By Joseph Trevisani, Published: 02/09/2010
The euro is just over a decade old. In its short existence it has been embraced by every level of the international currency markets. Central banks, national treasuries, sovereign funds and multi-national corporations store their wealth in the euro and trust the European Central Bank (ECB) to maintain value. Institutional and retail traders have made it the highest volume currency after the ubiquitous US Dollar.
But the euro and its institutions have never been tested. Until recently the ten year span of the united currency had been one of expanding economies, stable inflation and low unemployment. In comparison to its chief competitor the US dollar it looked fresh, unmarked by political and policy controversy and backed by the unequivocal anti-inflation stance of the ECB, viewed by many as a new order German Bundesbank. But the European sovereign debt crisis has brought the euro and the ECB down to earth. No central bank policy has ever stood apart from the economic and political realities of its time for very long. And no currency has ever been unscarred by the policy exigencies of its government.
The euro became operational in currency markets on January 4th, 1999 and in retail transactions in 2002. But the dollar remained the primary trading instrument. In the Bank for International Settlements' triennial surveys of the world's currency market the percentage of Forex turnover in which the US dollar was one side of the transaction has stayed remarkably stable. In 1989 it was 90%; in 1995 it was 83%; in 2001 it was 91% and in the latest survey of 2007 it was 88%. The dollar is still the central transaction in world's currency market.
In comparison we can look at the value of the euro versus the dollar from 2002 until 2008. Of the three general factors that govern the medium term valuation of a currency, interest rates, economic growth and inflation, does any adequately explain the behavior of these currencies in this period?
From early 2002 to mid 2008 the dollar lost over 60% of its value against the euro. But during that time these comparisons were largely neutral, or favored one side or the other for certain periods of time but without long term bias. But however changeable the relationship between these factors was, the euro ended the decade far more valuable than when it began.
Over the past ten years United States' GDP was generally higher, averaging around 1.9% versus 1.5% in the EMU. Core CPI was also higher in the US at 2.2% with EMU at 1.7%. Even interest rates, the most correlated of all currency factors, do not fully substantiate the euro rise. In 2004 and 2005 the Fed was raising rates ahead of the ECB. The Fed halted in mid 2006 at 5.25%, the ECB did not halt until a year later at 4.00% where it stayed until the financial crisis in 2008. It did commit one heroically ill judged and now forgotten 25 bps hike in the summer of 2008 just before the financial collapse. These rate changes coincide well with the blips in the euro, in 2005 the euro fell from 1.3500 to 1.1800 and certainly a good portion of the run higher in 2008 to above 1.6000 was due to the Fed rate cuts which began in late 2007, fully a year before the ECB saw the light.
But the rise of the euro in this period is also due to one additional factor: its adoption as a long term store of value, or as it is better known--its usefulness as a reserve currency. The best measure and the best proxy for the world's changing view of the euro in this largely governmental role is the percentage of official reserves held in dollars.
In 1995 59% of the world's official foreign exchange reserves were held in dollars. By 1999, the year of the advent of the euro that had risen to 70.9%. These are IMF figures. The euro had a rocky beginning. It fell below parity with the dollar at the end of its introductory year and stayed there until mid 2002. Not a comfortable start for a potential reserve currency. But incipient users were simply waiting out the introduction. In 2000 the percentage of dollar reserves began to fall, to 70.5% that year, 66.5% in 2002, 64.1% in 2007 and 61.6% in the third quarter of 2009. The euro was the major beneficiary of this reserve switch.
Many political factors play into this shift in reserve holdings, but there is no reason to discount what the Russians, Chinese and many others have plainly stated--they are worried about the long term valuation of the dollar; the unstated converse is that they are happier with the long term potential of the euro. To say this represents a realistic concern for the long term continuation of the dollar as the world's reserve currency is overstated. The dollar is too useful as a measure and medium of exchange, too well entrenched in the worlds' financial system and its debt markets are too deep and without substantial liquid competition. But the movement into the euro expressed both a desire for diversification and an endorsement of ECB policies. The European Bank's specific 2.0% inflation target, its relentless anti-inflation rhetoric and the sense that in order to draw together the disparate economies under the EMU a narrow but deep strain of monetary policy was necessary, gave the euro an edge over the dollar in long term valuation.
Has that euro advantage been diminished due to the European debt crisis?
From September 2008 until March 2009 the dominant currency trade was a direct kin to the panic in the financial markets. A huge bubble of liquid dollar assets was created with foreign and domestic money. Compared with the rest of the world the United States was the safest holder of wealth. The euro was depreciated by the direct rise of the dollar and by the enormous deleveraging movement in the yen crosses.
The strength of the dollar in this period owed nothing to the traditional standards of economic and currency comparison. This dollar bubble had largely reversed itself by the end of 2009 and the euro was again one of the chief beneficiaries. In the nine months from March to the beginning of December 2009 it gained 22.5% on the dollar.
In two months the current European sovereign debt crisis has eliminated half of that gain. But unlike the dollar panic ascendancy of last year, which was always destined to end, the European change is structural. The debt amassed by the EMU members will undermine the strict anti-inflation policies of the ECB for many years. The bulwark of the Stability and Growth Pact's debt and deficit limits has been breeched. The odds are very much against it being repaired. The necessary financial rescue of Greece and perhaps others will inevitably restrict the central bank's freedom of action. Politics has entered world of the ECB and nothing in European monetary or inflation policy will be the same again.
Chief Market Analyst