The Sick Money Of Europe
For most of its brief 16-month life, the euro has been falling. On Jan. 24 it tumbled below parity with the dollar, and on May 3 it broke through the 90 cents barrier, sliding to 88.87 cents. "I'm very concerned," says Martin Hufner, chief economist at Hypovereinsbank in Munich. "The market is not willing or able to arrest the slide."
A torrent of money has rushed out of Europe as businesspeople and investors have fled the Continent's anemic economies. Last year alone, a net $160 billion in investment cash left Europe. The $13 billion-a-month outflows made the euro a one-way bet on foreign exchange markets. The missing billions poured mostly into the U.S.--its hot stock markets and bubbling economy.
But that may be changing. In January and February, the stream of cash to pay for mergers turned in Europe's favor. Two months don't make a trend, of course, but there are reasons to think that it could continue. Growth in Europe is quickening (table), while inflation appears to be rising in the U.S., so the the Federal Reserve may hike interest rates sharply--finally slowing growth. "When the Fed becomes more aggressive in tightening, investors will start to question the great U.S. story," says Joachim Fels, European economist at Morgan Stanley Dean Witter in London. Fels is still forecasting a euro worth $1.15 by yearend, which he admits is a "stretch."
Most observers are much more pessimistic. They think that the euro's image is so badly dented that economic fundamentals alone won't turn the tide. If the euro crashes and burns, confidence in Europe will be wrecked. And that could prove costly. The region's burgeoning capital markets have been a big success so far. Companies raised $81 billion in euro-denominated debt in 1999, twice the previous year's haul. But there are signs that the euro's weakness is blighting this market. Total euro debt issued in April was just half of what it was the year before. "If the euro continues to fall, that will be negative for the development of the corporate market," says Stephen Penwell, Morgan Stanley's head of European fixed-income research.
UNFAZED. But so far, European governments have not seemed unduly worried about the exodus of money, though it has meant lost investments. Many figured that a weak euro would make their exports more competitive--a big plus when their countries faced slow growth and double-digit unemployment. But now that Europe's economy is recovering, governments' benign neglect may prove to be both short-sighted and costly.
That's why many analysts are calling for big policy changes. Some want the European Central Bank to lift rates dramatically, believing that ECB President Wim Duisenberg has sat on his hands way too long. "There has been a major policy screw-up in the last three months," says Jim O'Neill, chief currency strategist at Goldman Sachs International in London.
A senior ECB official admits that the bank has drifted into a nasty predicament. If the bank raises rates now, it will be criticized for choking off the recovery. If it leaves them unchanged, the euro might linger at current levels or even slide further. The official admits the ECB probably should have shocked the markets with a couple of 0.5% hikes rather than the series of 0.25% increases it has made to reach 3.75% on its key rate. "The markets would have taken notice more," he says.
Another move that would grab attention, some analysts say, would be for the ECB to ditch some of its massive non-euro reserves. That would show that the central bank, at least, has faith in Europe's currency. The euro-zone central banks and the ECB are holding about $228 billion of such reserves, mostly in dollars, says Goldman's O'Neill. But the ECB needs no more than $72 billion to cover payment needs. O'Neill is calling for a dollar sell-off of $60 billion to $90 billion over the next six months. "Why should the rest of the world buy euros if the ECB won't take its own money out of the dollar?" he asks.
But the ECB worries, rightly, that such a major intervention would just waste taxpayers' money. Officials believe that buying euros could only help strengthen the currency if the U.S. joins in--very unlikely at this point.
The ECB's inability to act forcefully one way or another has seriously damaged its credibility. Indeed, it seems unlikely that the reputations of Duisenberg and his fellow board members can easily recover from the knocks they have taken. "The ECB is like a rabbit caught in the headlights," says a German institutional investor. "It doesn't know what to do."
Certainly, that has badly spooked some of the euro's early fans. Many Japanese and Asian investors wholeheartedly bought into the story that the euro would quickly become a rival to the dollar and helped drive up the value of the new currency before its Jan. 1, 1999, launch. But now, according to Yukiko Hashimoto, a vice-president on the foreign exchange sales desk at J.P. Morgan & Co. in London, they are thoroughly turned off after absorbing some brutal lessons and losses. "I think Japanese investors are too scared to get into the euro at this point," she says. "They say, `If the euro is really going to go up, let's wait for it to reach 95 cents."'
Indeed, central bankers in Asia, who control about $600 billion in reserves, have limited their exposure to the euro because of its poor performance. "Nobody buys the euro outside of Europe because it is such an underachiever," says Michael Dee, a managing director of capital markets at Morgan Stanley Asia Ltd. in Hong Kong.
FINEST HOUR. The funny thing about currencies, though, is that they tend to strengthen at times like this, when they are earning nothing but scorn. "There has never been such a universally negative view toward the euro as there is now," says Raymond Dalio of Bridgewater Associates, a Westport (Conn.) investment firm that manages $22 billion in currencies and bonds. "And a universal view in any market leads to an extreme reaction." Remember what happened to the Japanese yen in 1995? It was trading at 80 to the dollar in April and at 105 by September.
No one can say when the euro turnaround will begin. But to a growing band of contrarians, it's easy to imagine all those investors without a euro to their name one day falling over each other to buy some. It would be a classic about-face: unsettling, unruly, disruptive for businesses, a challenge for fund managers. The mere possibility of it has the ECB worried. "We think the euro should be stronger," says a senior official. "But we don't want it to strengthen suddenly, and that's what we fear could happen when the tide changes."
At some point, of course, the euro will begin to reassert itself. The prospects of the European Central Bank restoring its credibility aren't so sure.