Weak euro does not help Republic

Europe's new single currency, the euro, has been getting all the headlines recently but for all the wrong reasons.

It briefly slipped below parity against the US dollar and has threatened to go below the rate of 100 versus the Japanese yen. In recent days the beleaguered currency has enjoyed some respite from this most recent bout of weakness in response to data which showed that German factory orders rose a better than expected 3.2 per cent during October.

The reasons for the euro's weakness are varied but one of the key factors underlying this weakness is totally outside Europe's control. This is the ongoing buoyancy of the US economy, which continues to defy all predictions of a slowdown. Furthermore, the US is managing to sustain this rapid pace of growth without generating any serious inflationary pressures.

The US stock market has risen to fresh peaks as the US capital markets continue to attract large investment flows. The resultant demand for dollars has been a key factor in the dollar's recent bout of strength.

Further afield the Japanese yen has been attracting even greater investor interest during 1999. Not alone has the yen strengthened by more than 20 per cent against the euro, but it has also strengthened by around 10 per cent against the dollar so far this year.

While economic growth is still low in Japan, it is recovering thus encouraging Japanese investors to repatriate their foreign investments and driving up the value of the yen in the process.

In contrast to the buoyant US and recovering Japan, the European economy presents something of a more mixed picture even though the underlying economic trends in the euro zone are reasonably good.

Economic growth is improving and inflation is predicted to remain below 2 per cent for the foreseeable future. Next year most analysts are predicting that Europe will grow at a somewhat faster pace than the US.

Therefore, it is not that Europe is performing that badly, it is just that it is not doing quite as well as its largest competitor. Given these circumstances, is the current bout of euro weakness sowing the seeds of future problems? It would seem that the body entrusted to manage the euro, the European Central Bank (ECB), believes the weak exchange rate does not pose a serious threat to the euro zone economy.

Its attitude would seem to be one of benign neglect laced with occasional signs of internal dissension. However, it does seem that the overriding view of the ECB is that as long as there is no inflationary threat it is better to let the foreign exchange markets determine exchange rates.

This is the type of policy that has been adopted successfully by the US authorities for many years. The history of attempts to manage exchange rates is littered with corpses - witness sterling's costly and embarrassing exit from the Exchange Rate Mechanism in the early 1990s.

Furthermore, the larger the currency bloc the easier it is to adopt a policy of benign neglect. Trade between countries within the euro zone is far more important than trade between the euro zone and other economic blocs. The Republic is an exception in this regard, but for most European countries the bulk of their foreign trade is now conducted in euros.

Therefore, the currency would have to decline substantially and remain at the lower levels for a prolonged period before it would lead to a significant rise in inflation. Indeed, looked at objectively, the new currency has been responding quite rationally to the relative economic strength of the US and Europe since its launch. It is quite likely that the current bout of weakness is already sowing the seeds of a recovery next year since the weaker currency enhances European international competitiveness.

For the Irish economy the picture is somewhat more complicated given that a high proportion of our trade is still with the UK and the US. With the economy running at full stretch the decline in the value of the pound against sterling and the dollar merely serves to increase the risks that the economy overheats.

International investors, who are already worried about the overheating risks facing the Irish economy, seem likely to view the recent exchange rate weakness as another reason for avoiding the Irish equity market.

It remains the case that higher interest rates and a stronger euro exchange rate would be far more appropriate to Irish economic conditions but such a development remains highly unlikely.