Euro's fall from grace provides valuable breathing space


ECONOMICS:The weak euro is likely to delay interest rate rises and presents opportunities for Irish exporters and tourism, writes AUSTIN HUGHES

IT IS understandable that talk of EU bailouts, bust-ups and possibly even break-ups has captured most attention but the recent weakening of the euro reflects several influences. The fact that a range of forces are pointing in the same direction argues against a dramatic rebound even if forecasts that call for further dramatic losses or even complete disintegration hint that pessimism is becoming overdone.

One important and possibly underrated element in the euro’s fall from grace is the fairly miserable recent growth performance and prospects of the euro zone economy. In the past six months, GDP has risen a paltry 0.2 per cent whereas the comparable figure for the US was 2.2 per cent. While there have been signs of strength in some euro zone indicators of late, these have underlined both an excessive dependence on export growth and dramatic differences between conditions in various countries. This unbalanced upturn has also raised concerns about longer-term growth prospects for the euro zone.

Weak euro zone growth has led to a marked reassessment of how far away a European Central Bank (ECB) interest rate increase might be. Through last summer and autumn, the ECB started to lay out an “exit strategy” from the exceptional support measures it has provided to the banking system. This led analysts to believe the ECB would probably raise rates later this year.

In turn, this boosted the euro against both the dollar and sterling. Now, the first ECB rate rise looks a far more distant prospect and this is depressing the euro. Markets think the ECB will be unable to raise interest rates until very late in 2011 or possibly even 2012. This reflects the current sluggishness of activity, the prospective impact of severe budget cutbacks and the absence of serious price pressures in the western world.

While some ECB hardliners have warned of potential upside inflation pressures, the recent softening in global oil prices and record low underlying euro zone inflation in April suggest such risks are remote and possibly irrelevant at present. Weaker euro zone growth prospects and the associated pushing back of the first ECB interest rate increase are weighing on the euro.

However, most commentary on the “crisis” in currency markets has focused on what has been an unnecessarily painful, protracted and very poorly managed attempt to minimise the spillover costs of Greece’s budgetary difficulties. This chapter of the financial crisis is very different to most of those that preceded it in many respects.

One is that the fall in the value of the euro has been relatively orderly and has merely returned the euro closer to its historic average and most estimates of its “fair” value.

More significantly, from an Irish perspective, the weaknesses of the euro and what it tells us about the outlook for global growth and euro zone interest rates presents significant opportunities. Strong growth in key trading partners and subdued euro zone interest rates represent a more supportive external backdrop that makes it easier to address domestic frailties.

The most obvious impact of a weaker euro is on Irish exports. The fact that the fall has been less pronounced against sterling than the dollar lessens the impact for much of indigenous industry. However, the favourable effect on a wide range of US-focused companies operating here shouldn’t be underestimated. Neither should the effects on tourism. There are also widely dispersed gains from an admittedly more modest drop against sterling. The fact the euro has weakened rather than strengthened against a UK currency beset by uncertainty about the future political and economic direction Britain may take is hugely helpful to a wide range of Irish firms doing business in the UK or facing intense competition from imports and cross-Border shopping.

This boost to the diverse companies and industries that make up Ireland’s traded sector should amplify the effects of healthier global activity and ensure an improving Irish economy as the year progresses. The key risk is that this would lead to complacency about competitiveness.

How much Ireland’s relative costs have improved since the crisis took hold is unclear. One indication is provided by a 10 per cent faster rise in consumer prices in the UK than in their Irish counterparts in the past two years. While the adjustment has differed widely between companies and sectors, significant progress has been made.

A weaker euro may put upward pressure on imported prices and it is vital that domestic costs don’t drift up in response, if painfully won gains are not to be frittered away.

The recent turmoil in bond markets has raised the cost of Irish Government borrowing, even if the associated weaknesses in the euro area economy means most domestic borrowers will enjoy a less threatening interest rate environment somewhat longer. This breathing space must be used to lessen the impact of more distant but inevitable rate increases.

If corporate and household borrowers have a little more room, the Government has somewhat less and needs to undertake significant further adjustments. Here too, the crisis isn’t entirely bad news. There is an increased public understanding of the need to make often painful cutbacks before markets or authorities abroad threaten even more draconian actions.

So, the euro crisis nudges the Government a little further down a path on which it had already embarked. The same is also true of the broader Irish economy. The Euro FX “crisis” hints at a more uncertain world but it also provides breathing space for the Irish economy and pushes it further towards a future driven by competitiveness rather than credit.

Austin Hughes is chief economist at KBC Bank Ireland