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Europe: Why Is The Euro Falling? (Part 1)

  • Mark Baker

The persistent weakness of Europe's common currency, the euro, has bedeviled financial officials. Since the euro was introduced in 1999, the currency has lost almost one-third of its value relative to the dollar, even as the euro-zone economies have performed well. Some economists now say the weakness has less to do with economic fundamentals than with uncertainty related to the introduction of euro notes and coins in six months. In this first of a three-part series on the single currency, RFE/RL correspondent Mark Baker looks at the reasons behind the euro's weakness.

Prague, 12 June 2001 (RFE/RL) -- When officials of the European Union's 12-nation euro-zone first launched the euro two years ago, they had high hopes for the currency's future.

Initially pegged at a value of more than one U.S. dollar ($1.17), the euro was expected to rival the dollar and the Japanese yen as "world currencies" -- pillars of the international financial system and the primary units of exchange for companies and governments.

The euro has made undeniable progress since its launch. The 12 nations that agreed to adopt the currency have held to the strict monetary and financial requirements required of euro-zone members. The European Central Bank, the bank charged with managing the euro, has emerged as an important player in international finance.

Yet, since its inception, the euro has steadily lost value. This week the currency was trading at just 85 U.S. cents, almost 30 percent below its value at launch.

Last year, officials could blame the euro's weakness on the strength of the U.S. economy and the attraction of the U.S. stock market. European citizens, they said, were buying dollars in droves to take advantage of the relatively higher returns on investments available in the United States, and thus driving up the value of the dollar.

But this year the story is different. The U.S. economy has cooled off dramatically, interest in U.S. stocks has dropped, and economic prospects for Europe look relatively good.

And yet the euro is still falling.

Professor Hans-Werner Sinn of the Institute for Economic Research (IFO) in Munich says economic fundamentals can explain only part of the weakness. Sinn recently researched the issue and says uncertainty ahead of next year -- when national currencies such as the German mark will be withdrawn and euro notes and coins will begin circulating -- is also dragging the euro down.

He tells RFE/RL that much of the uncertainty is among populations in Eastern and Central Europe, where at least one-third of all German marks circulate.

"We explain [the weak euro] with reduced demand for deutschemarks in Eastern Europe. The uncertainty about the currency conversion means that many people want to be on the safe side and go out of deutschemarks and into dollars." Sinn continues:

"They [East Europeans] have heard the rumor that the deutschemark will be abolished, and another rumor that there will be the 'euro' instead of the deutschemark. But they are not really sure who will convert the deutschemarks into euros, what the exchange rate will be, whether there will be commission charges, and so on. And for that reason, they want to be on the safe side and go into a currency that is not affected by the conversion into euro."

Nicholas Stamenkovic of Nomura Securities in London agrees that people are apprehensive about the switchover and may be dumping some of their European currencies for dollars. He blames the European Central Bank (ECB) for not properly communicating its policies:

"The ECB has been [so poor] in communicating its policies to the markets that there's still some lingering concern -- even though a lot of preparation has taken place and a lot of warnings -- that the process will not go that smoothly. There's even been talk that shops and retailers will use this as an opportunity to push up prices."

IFO's Sinn says, in addition, that holders of "black money," or money obtained through illegal means, feel threatened by the switchover. Citizens will have about two months after the introduction of euro notes to exchange their old national currencies for euros. But Sinn says that people who are hiding money are exchanging cash into dollars now to avoid disclosure requirements.

This, he says, pushes the dollar up at the expense of the euro: "Holders of black money would have to bring this money to their banks, show their passports and declare what they have, and convert it into euros. Certainly, they don't want that. If you have black money, you don't want to officially convert it."

Theories that piles of illicit cash -- denominated in deutschemarks and slowly being converted into dollars -- are responsible for the weakness of the euro have been around for as long as the euro has existed. Yet there has been little evidence to support them.

Sinn says his research now shows that black money is indeed pushing the euro down. He cites as proof the fact that the number of German marks in circulation is falling in absolute terms. He says this is unprecedented.

Sinn says that a net number of marks is now being returned to the central bank, which has an obligation to buy them back. This accounts for the simultaneous fall both in the number of marks in circulation and in the currency's value.

Nomura's Stamenkovic agrees that special factors may be contributing to the euro's weakness, but he says it's important not to use these as an excuse for all of the currency's ills.

"I don't think we should use [this] as an excuse for the euro weakness. It clearly may have been a contributing factor, but there are clear underlying fundamental and structural reasons why the euro has been so weak."

Stamenkovic says that despite slowing economic growth in the United States, European investors are still drawn to the U.S. because they feel it has better potential to generate wealth.

If Sinn's analysis is correct, the euro's weakness is temporary. Once the conversion is complete, holders of euros -- whether obtained legally or not -- will treat the currency like any other.

"There will be further downward pressure on the euro until the physical [that is, actual] conversion. Once the physical conversion of old European currencies into the euro has been completed, the trend will be reversed."

Sinn says that once people see actual euros and hold them in their hands, the demand for euros -- and thus their value -- will rise. However, if Stamenkovic is correct and the changeover to physical euros is simply one of several factors responsible for the weak currency, it may be some time before the euro rivals the dollar as the world's currency of choice.