ECB passes credibility test as major powers back action

Timing is everything, particularly when it comes to central bank intervention in the foreign exchange markets. The European Central Bank's decision to intervene to support the euro with the assistance of the US Federal Reserve, the Bank of Japan and the Bank of England represented a major credibility test for the relatively new central bank. Judged by the performance of the euro on the day, the ECB's inaugural intervention will be deemed a success in political terms and reasonably effective in market terms. European central bankers and government officials will be relieved and pleased at the concerted nature of the intervention as they head to the G7 meeting in Prague. But the intervention is unlikely to represent an immediate turning-point in the euro's fortunes against the dollar and yen. The foreign exchange market remains negatively disposed towards the euro and is expected to test the commitment of the major central banks towards it.

Yesterday's intervention is likely to be repeated next week. The markets await a statement from the G7.

The euro started its European trading day on Friday at just below $0.86. It had risen to about $0.87 just before the first of two rounds of intervention shortly after midday. It rose to a high of $0.9015 and closed in Europe at $0.8803, up around 2.5 per cent on the day. The currency also gained 4.2 per cent against the Japanese yen on the day in Europe, but it rose by less than 0.2 per cent against sterling as the UK currency also advanced against the US dollar by almost 2.5 per cent.

Later in New York, the euro continued to hold most of the gains made in Europe against the dollar and yen as the market remained wary of future concerted intervention. Though the euro failed to hold above $0.90, the intervention can be deemed effective as it reinforced the upward trend in the currency which occurred in the morning session. One of the hallmarks of effective intervention is that it goes with the flow.

It is extremely difficult for central banks to reverse a downward trend. In this regard, the question of whether yesterday's action constitutes successful intervention depends on one's yardstick. Intervention will not change the market's fundamental view of a currency. As the Bundesbank president, Mr Ernst Welteke, said, structural reforms need to be continued and there is a need for more co-ordination of economic and financial policy among euro member-states.

The key to yesterday's effective intervention was that it was concerted action by the major central banks. Intervention by the ECB alone would not have produced the same result.

The ECB's announcement on September 14th that it would sell interest income on its foreign reserves surprised the markets and caused some recovery in the euro that day. This was not regarded technically as intervention, but it gave the ECB some early practice. The €2.5 billion sale of foreign exchange for euros had no lasting impact on the currency.

Indeed, the euro continued to set new lows almost daily. Increasingly, there was talk in the markets of the euro falling to $0.80 or below. The scale of yesterday's intervention is unknown, but the timing and concerted nature of the move made it effective.

The market was surprised by the intervention because it came before and not after the G7 meeting. But the big surprise was that the US Federal Reserve was involved. Based on comments from Bank of Japan officials, it is clear that they shared the ECB's concern about the fall in the euro's value. The euro had fallen to around 90 yen during the week, representing a cumulative fall of 33 per cent against the yen since its introduction.

Japan's fledgling economic recovery could be put at risk from serious currency misalignments. The extent of US support for the euro is unclear. A US treasury spokesperson, commenting on the Fed's role, kept to the official ECB press release that "at the initiative of the European Central Bank, the monetary authorities of the United States and Japan joined with the European Central Bank in concerted intervention in exchange markets because of their shared concern about the potential implications of recent movements in the euro for the world economy".

As the euro fell towards $0.85, it became increasingly obvious that the weak euro/strong dollar discrepancy was having an impact on US corporate profits in dollar terms. In recent weeks, US companies had reported that their profits would be adversely affected by a further fall in the euro. The risks were increasing, therefore, that the decline in the euro would become a global problem. With the Danish referendum next week looking less positive for the euro, the case for intervention became more convincing.

The involvement of the Federal Reserve should not be seen as a reversal of the US's longstanding "strong dollar" policy. The strength of the dollar has helped to sustain a high rate of economic growth with limited inflation. This has allowed the Fed to maintain a wait-and-see strategy in respect of interest rates. Unless the euro falls significantly below the $0.85 level, the US will not be too worried by the current level of the dollar on foreign exchange markets.

The ECB's first official intervention may not have produced a dramatic rise in the euro's value, but it showed that the bank was willing to defend the currency from excessive weakness. In the US, the strong dollar policy continues because, as Mr Larry Summers, the US Treasury Secretary, stated yesterday: "It is in the national interest of the United States."

But if the euro falls below $0.85, the US will be forced to change its view as its economic prospects will be damaged by a euro currency in freefall.

John Beggs, chief economist at AIB Group Treasury, is at www.johnbeggs.com