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Business Chronicle: Does a strong euro reflect European strength ?

The euro is extending a four-year high against the dollar these days, supported by the European Central Bank’s decision on Thursday to keep benchmark interest rates at 2.50 percent; the rate stands now at $1.15 to the euro.

As the euro rises, European exports are becoming more expensive, limiting sales of European industries. It was calculated that every 10 percent rise in the currency against the dollar translated into a three percent fall in European company earnings.

Now, if the euro rises much further, it will create additional problems for Europe and there will be serious economic difficulties. Industry will suffer and unemployment will rise. (Unemployment in the 12-euro nations hit a three-year high in March, at 8.7 percent)

But the question is: Does a strong euro reflect European strength?
The answer is: No!

The euro is high because the dollar has fallen sharply; the dollar is declining in value against most major world currencies for three primary reasons:

First, The US benchmark interest rate is set at only 1.25 percent (a four-decade nadir), which puts it among the lowest in the world. In comparison, Europe’s benchmark rate is set at 2.5 percent. This makes investors’ move out of dollars to buy currencies that pay higher interest, including the euro.

Second, the US trade gap recently topped $500 billion. The larger the trade gap, the more US dollars are being sent abroad, lessening demand for them. So presently, a strong euro does not reflect European strength but rather American economic problems.

Third, the US may welcome a weaker dollar, given the absence of secure domestic recovery, as a surge in exports could jumpstart economic recovery.

In other words, the euro’s strength has nothing to do with economic growth, it is far from it.

Japan experienced a similar criterion in early ‘90s. The Japanese yen rose strongly in the first half of the decade despite the weakness of the Japanese economy and the persistent decline in Japanese asset prices.

Eventually, the yen’s strength contributed to Japan’s economic depression. The Japanese were too slow in cutting interest rates, in loosening fiscal policy and in recognizing that they had severe balance sheet problems within the private sector. So the Euro Zone must avoid the mistakes that Japan made then.

Knowing this, the Euro Zone must follow at least a few obvious steps; cut interest rates and co-ordinate fiscal and monetary policy to secure a more efficient policy mix. Monetary policy affects the interest rate conditions, which have a significant impact on interest rate expenditure. On the other hand, fiscal policy has an influence on aggregate demand and long-term interest rates, which may be manipulated to supplement the direct impact of monetary policy.

Khair Mikkawi is a financial consultant based in Riyadh. He contributed this article to The Star

Amman,05 19 2003
Khair Mikkawi
The Star
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