Euro needs more than a rate rise

Why is the euro weak?

The European economy has been outpaced by the US, which is still growing at a quite remarkable pace.

At the same time, euro interest rates, at 3.25 per cent after yesterday's rise, are still much lower than British and US rates at 5.5 per cent and 5.75 per cent respectively. This is encouraging investors to buy the dollar and sterling because higher interest rates mean a higher return for holding a particular currency.

The euro's value, according to Mr Jim Power, chief economist at Bank of Ireland, is also being undermined by the lack of confidence on the part of international investors in the European economic model.

What could boost the euro's value?

Growth in the European economy is still picking up, particularly in France and Germany. At the same time general restructuring has started and a surge in merger and acquisition activity is under way.

To reap the benefits of these developments, international investors have to buy into the euro story. The booming US economy, now into its longest period of sustained growth, also needs to start slowing down.

But does the euro's value really matter?

From a European perspective, the value of the euro matters very little. After all, the euro zone is a very closed economy, as indeed is the US. This means that the vast bulk of the euro zone's trade is with other members of the euro zone and many companies no longer have to buy large amounts of foreign exchange.

The low value of the currency, none the less, will add to inflationary pressures and, according to Mr Power, could mean 0.4 of a percentage point on average inflation in 2000.

The implications are more marked from an Irish point of view. Around one-third of imports to this State come from the UK, which is not in the euro zone. The weakness means that import prices are rising substantially. This can be passed on in higher costs to consumers or taken in lower margins, or a combination of both.

While it is good for exporters, it provides the kind of boost the economy does not need with stimuli coming from every side and signs of overheating already evident.

So what's the outlook for the currency?

Investor confidence is still pretty weak and, according to Mr Power, a remarkable turnaround is still very unlikely. The euro could stabilise, he says, but it will be later in the year before there is a significant recovery. In the meantime, the pound could fall to around 75p against sterling, which would be around 95 US cents for the euro.

Will the ECB's decision yesterday to raise rates make a difference?

The bank's president, Mr Wim Duisenberg, insisted in Frankfurt that the move was not a panic reaction to the low value of the euro. And, for the moment, he appears to have won that argument, with the value of the currency rising slightly.

However, the decline in the currency did heighten the bank's inflation worries and almost certainly contributed to it raising rates earlier than expected.

There are unlikely to be further beneficial effects in the days ahead as the underlying picture and the strength of the US economy remain the same. The markets will no longer be able to criticise the bank for its policy of benign neglect of the currency but most analysts expect the euro to weaken again.

How much higher will rates go?

According to Mr Power, another rate rise is likely in April as economic growth continues to pick up. A third rise is possible towards the end of the year and interest rates are likely to end 2000 at around 4 per cent.

They may be as high as 5 per cent at the end of 2001 and could peak at 6 per cent in 2002, Mr Power warned. That would be the equivalent of an increase of £120 per month in the cost of servicing a £75,000 loan.