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Skip Navigation LinksHome :: Back Issues :: The rise of the euro

July 2000

The rise of the euro





The days of the weak euro seem to be over. The euro has bounced back from the nadir of $0.88 to $0.96 now. But it's still way below the level of $1.17, when it was launched nearly 18 months ago. At the time of its launch, I forecast that the euro would slump to 1:1 against the dollar. When it reached that level, I expected it to turn round and head back up. But that prediction has been confounded so far.
Up to now, the euro's recovery has been undermined by relatively weak European growth compared to the US; a big deficit on interest rates between Europe and the US; and huge capital flows into the US from Europe.
Over the last couple of years, euroland has run a $140 billion annual basic balance of payments deficit and Germany alone has accounted for almost 60% of that. The net outflow of long-term capital (much of it associated with investment in the US corporate sector) was worth between 2-3% of GDP. No wonder the euro had a difficult birth.
Of course, these capital outflows are themselves a reflection of deeper underlying concerns. Europe retains its statist mentality. Government spending accounts for between 45-50% of GDP, a figure that has consistently risen in real terms over the last three decades. The public sector also employs a disproportionate share of the labour force, accounting for a quarter of all workers in France, for example. Europe also lags the US in the cyber revolution.
But none of this explains why the net outflow of long-term capital from Europe towards the US has accelerated so dramatically of late.
Instead, this outflow is linked more to large, one-off, technology-focused deals inspired by an equity bull market at its peak. However, with the froth now blown off the top of the Nasdaq market, this kind of capital outflow from Europe is likely to slow and may even reverse.
Then there's growth. Since 1992, the euroland economy has consistently grown almost 2% per year slower than the US. The big question mark has been Germany. As it accounts for a third of euro area GDP, the German economy is clearly big enough to make or break the entire region's recovery. And there's no doubt that Germany has lagged the recent upswing in the rest of Europe.
This relative weakness was principally driven by weak consumption. But now, from a top-down view, the consumption outlook is actually much-improved. In a period of sustained low inflation, real wage growth will be solid, running at 1.5-2.0% year-on-year. Lower tax rates will boost household disposable income by 0.5-0.6%. And job growth will be rising at 0.6-0.8% by the end of 2000. With consumer confidence at historical highs, household savings rates should remain low too. So a 3% jump in real disposable income should underpin a similar rise in private consumption. That means Germany is unlikely to derail the European recovery.
With the nascent European recovery set to run at a steady 3.5% annual pace for the next year or two, the growth gap with the US will close.
And the latest data from the US on retail sales, housing and manufacturing activity do suggest that the breakneck pace of the US economy is beginning to ease. Indeed, for the first time since 1995, Europe may actually eclipse the US in the growth stakes.
It's been almost as long since US treasury bond yields traded below those in euroland.
But the prospect of slower, more balanced growth in the US points to a narrowing of the unusually high yield differential by the end of the year and into 2001. The recent ECB decision to hike interest rates by 50bp could be followed by the US Fed staying on hold. If that's the case, two of the main supports for the dollar will have gone.
The third support - that of net capital flows - will depend on a variety of factors, not least the willingness of Europe's politicians to embrace reform. In order to keep domestic entities operating at home and to encourage more foreign companies to do business in Germany, taxation needs to be trimmed. And that's exactly what's happening.
Before its summer recess, the German parliament will approve the Eichel tax reform package. Second, there should be an agreement on the reduction - if not complete elimination - of capital gains tax on the disposal of corporate cross-shareholdings.
And third, a preliminary agreement on pension reform should also be outlined.
Almost all of euroland's governments have significant pension liabilities to deal with.
By stimulating pan-European private sector pension schemes, mutual and pension fund inflows should continue to grow rapidly. And as European living standards become more closely linked to the performance of shareholdings, governments will inevitably become less meddlesome and more business-friendly.
Even France - the very embodiment of Europe's socialist model - has started to push some semblance of a reformist agenda. Negotiations between the employers' federation, Medef, and leading trade unions have come up with a new formula for paying unemployment benefits. The idea is to encourage the unemployed to get back into work as soon as they can, by reducing pay-outs over time. And in 1999, for the first time in three decades, public sector expenditure actually fell in nominal terms.
The combination of reform, faster growth and low inflation is great news for the euro. The main short-term risks for the euro and European financial assets are still political.
France takes over the presidency of the EU this month. France still epitomizes the anachronism of Europe's statist mentality - its public sector accounts for over a quarter of French employment and spends over half of the nation's GDP.
Furthermore, there are open calls within the French administration for a more cautious approach to EU-enlargement. The government is clearly worried about the electoral implications of far-reaching agricultural reform and the possible influx of foreign workers - especially since a large proportion of euroland voters evidently harbour similar doubts. All this suggests that the near-term rhetoric emanating from France's leadership of the EU could stand squarely in the face of the Anglo-Saxon capitalist model.
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