ECB in quandary over panic selling of euro

Yesterday should have been a rare good news day for the euro, as the London and Frankfurt stock exchanges announced their plan to merge into a new, pan-European exchange called iX - in which all shares could be listed in euros. But within minutes of the announcement, the European currency had broken through the psychologically significant figure of $0.90 and later fell below $0.89.

The currency also plunged to a new low against sterling, trading at just over 57p.

Just last week, the Bundesbank president, Mr Ernst Welteke, said he could "scarcely imagine" the euro being worth less than 90 US cents. But traders in Frankfurt said yesterday that, as panic selling gathered pace, the markets were now likely to push the currency below 85 cents - or even lower.

"Breaking through $0.9030 indicates already that there is plenty of room below," said one trader.

The euro has now lost 23 per cent of its value since its introduction last year and, if the present trend continues, it will be worth just 60 cents by the time Europeans are due to start using euro notes and coins in 2002.

The currency's decline has been so steep in recent weeks that some serious commentators are now considering for the first time the possibility that Economic and Monetary Union (EMU) could fail.

Such fears are probably unfounded, not least because so much political will has been invested in making the euro an institutional reality that the currency union is, in practical terms, almost irreversible.

Yet there is no disguising the fact that the enduring weakness of the euro is a major headache for the European Central Bank (ECB), its head, Mr Wim Duisenberg, and for Europe's politicians, currently being blamed for the currency's troubles.

The simplest explanation for the euro's weakness is that European investors are pumping capital into the booming US, where both economic growth and interest rates are higher than in Europe. But the fact that the euro has also fallen in value against sterling and the Japanese yen suggests the problem may lie deeper.

The ECB itself has been the target for much criticism for giving the markets the impression that it is indifferent to the euro's exchange rate. But when the Bank's vice-president, Mr Christian Noyer, attempted yesterday to dispel this impression, the euro promptly fell even further.

Last week's interest rate increase of a quarter of a percentage point has been perceived as a feeble move that was too modest to boost the euro's exchange rate but suggested that the ECB lacked the confidence to defy the markets by doing nothing. And ECB officials acknowledge privately that their endless repetition that the euro has the potential to appreciate is beginning to lose credibility.

A growing number of commentators blame the weakness of the euro on the failure of Europe's politicians to introduce sweeping reforms that would make markets - and people - more flexible. According to this analysis, Europe can never hope to replicate the astonishing rate of economic growth seen in the US in recent years unless it makes its economy more American.

This would mean privatising more state-owned businesses and utilities, accelerating the pace of deregulation and making it easier for companies to dismiss employees while encouraging more part-time and short-term work.

Germany's opposition Christian Democrats have called on EU leaders to make the euro's weakness the dominant issue at their next summit and to reform the European economy in a way that would please the markets.

But calls for closer economic policy co-ordination within the EU are unlikely to win support among politicians, most of whom are determined to maintain a firm grip on those economic levers still available to national governments in an increasingly globalised economy.

The latest fall in the euro's value has added to the clamour for the ECB to intervene in the market by selling some of its foreign currency reserves.

The ECB is entitled to intervene unilaterally any time it chooses but it has so far avoided such action in the belief that it would be ineffective. A concerted intervention involving Europe, the US and Japan would have a better chance of success but there is no evidence that Washington would agree to a move that would drive much-needed capital away from its shores.

Cool heads at the ECB believe that their best option is to allow what they regard as the hysteria gripping the markets to run its course and wait for the US economy to slow down later this year. A further interest rate hike in the US, which is expected on May 15th, should help to dampen US euphoria as Europe's economic recovery continues to gather pace.

Even if this strategy of facing down the markets succeeds, it is unlikely to relieve pressure on the euro in the short term. In the meantime, get ready for the 80 cent euro and think about cancelling that holiday in Florida.