific implication for the EU countries, particularly in the context of skyro cketing oil prices. As the international oil prices are quoted in terms of dollar, economists forecast rising oil prices would mean $11 billion more out of German consumers' pockets alone this year and $16 billion more than what was planned in 2001. This would mean lower GDP growth which may, in turn, trigger inflationary forces. The euro zone is particularly sensitive to fuel cost increases, as more of its goods are delivered by truck than say in the US. The extra cost would inevitably show up in price s of products the truckers deliver, sending inflationary pressures in the economy.

Concerns are being expressed in the US too about the adverse impact of a falling euro on the American economy, even though US imports from the euro zone and travel have become cheaper. American multinationals are already reporting that the weak euro has started dragging down their profits and the lower performance is sending shudders through the stock market. Particularly vulnerable are companies selling to consumers such as McDonald and Gillette and hi-tech companies increasingly dependent on sales to the Continent.

The slumping euro is hurting US exporters too. The farther the currency drops against the dollar, the more expensive the US exports become. and the less competitive they turn out to be. Not surprisingly, US exports to Europe fell sharply in July. As the US economy shows signs of slowing down, American companies will increasingly look for growth in Europe and Asia. But the weak euro is putting Europe's growth in danger, and Asian economies, which have been hit hard by higher oil prices, are also unlikely to become the engine of global growth any time soon.

In this situation, it is natural that there is considerable demand for the US taking part in a multi-nation rescue operations for the European currency. Despite the reluctance of the US Government to intervene in the currency markets in an election year, the fallout from the constantly shrinking euro has so perturbed some American corporations that it has become difficult for the Government to resist. The international community accordingly made a determined bid to prop-up euro. The US Treasury Secretar y, Mr Lawrence Summers, and his Japanese and Canadian counterparts with a group of the seven richest countries, decided on September 22 to lend a helping hand by intervening in the currency markets and expressing support for a stronger euro.

The international intervention did help euro to weather the crisis but only temporarily. After rallying marginally, the euro's value started eroding again. An ECB council member, the Austrian central bank governor, Mr Klaus Liebscher, conceded recently t hat the intervention was a ``possible, temporary measure and does not solve the basic problem''. The strength of the US economy and its comparatively high interest rates have made it more attractive for investors to put their money there.

The euro's fall has also implications for Asian economies, including India. As South-East Asia recovers from one of its worst economic downturns, it had, inter alia, targeted European markets for increased exports performance. But the weak euro not only puts a question mark on the anticipated robust European growth but would also result in their exports becoming costlier and, consequently, less competitive. It was in this context that Mr Michael Mussa, chief economic advisor to the International Monetar y Fund, said the weak euro was beginning to cause wider problems. It would complicate efforts to rein in US current account deficit and it could undermine Japan's economic recovery. He said, ``I used to say the weak euro is more of an embarrassment than a problem, but it has become more of a problem''.

As for India, due to the considerable decline in rupee as compared to dollar, it is unlikely to affect its parity with the euro to any appreciable extent. But the Indian economy may be adversely affected if the European economy slows down as a result. In dia has been particularly targeting its exports at Europe especially in computer software.

How does a weak euro impact other major currencies? It was observed that the weak euro was dragging other currencies down with it -- such as the pound, the Australian dollar and the South African rand. That was turning into a global problem since weak currencies make imports more expensive and, therefore, boost inflation. Second, the strength of the US dollar was starting to cause problems for US companies. A strong currency makes exports more expensive and could, therefore, damage sales and prof its. The US government also apprehends trouble on the Wall Street as a consequence of the weak euro, which it would like to avoid at all cost, in view of the presidential elections in November. Hence, it is more willing to encourage a stronger euro an d a slightly weaker dollar. However, Washington will also be at pains to emphasise that it wants to maintain a firm US currency.

With confidence in the troubled currency flagging and the stubbornly high oil prices, the ECB again resorted to hiking interest rates a quarter of a point to discourage inflation in the 11 nations using the euro. By raising interest rates, the ECB aimed to deter inflation and bolster the currency. But the action could also slow economic growth by making it more expensive for business sectors and industry to borrow money to hire new workers and step up production. Mr Duisenberg did raise fears about the impact of rising oil prices on the European economy and hinted that this might prompt the bank to raise interest rates again.

Notwithstanding the battering received by the euro, the economists on the Continent are inclined to believe that the currency is undervalued. The German economist, Mr Grebe said, ``Even after the current international intervention, the euro is totally un dervalued against other major currencies such as the dollar, yen and pound sterling. It is not in line with the current and future potential and productivity of the euro zone and its contribution in fostering competitiveness and efficiency among the user s are being ignored.'' The euro crisis, the proponents of the currency maintain, is shaped more by perception and emotion than by performance.

Mr Duisenberg also described the euro as a success but said he was disappointed by how much attention the media and public pay to the euro's slide. ``In my view,'' he said ``it is a mistake to evaluate the experience so far by primarily looking at the de velopments in the external value of the euro. This tends to eclipse the overall bright picture.'' But there are others who maintain that the fact that the international intervention was needed at all, even to support it temporarily, is a sure sign of the weakness of the euro. In fact, things have got so bad that the euro has become a problem outside of Europe. That was the reason behind the international intervention and one of the reasons that the Americans and Japanese were willing to lend a hand. The euro's weakness was becoming a problem for them as well.

Be as it may, the real proof of the pudding lies in eating. Only the next few months will show if the euro has the inherent strength to become a real engine of growth for the EU countries, at the same time contributing to the balanced economic growth of the world economy. Starting in January 2002, the euro is slated to cease to be a virtual currency used chiefly for non-cash transactions, and euro bank notes and coins will replace German marks, French francs, Italian lire and other national currencies o f the member-countries. Many analysts say the euro zone will be truly attractive to investors only when structural reform takes place.

(The author is former chief general manager, State Bank of India.)