Lure of notes may boost euro's value

ECONOMICS: With 'mattress money' and 'hot money' flooding into the retail sector, the spending increase delivered by the changeover will only be transitory

In recent days we have been witnessing the unfolding of what is potentially an epoch-making event.

I refer, of course, to the introduction of euro notes and coins across the 11 member-states of the euro zone and the demise of the respective national currencies. Whatever one's reservations about the event, there is no denying its significance. It is the final, most visible and most potently symbolic step of European economic and monetary union (EMU).

As such, it may cause a marked acceleration in the pace of European economic and political integration. For some, if it doesn't do so, it will be considered a failure. Indeed, there are those who argue that if EMU doesn't provoke a significantly greater degree of political integration among member-states, it will not be sustainable.

These are among the bigger issues one is prompted to reflect on by the changeover to the euro and, no doubt, the coming years will elucidate them. In the meantime, some more prosaic questions spring to mind. For example, will the introduction of euro notes and coins have any discernible economic effects?

One can think of several ways in which it might. By all accounts, there's a lot of "mattress money" and "hot money" around, denominated in currencies that will shortly cease to be legal tender. Intuition suggests that some fraction of this money will have been converted into goods and services, rather than into euros, before February 9th. Anecdotal evidence from retailers supports this view. Expect the retail sales data for the closing months of 2001 and January 2002 to show a marked pick- up in consumer spending on this account.

In fact, the latest available Central Statistics Office figures indicate that a "euro changeover effect" may already have been at work in September and October: over this period, core retail sales volumes rose at an annualised rate of more than 20 per cent.

Of course, unless the introduction of euro notes and coins in some way fundamentally raises consumer confidence - a proposition that some commentators are touting around but one which I'm quite unconvinced by - the boost to spending delivered by the changeover will be transitory. Still, it will muddy the water a bit and will, no doubt, be cited by the optimists as evidence that the pace of economic activity is picking up again.

A similar effect is likely to be evident in the consumer price index (CPI). Consumer watchdogs notwithstanding, it stretches credulity to imagine that all businesses will be scrupulously fair in translating Irish pound prices into euro equivalents. Some opportunistic expansion of margins is inevitable. Watch the CPI figures for December and January.

The impact is likely to be modest, however, and it is important that it be interpreted correctly as a once-off change in the price level, rather than an inflationary event.

Then there is the matter of the euro's external value. Will the changeover process have any discernible effect on the euro's exchange rate against the dollar or sterling? Is it likely that a significant proportion of cash balances which have been held in the national currencies of the euro zone will be converted into currencies other than the euro?

It is hard to imagine that this would happen in the case of legitimate businesses or ordinary households. What motive could a legitimate business in Germany have for converting its deutschmark cash balances into dollars rather than euro, for example?

A criminal enterprise, however, might have a strong motive for doing so, namely the desire to remain undetected and protect its assets. Criminal gangs across Europe, but especially in eastern Europe and Russia, have traditionally favoured the deutschmark as their cash currency, partly because of the availability of comparatively large denomination deutschmark notes and partly because of its reputation as a hard currency.

Some observers believe that criminals have been steadily converting their stashes of deutschmarks into dollars for some time now in anticipation of the deutschmark's demise.

They have been doing this because of their belief that it would be easier to avoid anti-money laundering procedures by converting deutschmarks to dollars over a relatively long period of time than by converting deutschmarks to euro over a six-week time frame.

Of course, members of the Russian mafia and their ilk are not the only non-Germans who have, up to recently, kept their savings in deutschmarks. Many individuals in eastern and southern Europe have traditionally done the same. For example, generations of gastarbeiters from countries such as Turkey and Yugoslavia have worked in Germany, remitted their earnings back to their families and eventually returned home to open small businesses.

For many of these, there may have been motivation to convert their deutschmarks savings into dollars (or other currencies) over the past few months rather than await what, for them, might have seemed an uncertain and poorly defined euro changeover process.

Estimates from the Ifo economic research institute in Germany suggest the decline in demand for deutschmarks by criminals and non-residents may have depressed the euro by as much as 25 cents against the dollar.

Take away this phenomenon (with all other things being equal), and the euro would now be trading at about $1.14 rather than the $0.89 available at time of writing.

This estimated loss of value occurred in anticipation of the changeover. An inference that may be drawn from this is, now that euro notes and coins are in circulation, at least some of the criminal and other demand for cash, which switched from deutschmarks into dollars, may switch to euro. If that's what happens, it will obviously be a positive (and could conceivably be a big positive) for the dollar/euro rate.

This is not quite the same thing as predicting an appreciation of the euro this year (again). There will be several other important influences at work. I'll come back to those in a later article.

Jim O'Leary is lecturing in the economics department, NUI, Maynooth.

jim.oleary@may.ie