EURO May Challenge the Dominance of U.S. Dollar
Three Experts Discuss the Implications of Economic and Monetary Union (EMU)

Copyright 2000 Barclay Trading Group, LTD.
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On January 1, 1999, Europe will undergo its most momentous change in economic policy arrangements since the creation of the common market in 1957. Economic and monetary union (EMU), if successful, will result in, among other things, a single currency for most of the nations of the European Union (EU).

Adoption of the Euro by the major European countries will have a powerful impact on banks and other currency traders. Banks will probably lose a bundle as monetary union reduces the number of currencies they trade. According to The Economist, Union Bank of Switzerland estimates that EMU will kill anywhere between 10% and 35% of their forex business.

On the CTA side, the analysis is not quite so straightforward. Certainly, less currencies to trade would translate into fewer profitable trading opportunities. However, many CTAs in the currency arena have already expanded their portfolios to include the currencies of 2nd tier European countries, Asian Tigers and emerging market nations throughout Eastern Europe, Asia and South America.

The conventional wisdom at this juncture is that EMU will happen. However, almost every monetary union in history that extended across national borders has broken down. Will the Euro succeed, will it be strong or weak, will it rival the U.S. dollar as a reserve currency? In order to get a better understanding of the issues involved, we've asked a group of currency experts to share their views with us on this topic. Our panel includes:

Gillian L. Manning, Toron Capital Markets, Inc. Ms. Manning is a political analyst at Toron, a financial risk management firm that designs and manages customized hedging solutions for corporate clients with currency and interest rate exposures. She has a Master's degree in international relations with a specialization in foreign policy analysis and systems theory.

George V. Marcus, CRT Currency Exchange Ltd. Mr. Marcus is the President of CRT Currency Exchange Ltd., a proprietary based currency forecasting system. CRT specializes in trading the U.S. dollar vs. D. mark, Sterling, Swiss franc and the Japanese yen.

Jon Percival, Chescor, Ltd., Mr. Percival is the currency trader at Chescor, the London-based CTA, which started trading in 1989. He also publishes the bi-weekly Currency Bulletin accompanied by a weekly fax service. He is the author of The Way of the Dollar.

Q: In mid-September 1997, EU leaders ended months of uncertainty about the method of fixing the conversion of national currencies into the Euro when they agreed that bilateral conversion rates would be pre-announced in early May 1998 to coincide with the selection of the EMU's founding members. What is the significance of this decision for currency markets?

Manning: We should begin by distinguishing between bilateral conversion rates and national currency/Euro conversion rates. The September agreement pertains only to the former. The exchange rate between each national currency and the Euro will not be determined until January 1, 1999.

The purpose of pre-announcing the bilateral rates is to decrease volatility in foreign exchange markets by reducing the incentive to speculate against the participating EMU currencies during the final six months before the Euro is launched. It is hoped that this will turn the final run-up to the single currency into something of a self-fulfilling prophecy. The obvious question, of course, is whether volatility will simply shift to the pre-May 1998 period. So far, there's no indication that it will. The only reason to speculate against the core European currencies is if you believe that those governments will seek to devalue their currencies before May 1998 in an effort to lock in a more favorable bilateral exchange rate. However, the most striking aspect of the EMU project thus far has been governments' restraint in the face of these kinds of temptations. Their tacit coordination on exchange rates has been bolstered in recent weeks by the move to establish a more uniform interest rate among the core EMU countries. This interest rate convergence is important because it diminishes the likelihood of competitive currency devaluations still further by reducing opportunities for interest rate arbitrage.

In the May 1998-January 1999 period, the interesting thing to watch will be the dynamics of exchange rate management. Bilateral exchange rates between the first round EMU currencies will be pegged, but trading will still occur. As a currency moves away from its pegged value, will the central banks intervene? As for the national currency/Euro conversion rates, EU leaders agreed at the 1995 Madrid Summit that the Ecu, the basket of fifteen EU currencies, would convert to the Euro at a rate of 1:1. This may pose a problem, because not all fifteen Ecu members will be entering EMU in 1999. At the moment, the plan is for each country's national currency/Euro conversion rate to be based on the currency's Ecu rate on the last day of December 1998, but that means the Euro rates will be influenced by the Ecu rates of non-participating currencies. In recognition of this potential for volatility, we're now seeing pressure for the formation of a second ERM (ERM II) which would manage exchange rates between the EMU currencies and the non-participating European currencies.

Marcus: The most significant effect of this decision for currency traders will be the convergence of currency volatility, toward the Euro vs. the U.S. dollar. The agreed upon bilateral conversion rates should give us our first chance to assess whether the Euro will initially be a strong or weak currency. On the short term it should also offer traders a unique opportunity to bundle the various currencies for conversion delivery. The character of the European Central Bank is key to assessing the long-term nature of the Euro. It has to establish itself in the market place. Its ability to calm initially inherent market volatility and soothe sovereign egos will determine the global perception of the Euro. We have all seen how aggressive hedge fund managers can cause havoc in the currency markets of the Far East. Theoretically, the depth of the Euro and a strong European Central Bank should safeguard Europe from these aggressive speculators who have the capital and will power to take on central banks of several countries.

Percival: It is now assumed that timely EMU with 10 or 11 members is a foregone conclusion, quite properly. It's also quite properly assumed that we know the May 1998 fixing parities, namely the existing central ERM rates (e.g. 3.354/DM for the French franc) for all candidates except Ireland - which would be fixed higher by negotiation. It follows that there is a proper price for each candidate currency already, which is the central rate adjusted for the interest rate differential against the DM, say - meaning a significant premium in the case of the Lira. The point is that speculation about candidate currencies is now misplaced though arbitrage is in order.

Q: Assuming that the EMU does begin as scheduled, will the Euro be a strong or weak currency?

Manning: There are two schools of thought. The weak currency argument emphasizes the economic base of a currency, and so focuses on the issue of membership in the first round of EMU. Proponents argue that if EMU is broadened to include the southern European economies, whose fiscal pedigrees leave something to be desired, the single currency will be weaker. This is currently the view that obtains among the German public, two-thirds of which opposes EMU largely because of fear that the Euro will be a weak substitute for the deutsch mark. The strong currency argument stresses the role that the new European Central Bank (ECB) will play in managing the Euro. The ECB was modeled on the Bundesbank, and like the German central bank, its principal mandate is to maintain price stability, and its independence from political control is enshrined in legislation - indeed, some commentators have noted that the ECB should be even more independent than the Bundesbank because its independence is rooted in European treaties rather than merely in ordinary law. As a new central bank, the ECB will no doubt act to establish its credibility immediately, and with Wim Duisenberg at the helm, it's quite likely that it would seek to do so by pursuing a tight monetary policy and a strong Euro. If you subscribe to this argument, the danger is that the Euro will actually be excessively strong given the underlying economic weakness of several of the EMU aspirants.

We think it's too soon to tell whether the new Euro will be weak or strong. The value of a currency is determined by many factors, and in Europe, those factors are still in the process of taking shape, so why make a call now? With U.S. rates at 6.5% and inflation virtually non-existent, you can get an excellent rate of return right here in North America, and also have a comfortable position from which to observe the redeployment of capital as the European picture clarifies itself.

Marcus: It is our belief that the Euro-skeptics will have their day in the market. Therefore, we envision a weak Euro on the short term. This is a political decision which must conform to a market driven valuation. Markets tend to discount uncertainty and the Euro is clearly an unproven and untested new commodity. The long-term picture for the Euro should be bullish as the dynamics of a unified European currency truly establish strong competition for the U.S. dollar as a reserve global currency.

Percival: The Euro will be weak against the Swiss franc.

Q: Most of the attention thus far has focused on whether or not EMU will happen. What hasn't been discussed is what will happen if the EMU does go ahead but then doesn't last. What can be done to manage the risk of individual countries withdrawing from EMU, or even of the monetary union itself coming apart?

Manning: That's a good question because most people agree that the EMU project has always been driven more by political will than economic logic. Political will may well be enough to take Europe across the starting line, but what about two or three years down the road? The biggest challenge will be for governments to learn how to re-define their interests in non-national terms.

Although we've seen them display an impressive degree of cooperation on maintaining stable exchange rates and interest rates, they have shown an equally strong resistance to other needed initiatives - most notably, product and labor market reform.

Product and labor market inflexibility is probably the most serious problem in Europe today and the gravest threat to the workability of EMU in the long run. Unfortunately, it is a problem that will be more difficult to address in the post-EMU period, because governments will no longer be free to manipulate monetary and fiscal policy to help ease reforms. For now, suffice it to say that, once the single currency has been introduced, foreign exchange traders will be able to express perceptions of risk only by trading credit and equity markets.

Marcus: If the goal of the EMU is to provide the world with a global currency to compete with the U.S. dollar, then it would seem that pressures to abandon the Euro by the founding members is a very remote possibility. Yet, the EMU is made up of sovereign states and as long as they remain sovereign entities they are capable of abandoning the EMU. Abandoning EMU should require the member country or countries to comply with strict and painful exit procedures. The withdrawal of any member from the EMU must address acceptable volatility parameters for the Euro, must be extended over a period of several years so as to provide for the opportunity of new members to join the EMU and finally, must be at the expense of the member country opting out. It is quite possible that the real problem in this regard is the opposite; the potential expansion of the group ( i.e. Eastern Europe) may cause greater strains on the Euro than the threat of abandonment.

Percival: Nothing can or should be done about the risk of either individual countries withdrawing - which is highly likely over time - or EMU falling apart. The reason for this is that speculation about such events will always run way ahead of the events themselves. So withdrawal would tend to be overdiscounted

Q: In the last two years, we have seen an extraordinary convergence of credit spreads among prospective EMU participants. Are these spreads likely to remain stable in the post-EMU period?

Manning: The question here is whether EMU members will remain as fiscally responsible in the post-EMU period as they have been in the run-up, and the answer will depend on the effectiveness of the stability pact agreed to at the December 1996 Dublin Summit. The stability pact is supposed to enforce fiscal discipline in the post-EMU period, but its sanction structure is vague and its enforcement mechanisms are untried. European governments have maintained an increasingly united monetary and fiscal front as the deadline for EMU approaches, but it remains to be seen whether this political solidarity will persist after the introduction of the single currency. If a free rider problem emerges in the post-EMU period, with countries starting to issue debt to fund regional development, for example, how will EU institutions respond? Will they be effective in dealing with defection from the regime of fiscal cooperation? It's too soon to say. However, trading patterns will be the best indicator of which countries to watch. Countries who trade mostly within the European Union have the biggest incentive to defect, because the brunt of the Euro's exchange rate re-alignment with currencies outside the Union will be borne by countries with large external trade flows. The British example is telling. The bulk of Britain's trade is outside the Union. When the Bundesbank's policy of credit restraint drove up the deutsch mark in the early 1990s, sterling rose along with it, dragged upward by the ERM's tight trading bands. British exports became uncompetitive, exacerbating the recession and contributing to the 1992 currency crisis that saw the pound's ignominious ejection from the ERM.

Marcus: Yes, I think credit spreads should remain stable in the post-EMU period. It is most likely that between the period of pre-announced bilateral conversion rates and the launch date of the Euro, credit spread volatility should increase as the various forces employ their strategic planning objectives. The real test of this stability relates more to the character of the European Central Bank. If it is perceived as a weak decision making body, then credit spreads will become more volatile. If it is a strong governing body then the convergence of credit spreads will remain stable.

Percival: After a period of stability which will be measured in years (say, two?), speculation about individual members flying off will be expressed in higher yield spreads.

Q: It has been suggested that the broad, pan-European base of the new single currency gives it the potential to rival the U.S. dollar in strength. How will this affect the dollar as a reserve currency? What are the implications for financial markets of a shift from a unipolar currency system (i.e. U.S. dollar hegemony) to a bipolar or even tripolar (USD/Euro/Yen) system?

Manning: Initially, there will be little impact on the U.S. dollar's status as a reserve currency because it will take time for the Euro to establish an identity for itself. The U.S. dollar presently has two clear advantages - a strong central bank and highly liquid financial markets. The Euro will not be able to challenge U.S. dollar hegemony until the ECB has attained the credibility of the Federal Reserve and European financial markets have achieved much greater liquidity. Having said that, should these two things occur, the role of the U.S. dollar as the premiere reserve currency will diminish. For the United States, the most significant impact of a shift in the status of the dollar as a reserve currency would be on the government's ability to finance the U.S. budget deficit. Foreign central banks have shown an almost insatiable demand for U.S. debt over the last ten years. If the Euro becomes a viable alternative reserve currency, the U.S. will find itself competing for capital along with other countries. Still, the threat is mitigated by the fact that the shift, if it occurs at all, will be gradual, and also by the fact that the U.S. has begun to reduce its budget deficit. If the U.S. government stays the deficit reduction course, its reliance on foreign central banks will be on the wane as the Euro is beginning to come into wide circulation.

Marcus: The potential to debase the U.S. dollar leadership is real. As the depth of the Euro establishes itself in the market place, the ability of the Euro to attract and compete with the U.S. dollar will become self-evident. It is not hard to imagine a situation where the Euro would offer a foreign country a realistic opportunity to invest in treasury products which now tend to be over-weighted in U.S. dollar deposits. A bipolar currency is definitely in reach and as this potential begins to emerge, we believe that the role of the U.S. dollar as the world's reserve currency will be fundamentally altered forever. The emergence of a united Asian currency lead by Japan is only a matter of time.

Percival: The Euro is almost sure to replace the dollar in trade between Europe and the rest of the world outside America (as well as within Europe) while the dollar continues to dominate U.S. trade. But this won't result in a comparable change in the dollar's share of international financing or indirect investment - at least not soon. The role of the Japanese yen will diminish in terms of trade and not increase in terms of investment. So yes, we would have a 'bipolar' currency system.

Copyright 2000 Barclay Trading Group, LTD.

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