On the eve of the euro’s launch in January 1999, most analysts and market participants expected it to appreciate. Their chief fear was that an overly strong new European currency would exacerbate the slowdown in activity then underway in the euro area.
In the event, the currency weakened almost uninterruptedly through all of 1999 and most of 2000, boosting exports and helping make 2000 the best year for growth and employment in a decade. While for a time commentators welcomed the depreciation as a desirable cyclical adjustment, its persistence in 2000 sparked concerns about the implications for inflation. It was also increasingly felt that the exchange rate had lost touch with fundamentals.
Although many observers acknowledged after the event that the currency might have started from a relatively high level, its continued depreciation came as a surprise. The euro ended its second year at 93 US cents, 21% below its inaugural level. It depreciated somewhat less against other currencies, but even so, compared with exchange rate swings in the past, this was a large one.
Many theories have been put forward to explain the euro’s anaemia, but no single version is fully convincing. One popular explanation relates the euro’s fortunes to cyclical divergences. Over certain periods, the dollar/euro rate indeed mirrored the expected growth differential. But markets tended to react somewhat asymmetrically, seemingly giving more weight to US than to euro area news, be it positive or negative. Interest rate differentials, which are partly related to cyclical divergences, turned out to be only loosely correlated to the exchange rate.
An equally striking parallel, although one that has attracted less comment, can be drawn between the evolution of the euro exchange rate and the oil price. Production is nowadays far less oil-intensive than in the early 1970s but large oil price swings still have a direct impact on inflation, output and current accounts, and therefore on exchange rates. In addition, the rising oil price led to increased euro/dollar conversions by euro area based buyers, putting more downward pressure on the euro. On the other side of the oil trade, oil producers likely exchanged only small proportions of their dollar proceeds into euros, therefore doing little to support Europe’s currency.
Another set of theories has concentrated on equity markets. Higher US rates of return were said to draw investment out of the euro area, weakening the euro. But in 1999-2000, European stock markets outperformed US stock markets in own-currency terms. The relationship between stock prices and exchange rates is in any event hard to interpret since both react to interest rate movements.
One rationale for the large net capital outflows from the euro area has been “eurosclerosis”. But while market rigidities and high tax levels have been more prominent in Europe than in the United States for a long time, there is little evidence that they have become relatively worse since the launch of the euro in 1999. Furthermore, the surge in foreign direct investment (FDI) outflows from the euro area in the late 1990s was accompanied by an equally spectacular rise in FDI inflows, and in 2000, FDI inflows almost matched FDI outflows.
On the other hand, the surprisingly vigorous performance of the US economy until late last year prompted many analysts to raise their estimate of US potential growth, while such revisions have been more scattered and timid as regards the euro area. This may have weakened the perceived euro equilibrium exchange rate.
A completely different explanation for the euro’s fall is poor communications. Statements in the early days from European Central Bank (ECB), national central bank and government officials were clearly insufficiently co-ordinated. Euro area finance ministers agreed during 1999 to exercise restraint in their comments about the exchange rate, and now generally base their pronouncements on language agreed in common, in co-operation with the ECB. In any event, while dissonant official messages may add to exchange rate volatility in the very short run, they are unlikely to drive exchange rate trends over longer time spans.
Finally, some analysts consider that the euro’s depreciation was at least partly due to the herdlike behaviour of the market. The dollar’s appreciation would thus be viewed as evidence of the strength of the US economy, while the focus as regards Europe would be on rigidities. These beliefs would reinforce the euro’s depreciation, which in turn would consolidate those beliefs. The process could last for a while, as it did in the first half of the 1980s when the dollar’s appreciation seemed unstoppable, until the credibility of the beliefs starts to be eroded by the widening discrepancy between fact and perception. A small trigger could then reverse the process, as the Plaza Agreement by the G5 countries seems to have done in 1985. In such a case, it is critical to try and ensure an orderly reversal of the previous misalignment, to avoid overshooting in the opposite direction.
As the euro kept falling, proponents of central bank intervention on the foreign exchange markets became more vocal, emboldened by the fact that at well over 250 billion euros, the reserves of the Eurosystem are among the highest in the world. During the first 20 months following the euro’s launch, intervention was merely verbal, but on 22 September, 2000 the ECB announced a joint G7 intervention, citing “shared concern about the potential implications of recent movements in the euro exchange rate for the world economy”.
This was the first transatlantic co-ordinated intervention since 1995 and came as a surprise both because of its timing – ahead of, rather than after, a G7 meeting in Prague – and because of US participation in the run-up to presidential elections. Some 6 billion euros were bought. Within hours, the euro jumped from 85 to 90 US cents. It then settled at around 88 cents for about a week, but depreciation soon resumed and by mid-October the euro had dropped below its previous lows. A round of unilateral ECB interventions followed in early November, but this time the euro reacted less markedly.
It is difficult to assess the effectiveness of these interventions, although they did succeed in instilling some uncertainty in market participants’ minds, showing that the Eurosystem stood ready to intervene either multilaterally or bilaterally and without having to wait for specific government instructions. The euro has rebounded somewhat since last autumn, but given the external imbalances between the three major currency areas, it would seem to have ample room to appreciate further, although whether it will, and at what speed, remain anybody’s guess. Among other things, this may depend on the impact of the introduction of cash euros at the beginning of 2002.
• OECD, Economic Survey of the Euro Area, Paris, 2001.
• Koen, V., Boone, L., de Serres, A., and Fuchs, N., "Tracking the euro", OECD Economics Department Working Paper, forthcoming.
©OECD Observer No 226/227, Summer 2001