Commentary: Why Europe May Be Forced To Drive The Euro Down

With Asian currencies held steady, the euro is bearing the brunt of the dollar's fall

What on earth's going on in the currency markets? China is booming, the U.S. economy is motoring along at its fastest clip in years, and Japan looks likely to beat the 1.8% growth rate forecast for the euro zone. Yet it's the euro rather than the yuan, dollar, or yen that's scaling to record heights. Europe's five-year old single currency has surged 21% against the greenback over the past 12 months, and more than 53% since it reached its low in October 2000 -- doing serious damage to Europe's export economy. It briefly reached a high of $1.29 on Jan. 12 before retreating slightly over the next two days.

The yen, by contrast, appreciated just 13% against the dollar in 2003. And the yuan has gained nary a cent, since it's fixed against the dollar. Things are likely to get worse for the euro before they get better. Most currency traders expect it to climb to $1.30 within the next few weeks and to $1.40 by yearend. No wonder executives and policymakers on the Continent increasingly fear that Europe's weak, export-driven recovery will fizzle before it really gets going. "The situation is becoming tense," says German Economy Minister Wolfgang Clement.

Rule-Bound Europeans

The lesson of all this is that no good deed goes unpunished. The Europeans have been virtuous, refusing to cut interest rates in the face of persistent inflation and upholding the G-7's commitment to floating exchange rates by refusing to intervene to counter their currency's damaging rise. Contrast that stance to the U.S., where policymakers have slashed interest rates to record lows and all but abandoned a strong-dollar policy in order to boost exports and sustain growth. "Nobody buys the euro to invest in European growth," says Charles Gave, an analyst with GaveKal Research Ltd., an independent research house. "They're buying it because interest rates on euro-denominated bonds are higher."

While the U.S. can be faulted for benign neglect of the deflated dollar, Japan deserves more blame for shamelessly manipulating the yen-dollar rate. The Bank of Japan shelled out $190 billion intervening in the currency markets in 2003 and says it will spend even more this year if needed to hold the yen down. China, meanwhile, has steadfastly resisted calls for it to bend its yuan-dollar peg, stuck for a decade at 8.28 to the dollar. The rigidity of the Asian currencies means the euro bears the brunt of the dollar devaluation, itself driven by America's huge $500-plus billion annual trade deficit with the rest of the world. "Some currencies that arguably should rise, can't," says Nick Parsons, a currency strategist at Commerzbank (CZRBY ) in London. "The markets aren't able to act where they should, so they act where they can."

Worse, the bulk of that imbalance in U.S. trade stems from Asian imports. If Asian currencies were allowed to rise freely against the dollar, experts say, the euro would be about 10% lower than it is now. And the euro's rise will do little to correct the trade gap. "If anything," says Gave, "the euro's appreciation tends to increase global trade imbalances because it pushes down the overall value of the yen and yuan, making Asian exporters even more competitive than they already are."

What should be done? That's not clear, but the Europeans want the problem high on the agenda when G-7 finance ministers and central bankers meet in Boca Raton, Fla., on Feb. 6-7. Jean-Claude Trichet, president of the European Central Bank, warned on Jan. 12 that "brutal moves" in the exchange rate are not "welcome or appropriate." If Europe doesn't get some relief, don't be surprised to see the ECB reluctantly join the pack of currency interventionists, in what would be yet another blow to the free workings of markets.

By David Fairlamb

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