Memorandum by Roger Bootle, Specialist
Adviser to the Committee
CAUSES OF THE EURO'S WEAKNESS
1. To some observers, the weakness of the
euro since its inception are obvious and require little thought
or analysis. They do, to some eyes, though, have equally obvious
implications for Britain's stance with regard to membership. In
my view, however, a careful look at the arguments reveals that
the extent of the euro's weakness, if not the mere direction of
its movement, presents something of a puzzle. Although enormous
uncertainties remain about the relative roles of different factors
in explaining the currency's weakness, the conclusion reached
here is that the likely factors which explain it have few, if
any, implications for the question of whether the UK should adopt
the euro.
2. There are umpteen suggested reasons for
the euro's weakness but they all fall into one of two camps: reasons
why a rational analysis of the economic fundamentals in the euro-zone
justifies something like the euro's current value; and structural
reasons why the market has reached and sustained a value for the
euro which cannot be justified by reference to the economic fundamentals.
It is helpful to analyse the euro's value by asking whether any
of the reasons appearing under the first group can justify the
current level and if they cannot, then going on to ask whether
any of the structural factors can offer a convincing explanation.
3. Euroland is a sluggish, slow growth
area. It is true that for much of the last decade, growth
has been lower in Euroland than it has been in the United States,
but the gap looks set to narrow sharply and soon may even reverse.
But in any case, the growth explanation on its own is pretty unconvincing.
Comparison with the UK is particularly interesting in this regard.
You would think that the logic of the "slow growth"
explanation would tie in with strong UK growth, since the pound
has been so strong against the euro. In fact, last year the UK
was well down the European growth league and will be so again
this year. Both France and Germany will probably grow faster than
the UK.
4. Moreover, such "explanations"
do not justify exchange rate levels. For according to efficient
market theory, it should not be possible systematically to make
a profit by exploiting publicly available information. Now if
an exchange rate were systematically depressed by equity capital
deserting the euro-zone because of poor real growth and hence
earnings prospects, but which did not adversely affect prospective
inflation, then it would be possible for speculators to take an
open position in euros, invested in bonds or deposits and hope
to gain substantial profits on an eventual recovery of the euro.
Theoretically, the interplay of these forces should mean that
a currency never becomes "under-valued" or "over-valued".
5. European interest rates are low.
This is a variant of the low growth argument but it can be deployed
somewhat differently. The elementary idea is that a currency which
offers higher interest rates should be stronger than one which
offers lower rates. But in fact this simple idea does not get
you very far. If interest rates are increased by 1 per cent and
will be sustained at that level for a year, the simple increase
in interest income would be offset by a prospective fall of the
exchange rate of only 1 per cent. Once the exchange rate has risen
by 1 per cent following an interest rate increase of 1 per cent,
other things equal, the currency can now be viewed as prone to
a 1 per cent greater fall over the year than before. So the exchange
rate should strengthen by only 1 per cent. Therefore, the simple
argument can explain only tiny movements of the exchange rate
yet the movements that we actually observe in currencies are enormous.
6. Nevertheless, once you assume that investors
may continue to be attracted by a higher interest rate even after
the currency has risen, (and indeed they may be even more attracted
if they now believe the currency is set to appreciate in the future),
then interest rate differentials can have a powerful effect on
currency values.
7. But in this case the really powerful
factor is how investors' expectations of future currency values
are determined. In this story, it is the fact that once the currency
has risen they think it no more likely to fall than before, and
perhaps even more likely to rise, which gives the apparently striking
relevance of interest rate differentials.
8. Moreover, differentials often do not
have the effect described in the above account. Raising interest
rates can depress a currency, as happened when sterling failed
to hold its floor in the ERM. Equally, low interest rates may
be no barrier to great currency strength, as has happened several
times with Japan. In the case of the euro, it is striking that
on several occasions, prominent market players have argued that
higher interest rates would depress the euro because they would
tend to reduce growth prospects. If that view is correct then
higher interest rates would only serve as a boost to the euro
by proxy, that is to say when they were a reflection of a strong
growth environment in Euroland, but when they were imposed by
the ECB for some real or imagined policy reason, but without justification
from a strong underlying growth environment, then they might depress
the currency.
9. Long-term inflation prospects in Euroland
are poor. This is the view encapsulated in the notion that
whereas investors were sold the idea of the euro as a super-deutschmark
in fact it is more like a souped-up lira. Again this view has
several variants. The ECB is incoherent and subject to national
pressures; under fire it would not be resolute in the way that
the Bundesbank would; now that they are inside the single currency,
countries with a poor past record on financial discipline and
the control of inflation, such as Italy, will relax fiscal restraints
and return to high wage inflation, thereby presenting the ECB
with a classic stagflation dilemma, and it would be inclined to
take the line of least resistance; the eastward expansion of the
EU, and ultimately the euro, will increase the force of this factor;
some countries (and Austria is the most frequently quoted example)
may seek to leave the euro and perhaps even the EU, thereby provoking
a wholesale political and economic crisis.
10. There are undoubtedly widespread concerns
of this sort in the markets but I find this class of explanation
for the weakness of the euro wholly unconvincing. You do not need
to weigh up the merits of each individual argument, although many
look pretty shaky, but rather observe the behaviour of European
bond markets. If the euro is so weak because of investor fears
of long-term inflation, why are European bond yields so low?
11. So I come to the conclusion that the
low value of the euro is not reasonably explicable by reference
to the economic fundamentals and accordingly that it is appropriate
to seek an explanation from structural factors. There are two
which appeal to me, with a third which may play a powerful supporting
role.
12. First, when the euro was about to be
launched, most market analysis centred on the way that the new
currency would prove much more attractive as an investment than
its forebears, the constituent currencies. In fact it might soon
come to rival the dollar. They mostly neglected the other side
of financial balance sheets. In fact, what has happened is that
the euro has greatly increased the attractions for borrowers by
forging a single unified capital market, much more liquid than
before. Increased international borrowing in euros for sale into
various domestic currencies will have weakened the new currency.
13. Meanwhile, investors and depositors
have had one reason, at least, for finding the euro less attractive
than its constituent currencies, namely the reduced demand which
results from pooling. Depositors, who include many multinational
companies, have been used to keeping balances in several European
currencies to facilitate transactions. Now they need balances
only in one, and balances held in euros can serve as a "float"
or buffer for prospective expenditures or financial flows in any
part of the euro area.
14. For real investors, the change comes
about mainly from the loss of diversification possibilities from
the merging of the European currencies. While they were separate
monetary areas, investments in these different countries possessed
rather different risk characteristics. Now they are more similar.
So, ironically, while the euro has been attractive to borrowers,
it has been rather unattractive to depositors and investors.
15. Nevertheless, such structural explanations
still leave most economists rather uneasy because they leave an
apparent opportunity for profit—in this instance, by buying
the euros which the borrowers and uninspired depositors and investors
sell, whenever the price in the market dips below "fair value".
So why has this not happened?
16. One answer is that the currency markets
rarely work this way because they are dominated by short-term
players whose expectations are extrapolative, rather than being
fixed by ideas of reversion to some measure of fair value. And,
in my view, this point has much to commend it as an explanation
of why currency markets behave the way they do.
17. But there has been something more specific
about the market structure of the last year which may bring added
explanatory power to bear. For the one category of market player
who might be thought likely to place big bets on the direction
of currency movements on the basis of fundamental economic analysis
is the hedge funds. It is notable that the two large macro funds,
Quantum and Tiger, have virtually shut up shop. Perhaps this has
something to contribute to an explanation of why the market price
of the euro has not reflected economic fundamentals.
CONCLUSION
18. The weakness of the euro on the exchanges
is not to be interpreted, in my view, as a sign that the currency
is fundamentally flawed, nor even that international investors
see it, and its prospects, as dire. Indeed, the scale of the market
movement is well within the scale of movements seen in the value
of currencies such as the dollar, yen and pound over the last
twenty years. Frequently over that period, abrupt movements in
one direction have been reversed, without obvious or convincing
justification from the economic fundamentals.
19. In my judgement, this is likely to happen
with the euro. Given that its weakness cannot reasonably be said
to reflect a genuine market assessment of long run value, the
fact that the currency has been weak so far should play very little
part in any decisions the UK takes about adopting the euro—except
in so far as it affects the exchange rate at which entry might
be possible.
25 May 2000
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