The Euro: We Have Liftoff!

The new currency's strong launch is hailed around the world

The mood was giddy just about everywhere on the Continent as Europe's new currency, the euro, made its grand debut. In Frankfurt, dignitaries ceremoniously launched Germany's first euro-denominated stock trading on the morning of Jan. 4 as strobe lights flashed and the uplifting strains of Beethoven's Ode to Joy wafted through the bourse. Stock markets from Frankfurt to Paris to Milan responded to the euphoria by soaring more than 8% over the next three days.

The triumphant music seems appropriate, at least for now. After years of skepticism from critics on the Continent and abroad, Europe has its common currency. To the delight of its champions, the euro is a robust newborn, not the pipsqueak its doubters had expected. The $1.17 kickoff rate set by European authorities already includes a rise of about 10% in major European currencies during the runup to the new currency this fall. According to J.P. Morgan, the euro will climb a further 12% by yearend, to $1.31.

NEW GAME. Even without such a dramatic rise, the euro is a force to be reckoned with. The long-term effects of melding an 11-nation, $6.5 trillion, 290 million-person region into one economic and financial bloc are giving Continental Europe new cachet. Companies around the world are eager to exploit what they hope will become a true single market. If the euro acts as a catalyst for regulatory and economic reform, nudging the Continent away from its socialist-flavored capitalism, Europe could become a competitive power, attracting new investment from around the globe.

Already, the euro has instantly created a $2 trillion government bond market, 20% bigger than the U.S.'s, and should over time expand anemic Continental stock markets and corporate bond markets to nearly U.S. dimensions. That potential makes Europe a compelling investment story for foreigners and locals alike. "Now that there is no fragmentation of European currencies, we expect to see enormous investment flows into the new currency," says Luis Manas, deputy chief financial officer at Spanish oil company Repsol.

That prospect changes the game for Washington as well as Wall Street. From now on, the world's central bankers must watch the euro while setting their own monetary policy. The U.S. Federal Reserve may find that the upstart challenges the dollar as a reserve currency. That could alter monetary policy: With every move it makes, the Fed would have to take into account the effect on the dollar-euro rate. Tokyo, instead of monitoring just the crucial yen-dollar relationship that regulates the Japanese export machine, must now keep a nervous eye on the euro-dollar link as well. On the bright side, a strong euro will help Japan export more to Europe.

Underpinning the new currency's initial strength are potent economic fundamentals. Economic growth in the euro zone is expected to rival the 2% rate projected for the U.S. this year. And despite the falloff in Asian demand, Goldman, Sachs & Co. expects the region's current-account surplus to hit $109.6 billion, slightly more than last year. That compares with the punishing $250 billion-plus deficit projected for the U.S. "There will be upward pressure on the euro against the dollar for the next year or two," predicts Richard Portes, president of the Centre for Economic Policy Research in London.

At the same time, the euro virtually ensures that European governments keep their fiscal houses in order. Under euro zone membership rules, national deficits must be less than 3% of gross domestic product. Meeting that rule drove inflation in the region down to 0.9% late last year, compared with 1.7% in the U.S. "I'm still bullish on the European economy," says Leonhard Fischer, a board member at Germany's Dresdner Bank. "Despite all the troubles in the world, I think that in Europe the dynamics of the euro will take over."

POLITICAL BACKLASH? A strong euro would be welcome in most of the rest of the world, too. It would ease the economic crisis in Asia and other emerging markets by helping make companies there more competitive when selling to Europe. It also would lessen the strain of the trade deficit on the U.S. economy by giving American exporters a similar boost.

But there's a dark side to those dynamics. For Europe to prosper, the euro can't soar too high. A too-strong euro could increase strains inherent in the new monetary union. The euro bloc throws together nations with vastly different financial traditions and growth prospects, under one low interest rate tailored for slow-growth Germany and France. The current boom in fast-growth nations like Spain and Ireland could turn into a Japan-style bust if it lasts too long. And rigid labor regulations mean that pockets of high unemployment could crop up in Germany and France at the first hint of recession.

If that happens, pessimists fear that Europe's new left-wing governments will abandon fiscal prudence and go back to their old tax-and-spend policies. That in turn will undermine global confidence in the new currency and send investors fleeing. "How we manage our economy and how Europe manages its economy will ultimately determine the euro's value," predicts Deputy Treasury Secretary Lawrence H. Summers.

Another danger of a supereuro is political backlash. Leaders in Germany and France, which account for more than half of the euro zone's GDP, fear that by depressing growth, business investment, and consumer confidence, a too-strong currency could stall the Continent's already dicey economic recovery. That's one reason German Finance Minister Oskar Lafontaine is calling for a formal trading band to forestall huge swings between the euro, dollar, and yen. U.S. officials reject the idea, but the Japanese are entertaining it, prodded by the Germans and French.

Indeed, the left-of-center governments that have come to power across Europe in the last 18 months are counting on a euro-related boost to help slash the region's unemployment rate, which averaged 11% last year. A supereuro could slam European exports, slow business investment, and kill off the consumer recovery the politicians are counting on. Goldman Sachs equity strategist Peter Sullivan figures that a 15% rise in the euro, to about $1.35, would be enough to begin stunting corporate profit growth and clobber booming Continental equity markets.

TAKEOVER BINGE. At least to begin with, the euro is likely to energize Europe's economy. Already, restructuring is rampant among its biggest companies. The massive mergers rumored to be imminent in the auto industry--with BMW, Volvo, and others believed to be takeover bait--are just one sign of the rush to build greater critical mass. One reason: For carmakers, consumer goods companies, retailers and others, the single currency is suddenly making prices transparent across national borders, unmasking protected profit havens, and forcing the overall level of prices down. Global players such as Volkswagen and DaimlerChrysler can better withstand the strain.

Plus, by boosting the balance sheets and share prices of European companies, a strong euro could accelerate Europe's buying spree in the U.S. Some analysts think Daimler Benz's $94 Billion takeover of Chrysler and Deutsche Bank's $9 billion bid for Bankers Trust were signs of a huge takeover binge to come. Germany's Dresdner Bank and the Netherlands' ABN-Amro are already scouting the U.S.

At the same time, U.S. companies in many sectors are mapping massive expansion plans. Investment banks such as Morgan Stanley Dean Witter, Merrill Lynch, and Goldman Sachs have moved whole teams of bankers from New York to Europe. In three short years, they have come to dominate European mergers and acquisitions. In retailing, Wal-Mart Stores Inc. has bought up two German chains and is building a major European presence. Long-entrenched U.S. companies know they have to beef up. "My guess is [the euro] will pull investment capital into Europe," says Mike Burns, the new head of General Motors Corp.'s European operation.

Euro skeptics may be underestimating the new currency's appeal in Asia, too. Tokyo-based Warburg Dillon Read economist Kazuko Mizuno predicts that Japanese life insurers, for instance, will quickly start shifting some of their massive investments into euro-denominated bonds. Toyota and other Japanese companies have announced big new investments in the euro zone, because they think the new currency will boost the Continent's economy.

WILD CARD. Buying by Asian central banks could also buoy the euro as they swap euros for dollars in their reserve holdings. The central banks say they plan to monitor the euro for now, but "there will definitely be some switching if the euro turns out to be a firm, stable currency," says Friedrich Wu, chief economist for state-owned Development Bank of Singapore. Some analysts think the banks will start buying sooner and faster than expected if the euro shows signs of a sustained rise against the dollar.

The wild card in the euro's prospects is interest rates. With U.S. growth at last projected to slow, to about 2% in 1999 after four unexpectedly strong years, economists figure that U.S. Federal Reserve Chairman Alan Greenspan will continue cutting rates from the current 4.75%. At least initially, the European Central Bank also has been easing. It orchestrated a cut to the current 3% in December, even before it officially took over monetary policy. Many economists expect another cut this year. Deutsche Bank thinks euro zone rates could go as low as 2.5% by midyear. That would make the euro a less attractive investment than the dollar even if Greenspan eases considerably.

But the ECB is trying to use its accommodating stance as a carrot for European policymakers. The bank continues to call for more deregulation and other economic reforms. "When the central bankers eased in December, they were saying to the politicians, `You have to follow through with structural and labor market reforms,"' says Frankfurt-based Bank Julius Baer economist Gerhard Grebe. European central bankers know that a new currency alone won't cure what still ails the Old World. But for now, it's a pretty good tonic.

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