Which way for the euro now?


David Roche
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When the euro was first launched in January 1999, the consensus was that a strong central bank, a huge trade surplus and low inflation would drive the new currency upwards from its opening level of $1.17. I had little confidence in that view.

The divisions in the speed of economic growth and in the policies of national governments in the eurozone would make it difficult to conduct a clear monetary policy. Above all, the failure of Europe to deregulate markets, restructure its corporate sector and shrink the size of its state would soon weaken the currency.

So it proved. The euro sunk below parity with the US dollar in January this year. But here I went wrong. I became a euro bull. I reckoned the US economy would slow while Europe's rebounded and the interest rate advantage of holding dollars over the euro would also disappear.

But that hasn't happened. I've run out of reasons to own the euro. Coordinated central bank intervention of the sort that we saw last month will stop the currency going much lower than $0.80. But the catalysts for a sustained recovery above $0.90 are missing. The economic growth gap between Euroland and the US has widened, the interest-rate gap hasn't closed quickly enough and capital flows remain hugely negative. Add to that the lack of credibility in Europe's leadership and there's very little reason to expect an imminent rebound.

Of course, the recent tax reforms in Germany and France will help boost growth in 2001 and beyond. And a probable deal on pension reform in Germany will gradually begin to remove some of the impediments to competitiveness that have stifled Europe's corporate sector for so long. But this is insufficient, near term, to close the corporate profitability gap with the US. And as long as companies can make more money operating in the US, capital will flow out of Euroland and the euro will struggle.

It's clear now that euroland growth has peaked. The third consecutive decline in Germany's business climate indicator points to a trend slowdown in its GDP. The current expansion may be the fastest since the post-German unification boom, but it pales in comparison with the performance of the US economy. During the second quarter, the US managed to expand at a 6% year on year rate compared with euroland's 3.8%. And, although the US pace is likely to moderate to 4.5% year on year over the coming two quarters, it will remain well above that in Europe.

Similarly, while the interest rate gap between the two blocs may have halved since the beginning of the year (to 145 basis points at the short end and to 55bp at the long end of the yield curve), this has done little to stem the outflow of long-term capital from euroland to the US.

Indeed, the one-sidedness of the corporate flows, in particular, is stunning. During the first half of 2000, deals involving the purchase of US entities by Euroland acquirers were worth $168 billion. Reciprocal US purchases of Euroland companies were worth a paltry $3 billion. In other words, long-term capital outflows linked to M&A activity are equivalent to an annualized 5% of Euroland GDP.

Although there's another $50 billion to $60 billion worth of capital exodus in the pipeline, the net deal outflow will probably moderate somewhat from here. After all, manufacturing sector labour costs in Euroland are now below those in the US and financial assets look comparatively cheap. But it's unlikely to reverse the flow in a hurry.

Structural reform has been the main ingredient missing from Europe during the 1990s, as successive governments around the continent failed to roll back the state sector. Europe remains saddled with big government and big taxes. Hopes that recent changes to the tax regimes in France and Germany would boost investor confidence have proved elusive.

In Germany, the corporation tax on retained earnings will be cut from 40% to 25% from January 2001. Including the local trade tax of 13% and the solidarity tax charge for eastern Germany, the total tax burden for German corporations falls to 38.6%. That takes German companies tax burden to nearly two percentage points below that of the average US company.

Germany is also cutting the top personal income tax rate from 51% to 42% by 2005. And of course most significant of all is the exemption from capital gains tax for German corporates for sales of cross-shareholdings.

But that will not come into effect until 2002.

France's tax measures are similar, if less dramatic. Corporation tax is being cut by three percentage points to 33.3% from 2001.

That puts overall corporate tax for France even lower than Germany. Personal tax cuts are less generous, with only 1.5% points off for the top income bracket. However, these measures will ultimately bring the average income tax burden on French and German households below that of the average American household.

But even after adjusting for the impact of these reforms, the overall tax burden in euroland as a share of GDP - including direct taxes on personal and corporate incomes, indirect taxes on spending and taxes on employment - remains far higher than in the US.

Headline corporate tax rates may be on their way down, but the social security contributions that employers have to make have hardly changed. And it is here that the burden on profits, job creation and economic growth is so severe. In most of Europe, around 25% of the average cost of employing each worker is still accounted for by social security contributions, compared with just 7% in the US. So it's still more profitable to run a business in the US. And with US real labour productivity growth eclipsing that in Europe by a factor of three, there's little to suggest that Europe is closing the gap.

The European Central Bank has been reluctant to intervene directly in the foreign exchange markets - the possibility of failure simply risks undermining its already minimal credibility. But now that economic growth has peaked, further large-scale interest-rate hikes are out of the question. Moreover, as investors in equity prefer growth to higher interest rates, a rate hike might not even attract long-term capital flows. That's why the leading central banks in the OECD finally decided to act.

I've been long the euro - and wrong! My optimism on euroland growth and interest rates has been disappointed. Structural reform is happening, but at a snail's pace. And the US economy continues to outperform expectations.

Until these factors change, there's little to drive the euro higher.

At the same time, the euro is unlikely to fall much further. With European companies looking cheap, I expect acquisitive US companies to start bottom fishing. That should offset at least a portion of the capital outflows from euroland. And central bank intervention limits the potential downside. So, for now, I reckon the euro is range bound.

Productivity growth (% year on year)

David Roche is president of Independent Strategy, a research firm based in London. www.instrategy.com