27 November 2000
The euro started out at $1.18 and fell at one point under 85 U.S. cents. The euro has not made a good showing recently. Japanese and other capital investors, who had initially placed high hopes in the euro, have, after long hesitation and after having written off substantial losses, withdrawn disappointed, and a turnaround is not in sight.
We should not overdramatise this development. Today's exchange rate is at about the German purchasing power parity for a U.S. commodity basket, which amounts to about 85 U.S. cents. The exchange rate still has not reached the low point of the D-mark in February 1985 where purchasing power parity was at only 56 U.S. cents. But the fall of the euro is still surprising. The euro-11 countries export more to the rest of the world than the U.S., and the American combination of a decline in private savings and a very high current account deficit of 3.6% of GDP is anything but reassuring. Why then has the euro fallen?
It has fallen because many who up until now have held European currencies are not comfortable with the announced exchange to euros. Many are afraid to exchange the old money for the new because their old money is tainted and because banks must register the exchange of larger sums by name to prevent money laundering.
Many if not most of the people outside of the EU that hold European currencies do not realise that the currency union is already reality. They hear the rumour that the European currencies will be abolished, supposedly to be replaced by a new currency. But they don't know how the exchange will take place and are afraid of taking a loss. Converting their money, while there is still time, into concrete, visible currencies like the dollar or the pound, seems to be what reason dictates in these circumstances.
When the euro was officially introduced, the central bank monetary holdings outside Europe in D-marks alone were valued between 60 and 80 billion D-marks. These were considerable holdings amounting to twenty to thirty per cent of the German monetary base and eight to eleven per cent of the monetary base of the eleven euro countries. The many thousand D-mark notes in Turkish mattresses are just as much a part of this as the D-mark holdings in Croatia, Slovenia and other Eastern European countries that have been tolerated as transaction currency. This money is certainly a large portion of the holdings whose owners are now losing confidence.
The argument is often heard that the euro's dollar exchange rate reflects the poor earnings expectations for European stocks in comparison to U.S. stocks. These expectations in turn depend on the level of economic activity. This connection does exist but it is much less important than generally assumed. Earnings expectations are already reflected in interest rates and stock prices.
International portfolio restructuring with regard to interest-bearing securities does not lead to open net positions in terms of the desired monetary holdings but only in terms of the securities themselves. It can thus also only lead to changes in the value of these securities and not to lasting changes in the exchange rates. Movement in exchange rates comes when open net positions arise with regard to cash holdings. This is precisely the case when many currency holders inside and outside of Western Europe wish to exchange their holdings of old Western European currencies for other currencies not affected by the change to the euro.
The falling exchange rate of the euro could largely have been avoided if the ECB had introduced the euro in one fell swoop on 1 January 1999. This would have prevented uncertainty from arising in the first place. The three-year delay between the proclaimed death of the old currency and the expected birth of the new was a construction fault, which can certainly not be attributed to Wim Duisenberg.
The ECB should thus do everything in its power to move up the date for introducing the new currency, as far as this is technically possible. It should also announce clear exchange procedures for foreigners. Once foreign currency holders have the new money in their hands, their uncertainty will vanish. Then exchange rate of the euro will recover. Until this happens there is no other option but to take back the unpopular cash holding, i.e. to intervene in the foreign exchange market to shore up the euro exchange rate.
President of the Ifo Institute
Press and Public Relations