No respite in sight for long-suffering euro

Just two months after the president of the European Central Bank, Mr Wim Duisenberg was hailing the resurgence of the euro, the currency is once again under severe pressure.

In May, it plunged to an all-time record low of $0.8860 and there was much speculation of possible intervention and a crisis of confidence in Europe's new currency. But suddenly the euro recovered. After months of ignoring all good news emanating from Europe's recovering economies, it was suddenly back in vogue.

But the problem was that the recovery was influenced more by concerns the US could be heading for a hard landing, than by the euro itself. Forecasts that euro zone growth will average around 3.7 per cent this year - quite high considering the sluggish performance of key euro economies such as France and Germany - were not enough to boost the currency.

The euro's recovery in May was prompted by two months of US retail sales data showing sales had been declining significantly. The bears began talking of a hard landing, sparking a sell-off of the dollar.

But by the time the US second quarter Gross Domestic Product figures were released, fears of a hard landing had subsided. Labour costs were under control and, in fact, since the euro had peaked in mid-June, they had been falling back. A particularly benign testimony from Mr Alan Greenspan to Congress last month put the nail in the euro's coffin, at least for the immediate future.

Of course, there are underlying problems with the euro. Many longer-term investors are worried that the eventual entry of central and eastern European states will undermine the currency. Analysts say it is also possible that Greece's pending entry is hampering sentiment towards the euro. The prospect of a Danish no vote is also often cited as a negative for the currency.

Inflation poses another problem. The US has recorded very high levels of economic growth without a correspondent rise in inflation - mainly because of very high productivity levels. This was underlined once again this week when productivity in the second three months of the year grew at more than double the pace of the previous three months, and labour costs fell. The increase over the last 12 months was the largest in 17 years.

As Mr Jim Power, chief economist at Bank of Ireland, noted this is proof if it were needed that the new economy is still surging ahead in the US.

However, it is a very different story in Europe. European industries are still operating in a very different, more regulated environment than their US counterparts. In addition, many of key technological changes occurring in the US do not have the same kind of impact on Europe's economy. Europe's average inflation rate of 2.4 per cent - part of which has been blamed on oil prices - does not reassure the markets. Currency investors are now beginning to focus on whether the ECB's own self imposed mandate to maintain inflation between zero and 2 per cent is achievable without increasing interest rates to such a high level that it will kill off any hope of a recovery.

As Mr Power, points out even France and Germany historically had inflation rates above 2 per cent and when the far higher rates often prevailing in countries such as Spain and Italy are taken into account there has to be a question of just how feasible the target is. France is already calling for governments or Ecofin to set the inflation target and for the ECB to merely implement it - a similar position to that of Britain. However, such a proposition is unlikely to find widespread favour and would be dismissed by orthodox monetary institutions such as the Bundesbank.

Another problem for the euro is that in terms of capital flows it simply cannot win. The recent purchases of US companies by European institutions, such as the $50 billion purchase by Deutsche telecom of Voice Stream, is dollar positive and also takes some of the emphasis away from the huge current account deficit in the US.

Despite these factors, the fundamentals are very strong. Not only is growth surging ahead but French and German business and consumer confidence levels are at recent highs.

Even the IMF has recently written that "it is hard to remember a period when the fundamentals have been as good". Indeed there are few forecasters who believe that the euro is fairly valued at these levels and most are predicting an upturn either later this year or next. It could even happen as early as September as traders return from their long summer breaks and once again focus on interest rates. US rates are likely to be static while the ECB may increase theirs on August 31st. And if euro zone GDP does grow at a faster rate than the US next year the scenario could change rapidly.

But does the level of the euro really matter? After all, if you ask the average American what the dollar is worth he'll tell you it's a dollar. With the euro the entire zone is far more closed than it used to be and indeed is approaching US levels. There are countries, and particularly the Republic, where this is manifestly not the case but even for us there is a good deal of inter euro zone trade.

The impact the weak euro has had so far is broadly speaking positive. Much of euro zone economies' recovery has been through exports. The euro's weakness has given European manufacturers an enormous competitive advantage against both US and UK companies. But it has also driven inflation up - and that is the rub. Most analysts expect the current 4.25 per cent interest rate to have been increased to around 4.75 per cent by the end of this year. If the euro remains weak, the rate could reach 5 per cent, or higher. Increasing interest rates to curb inflation could terminate the recovery which exporting companies have been enjoying to date.

For the Republic, the situation is more serious. Inflation is already running at more than twice the European average. Those who believe it is destined to fall broadly base their predications on a strengthening euro and declining oil prices. Oil prices may be declining again, but a weak euro certainly keeps pressure on inflation. Both the ECB and the Irish authorities will be hoping that it can once again turn the corner and help them with the battle against rising prices.