The Euro Issue

At a time when large nations are disintegrating the world over, a totally different economic phenomenon is taking shape in Europe.If current trends persist, January 1, 1999 will see the unification of European currencies. Although it is premature to predict how many European countries will actually enter the European Monetary Union (EMU) in the first phase of unification,it will spell a very significant change in the international monetary system.

In fact, economists presage that it will be the most significant change ever since the Bretton Woods system of fixed exchange rates broke down in the early seventies. The prospect of having a unified European currency within less than two years is sparking off a great deal of speculation about the impact it will have on the global economyif the concept does take concrete shape.

There is no doubt that the Euro will take concrete shape. With so much of effort and investment having gone into it, the costs of dumping it would be too high, says P H Ramaswamy, head (treasury),Credit Lyonnais. Furthermore,the grounds have already been laid, as S Surendranath,corporate chief with Batlivala & Karani Forex Management Services points out. Says he: The European countries have been running a de facto monetary union for some time now by linking their currency through the exchange rate mechanism. (See box: The journey). Mitul Kotecha, treasury economist with Standard Chartered Bank, London, feels that the success of this exchange rate-based currency-linking exercise indicates just how succesful the Euro could be.Except for a brief period in 1993, this concept has worked well,says Kotecha.

With the unified European currency being more or less a certainty, money managers the world over are now debating about the global implications of such a system. According to Prof. Dr.Hermann Remsperger, economist and director at BHF Bank,Germany: Once the Euro is in place, there are two trends that will have to be observed. First, will the Euro ease out the American dollar as the main reserve currency? And second, will the Euro make the global monetary system more stable?

Dollar dilemma

Currently, 63 percent of worlds official reserves are in dollars. Though this has come down from a high of 73 percent in 1973, it is still by far the most dominant currency traded on foreign exchange markets. Will the Euro change these equations?

The dollar is not likely to lose its dominance in the short run. Weakening, if any, will be gradual, says Kiran Umrootkar senior vice president (treasury), Tata Finance.Jon Bowen, manager (treasury and money markets), HSBC,feels that central banks the world over will play a decisive role in this matter.The performance of the Euro will depend upon the decision of the central banks about the currency they prefer to hold their reserves in,i.e., dollar, Euro or yen.

If the Euro does come into existence, there can be a sea change in the status of the dollar as currency reserve, as much of the changing equations will come in at the expense of the dollar. If the Euro tends to be a strong currency from the outset, the impact will be much more severe on the dollar, says Surendranath.

To quote from a report published by Deutsche Morgan Grenfell: Currently, several Asian and Latin American central bank combines hold reserves of more than $ 700 billion. Even a minor shift into Euro and out of the dollar will have profound implications for the structure of international reserve holdings and also potentially on the dollar-euro exchange rate. Says Ramaswamy, Japan has reserves worth $ 207.3 billion-almost wholly in dollars today. At least $50 billion of these reserves could be in Euro once it comes into being. The US holds more than $ 20 billion in DM; that could then shift to the Euro.

Fred Bergsten, director of the Institute for International Economics in Washington has gone on record as stating that as far as European nations are concerned, in the first half of last year, core European countries held about $ 200 billion in reserves, of which about $ 40 billion was in DM and $ 10 billion in French francs. This will shift to the Euro. There may also be increasing demand for Euro assets from Eastern European central banks as well as from European Union central banks that do not formally join the first phase of the European Monetary Union.

However, such a major shift can happen only under certain conditions.Says Prof. Remsperger: The Euro can challenge the dollar, only if two conditions are fulfilled. First, the Euro must be supported by the economic potential of the EMU countries. Second, the EMU countries on an aggregate have to show good economic results. Says Ravi Pai, vice president (forex) HDFC Bank: Till the Euro stabilises, the demand for the dollar could increase substantially. And that is because the dollar could become the safe haven currency on account of the uncertainties hounding the Euro. In fact, adds Kiran Umrootkar, Euro will have a tough time gaining an edge over the dollar, specially in Asia and some of the emerging markets of Latin and South America. Here the greenback will remain the king. The Euro may not be able to dislodge the dollar for quite some time to come.

Greenback gains

Any shift in the reserves position will have its effect on the value of major currencies. What will be the impact of such a shift on the value of the dollar and on other major currencies?

The value of dollar will remain firm, says Kiran Umrootkar. Adds Ramaswamy, The fundamentals of Euro in the short run look unstable and this will act in favour of dollar. One reason is that there are weak currencies and economies in the basket. There is a positive side to a gradual rise in Euro, as it will benefit the member countries, any quick rise of the Euro would hurt European exporters.

Exchange stability

The other implication of the Euro will be felt in terms of volatility in the global currency markets. One of the basic purposes of setting up a unified currency system is to remove fluctuations in the forex market. Will this purpose be achieved ?

The European currency market will not be without its fluctuations, feel many. In fact,the past few months have already shown that the higher the probability for a timely start of the monetary union, the more the DM will come under pressure since DM is a stronger currency merging with weaker currencies under the Euro system.

Postponing the EMU, therefore, will be dangerous as it will make the DM stronger. There could be political implications to this, too. Says Ramaswamy: There will be a serious depreciation of other currencies against the DM especially the franc. This can lead to immediate political tensions between Germany and France.

An article published in Deutsche Morgan Grenfell (a newsletter published by Deutsche Bank)stated that the exchange rates for the US dollar against the European currencies (ahead of EMU) and for the dollar to the Euro (after the EMU) is likely to continue to be dominated by three factors: the relative cyclical positions of the USA versus Europe, macroeconomic policies, and expectations of private asset holders as to the stability of the European currencies and the Euro, respectively.

Living with uncertainties

Optimism about the Euro coming in is laced with doubts, though. For example, the third condition of the Maastricht Treaty ( which stipulates reduction of budget deficits to 3 percent of GDP as a pre-condition to qualify for the EMU) could pose a problem. The problem, as pointed out by Kiran Urmootkar is that people consider this clause to be an attack on the generous welfare benefits to which Europeans have become accustomed. This, along with the threat of nations losing their sovereignty, might lead to resistance to the concept itself.

Currently, the major hindrance faced by the Euro is the uncertainty over the elections in France. With the difference between the right wing (pro Euro) and the left wing (anti Euro) said to be narrowing down, many doubt the launch of the Euro if the left wing wins.

In the ultimate analysis the decision to participate will be a very political one. Denmark and Sweden are not joining the EMU. Italy (which is one of the founding members of the EMU)and Greece may fail to qualify, as might Spain and Portugal. This may lead to political unrest. On the other hand if they do manage to join the EMU, the Euro will be considerably weakened.

Surendranath adds: For a qualified majority (for Euro to come through) you need 62 out of a total of 87 votes (from 15 European Community member countries. It would be very difficult to get this qualifying majority if Italy, Spain and Portugal are refused admission.These three countries together hold voting rights to the tune of 23 votes.

Further, the tax difference is a major bone of contention among the member states. Many accuse the current system of being a beggar-thy-neighbour one. For example, tax havens such as Luxembourg,Ireland and Dublin Docks are accused of creaming off valuable revenue by offering favourable business opportunities in terms of low taxes.

All these uncertainties are having a negative effect on the European economy in terms of low economic activity. This, in turn, is making it more difficult to reduce government budget deficit and debt levels. Adds Vishnu Deuskar, country treasurer, ABN Amro Bank: There is also a supposition that huge income transfers to the weaker countries will be necessary to narrow the convergence gap.

If anything,these uncertainties are magnifying the issue of the Euro. If the Euro currency does come through, it would seem in retrospect that the emergence of Euro was the most important economic development shaping the world in the latter part of the 20th century.

The Asian power

Will the disappearance of currencies like the DM and franc shift traders focus towards the Asian currencies? This seems to be a definite possibility, since so many currencies will cease to exist.

Already, many European banks are beefing up their foreign exchange trading operations in Asia to make up for the potential loss of trading operations in Europe. For example, Singapore has become the fourth largest currency trading centre in the world. The average daily turnover is now more than US $ 190 billion as against $ 111 billion in 1995 and $ 100 billion in 1994.

What will be the impact of the Euro on India? Says Vijay Meghani, BHF-Bank: The Indian borrower in DM could stand to gain as the Euro is expected to be weaker than the DM, against the US dollar. Further,borrowing in DM could increase due to the likely conversion of the DM into a weaker Euro. That is because a medium term borrower would then be borrowing in a potentially weaker currency, which would obviously be a wise strategy.

Says Kotecha: Faster economic growth in India will ultimately increase imports from the European Union (EU) and EU links with India will gain more importance as Indias global influence grows. But as of now it will not have much of an impact on Indias trade, says Kiran Umrootkar.

Will the Indian central bank change the weightage of the currency basket against which the rupee is pegged? Meghani feels that the dollar appears to have the highest weightage in the basket. This is because it is the main currency of the countrys foreign trade and it will take time for any new currency such as the Euro to establish itself as a major currency of choice for invoicing of global trade.

Will the rupee gain prominence? Surendranath feels it has the potential to materialise, but only when India goes in for convertibility on capital account. In fact, most analysts feel that the dollar will continue to be the main currency in Indias trade basket,and the Euro will have relatively less impact in the foreseeable future.