July 10, 1999

Slide in Euro Puts a Chill on Economies of Continent

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    FRANKFURT, Germany -- It was supposed to be a symbol of new strength and unity, a sign that Europe had achieved economic parity with the United States.

    But today, little more than six months after 11 European nations adopted the euro as a new single currency, it has become a source of embarrassment and anxiety.

    In a slide that has alarmed many government officials and surprised most economists, the euro has steadily declined against the dollar from nearly $1.18 at its introduction on Jan. 4 to just below $1.02 by the end of Friday.

    Despite continuous exhortations by European central bankers about the euro's fundamental value, it now has a good chance of dropping below the value of a dollar.

    The relentless decline has become a mirror of Europe's economic weakness and political disunity. It also is a daily reminder of the contrasting economic boom still under way in the United States.

    For Americans, the euro's decline is good news. Europe has become a far more affordable place to visit -- prices in dollars have fallen nearly 15 percent since January because of exchange rates alone. European imports are a bit cheaper.

    But for Europeans, the euro's weakness is beginning to pinch financially. Worried that the euro could fall even more, global investors have in recent days begun demanding a risk premium -- slightly higher interest rates -- when buying euro-denominated bonds.

    In effect, that means the cost of borrowing for corporations as well as for people buying homes and cars is edging upward.

    Doubts about the euro have intensified before it has even become a full-fledged currency. It is still used only in corporate and government financial transactions -- euro notes and coins will not enter circulation until 2002. But the national currencies of the 11 euro countries are locked into the value of the euro, rising and falling with it.

    There is nothing magical or even good about a particular exchange rate. The dollar has itself fluctuated widely over the years in relation to other currencies.

    A weak euro also has practical advantages for Europeans. It promotes European exports by making them cheaper in dollar terms. It creates opportunities for foreign investors looking at European properties.

    Many experts believe that the euro will climb again in the months ahead. Economic growth is picking up again and inflation is still negligible, trends that should tend to strengthen the euro. The currency also should gain from Europe's big trade surplus, which increases demand for euros and raises their value as European exporters repatriate profits from healthy sales overseas.

    By all accounts, the biggest cause of the euro's decline has been Europe's persistently slower growth, running at a rate of about 2 percent so far in 1999 compared with more than 3 percent in the United States.

    Germany, which accounts for a third of the economic output of the 11-nation euro zone, slumped badly after the Russian financial collapse last summer and is only beginning to bounce back. Italy, the euro zone's third-largest economy after Germany and France, stalled as well.

    But the euro has been wounded by political uncertainties, too. Even as European leaders toasted its introduction on New Year's Eve, left-of-center leaders in countries like France and Germany were balking at the inflation-fighting priorities of the new European Central Bank.

    Germany's new Social Democratic government under Chancellor Gerhard Schroeder added to the problems. Schroeder's first finance minister, Oskar Lafontaine, unnerved investors by loudly badgering the European Central Bank to lower interest rates, which would promote more economic growth but make the euro worth less. He also infuriated industry leaders with plans that would have raised taxes for many companies and added to regulation.

    Lafontaine abruptly resigned in March and Schroeder has now veered back toward the political center. But Schroeder's shaky stewardship rattled business confidence, which is only now beginning to recover.

    Political miscues elsewhere in Europe have hurt the euro as well. Last month the currency tumbled on a suggestion by Romano Prodi, the former prime minister of Italy who has since become the European Commission president, that Italy eventually might have to quit Europe's single currency. Although Prodi said his remarks were taken out of context, it was the first time a senior official had even hinted at the possibility of a breakup.

    Prodi contributed to the euro's weakness on Thursday, saying he was not worried about its decline. Germany's new finance minister, Hans Eichel, went even further. He said on the same day that the weak euro was "good for exports" and "no problem."

    Oddly, the euro's newest low point comes as signs of economic strength are becoming more numerous. Industrial orders are up in Germany. Business confidence has climbed significantly in France. Italy, which retreated from its earlier deficit-reduction goals last month, is tightening up again.

    But confidence in the euro has not recovered.

    "Credibility is very easy to lose and very hard to regain," said Thomas Mayer, a senior economist at Goldman, Sachs in Frankfurt. "Right now, there seems to be a very negative feeling in the market that is very hard to counter. What we really need is a significant change in perception, and it is not clear at this stage what would bring this about."

    Almost daily the last several months, European central bankers have earnestly tried to talk up the euro as if they were members of a booster club.

    But the bankers have often seemed torn between their laissez-faire principles and their discomfort at the euro's decline.

    Wim Duisenberg, the Dutch president of the European Central Bank, caused a fury among many of his colleagues in April when he described the bank's approach to exchange rates as one of "benign neglect."

    The comment prompted Hans Tietmeyer, president of Germany's central bank, to publicly dispute the idea of neglect and to complain that "a significant further change of the euro's level would not be appropriate."

    But the central bankers also appear convinced that if they intervened in the foreign exchange market, buying euros and selling dollars to strengthen the euro's value, they would simply undermine the euro's credibility as a currency that can stand on its own.

    Instead, they have offered new pep talks every time the euro slips a bit more.

    "The euro is a currency firmly based on internal price stability and therefore has a clear potential for a stronger external value," said Jean-Claude Trichet, president of the National Bank of France, at a conference on Wednesday in Hong Kong.

    Some experts agree.

    "One should not over play the current fears," said Daniel Gros, deputy director of the Center for European Policy Studies, a research center in Brussels. "The economic outlook for Europe in the medium term has improved considerably. The business cycle looking forward does not support a euro at this level."

    But even Gros acknowledged that he was surprised by the euro's decline. Investors behaved much differently toward the euro than he and many other experts had expected.

    Six months ago, many economists and investment analysts predicted that foreign financial institutions, including central banks, would start selling dollars and buying euros.

    But that did not happen. Rattled by problems ranging from Russia's collapse to the looming war in Yugoslavia, investors treated the dollar even more as of a haven than they had before.

    Something else happened as well. Because European interest rates are lower than those in the United States, corporations and governments sold billions of dollars in new euro-denominated bonds to take advantage of the lower financing costs. The pace of new euro-bond offerings actually exceeded that of dollar-bond offerings in recent months.

    The most recent pressure on the euro has come from diverging interest rates between Europe and the United States. In a significant move to stimulate growth, the European Central Bank reduced its core interest rate from 3 percent, to 2.5 percent, in April. By essentially pumping more euros into the economy, the move put downward pressure on the value of the euro itself.

    Then on June 30, the Federal Reserve moved in the opposite direction. Worried that the American economy could overheat, it increased its central short-term interest rate from 4.75 percent, to 5 percent. That pushed up the dollar at a time when the euro was already weakening.

    In a survey of European economists, Reuters reported on Thursday that 66 percent now expect the euro to reach parity with the dollar and some believe it will drop even lower.

    Many European experts are convinced that government leaders quietly support the idea.

    "The fall of the euro in the last six months does not mean that the euro lacks credibility," said Dominique Moisi, deputy director of the French Institute for International Relations in Paris. "It simply means that various European governments have found it very comfortable."

    Recent statistics suggest that the weakened euro has begun to stimulate new exports and growth in Germany, where growth stagnated the end of last year.

    But the weak euro now seems to be pushing up bond rates, which means that borrowing money is becoming costlier. Mayer of Goldman, Sachs noted that the difference between yields on 10-year bonds in Europe, which had carried yields about 1.6 percentage points lower than comparable Treasury bills, narrowed significantly the last week or so.

    The shift reflects a new risk premium that investors in euro-denominated bonds are demanding as protection against further declines in the euro's value.

    "Until now, people could say that the decline of the euro didn't cause any real problems," Mayer said. "This is a clear warning sign that something unpleasant is taking place."

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