Online Extra: The Euro: Born to Be Weak?
By Peter Luxton, S&P MMS
Over its short life, the euro, the single currency of the eurozone, has continued to disappoint. Early-year rallies have quickly turned sour, and 2001 is no exception. While the currency may be above its lows for the year, another sell-off can't be ruled out if it sticks to its past pattern of behavior. Each time, different "excuses" have been used to explain its failure to garner sustained support. But the longer this goes on, the more the question arises as to whether the euro itself is endemically a weak currency.
With an economic size rivaling that of the U.S. and over double that of Japan, the eurozone hoped that its new currency would be a potential rival to the greenback. The euro was predicted to become a powerful global medium. Almost three years after its launch, the initial hopes have been shredded by the currency's repeated tumbles and both official and private investors' continued, clear preference for the dollar.
NO EXCUSES LEFT.
The euro's underperformance is most notable against the U.S. dollar. After kicking off at the top of 1999 at around 118 U.S. cents to the euro, it ended its first year just above parity. The start of a January, 2000, rally soon petered out, and by May, the euro was around 90 cents. A subsequent push back above 95 cents then fell apart as the currency rushed to record lows of under 84 cents. Even currency intervention by G3 (U.S., Japan, and England) central banks and the euro's follow-through charge to January, 2001, highs of 95.92 cents failed to be sustained. It dropped back to 84 cents in early July. The recovery since then is now under threat, and observers experience a familiar sense of deja vu.
Even slowing U.S. growth that morphed into a recession, the Nasdaq tech wreck, and a halt of massive merger and acquisition financial flows from the eurozone to the U.S. have all failed to provide more than a short breathing space for the euro against the greenback, thus negating all the favorite excuses the currency's defenders cite to explain its weakness. The euro currently buys only 90 cents. Higher money-market interest rates in the eurozone and a shrinking of the U.S. Treasury's benchmark 10-year yield premium over the Bund (10-year German government bond) equivalent have not boosted the euro against the dollar like they did the German mark previously.
Even given the dire economic, financial, and policy record in Japan, the euro has failed to make any headway against the yen. From a starting level above 130 yen to the euro, the currency steadily declined to lows of around 90 yen by October, 2000. The subsequent recovery to 112 yen has since faded, and the pair has remained range-bound ever since. However, in this case, the huge underlying Japanese current-account surplus/net international creditor position has provided a powerful influence support for the yen.
Such poor performance may suggest that the euro is endemically weak. Partly, this may be because it's still a "virtual currency", something that will change at the start of next year with the introduction of euro notes and coins and the disappearance of the residual currencies. In Germany, this occurs at the turn of the year, although most other European Monetary Union countries will have a phase-in period of up to two months.
However, while this may ultimately build domestic confidence in the new currency, it does little to alter the other problems that continue to afflict it. Indeed, the EMU itself is a unique experiment, a monetary union of a large number of diverse sovereign countries that will inherently contain the seeds of its own policy conflicts -- and the currency's weakness. Furthermore, the monetary union aims ultimately to encompass Emerging Europe -- twelve candidate countries ranging from heavyweights, such as the Czech Republic, Hungary, and Poland, to to tiny Malta and Cyprus, and eventually the laggards of Romania and Bulgaria. The expansion has its own set of problems, and the euro may well continue to punch below its weight vis-a-vis the region's economic power in the world.
Perhaps the euro's boosters underestimated the impact of monetary union's complications on the currency, hence their too-high hopes and too-ambitious expectations. Most estimates place the euro-U.S. dollar competitive exchange rate in a 1.07 to 1.16 cents range and euro-yen around 135 yen, which leaves both pairings undervalued by a substantial 20% at present levels.
However, S&P MMS' far more modest estimates place the euro at around parity against the greenback. And a euro is expected to buy just 100 yen. Using this as a yardstick, the currency is around 9% overvalued against the yen, and far less undervalued against the greenback. Indeed, if our estimates are taken as the ballpark, the euro seems weak only because of the high hopes at its launch.
Luxton is S&P MMS' global economic adviser.
Standard & Poor's MMS real time analysis of the global fixed income, forex and emerging markets is available on the Web at www.GLOBALMARKETS.COM