22 June 2005


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Racing the ‘teflon dollar’- can the euro catch up?

“The euro has to go," Maroni the Italian minister from the Northern League Party said last month. In his opinion it has caused devastating price increases for the average Italian family and made the small and medium-sized companies that are the core of the Italian economy uncompetitive. While a return to the lira is technically possible nobody seriously expects a lira comeback, but when a European government minister dismisses the euro, it is a serious matter.
The Italian economy is in recession; it shrank in the past two quarters. Italy’s growth since the early nineties was artificial, based on the lira's continued depreciation and the accumulation of government debt.
Italy’s export-driven growth has been undermined by the loss of the lira's exchange-rate flexibility and by the fact that some of Italy's main export industries are in sectors like shoes, textiles and clothes that are particularly vulnerable to Far East competition.
The fact is the long-term future of the euro is one of the central questions posed by the European Union's recent upheaval following the two member rejection of the constitution.
The recovery in the Eurozone has lost momentum since mid-2004, but commentators believe it should resume in 2006. Many contend that the euro area lacks resilience against adverse shocks amid slow trend growth -- less than 2% per annum. Both are shaped by structural factors. Structural policies should aim at completing the European internal market, boosting labour market performance and encouraging innovation as can be seen by reading the dictum of the Lisbon Summit agenda. . Last week the euro currency has experienced a rise against the dollar reaching as high as $1.2121 after European Central Bank council member Klaus Liebscher suggested the ECB isn't preparing for a reduction in interest rates. Nostalgically seen the euro dropping by 3.8 percent in the three weeks since French and Dutch voters rejected the constitution, hindering integration of the region's economy, the recent upward movement can be a relief. However when advocating a "pause for reflection" called for by European leaders last week in Brussels this may be interpreted by the currency markets as an admission of paralysis. On a structural level, we must admit that global manufacturing is shifting eastwards, reflecting globalisation, free trade and cheaper unit wage costs. This is a long-term trend, but the European manufacturing enterprises have been hit by weaker demand in Europe and a strong euro currency. Manufacturing was also in recession in Malta and we saw a 0.1 per cent drop in GDP in the first quarter while exports have moved down by 14.1 per cent according to the National Statistics office. Currently there are fears that the ST Microelectronics plant presently the largest private employer in Malta will soon announce cost cutting measures due to a persistent decrease in demand for its microchip products. ST is perceived to the suffering from the pincer effect of a weak dollar and escalating labour costs in Europe. Turning to the Irish economy we notice that here output declined by 1.7 per cent in the first three months and the multinational sector had been hit heavily. But what can the Barosso administration do amid so many omens?
Certainly the long delayed fiscal policy has now started to show its effect. Ideally the Barosso administration ought to implement better fiscal controls which should be rooted in long-term sustainability goals.
The EU budget is also undergoing severe pressure from fee paying contributors who are seriously questioning whether they could alleviate their burdens. Typically one mentions the UK’s EUR 3 billion plus annual rebate from the EU that other EU members want to renegotiate but the UK is refusing to. To be fair the ongoing budget debates are focusing on the 2008-2013 period so they are unlikely to imperil the EU for a couple of years but the degree of debate and contention is catching a lot of attention from currency traders. This paralysis was evident in the suggestion from the French president, Jacques Chirac, that further expansion of the 25-member EU was inconceivable "without the institutions capable of making this expanded Union function efficiently."
A fundamental monetary paradox has come to a head marking the imbalance in strengths of the British and Scandinavian economies compared to the weak performance of Franco /German / Italian axis. Are Europe's unifying forces faltering? The answer is not easy to predict. Within the Eurozone growth has been dismal during 2004 reaching just below 2% and will drop to 1 per cent in 2005 before recovering to around 2% in 2006, with final domestic demand firming.
Regrettably the overall output gap will remain negative and the unemployment in the old 15 member group rate remains stubbornly high at over 8 per cent. One may add to the economic travails the adverse impact of the oil price hike. Should this peter out to below $40 a barrel then hopefully headline inflation is expected to fall to 1 per cent. On the converse another hike in oil prices or a further appreciation of the euro against the dollar and this could sap the recovery even further. On a positive note we can view that the euro/dollar conundrum by admitting that the US fundamentals are weakening and so far, US economic data has not justified the conversion rate with the euro. With hindsight we can say that , the US economy is finally experiencing a bit of what Europe has had to deal with for the past few years.
Eurosceptics laud it as the “Teflon dollar “ - it seems to be non-stick at the moment - helped by concerns about the EU constitution and EU budget problems and the no vote to the constitution at the French and Dutch referenda. But is the problem directly related to the fact that the euro currency’s perceived strength is crimping growth, not because of impressive rise in fundamentals but rather a structural weakness in the US economy. The tables have now turned and the dollar is rallying because of political and structural problems across the Atlantic. On a positive note economists point out that with declining inflation in Eurozone and a large output gap prevailing in 2006, there is room to ease monetary policy, even though liquidity will have to be withdrawn again once the recovery is firming towards the end of the projection period. Even in the short term, Europe's lack of political coherence can cause economic problems in the euro zone.
In conclusion one may add that the euro area’s susceptibility to shocks makes short-term forecasting a highly contingent exercise.
Will the race against the “Teflon” coated dollar be won by the euro. Perhaps the answer may lie in the prudent advice that the economic travails of the eurozone economy can only be cured once the medicine is administered in a gradual and programmed dosage.

gmm@pkfmalta.com
The author is a partner in PKFMALTA an audit and business
advisory firm



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