Select Committee on European Union Eighteenth Report


PART 6: WHAT IS HAPPENING TO THE VALUE OF THE EURO?

THE EXPLANATIONS

135. In our previous inquiry, Sir Nigel Wicks (then Director, Macroeconomic Policy and Prospects Directorate, HM Treasury) told us that the euro would be "loved and trusted" if it retained its domestic value and, over a period of time, its value against other major currencies[124]. For HM Treasury, Mr Ramsden pointed out that the first of Sir Nigel's conditions had been met: the ECB's policy had been successful in protecting domestic purchasing power. Although the value of the euro against other major currencies had fallen, this was less important because only a small proportion of the trade of participating Member States was with third countries[125] (Q 53). The Dutch Ambassador suggested that this fact was beginning to affect public attitudes: people would soon consider that "the value of the euro is the euro" (rather than expressing it in terms of some other currency) (Q 348).

136. Nevertheless, on 8 May 2000 the euro-group expressed its "common concern about the present level of the euro"[126], and on the same day the Chancellor of the Exchequer agreed that the value of the euro was not reflecting its long-term fundamentals. Giving evidence at the end of July, Mr Trichet said:

    "In my opinion the euro is undervalued in a way which is absolutely indisputable" (Q 109).

He added that this was a generally held view: "pretty well all big signatories of the market today [consider] that the potential for appreciation of the euro is very big" (Q 122). But he refrained from commenting further other than in what he referred to as three standard sentences:

    "We are pursuing a policy of a solid, stable, strong euro … The euro has strong potential for appreciation … A strong economy goes along with a strong currency" (Q 121).

137. The Governor of the Bank of England agreed that on the basis of fundamentals it was difficult to understand the fall in the value of the euro. He believed that the fundamentals would reassert themselves "at some point", possibly through a change in the relative prices of assets (Q 268). Dr Duisenberg is on record[127] as finding it "somewhat disappointing to note how much of the media and public attention concentrates on developments in the foreign exchange market" rather than the "overall bright picture so far". He was confident that a strong potential for the euro existed; the ECB had consistently argued strenuously that the value of the euro at 1 October 2000 (US$0.85) was much less than was justified on the basis of economic fundamentals[128].

138. In his evidence to us, the Governor of the Bank of England dismissed many of the explanations which had been put forward for the weakness of the euro. He did not consider that it was due to the way in which the euro had been managed; to short-term interest rates[129]; to "the lack of government to interface with the ECB"[130]; or to the lack of co-ordination between fiscal and monetary policy. Nor could it be explained by comparisons of relative rates of inflation or of current account deficits (QQ 258 and 268). Instead, he suggested that the explanation was to do with long-term capital flows. Over the 18 months following the start of the euro, the United States had a current account deficit of about $500 billion, more than financed by long-term capital inflows. The euro-zone, on the other hand, had a "pretty well flat" current account, but "a very large long-term capital outflow—direct investment net and portfolio investment—of about $275 billion" (Q 258). The pattern of flows is shown in Tables 7 and 8 below.

Table 7: Foreign direct investment, flows from Europe to USA (million dollars, not seasonally adjusted)

  
1994
1995
1996
1997
1998
1999
2000 q1
q2
Austria
121
248
175
105
205
419
15
-51
Belgium
818
-68
354
1,584
4,040
1,045
711
3,291
Finland
535
619
-47
655
688
888
624
-509
France
4,394
2,725
7,244
10,932
10,371
19,310
9,600
6,554
Germany
6,116
7,908
19,616
12,186
42,110
22,701
5,127
3,615
Ireland
1,430
1,657
2,544
4,711
2,554
2,472
-605
1,823
Italy
143
197
333
-245
1,044
1,056
112
79
Luxembourg
1,256
3,429
-2,230
5,334
14,299
25,888
4,226
3,050
Netherlands
-2,006
-1,526
12,262
12,710
9,606
32,845
4,072
8,348
Spain
435
789
60
325
235
353
255
232
EU-11 (a)
13,242
15,978
40,311
48,297
85,152
106,977
24,137
26,432
UK
10,063
16,255
14,404
11,395
65,701
116,605
8,225
36,956

Source:  US Department of Commerce, Bureau of Economic Analysis, International Investment Data
Note:
  (a) EU-11 excluding Portugal



Table 8: Foreign direct investment, flows from USA to Europe (million dollars, not seasonally adjusted)

  
1994
1995
1996
1997
1998
1999
2000 q1
q2
Austria
744
513
105
-14
1,122
20
37
157
Belgium
2,004
2,750
1,349
-46
816
26
370
-229
Finland
118
158
175
327
327
226
142
-167
France
2,634
5,196
4,463
2,971
3,805
786
610
145
Germany
2,863
3,349
1,956
2,464
3,284
5,875
2,133
514
Ireland
-337
695
1,954
2,266
5,649
3,436
1,504
1,370
Italy
2,646
2,506
416
123
-606
3,211
3,236
772
Luxembourg
517
-477
1,041
2,444
3,942
1,221
599
696
Netherlands
7,605
9,386
6,308
12,450
24,034
7,980
4,883
3,891
Portugal
252
137
245
86
5
99
28
42
Spain
1,551
(a)
1,183
204
1,850
-910
465
588
EU-11
22,591
26,208
21,191
25,272
46,226
23,969
14,007
7,779
UK
9,615
13,830
16,421
22,961
36,552
29,824
11,496
9,233

Source:  US Department of Commerce, Bureau of Economic Analysis, International Investment Data
Note:  (a) suppressed to avoid disclosure of data of individual companies.


139. The Governor said that capital had been attracted to the United States partly by the "magnet effect" of the acceleration of productivity growth there, as well as by the perceived flexibility of labour markets and the greater rate of technological innovation (compared with "supply side deficiencies" within the euro-zone) (Q 258). According to Professor Lord Desai, the euro-zone economies were "bleeding capital" because of the "good fundamentals" in the United States economy, and partly because of the takeover of United States companies by German ones, the reason for which was that profit opportunities were better outside the euro-zone[131]. Dr Walter attributed the euro's weakness partly to the "considerable and unexpected differential between growth rates in the United States and Europe", while interest rates had been moving in the same direction (p 124), and the Commission agreed that it resulted partly from "the unexpectedly robust performance in the US economy relative to that of the euro area"[132]. Professor Fitz Gerald (of the Irish Economic and Social Research Institute) put the point the other way round, attributing the problem more to the strength of the dollar than to the weakening of the euro: he thought that the Federal Reserve Board had "operated too lax a policy", allowing the balance of payments deficit to increase each year, funded by foreign investment, and thus making the task of the ECB very difficult (Q 250). The Governor of the Bank of England said that it was "difficult to argue that the United States has let its economy run out of control and that is driving the current account deficit—we certainly cannot argue that that is what is generating the weakness in the euro". However, the deficit was over-financed by capital flows; it was possible to argue that this had driven up the exchange rate, which was in turn contributing to the deterioration of the current account (Q 270).

140. Like the Governor of the Bank of England, a number of other witnesses suggested that structural factors were influencing the views of the market. Dr Walter said that tax and pension reform, deregulation and market liberalisation in a number of participating Member States had been criticised as moving too slowly (p 124). Mr Power believed that there were fundamental structural problems in the euro-zone which caused investors to feel more confident with structures in the United States; this in his view highlighted "the imperative for European policy-makers to continue and accelerate the process of deregulating labour markets, goods markets and all product markets" (Q 178) But a recent Economist editorial[133], while agreeing that "Europe's overtaxed and overly regulated economies are certainly more arthritic than America's", doubted whether this could be the real explanation: the same had been true two years earlier, when the value of the euro had been more than 30 per cent higher. The Governor of the Bank of England thought that "you can exaggerate the lack of progress on the supply side", pointing to tax reform in Germany and privatisation in France: what mattered was the perception that the supply side was more flexible in the United States. The Deputy Governor added that investment as such was not the cause of the problem: Europe had had good investment rates in comparison with the United States. The issue was the type of investment, which in the United States was "investment in particular types of technology with particular types of organisation that have created an environment in which people think these investment opportunities will prove every profitable". So people in the United States expected real incomes to grow faster than before, which stimulated both consumption and investment; this could not be financed domestically, and so led to borrowing abroad. One would expect the dollar to come back down as the borrowing was repaid and the high-consuming households came back into equilibrium, but "it will not happen quickly". Meanwhile, the issue was the quantitative weight which the markets attached to the qualitative explanation, and one could not know when that might change (Q 273).

141. It is generally agreed that at the end of 1998 the value of the ECU (which the euro inherited) was very high. The Austrian government referred felicitously to the "europhoria" prevailing in the second half of 1998, and Mr Peet recalled that "many commentators, before the euro came into life, were actually suggesting that it would appreciate against the dollar because people would move into the new currency and there would be a shift of reserves into the new currency" (Q 72). The Commission took the view[134] that a further reason for the fall in the euro was "the unwinding of euro-denominated investments made in the months preceding the launch of the euro" when "enthusiasm for EMU was at a high point and markets were concerned about the implications of the Russian debt default for the US economy and financial system". Mr Trichet said that the initial exchange rate could not have been sustained; the market had overshot, and correction would take a little time (Q 110). He saw no reason why the euro should behave totally differently from the underlying currencies (in effect the franc and the mark) (Q 122). Professor Minford (Q 209) and Professor Fitz Gerald (Q 230) also suggested that the devaluation of the euro simply reflected what would in any case have happened to the mark given the weakness of the German economy.

142. Even if there were good initial reasons for the fall in the euro, our witnesses agreed that it was worrying that (in the words of Mr Power) "the euro continues to react negatively to good economic news" (Q 178). By the beginning of 2000, forecasts for growth in the euro-zone were more optimistic—yet this did not lead to an increase in the value of the euro. The German government said: "Public debate frequently fails to take adequate account of the exceptionally favourable trends in the euro-zone" (p 97). As the Economist put it:

    "somehow, America's economic imbalances are ignored. A Martian investor might at least wonder why an economy with the biggest current account deficit the world has ever seen, a negative personal savings rate, record borrowing by firms and households, not to mention a dangerously overvalued stock market, has such a strong currency"[135].

143. Nor did intervention seem to help much. The Governor of the Bank of England saw the point of the G7 intervention in September as having been to pose the question to the markets of when fundamental value of the euro would reassert itself; the fact that the euro had been relatively stable since then meant that the markets were still pondering the question (Q 268). Dr Duisenberg said that the intervention had shown how seriously the ECB was concerned at the possible negative impact of "the excessive depreciation" of the currency on the prospects for price stability in the euro-zone, as well as showing the determination of the world's major central banks to act jointly when needed[136]. The interventions by the ECB (acting alone) in early November can be interpreted as further evidence of this. The ECB said that it was intervening "out of concern about the global repercussions" of a weak euro, provoking the comment that "what had looked like a tactic started to resemble a strategy"[137]. But, as the Economist suggested[138], the interventions could also be perceived by the markets as "further evidence of the ECB's confusion".

144. To the extent that the weakness of the euro is a result of capital flows, one would not expect intervention to help to restore its value. And to the extent that intervention is sterilised (that is, undertaken in such a way as to prevent it from having an effect on domestic monetary conditions) rather than unsterilised[139], one would expect its effect to be limited. Sterilised intervention is thought to have only limited and temporary effects, basically because it is not backed up by the tightening of monetary policy. It merely replaces dollar-denominated with euro-denominated assets in the balance sheet of the central bank. The counterpart of this is that the financial markets around the world are left holding more dollar assets and less euro assets. So there is a small change in portfolios. Apart from this portfolio change, the fundamentals that influence (or should influence) exchange rates, which include the monetary conditions in the euro-zone, remain unchanged.

145. Dr Walter considered that:

    "The G7 were right in trying to signal to the markets by concerted forex interventions that the depreciation of the euro is overshooting. But one should not expect too much of such interventions which—if not part of a consistent and credible policy—tend to have little effect as they make only a short-term impression on market participants and are generally perceived as a last resort. But the art of interventions has to be learnt by the ECB which should be wise and cautious in public statements on this issue" (p 124).

146. We wondered whether this indicated that some people were "worried about the euro as the euro". Mr Power surmised that, "with a credible central banker at the helm", the euro would be reflecting a higher value (Q 183). We felt obliged to pursue that reference to "a credible central banker", particularly because Mr Power was giving evidence the day after the publication of Dr Duisenberg's now notorious press interview, in which he was reported as saying that it would not make sense for central banks to get into the market if a sharp change in currencies were caused by war in the Middle East[140]. Mr Power did not mince his words:

    "Quite simply, the European Central Bank has not managed to establish credibility in financial markets. Interest rates have been increased seven times since last November, and on every occasion the euro has been weaker within 24 hours" (Q 178).

Particularly in the early stages of the life of a central bank, it is of course difficult to distinguish its credibility from that of its leader. The Economist suggested[141] that although the Federal Reserve Board lacked a clearly defined goal, and Mr Greenspan was at times "far from transparent", he got away with it because the markets thought he could do no wrong.

147. For HM Treasury, Mr Taylor argued that one would expect a slow response to what was after all a new currency (Q 59). Mr Peet commented that "confidence in a central bank is very important but it takes a long time to acquire". He thought that the first two years of the ECB had been "quite good", and that among financial commentators and economists it was "held in reasonably high esteem. It does not yet seem to have made any big mistakes, which is perhaps the most important thing for a central bank" (Q 94). Ms Schulz agreed, saying that the ECB was compared with the Bundesbank, for which there was "obviously high regard" (Q 96). Commissioner Prodi is reported as having said on 6 November that it was still early days, arguing that since the US Federal Reserve Board had taken 20 years to function correctly the ECB should at least be allowed at least two years.

148. There was disagreement as to how much responsibility for the fall in value could be attributed to governments. Perhaps they had not done enough: Dr Walter suggested that "the failure of European policy makers to institutionalise coherent economic policies in the EMU area has met with disapproval in the markets. Here, there is room for improvement" (p 124). Professor Minford suggested that the fundamental problem undermining confidence in the euro was the lack of "political glue", which might mean that the whole project would founder (Q 201)[142]. Yet in another sense Professor Minford thought that politicians had done too much, with the fall reflecting pressure from them to which "the ECB was quite willing to turn a blind eye; there was benign neglect and the politicians were delighted, industry was delighted" (Q 220).

DOES THE FALL IN VALUE MATTER?

149. The German Ambassador commented: "The beauty of any subject is always in the eye of the beholder, and the fixation of some beholders on the exchange rate is what I would call extreme short-termism" (Q 295). The Governor of the Bank of England said that the weakening of the euro had in one sense contributed to the success of the euro-zone (Q 272). In their evidence to us some participating Member States explicitly welcomed the depreciation in value and the growth of exports which it had stimulated (the Netherlands: p 105; Finland: QQ 127 and 155). According to Mr Power:

150. But the depreciation was not good news for all. Mr Power himself noted that depreciation against sterling had been inappropriate for Ireland, with the United Kingdom as a major trading partner (Q 170)[143]. And Mr Peet and Ms Schulz suggested that the "psychological impact" of the decline in the value of the euro might have been greater than the actual economic effects (Q 72). Dr Walter agreed that the weakness of the euro on the international foreign exchange markets had "put a damper on the pleasure over the currency's successful launch" (p 124). According to the Federation of German Industries:

    "The continuing fall of the euro on the foreign exchange market since its introduction has led to confusion. Long-term effects of a persistent euro weakness should not be trivialised. First of all, the confidence of citizens and the economic in the euro is less stable than would be desirable and also essential for the success of the new currency. Secondly, the weak euro carries some risks for price stability; and thirdly, the weak euro leads companies to believe their competitiveness has increased, a belief which in many cases is not well-founded" (p 121).

Professor Lord Desai took the fall so seriously that he suggested suspending trading in the euro and reinstating the Exchange Rate Mechanism (ERM), relaunching the euro only when its implied value had been stable for at least six months[144].

151. Of course, despite the euro's weakness, participating Member States may still be better off than if they had remained outside. The Irish Ambassador invited us to "consider the position of a small currency like the Irish pound. Is it likely to have the greatest protection against speculative attack on its own, or linked to another currency, or inside a larger euro?" In the view of his government, the euro-zone gave the Irish pound far greater protection against speculative pressures than it would have standing alone (Q 232).


124   Op cit, Q 118.  Back

125   The Commission has put this proportion at 16 per cent (reply in March 2000 to question H-0170/00 from Mr Richard Corbett MEP, supplied to us by Mr Corbett; not published with this Report). Figures in the ECB Monthly Bulletin, October 2000 (Table 8.2) suggest a ratio of 17.2 per cent for exports and 15.5 per cent for imports in 1999. See also Appendix 3, Table 3.10. Back

126   See p 6.  Back

127   Lecture at European Business School, op citBack

128   See lecture at European Business School op cit and ECB Monthly Bulletin, October 2000, p 31. Mr Power considered the fundamental equilibrium value for the euro to be around 1.10 euro to the dollar (1 euro = $0.90) (Q 183). Professor Minford thought that this rate was too high: at present [17 October] the rate was about 1.17 euro to the dollar (1 euro = $0.85), and he thought that it could appropriately fall even further, say to 1.20 euro to the dollar (1 euro = $0.83) (QQ 224-225). Back

129   Which, as Mr Trichet pointed out, were now lower for euro-denominated financial instruments than they were in the United States: a sign of confidence (Q 123). Back

130   See paragraphs 152 - 157. Back

131   In a letter to the Times (27 October 2000), followed by an article in the Daily Telegraph (8 November 2000). Back

132   Reply to Mr Corbett, loc cit. Back

133   11 November 2000. Back

134   Reply to Mr Corbett, loc citBack

135   Loc cit. Back

136   Lecture at European Business School, op cit. Back

137   Financial Times, 10 November 2000, discussing the interventions on 3, 6 and 9 November. Back

138   Loc cit. Back

139   When a central bank intervenes in the foreign exchange market, it buys up (in this instance) euros and sells dollars from its foreign exchange reserves. In an unsterilised intervention, the central bank would take payment for its dollars in the form of money transfers from euro bank accounts; the consequence would be a fall in the liquidity of the euro-zone banking system, a fall in the money stock in the euro-zone, and probably a rise in the short-term interest rate in the euro zone. There would be an automatic tightening of monetary conditions in the euro zone; the central bank(s) would reduce their holdings of foreign exchange reserves, and the balances held by the euro-zone commercial banks in the central bank(s) would fall. This kind of intervention is believed to have substantial and lasting effects. In a sterilised intervention, at the same time as intervening in foreign exchange markets the central bank would aim to stop the fall in foreign exchange reserves from affecting the money supply, by using (in this instance) the euro revenues from sales of dollar reserves to purchase euro-denominated government bonds on the open market, thus matching lower holdings of dollar reserves with higher holdings of euro-denominated government bonds in its portfolio of assets. As a result there would be no fall in the balances held by commercial banks at the central bank, no fall in the "monetary base" or in the liquidity of the banking system, and no tendency for interest rates to rise. Back

140   Times, 6 October 2000. Back

141   Loc citBack

142   See also paragraph 156. Back

143   Though a rapid recovery could cause problems as well: Professor Fitz Gerald described the prospect as "most unpleasant" (Q 254). Back

144   Loc cit. Back


 
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