Belgium, Austria, Finland, Spain, Ireland, Portugal, Germany, France, Netherlands, Italy, Luxembourg, Greece, Vatican City, San Marino, Monaco, Martinique, Andorra, Canary Islands, French Guiana, Madeira, Reunion Island, Montenegro, Slovenia
The Euroland euro began trading as Europe’s new single currency in 11 of 15 European Union (‘EU’) countries on January 1, 1999 as a bookkeeping tool for corporate and investment transactions ‘virtual currency’. Euro coins and paper-bills became a fungible currency as they were introduced on January 1st, 2002. In the meantime, individual currencies national banknotes (ie. lira, franc, etc.) and coins had legal tender status until July 1, 2002. Greece which had high inflation and budget deficit challenges had their euro acceptance delayed until January 1, 2001 at which time they became the 12th EU member to use the euro as new national currency. Of the 3 remaining members of the group of 15 EU countries at time of euro inception, Denmark in September 2000 and Sweden in September 2003 in a national referendum rejected the euro in favour of their own respective national currencies the ‘krone’ and ‘krona’ for the time being. The United Kingdom is expected to vote at a later date in a national referendum or in a mandate during a general election widely expected in 2006-07.
The eurozone is a wealthy trading bloc with a combined economic GDP (gross domestic product) of $8.7 trillion USD at current exchange rates. The euro is the world’s second-most widely used hard currency and will be a dominant currency as the world moves into regional currency blocs in the years to come. Total GDP for the eurozone will continue to grow when new EU member countries graduate to euro ciruclation. Those nations with the euro as national currency now include the 12 EU members, potential membership of the other 3 EU members of UK, Sweden, Denmark, plus EU enlargement for another 10 countries that joined in May 2004 from Central & Eastern Europe in addition to the participating CFA franc countries in Africa where the CFA franc is linked to the euro. Moreover, there are several outher countries such as Tunisia, Morocco, etc. that have some form of a currency link or anchor to the euro.
POLITICS: the introduction of the euro is an interesting concept, one currency for many different sovereign national governments from one centralized bank, the European Central Bank (ECB). There is no historical precendent for the euro where each country gives up power over its internal monetary policy to an entity not under its political control. Although to date, the introduction of the euro via a fixed exchange route to currency integration has been a huge success. The euro was primarily driven by political rather than economic forces.
The European Union Parliament is based out of Strasbourg, Brussels and Luxembourg. The political structure is somewhat similar to the United States where a European Commission composing of commissioners including the Presidency which rotates every 6 months amongst each EU member along with the Council representing a minister from each of the current 25 EU members. It is this European Commission that proposes the policies & legislation that is submitted to the revised 732 members (25 EU countries - May 2004) of the European Parliament for debate. This radical change of thinking in Europe by sovereign governments giving up monetary policy to one central bank is going to change Europe dramatically. Europe is now evolving to a similar political and economic structure to that of the United States where one central bank exists for each of the 50 U.S. states within the American union. Within Europe, further planned EU enlargement from the current 25 EU states may include: Romania, Bulgaria, Croatia, Serbia, Montenegro, Macedonia, Albania, Bosnia, Kosovo and Turkey for a total of 35 EU member countries within the next few years. Europe is now well on its way to becoming the United States of Europe, a European superstate where similar inflation rates exist throughout the EU and whereby citizens from one part of the EU can now freely move and work anywhere within the eurozone.
The implementation of the euro through political stewardship is setting a precedent for the future of many of the world’s 180 currencies that currently exist. The euro is the tool that will unite the European Union and it will inevitably threaten national independence. At present, Euroland is less politically mature than the United States but with time is developing towards this superstate entity. Some believe that Europe lacks the political will for structural reform. However, it should be noted that labour market flexibility is improving coupled with productivity increases. Europe on the whole still tends to be more bureaucratic, less entrepreneurial, more government subsidies and higher taxed when compared to the United States. The move to the euro is shifting the differential in wages that currently exist in different regions of the EU as noticed with relocation of some manufacturing to poorer countries within the EU with favorable labour rates & payroll taxes. In due course, similar to the United States, inflation will even out somewhat amongst all regions of the eurozone.
ECONOMY: the mature developed eurozone economy fundamentals are relatively sound although the eurozone has had three years of slow growth. The appreciation of the euro over the last couple of years have marginally impacted eurozone exports even as many Asian market economies are linked to the USD themsleves. Eurozone manufacturing has actually been going at a very healthy clip. The two largest economies in the eurozone, France & Germany have had dismal economic performances in 2003 as the stronger euro hit corporations bottoms line including Germany’s Vokswagen as exports were less competitive with the currency exchange rate. Both France and Germany have been flirting with recession, growth is stagnant although France has shown recent positive economic growth signs. Germany’s difficulties are more structural, not cylical. Long term GDP growth rates forecasted for the eurozone are between 2.0 to 2.5 percent with the European Central Bank ‘ECB’ having an inflation price ceiling target of 2 percent annually with a preference of keeping inflation just below the ceiling.
The eurozone ‘Stability and Growth Pact’ which sets national government borrowing limits. It states that each individual member country can have a budget deficit of no more than 3 percent of GDP, if it is bigger, subject to fines of up to 0.5 percent of GDP. The challenge for the eurozone is coordinating fiscal & monetary policies within the 12-member EMU (Economic and Monetary Union). Germany, the eurozone’s largest economy recorded a budget deficit in year 2001 at 2.6 percent of GDP, just below the 3 percent ceiling set by the stability pact but 2002 breached the ceiling recording a figure of 3.8 percent shortfall. Year 2004 for Germany is on projection to breach the fiscal deficit ceiling again of 3 percent. A real threat to the EU is the possibility of German deflation with German unemployment reaching 10 percent, Germany has experienced a drop in private sector investment coupled with lower lending. Germany has high chronic unemployment, highest real interest rates, experienced recessionary growth in 2003, lowest inflation rates within the EU flirting with deflation as many areas of the German economy are swamped in debt. Overall, the transition to the euro has been tough on Germany economically. Many in Germany wish to keep deficit spending to increase sluggish consumer demand. Italy too is experiencing a slower tougher economy while Portugal has been experiencing fiscal deficit difficulties.
There has been discussions about the viability of the ‘Stability and Growth’ pact as some analysts believe it is a flawed ideology. Similar to Germany, France is having budget deficit difficulties as France breached the 3 percent deficit ceiling over the last couple of years recording a fiscal deficit of 4 percent in 2003 of GDP after 2002 shortfall at 2.7 percent. France wants to ease the stability pact with the option to stimulate growth when the economy is slow. Others have suggested that the pact needs reform, even perhaps switching to a formula of each individual country member of the eurozone targetting debt to GDP objectives rather then 3 percent deficit targets. Member countries would be allowed to run deficit shortfalls providing they meet the debt to GDP guidelines. Since each country has different timing for economic cycles, this may provide greater stability to the eurozone economies.
However, overall within the EU there are no serious economic imbalances such as an inflated stockmarket, no large current account deficit (modest balance of trade surplus) and no high consumer debt loads of which are all prevalent within the United States. Structural rigidities include weak consumer demand as rigid labour laws do exist in the eurozone but are being reformed. Ultimately, water seeks its own level as essentially lower cost regions such as Portugal and Greece are benefiitting from Germany’s high cost production zone. The outlook for the eurozone is bullish as there has been talk from Brussels of cutting taxes, removing labour constraints and agricultural subsidies. This course of change of economic policies will give the eurozone an economic boost. A stronger euro will increase efficiencies, provide for cheaper imports, increase innovation & productivity. Even in Germany where challenges remain, the economy is highly competitive with little idle capacity, there is no bubble in either the stock and real estate markets, stability resides unlike North America.
Economic Statistics
GBP growth for 2004 is estimated at 1.8 percent of GDP, GDP growth 2003 recorded a sluggish 0.5 percent figure. QTR 1 2004 was good at 0.6 percent or 2.4 percent on an annualized basis. April 2004 inflation at 2 percent, expected to climb modestly with higher oil prices. Both Ireland and Greece have higher inflation rates. Current account surplus projection for 2004 is from 0.5 to 0.7 percent of GDP. For comparison, the current account was in deficit in 2000 at 60 billion EUR and year 2001 at 14 billion EUR shortfall. Year 2002 recorded a current account surplus of 60 billion EUR as a reversal of capital flows occurred. Unemployment is at 9 percent, low participation rate. Both Portugal & Greece have high current account deficits, 5 percent and 6 percent respectively for 2005 projected.
POSITIVE: the new currency is resulting in an increase in mergers and acquisitions creating greater corporate efficiency, euro’s strength is forcing Europe’s economy to restructure and advance forward to provide for better conditions for investment & growth, eurozone is continuing to attract more FDI, high savings rate. CONCERN: high taxes & labour costs, challenging regulatory business environment for entrepreneurs, tax system needs revamping, fiscal policies constrained to 3 percent shortfall, high oil prices, chronic weakness in consumer demand, pension obligations.
CAPITAL FLOWS: capital flows and equity investments are a strong determinant of exchange rates. With the decline of U.S. equities and the USD over the last 3 years, capital flow reversal has taken place in favour of the EUR when compared to the late 1990’s- year 2000 during a time of a red hot U.S. stockmarket. Portfolio outflows from the Euroland area have dramatically fallen from 345 billion EUR in 2000 to now under 100 billion EUR for 2003. Current strong inflows correspond with an appreciating currency. A look at interest rates shows a 1 percent favour for the euro with the U.S. Fed rate at 1 percent and the ECB holding the refinancing rate at 2 percent. Expect this differential to narrow as it is widely expected that U.S. rates will begin to rise gradually while the repo rate will fall as projected by BI.C to a medium term rate of 1.50 percent by 2006 to counterbalance a rising euro. The repo rate peaked in May 2001 at 4.75 percent.
BANKING SYSTEM: European Central Bank ‘ECB’ was established by the EU on January 1, 1998 to oversee the introduction of the single currency, the ‘euro’ and to set monetary policy across the eurozone. ECB says structural economic reform rather than loose monetary policy is the best way to increase GDP growth. The ECB has set price stability a key objective with a 2 percent price target for inflation rather than a band of 1 to 3 percent currently in use by other industrialized nations such as Canada. Overall to date, the ECB has provided the eurozone with a sound monetary policy, a better monetary policy than previous with individual currencies. The ECB has been criticized for being slow to respond for cutting interest rates, but they are acting prudently in managing monetary policy. The euro has brought lower interest rates to eurozone members, monetary policy has been a success. This will help the EU grow and prosper over the long term particularly with the elimination of currency speculation amongst EU member currencies as they have been replaced with the euro, this is much better scenario for the smaller EU member countries.
On November 2, 2000, ECB intervened to buy euros to help support and lift the euro for the second time in year 2000 as the euro at that time was hitting all time lows in valuation versus the USD in a mini euro currency crisis at that time. The ECB has a clear mandate to focus on monetary policy on the domestic objective of price stability rather than on the exchange rate. With time, the ECB is gaining valuable experience in management and the learning curve is shortening. There is far too much on the line with litterally hundreds of billions USD equivalent invested in the banking system transition including accounting systems to rollover of banking activities for the success of the euro. Domestic banking institutions will see industry consolidation take place in the years to come with fewer but much larger banks serving the needs of the eurozone citizens. As of February 2004, official reserves were measured at $240 billion USD equivalent exluding gold. Several individual central banks for member countries have been selling gold reserves ie. Germany, Netherlands. The ECB has 760 tonnes of gold pledged by independent member central banks.
REGIONAL and GLOBAL ANALYSIS: EU Enlargement
On May 1, 2004, ten new Member States joined the European Union bringing to a total of 25 EU member countries. These new countries include Cyprus - Greece, Czech Republic, Estonia, Latvia, Lithuania, Hungary, Malta, Poland, Slovakia, Slovenia. Each new euro accession country is legally committed to accepting the euro ’EUR’ but there is no rush to do so. Accession Member States will be able to join the euro as new national currency once they achieve the following: price stability, stable exchange rate, converged longer term interest rates, countries must keep their budget deficit below 3 percent of GDP, maintain low inflation, public debt can account for no more than 60 percent of GDP, criterion on human rights, establishment of solid democratic governments.
EU enlargement has taken total population for EU 15 of 380 million to now over 400 million EU citizens with this new recent round of enlargement. The current phase of EU enlargement may bring down the average GDP/Capita income over the short to medium term as many of the new members are relatively poorer as they are from the old Warsaw pact countries. Average GDP/Captia of EU 15 is 24,300 EUR, the 10 new members have a GDP/Capita of only 12,000 EUR approximately. It is interesting to note that the 10 new member countries will only account for 7 percent of GDP for the eurozone and a modest 10 percent increase in population size. These new countries will have minimal impact on euro soundness and will not in anyway derail euro stability. Switzerland has decided to stay outside of the European Union as its citizens voted down the opportunity to join in order to maintain the Swiss franc ‘CHF’ as national currency while protecting its highly lucrative Swiss banking industry.
It is widely expected that later in year 2004 that Cyprus - Greece, Estonia, Lithuania and Slovenia may join Exchange Rate Mechanism ‘ERM’ II, a two year initiation before adopting the euro. Euro expansion would now be set for 2007 after this first group of 4 countries spends a two-year period in the ERM II exchange rate mechanism which sets a band for currency fluctuation against the euro. The second group may consist of Latvia, Lithuania, Slovakia and Malta. Both Poland and Hungary are looking at a 2009-10 time frame for euro adoption. Other countries seeking EU membership include Bulgaria & Romania in 2007, Croatia in 2009, Macedonia (2010), Albania (2010), Serbia (2012), Montenegro (2012) Turkey (2015), Bosnia & Kosovo (2015). Each of these countries have much work to do in meeting economic and social requirements for qualifying.
The final outstanding question for EUR enlargement includes the United Kingdom, Sweden and Denmark. Euro membership for Sweden and Denmark are now uncertain as both nations have declined membership narrowly in national referendums. The United Kingdom is not expected to join in the foreseeable future as the UK is currently not ready particularly in the area of convergence. It is quite possible that a vote may take place in the next couple of years, hence the pound will remain as national currency for the UK for the time being. At today’s exchange rates, the British pound would may have to depreciate by upwards of 20 percent to the Euroland euro in order to gain entrance.
KNOWLEDGE: the USD is currently overweighted in central banks holdings around the world. Central banks particularly in reserve rich areas like Asia and the Middle East may begin the process of diversifying away from the USD and into the EUR, Japanese yen and gold bullion. This may become more prevalent with Islamic hesitance towards the United States. Asia has over 55 percent of the world’s foreign exchange reserves. As the euro attains international acceptance with time, the credibility of the euro currency will attract the eyes of foreign central banks. BI.C predicts that central bank reserve holdings of euros will ultimately match those of the USD. Currently, central banks worldwide hold 65 percent of their reserves in USD and only 15 percent in euros. This figure could easily narrow in the short to medium term to say 50 percent for the USD and 30 percent for the euro. This change in portfolio holdings is indeed bullish for the euro. The euro will become a major reserve currency worth $100 billion USD/year for the next 10 years as $1 trillion USD will shift into the euro. Many central banks including countries like China are beginning to diversify their reserves into the euro & gold bullion away from USD.
CURRENCY: ISO symbol, ‘EUR’, Euroland euro, euro. At time of review on May 18, 2004, the Euroland euro had an exchange valuation of 1.1955 USD to 1 EUR and/or 1.4763 EUR to 1 GBP (British pound). Exchange valuation for the euro immediately after currency launch performed well hitting an exchange valuation of $1.17 USD for 1 EUR in January 1999. The euro has since shown great volatility falling by upwards of 30 percent from this early valuation. The euro hit a record low versus the USD on October 25, 2000 at 82.74 US cents. Conversely, the euro reached a high of $1.293 USD to 1 EUR in February 2004, a 19 percent appreciation to the USD year over year on top of an 18 percent appreciation to the USD in year 2002. As measured by purchasing power parity as of May 17, 2004, the EUR is 11 percent overvalued in relation to the USD. Currently, there is a strong direct correlation with a strengthening EUR and a rising gold price, that is, when the USD falls in relation to the EUR, gold bullion rises in USD pricing.
At present, the USD is used worldwide, the yen only in Japan and the euro mostly in Europe. Only the USD has that global transactional purchasing power, but this trend may change in the years to come in favour of the euro. The world over the next 25 years will enter into regional currency blocs with the major currencies including the USD, the Japanese yen, China’s renminbi yuan and the Euroland euro.
CURRENCY HISTORY: it should be noted that the basket of European currencies that make up the euro hit a low versus the US-dollar in 1985 at equivalent $0.69 USD. The euro was launched at a precarious time in investment history in the midst of the wildest greatest stockmarket boom the world has has ever experienced, primarily the U.S. stockmarket technology boom. Consequently, strong global demand including large sums of monies from the eurozone for US-dollars especially from mid 1999 to mid 2000 at a time when the U.S. economy was growing at 6 percent while the euro was at a respectable 3 perent growth. At that time, there was a tremendous amount of bad press and pessimism towards the euro, poor public relations campaign on the part of the euro members to attract and build confidence. Currency markets have a tendency to overshoot their highs and lows. Other valuations for the euro include: January 1999 at 1.1590 USD to 1 EUR, January 2000 at 1.01281, October 2000 at 0.85 USD to 1 EUR, September 2001 at 0.91183, February 2002 at 0.87073, November 2002 at 1.001, June 2003 at 1.16755, January 2004 at 1.26263, April 2004 at 1.19851. For those interested in currency facts, the former French franc was first minted in year 1360 and remained in ciruclation for 641 years until the euro ultimately replaced the franc. Conversely, Germany has had several currencies, the more recent German deutschemark came into circulation in 1948.
CURRENCY FORECAST: the euro to appreciate versus the USD particularly over the long run with more particpating countries joining the euro, greater purchasing power. BI.C currency estimates have the 12-month forecast for the euro at 1.37 USD to 1 EUR and to reach a trading range of 1.50 to 1.60 USD to 1 EUR. At this ceiling level of 1.60 USD, expect the ECB to lower interest rates (ie. repo rate to fall to 1.25 - 1.50 percent range) to provide downard pressure to the euro settling in the 1.25 USD to 1 EUR level as continued EU enlargement takes hold. The primary issue for the eurozone and the United States economies are the twin massive shortfalls for the U.S. economy which include the trade and fiscal deficit position of America. The trade misalignment will correct but only after the USD continues with its currency depreciation. Capital flows will also provide appreciation pressure to the EUR as United States stocks are still in a land of very high valuation (see write-up on UNITED STATES in this BI.C currency index). BI.C forecasts the euro to appreciate upwards of 15 percent against the British pound as the UK debates joining the eurozone. It is a widely held view that sterling will have to devalue to make euro entrance feasible.
A final look at cycles reveals interesting knowledge. There has been a consistent 5 to 10 year cycle in relation between the USD and German deutschemark/euro. From 1980-85, the USD appreciated to DM1.72 to DM3.42. Conversely, from 1986-95, the USD fell 60 percent to DM1.36. Again, the powerful bull market rally for the USD began in 1996 lasting another 5 years. In this USD/EUR cycle, BI.C predicts the USD will remain in a bear market for another 5 to 7 years as ultimately the United States economy corrects their trade and fiscal economic imbalances as they reverse to surplus in due course. Today, the EU as an entity is relatively debt free, high home ownership with lower debt levels than America and a higher savings rate within the Euroland countries. Further, there appears to be a trend for unwinding the socialist policies that prevail in much of Europe ie. subsidies.
SOME TOP ANALYSTS ARE STILL SKEPTICAL ABOUT THE EURO
They argue the euro will not be in existence in 20 years. They believe the euro will only work reasonably well when the global economies are relatively strong. But if we go into a difficult economic climate, the euro may not survive. Why? Governments like to use monetary policy to stimulate their national economies and print currency to pay their bills. The European Central Bank may become an inconvenience for them to meet their national political agenda. Some have argued the euro may result with increased political conflict with growing pains.
BI.C disagrees, we see the Euroland area becoming the next United States of Europe, a superstate. With free mobility and work visas throughout the eurozone, Europe is going to integrate and change dramatically over the next 50 years. The world is advancing very rapidly. True there is no historical precendent for the success of the euro, but with technology & communication, the world is becoming highly interchangeable and is much different to Europe 30 or 50 years ago. Further with EU enlargement, productivity shifts in the EU will evolve as barriers to trade are eliminated within the eurozone as many businesses are now able to lower costs by avoiding currency risk & hedging costs unlike before with separate currencies. Further, the euro is gaining worldwide popularity as it becomes more transactional for payments & trade ie. oil. The euro will joing a select small club of currencies that will rule monetary commerce in the future, this is more evident as several countries now anchor their currency to the euro. BI.C believes political leadership in Brussels realizes the initial difficulties in euro launch and is working to correct the weak internal domestic demand, relax the labour laws, reduce the bureaucracy, reduce taxes and reduce social spending. Greater efficiencies and productivity gains will take hold resulting in the long term success of the euro currency. The euro will be one of the world’s premiere currencies as the global financial system moves into regional currency blocs.
UPDATED: May 18, 2004
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