Beware The Brawny Euro

As it strengthens, Europe's currency threatens to snuff out a tenuous recovery

It has been a good year for Europe's big multinational companies. Exports will be up an estimated 6.2% in 2004, with corporations such as Siemens (SI ), BASF (BF ), and Luxembourg-based steelmaker Arcelor reporting better-than-expected earnings in recent weeks. But is the rising euro about to upset the apple cart? The single currency, near an all-time high largely because of investor unease about the U.S. trade and budget deficits, is raising the price of European products abroad and making it harder for companies to compete globally. And it could get worse: Many analysts expect the dollar, now trading around $1.30 to the euro, to sink to $1.40. Here are some questions and answers about the risks to European growth:

How bad will it get?

Currency movements are notoriously difficult to predict, but signs point to further weakening of the dollar. Strategists at Barclays Capital Inc. in London argue that currency traders still haven't taken profits from the dollar's fall and will sell dollars if there is any sign the market is reversing course. On Nov. 8, European Central Bank President Jean-Claude Trichet declared that the rapid descent of the dollar was "not welcome from the standpoint of the ECB," and he has called on the U.S. to boost its savings rate as an antidote to the budget and trade deficits.

The effects on growth from a further dollar decline could be substantial. Deutsche Bank calculates that the dollar's fall in the past two months could subtract one-half of a percentage point from Europe's growth rate next year. The negative effects are exaggerated by slower global growth, which reduces demand for European products. Lehman Brothers Inc. (LEH ) expects European growth to slow from a projected 1.8% this year to 1.5% next year if the dollar hits $1.40 to the euro.

The long-term picture may be less alarming. Oil prices are down from recent highs, which has boosted U.S. stocks. The dollar should stabilize as foreign investors put money into U.S. markets. It will also help if inflation picks up in the U.S., forcing the Federal Reserve to raise interest rates more aggressively, says David Woo, global head of foreign exchange strategy at Barclays in London.

What are the chances central banks will intervene to support the dollar?

Slim. Central banks could buy dollars, thus putting more euros in circulation and driving down their value, but this strategy has little chance of success unless the ECB, the Fed, and the U.S. Treasury act in concert. And despite Trichet's jawboning, that's not going to happen. The U.S. is benefiting from a weak dollar, which helps reduce the trade deficit. U.S. Treasury Secretary John W. Snow, traveling in Europe in November, put the onus back on the Europeans, who he said need to carry out structural economic reforms and address their own "growth deficit." In any case, massive buying of dollars to boost the currency would be a high-risk move. Speculators, who profit from volatility, would try to test the banks' resolve, and the result could be less stability, rather than more.

What's the effect on corporate profits?

A strong euro is most damaging for companies that produce in Europe and sell in the U.S. That is particularly true of consumer goods, where a rise in price can quickly drive away customers. An example is Volkswagen, which has been slower than competitors such as BMW to set up factories in the U.S. and hedge against exchange-rate risk -- and is now suffering the consequences. VW's U.S. unit sales fell 14.1% in the nine months through September, compared with the year-earlier period.

British companies are also suffering because the pound, now up to about $1.85, has tracked the euro's rise. In the first six months of 2004, London beverage-can maker Rexam PLC (REXYM ) saw sales stall at $2.9 billion, as currency volatility knocked $196 million off its top line. Sales at British drugmaker GlaxoSmithKline PLC (GSK ) fell 8% in the third quarter, to $9.3 billion, while pretax profit was down 10%, to $2.8 billion. "The weak dollar has had a big impact on us," says CEO Jean-Pierre Garnier.

Do any companies benefit from a strong euro?

Sure. Companies that manufacture abroad and sell in Europe benefit, such as German sporting-goods makers Adidas-Salomon and Puma. Munich film producer and distributor Constantin Film, another beneficiary, pays dollars for the right to distribute films such as The Motorcycle Diaries in Germany but collects revenue in euros. "At the moment, the exchange rate is good for us," says Fred Kogel, CEO of Constantin. Companies that use imported raw materials also benefit. Germany's BASF saw third-quarter profit nearly triple, to $438 million, in part because the strong euro gave it extra buying power for petroleum-based raw materials, which are priced in dollars.

What are companies doing to protect themselves?

Most companies that do business outside Europe hedge, using currency derivatives to protect themselves from exchange-rate swings. But that also means they cut themselves off from some of the upside. Hedging also costs money in bank and brokerage fees. And there's a limit to how far in the future companies can hedge. That's why managers prefer exchange-rate stability above all else. Many companies also create so-called natural hedging situations by moving manufacturing overseas. Electronics giant Siemens, for example, employs 70,000 people in the U.S., nearly a sixth of total staff. The big U.S. presence helps insulate the Munich-based company from dollar swings. And VW has learned its lesson. It plans to manufacture its new Fox subcompact in Mexico.

In the mid-1990s, the German mark -- Europe's benchmark currency -- was stronger than the euro is now. Why is the current situation more alarming?

Because the world is more competitive. Germany is coming off a decade of slow growth. China has emerged as a powerhouse. "Other countries have developed more dynamically than Germany," says Matthias Schoder, a currency analyst at the Association of German Chambers of Industry & Commerce. But at least Germany has some experience with a strong currency. Italian companies, used to a weak lira before the advent of the euro, face a bigger adjustment.

What could make the euro sink against the greenback?

If China allows its dollar-linked currency to float, traders would buy yuan and take pressure off the euro. Only a small adjustment in the fixed value of the yuan, however, is likely. There's also a risk lurking in Asia. The U.S. trade deficit is financed largely by Asian investors. They are already nervous about the growth of the trade and budget deficits, and face pressure to diversify their currency holdings by buying euros. That could cause the euro to strengthen even more. "Asian economies have a lot of dollars," says Johannes J. Reich, head of Metzler Equities in Frankfurt. "That can't continue forever." Europeans hope it continues long enough for their currency to fall back to earth.

By Jack Ewing in Frankfurt and Laura Cohn in London, with bureau reports

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