Pushing the euro uphill?

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The European Central Bank's intervention on Friday, 22 September in support of the falling euro, acting in cooperation with the Bank of Japan and the US Federal Reserve, briefly evoked memories of the 1985 Plaza accord which successfully drove down the dollar. But the time when world central banks could dictate exchange rates to the markets have passed.

Market participants did widely welcome the intervention as "a clear signal that the ECB is not standing by watching the risk of a potential crisis increase further," says Julian Callow, chief European economist at Credit Suisse First Boston. The intervention was perceived very positively. It came as something of a surprise ahead of the G7 meeting and the participation of the US gave it far more credibility.

But, while central bankers basked in the glory of their achievement at the IMF/World Bank meetings in Prague that weekend, many market participants were getting confused as early as Monday, as they expected more action.

By Tuesday, Robin Marshall, director of European research at Chase Manhattan, was wondering whether the stabilizing effect will have any lasting impact at all. "The euro is likely to be under more downward pressure - with a 'No'-vote on the euro by the Danes, the ECB will be in exactly the same position as a week before. After the first intervention, the ECB may find that it is trying to push a large stone up a hill."

In the week following the central bank intervention, the exchange rate recovered, rising to $0.88 up from $0.86. But in the run up to the Danish referendum vote, which turned against euro membership, the central banks' efforts could not initiate a visible reversal of the euro's weakness. "The markets have reacted respectfully, but in terms of private capital flows that dominate the market, the intervention was somewhat of a non-event," says Steven Englander, global currency economist at Salomon Smith Barney.

Time will tell whether this dismissive judgement is premature. "With past interventions, it usually took one or two months before markets followed the central bank," says Steven Bell, chief economist at Deutsche Asset Management.

Jim O'Neill, Goldman Sachs' chief currency economist could be proved right when he considers the intervention "a major turning point in the currency markets." But for now dealers remain underwhelmed in the absence of any clear expression of what the world's central banks are trying to achieve. "Unlike past 'classic' interventions that were implemented in the context of defending a policy regime," says Kevin Gaynor, head of European research at UBS Warburg, "a clear policy target is notably absent now." Thus, while the president of the ECB, Wim Duisenberg, has boasted that the intervention will "introduce an orderly reversal", dealers took remarks by US Treasury secretary Larry Summers about the US preference for a strong dollar as proof that no long-term reversal operation had been agreed.

If the central bankers and finance ministers did merely want to stop the euro's decline ahead of the Danes' rejection of the currency, they have at least achieved that aim. "Without an intervention," says Gaynor, "the euro, which has seen one historical low after another, would have gone to the low $0.80s at the rate seen in the weeks preceding the intervention."

But the price the ECB eventually has to pay for stabilizing its unloved currency might cost more than the many billions of dollars that were pumped into the markets. The ECB has manoeuvred itself into a tricky situation. It now has to go all the way to stay credible. "They have made a stand," says Gaynor. "Once they have started this process, they cannot fail."

Bell thinks that, "if the euro comes under renewed pressure, the ECB will and should intervene again". But not all market observers agree that the ECB wants to draw "a line in the sand" - meaning it wouldn't allow the euro to fall below the level at which it intervened. "There is the danger," says Marshall at Chase, "that many people expect a lot more interventions to occur along the lines of the 1985 Plaza accord, which set off waves of interventions by the world's main central banks to drive down the dollar. Those expectations are unlikely to get fulfilled."

Marshall thinks that it is more likely to be a tactical, one-off intervention. "It is definitely not a return of '80s-style interventions," he says. "Although the euro may be slightly undervalued, there are no major misalignments between currencies of the type seen in the 1980s - that would threaten the global economy. Continued intervention would go against recent long term capital Flows. Secondly, FX markets are different today, in that less speculative players are around. The 1985 interventions were so successful because they punched a speculative bubble in the US dollar."

The weakness of the euro is not driven by speculators, but by the net outflow of long-term capital to the faster-growing and more rewarding US market.

"Although flows in bonds are slightly positive, equity and foreign direct investment favour the US over euroland - adding up to a net outflow of e51 billion in the first half of 2000," says Michael Lewis, senior currency economist at Deutsche Bank. "Investors are still underweight US equities, and with changes in the MSCI index, there will be more bad news to come for the euro. It would be naïve to search for speculative short positions to explain its fall. Speculators were neutral on the euro, and have, in fact, always predicted its recovery."

Maybe the ECB simply wanted to buy time - in the hope that the euro will gather momentum on its own - until the slow down of US economic growth, which would finally stop the net outflow of capital. For now, the US offers stronger growth and higher interest rates than Europe, as well as a greater assurance that their currency will actually exist for another 10 or 20 years.

Higher interest rates might be a more effective means to convince investors to redirect their long-term capital into euroland.But higher rates can have ambiguous effects, especially if equity portfolio and corporate investors fear they will choke off long-term growth. The ECB may have chosen intervention over higher rates, at a time when new data suggest a slowing of eurozone growth.

Meanwhile forex traders might refer to a study by Deutsche Asset Management that has found "a 100% success rate that markets follow the central bank's move within three months of a G7 intervention." But that success rate only materialized in cases where the Fed was involved. This, says Bell at Deutsche, highlights the Fed's great credibility. "They are usually very reluctant to intervene, and only do so of it goes along with the underlying fundamentals. In 1985, for example, the dollar had clearly overshot the fundamentals."

The ECB, by contrast, is seen to intervene because it is incapable of changing the fundamentals. "The euro remains under downward pressure, because the real causes are not tackled," says one dealer.

The ECB would be well advised to Find a more effective way of communicating the benefits of investing in Europe. Governments must also avoid sending alarming signals such as the increases in spending that many European countries have resorted to, leading to inflated deficits often above the requirements set out in the Maastricht treaty.