The Euro: Southern Exposure

The apparent calm in the face of the Euro’s all-time high against the Dollar masks a growing sense of unease in Europe. Politicians, particularly in the north, seem to gloss over significant concern held particularly by the French and Southern Europeans who are worried about the strength of their export position.

German Finance Minister Peer Steinbrück, for instance, has been optimistic: "Germany sees few problems with the current strong Euro exchange rate because its exporters are less sensitive to price fluctuations than some other eurozone countries." In an export market of BMW or Mercedes and business-to-business technology, buyers are less likely to notice a few Euros here and there.

Italian Prime Minister Romano Prodi, however, sounds worried. While noting that Europe has so far handled exchange rate changes well, he said he hopes the Euro does not appreciate "too much." Similarly, European Central Bank (ECB) Chief Jean-Claude Trichet reminded currency traders that "there are two-way risks in any bet."

The difference is largely one of sector. Export goods from Germany and Finland are in high demand and benefit comfortably from the Euro’s appreciation via higher prices. And while Italy itself has a strong luxury goods market, other southern European countries such as Spain and Portugal have lost out, due to their reliance on lower value-added consumer goods like textiles, table wine and olives. And with high interest rates fuelling currency appreciation, the ECB could actually exacerbate these export issues.

During the French elections, Ségolène Royale was more bothered by the effect rising interest rates have on growth than on the high value of the Euro. However, Nicolas Sarkozy was more willing to see trouble; for example, he explicitly tied the difficulties of troubled European aircraft maker Airbus to the high valuation of the Euro.

"A weaker Euro should be a tool to help European industry," he said. "We didn’t create the Euro in order not to make a single plane in Europe.’"

Sarkozy also alluded to Article 104 of the Maastricht Treaty, which "gives control over the exchange rate to the EU finance ministers, acting by Qualified Majority Vote."

Laurence Parisot, Chair of France’s powerful business association, agreed.

"It’s evident that we do not have a true exchange rate policy at the European level," she lamented, stressing the need to keep exchange rate fluctuations within "a reasonable spectrum." Within the last six years, the Euro’s exchange rate with the U.S. dollar has fluctuated substantially between $0.82 and $1.36, a roughly 60% difference.

The ECB has been criticised for the strong Euro, caused in part by rising European interest rates. Should the Euro overtake the U.S. dollar as a reserve currency, the value of the Euro could appreciate still further, making European exports even more expensive than they are now.

This is the exact opposite of what the French originally intended.

"How can you continue to export" asked Sarkozy in a recent interview, "if the Euro is the only currency in world that is overvalued compared to the Dollar, the Yen and the Yuan?"

At the moment, Sarkozy is nearly alone in speaking out against the strong Euro. And while Italian Prime Minister Romano Prodi is on Sarkozy’s side, but most members of the European Union, including export-dependent Germany, believe structural reforms are a better solution to improve demand from foreign countries.

Looking back to the Euro’s launch, much has changed. Not long after the Euro was introduced in January 1999, ECB chief Wim Duisenberg came under fire for setting the exchange rate too low. And for a time, the worries of economists only grew. In September 2000, French Central Bank chief Christian Noyer said the Euro was "dangerously undervalued." In the same month, Michael Mussa, chief economist of the International Monetary Fund, echoed the French central banker’s concerns, warning "that the Euro was so significantly misaligned that it posed a risk not only to Europe’s recovery but to growth in the United States and Japan as well."

The initial low value of the Euro was "completely out of synch with the underlying economics," commented C. Fred Bergsten, head of the Institute for International Economics in Washington at the time, adding that "if the big currencies get way out of whack, it can cause serious problems."

Recognising the sensitivity of the topic, Duisenberg said as early as November, 1999 that "I am somewhat concerned that all the talk and all the hype about the external value of the Euro might, to some extent, undermine in the people’s mind the confidence they have in their new currency."

So, now what?

Becoming a reserve currency replacement for the U.S. Dollar would be a mixed blessing for Europeans: Certainly it is prestigious to have the Euro potentially equal the Dollar as an international currency of choice. And in fact, this is what many European politicians said they wanted when the Euro was first introduced.

But is it a good idea?

If the Euro takes over as a reserve currency, its value could appreciate still further, according to most experts, making European exports even more expensive than they are now, and causing an investor flight from the United States. For the French terms, this is also highly undesirable, given that "an exchange rate of $1.40 would endanger" the survival of Airbus. Sarkozy has made clear that he will not tolerate Airbus going bankrupt, particularly if a bankruptcy were caused by an abnormally high European exchange rate that is largely a political choice.

But the waves from a Euro worth $1.40 (or even $1.50) would wash up far beyond Airbus. While Germany and the Netherlands – both co-investors in Airbus – might have the economic strength to avoid being swamped by these levels, France, Spain and Italy do not.

In fact, a Euro worth more than $1.40 would be a disaster for Mediterranean countries heavily dependent on tourism from North America, where the strong Euro/weak Dollar equation has been particularly crippling — potentially re-launching the political debate over the mandate of the European Central Bank, something that Sarkozy has hinted at.

The initial discomfort brought about by the Euro’s "low" value to the Dollar was mostly a matter of prestige. Now that the Euro is worth far more than the Dollar and still rising in value, it is becoming a matter of tangible economic and political concern.