GROWING PAINS FOR THE EURO

Donald A. Nichols
University of Wisconsin–Madison
Department of Economics
Madison, Wisconsin 53706
nichols@lafollette.wisc.edu  
Phone   608-263-2327  
Fax       608-233-4022 

When the Euro was launched in January 1999, it was worth $1.15.  Its value was widely expected to rise.  Anticipating  its launch, European Central Banks had linked their currencies to each other, and in 1997 the value of the whole bloc was allowed to depreciate for reasons intended to be temporary.  In 1998, a widely cited academic study predicted a long-term value of $1.40 for the Euro, based not only on its underlying purchasing power, but also on the demand for Euro denominated assets as investments.  But instead of increasing in value, the Euro has steadily declined, trading below 89 cents in recent days. 

The many explanations of the decline range from the complicated to the silly, some calling into question the whole venture of the New Europe, including its ability to govern itself and control its welfare state.   A simpler explanation should be considered.  Large corporations who would otherwise finance their business with dollars have discovered the new Euro bond market and are raising their capital by selling Euro denominated securities.  In 1999, 40 percent of all new issues of negotiable securities were Euro Bonds.  These bonds would probably have been issued in dollars had the Euro not been launched.

While Euro enthusiasts point with pride to the growth of the Euro bond market, its growth derives more from the desire of corporations to sell bonds than to buy them, and it is well known that the sale of a security—whether newly issued or previously issued—will drive a currency down. 

But the motivation for large multinational corporations to sell Euro bonds should not be viewed as a lack of confidence in the future value of the Euro.  Rather, the new Euro bond market provides these companies with a relatively inexpensive way to protect large volumes of anticipated future Euro earnings against currency fluctuations.  Before the Euro existed, many companies earned profits in Europe and paid interest in dollars. This meant that their net earnings would fluctuate, sometimes widely, in response to fluctuations in the exchange rate.  But if these companies now issue Euro Bonds, both their profits and their interest payments will be in Euros, and their earnings net of interest costs will fluctuate less in response to currency fluctuations.                       

Because most existing bonds are still denominated in dollars, we can expect a flood of new Euro bond issues in the next few years as corporations seek to balance their obligations to reduce the currency risks they now carry.  From this perspective, the weakness of the Euro is likely to continue.  It is ironic that the weakness of the Euro=s value derives from the new strength it brings to world markets in the form of a new way to reduce risk.

Should we then expect the Euro to fall further?  The European Central Bank is caught in an unenviable position.  To prevent a further short term decline in the Euro, the ECB  must raise interest rates.  If European interest rates were high enough, bond issues would be unattractive.  But higher interest rates would hurt domestic growth and could make the Bank a target of anti-market sentiment. 

The alternative is to accept the low Euro for the time being.  The advantage to a low Euro is that it makes European products more competitive in world markets and helps the economy to grow.  The disadvantage is that a low Euro makes imported products expensive and lowers the European standard of living.  Which of these alternatives will be chosen by European decision-makers?  In Europe, unlike the U.S. or Japan, there is deep popular support for a strong currency.  If this sentiment prevails, we might expect to see European interest rates rise toward U.S. levels in coming years as the European Central Bank moves to strengthen its currency.  The loser in this strategy will be European competitiveness and employment. 

From a longer perspective, the problem of a low Euro could evaporate if the demand for Euro bonds would grow to match the increased supply.  This could well happen once European financial markets are fully mature.   If European pension funds were to grow, for example, a natural investment for these funds would be Euro bonds, and an increased demand for Euro bonds would support the value of the Euro.