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Euro power

November 4th, 2008 · 2 Comments

A decade ago and more, when we were in a previous life in the academe, we had lively discussions about the pro’s and con’s of the euro (we used to be pro, if you must know). We think the experiences of the last decade has comprehensively settled that debate. A daring idea it was, but the benefits have far outweighed it’s costs, especially in today’s turbulent environment.

Those issues back then mainly revolved around the question whether Europe was a so called ‘optimal currency area’. That question could be answered by a tentative ‘no’. Here’s why.

Permanently fixed exchange rates (and the euro certainly has achieved that!) give up one two adjustment mechanisms in the case two members of such a fixed exchange rate mechanism are hit by different economic events, or the same economic events impacts them differently.

If this sounds abstract, take the following example. Say demand for French products goes down, but for German products goes up. The French economy is in a recession (with higher unemployment), while the German economy is booming (threatening inflation). Something like this in fact happened after German reunification.

Ideally, the French would like to lower interest rates and the exchange rate, to cope with the falling demand (and rising unemployment), and the Germans would like to do the opposite because of the inflationary threat.

Since their exchange rate is permanently fixed (it’s the same currency) and interest rates are set for the whole euro area by the European Central Bank (ECB), neither country can embark on such policies.

So the question becomes, are there enough other viable adjustment mechanisms operative to deal with these kind of asymmetrical shocks?

Possible candidates:

  1. Wage and price flexibility
  2. Labour migration
  3. A centralized budget automatically adjusting (or some deliberate redistributive policy)

Neither of those is likely to provide a whole lot of adjustment. Prices and wages are notoriously inflexible in Europe. Labour migration (French unemployed moving to Germany, in the case of the example above) is also much lower compared to the US, for cultural, language, and regulatory reasons (it’s still hard to bring pension rights, medical insurance, qualifications, etc. to another country).

The budget of the EU is by no means large enough to automatically redistribute from the country with the declining economy (which, with falling incomes and profits would pay lower taxes) to the country with rising incomes.

There are some deliberate redistributory policies but these work more on the level of regions (the Euopean Regional Policy).

So, tentatively, alternative adjustment mechanisms are not terribly impressive. Still, the euro has held together, and now provides a beacon of stability. Without it, we would have seen chaos on the European currency markets, with currencies wacked out of their values by the markets on a daily basis.

This is still happening on the fringes of Europe though:

“It’s the euro, stupid,” New Europe finds belatedly

  • By Adam Jasser – Analysis
  • WARSAW (Reuters) – A Polish proverb “Jak trwoga to do Boga” (Run to God when in trouble) is a fitting description of how the financial crisis is shifting attitudes in much of the ex-communist central Europe toward the euro.
  • Stung by rapid depreciation of their currencies, credit rating downgrades and capital flight in the last few weeks, many “New Europe” politicians are waking up to the status of the euro as sanctuary in economic hard times.
  • In Poland, Hungary, Czech Republic, Romania and the Baltic states, governments look with envy at Slovakia which, thanks to its imminent adoption of the single currency on January 1, has suffered none of the investor anxiety or capital flight that the global financial turmoil has inspired elsewhere.
  • The crisis engulfed Hungary, once an economic leader in the region, seeing it become the first European Union state in 30 years to be bailed out by the International Monetary Fund after years of overspending and living on credit.
  • The plunge in the Hungarian forint and the drastic measures the beleaguered Socialist government in Budapest has had to take to save the country from financial collapse have sent shockwaves across the region.
  • Even eurosceptic politicians such as Polish President Lech Kaczynski have pointed to the Hungarian “events” as perhaps a good reason to pursue the euro after all.
  • This in itself is remarkable. Since joining the EU in two waves since 2004, only a few of the 10 ex-communist EU members have pursued the euro vigorously — despite committing to adopt it in their accession treaties.
  • Lulled by the fast economic growth that came with EU membership, a rise in the value of their currencies and access to cheap credit on global markets, governments of left and right assumed their risk profile was permanently hoisted above emerging market status.
  • With no determined push to meet strict euro zone criteria, original plans to adopt the single currency in 2008-2009 were pushed back or dropped altogether, with the exception of Slovakia and tiny Slovenia, a euro zone member since 2007.
  • For their part, investors contributed to this false sense of security, ignoring the slippage of euro timetables and reform in favor of pumping billions of euros into the region’s assets because the growth story was too good to be missed.
  • The benefits of eliminating currency risk, having lower borrowing costs, or being protected by the European Central Bank and wielding influence on the Ecofin council of EU finance ministers seemed too abstract for politicians and investors.
  • Even when the crisis started to bite hard in the United States and Europe, the region was considered a safe haven.
  • But in the last few weeks of panic, it became clear to all that with the wafer-thin capital stock and the absence of ECB protection, the “new Europe” economies were still wearing a rather large emerging market badge on their sleeves.
  • Those who were most exposed, like Hungary, were punished accordingly for its feeble and much delayed reform efforts.
  • “The biggest crime made by (Hungarian Prime Minister Ferenc) Gyurcsany was that his 2006 plan to rein in the budget deficit didn’t have euro adoption as an end-game,” said David Lubin, a veteran emerging markets economist at Citigroup in London.
  • Hungary’s current declarations that the euro should be adopted as soon as possible sound hollow given the tasks it faces just in stabilising its economy.
  • Of all countries converting to the euro gospel in the last few days, it is the region’s heavyweight, Poland, that is making the most serious effort.
  • The center-right government of Prime Minister Donald Tusk, a euro enthusiast, has adopted a formal goal of joining in 2012 and signs are emerging of necessary political consensus on the issue with Kaczynski and the opposition.
  • Poland is very close to meeting all the strict euro entry criteria on debt, deficit and inflation, but economists point out that, like Hungary, it had allowed the best opportunity to pass.
  • “Some central Europeans missed the bus,” said Witold Orlowski, chief economic adviser at PriceWaterhouseCoopers in Warsaw. “They can now sit and cry that they will not be joining with Slovakia on January 1, 2009.”
  • The bitter irony is that just as political determination to adopt the euro is on the rise, the economic environment in which it must happen has deteriorated.
  • Economists say several factors hamper euro adoption.
  • Currency volatility is arguably the key issue. Prior to entry, countries must spend two years in the Exchange Rate Mechanism and maintain a narrow trading band around the euro, prior to entry.
  • Meeting this criterion may require costly interventions in the face of general volatility and poor prospects of capital inflows into emerging markets in the medium-term. Trying to defend the band in case of economic trouble can invite a speculative attack and end a candidate country’s euro dream.
  • Slower growth is another risk. The next two years are set to see growth rates slashed and tax revenues fall, meaning some countries may bust the 3 percent of GDP cap on budget deficits and see debt rise above the 60 percent of GDP limit.
  • Meanwhile the appetite among existing euro zone members for expanding their club in the near term may evaporate.
  • But none of these difficulties should discourage central Europeans for trying hard, economists say, even if eventual membership could come later than they now hope for.
  • PwC’s Orlowski says the best time to enter the euro zone is two years after a recession at the start of the economic cycle when budget revenues are growing, inflation is low and currencies are typically in a mild appreciation trend.
  • If the fallout from current crisis lasts into 2010, then such conditions, last seen in 2004-2005, will materialize around 2011-2012, making the earliest realistic entry around 2014.
  • By that time, real convergence with the euro zone should go deeper across central Europe, making the process more palatable for the European Commission and the ECB.

Tags: Credit Crisis · currencies

2 responses so far ↓

  • 1 E.K. // Nov 6, 2008 at 5:31 pm

    Euro adaption of the individual countries has been seen as giving up a part of their cultural heritage.
    British (conservatives) were a classic example. But the difference with the smaller countries their amount in the trading volume. Like new European members after being a soviet satellite state they where very proud of their indentities. just joining European community was already a big step. Next step for join the euro was for the people of these new countries to fast.
    But like the example of Slovakia once part of bigger Czechoslovakia: After they freed them self from their big brother Czech republic they had enormous unemployment rate from almost 20%. In 2002 a new government with fresh ideas saw their chance to attract foreign (capital)investment. they made the base for a stable investment climate by working on the rules for euro adaption. Their plan was a big success. I personally see they are an example for every emerging economy to find the middle way for on one hand keeping their cultural values and building up a stable investment climate and prosperity for their inhabitants.

  • 2 admin // Nov 6, 2008 at 5:55 pm

    Good comment, E.K. We agree. Problem now is that the ECB isn’t cutting rates fast enough. Inflation has disappeared, they’re behind the curve.