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World: Dollar And Euro Compete For Global Trust

  • Breffni O'Rourke

The United States and the European Union are the world's biggest trading entities, and its natural that their currencies -- the dollar and the euro -- should be seen as rivals. Some 500 million people are directly affected by the relative values of the two currencies, and many more feel the reverberations through the world trading system. So what are the prospects for the long-established dollar and the newly created euro, as far as can be assessed?

Prague, 28 June, 2005 (RFE/RL) -- At present, its probably fair to say that the values of the dollar and the euro are more a reflection of weaknesses at home than strengths per se.

The dollar has lost more than one-third of its value against the euro and other currencies in the last year, amid market concern at the ballooning U.S. current-account deficit and the massive trade deficit, compounded by the costs and uncertainties surrounding the Iraq and Afghan conflicts.

The euro has been pushed to dizzying heights on money markets in inverse proportion to the dollar's fall. But it now has trouble at home, too. The EU's new constitution project has collapsed, and union leaders have failed to agree on a long-term budget. The euro has in recent months shed over 11 percent of its value against the dollar.

"At the end of last year the focus was on U.S. weaknesses: the current-account deficit, structural deficits, lack of capital inflows," currency analyst Karsten Fritsch of the Commerzbank in Frankfurt-Main says of the background factors. "But that focus [has since] changed to European weaknesses, given slower growth and problems in the European Union's integration process stemming from the failed EU constitution and the failed EU summit."

Despite its recent troubles, the dollar remains the world's mainstay currency. Some 70 percent of the world's financial reserves are in dollars, while the euro's share is some 20 percent.
The dollar has lost more than one-third of its value against the euro and other currencies in the last year, amid market concern at the ballooning U.S. current-account deficit and the massive trade deficit, compounded by the costs and uncertainties surrounding the Iraq and Afghan conflicts.


The European Union, however, is ambitious for its new monetary offspring and hopes it will become a key reserve currency alongside the dollar. Analysts say two currencies fulfilling such a role would make the international financial order less vulnerable to shocks affecting the one major currency.

Analyst Fritsch said the process of becoming a reserve currency is a slow one, but that the euro is moving in the right direction.

"Central banks, particularly in Asia, are shifting very slowly to the euro to diversify their reserves, as they know that if they do that quickly it could send the dollar sharply lower, which would devalue their dollar reserve holdings," Fritsch said.

As to where the two currencies are going in the short term, analysts believe the dollar will continue to gain. Currency analyst Stefan Schneider of the Deutsche Bank in Frankfurt-Main said that one solid reason for this is the higher dollar interest rates.

"Supporting the U.S. dollar is the widening short-term interest rate differential, meaning that the [Federal Reserve] is still seen as being on a rising [interest] course, whereas in 'euroland' the debate about a potential rate cut has actually come to the fore, and obviously that would [further] widen the interest rate differential," Schneider said.

European Central Bank (ECB) key refinancing rates at the moment are a historically low 2 percent, well below the Federal Reserve's rate.

In the longer term, analyst Schneider said he sees the U.S. government bond rates as sustaining investment interest in the dollar. He noted that although bond yields in the United States are less than 4 percent, that's still 85 basis points (0.85 percentage points) more than 10-year government eurobonds.

For analyst Fritsch, however, the long-term outlook is dominated by the state of the fundamentals. And he said the problems facing the United States have not gone away.

"Once the Fed signals a pause in its cycle [of interest-rate increases], then the market should shift its attention back to the structural imbalances, which are still in place, for instance the U.S. current-account deficit is 6.4 percent, and so we expect renewed dollar weakness in medium to long term," Fritsch said.

As for "euroland," as the 12-country euro zone is called, there are also problems. The major European economies remain sluggish, and unless carefully handled, the disarray over the constitution and budget could bite into the fabric of the union.

An anti-EU Italian government minister has already called for the euro to be dropped in Italy in favour of the old lira national currency.

Analyst Fritsch warned that the record prices for oil will start taking a toll on economies, also in euroland.

"If you look at oil prices, which have risen to $60 [a barrel], well, until recently rising oil prices were accompanied by rising euro prices versus the dollar, so the impact on 'euroland' was not so big," Fritsch said. "But this time we have rising oil prices and a falling euro, and this has severe consequences on import prices, and on the purchasing power of EU residents."

Analyst Schneider offered what he called a "crude measure" of where the dollar/euro exchange might settle, excluding crisis factors. He said that by looking at purchasing-power parity, experts calculate on this basis, that -- depending on inflation rates -- the price trends in the two economies give a result that puts the euro and dollar somewhere between a relationship of parity (that is, one euro being equivalent to one dollar) and a relationship of one euro being equivalent to $1.15.

Of course, the currency world should not be viewed only in terms of a bipolar Atlanticist framework of dollar versus euro. The Japanese yen remains an important member of the world monetary scene. And that other Asian giant, China, with its overwhelming economic growth, can be expected in future to play a key role.

The United States and other trading partners are pressing China to float its currency, the yuan, to create fairer trading conditions. At present the yuan is pegged to the dollar, and so China benefits enormously from the low dollar. Chinese Premier Wen Jiabao said recently that China will act, but not precipitously.
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