Plus ça change
The euro’s birth was a monumental event in monetary world history. On 1 January 1999 the euro replaced 10 national currencies that had been used for decades, or centuries, to make domestic and international transactions. The euro also eliminated the ability of central banks in the participating countries to use monetary policy to manage their national economies; interest rates could no longer be changed, while devaluing a currency to increase exports became a policy of the past.
The introduction of euro notes and coins, a couple of years later, was such a painless experience that the euro’s birth seems to have been an event hardly worth discussing. As anyone traveling in Euro-zone has experienced, it is no longer necessary to exchange one currency for another when flying from Ireland to Austria, or from Italy to Finland. Life is simply a bit easier.
The euro was created to accelerate unification of Europe and to improve the functioning of the EU. Although the euro’s impact was immediate in many areas, some of its long-term consequences are only now unfolding while unforeseen changes are also occurring.
The euro eliminated exchange-rate fluctuations in ‘core’ Europe, which initially resulted in a drop in global foreign exchange trading volumes. Figures from BIS’s Triennial Central Bank Surveys show that the FX volume declined from $1.5trn (e1.8trn) per day, in 1998, to $1.2trn in 2001. However, rapid globalisation has brought the volume to a new high of $1.9trn in 2004.
The euro was also created to provide price transparency that would boost increased cross-border trade and economic growth in Europe. While trade within Europe has been facilitated, the creators of the euro did not foresee that an explosion in internet-based shopping would force Europe to become more US-like, or ‘Anglo-Saxon’, as the French see it. Companies can now establish production facilities anywhere in Europe and rely on companies like Federal Express and DHL to ship directly to consumers, who can buy online 24/7 to ‘circumvent’ national laws requiring stores to be closed on Sundays. As these stores feel the pressures of the internet, laws will need to be changed to permit 24/7 shopping as in the US. Convenience for consumers will trump the preferences of unionised workers.
In the financial sphere, the euro has many obvious advantages. Shares can be listed and traded in various countries quoted in euro. That facilitates a consolidation of stock exchanges in Europe until one or two dominate – like the New York Stock Exchange dominates local exchanges in the US.
In the fixed income area, the opportunity set has shrunk. Although bonds issued by the Italian and German governments can be seen as having different credit risks, they are denominated in euro. Thus, the risk-premium associated with the historically weak Italian lira has disappeared. Nominal interest rates have converged across Euro-zone.
A more subtle change the euro has caused is in the expected returns of equities in various Euro-zone countries. For example, in nominal terms, long-term equity returns in Italy were higher than in Germany prior to the euro since nominal share prices responded to the different levels of inflation in Italy and Germany. As the Italian lira depreciated, shares rose in Italy to reflect the fact that the underlying real assets did not lose value as the lira fell.
With shares quoted in euro, nominal equity returns in Italy can be expected to be lower than in the past since they will not rise to offset a long-term weakening of the lira. Asset allocations based on long-term historical returns may therefore produce outcomes that are different than those anticipated.
In the fixed income markets, the focus is now on the ECB rather than the Bundesbank. The ECB’s role mirrors that of the Federal Reserve; it must set interest rates regardless of specific national needs. Thus, the birth of the ECB is also driving Europe to become more ‘Anglo-Saxon’. Although politicians may fret that it may disadvantage some countries in Europe, the fact is that there is no debate like that in the US. The Federal Reserve does not take into account the impact of its interest rate changes on Florida’s economy relative to those of California and New York.
The analysis of economic statistics from individual countries in Euro-zone will continue, but much of the data is no longer relevant for making investment decisions, particularly in managing currencies. With the euro it is no longer important to track if France has a trade deficit with Germany, since it cannot have any impact on the euro. With the French franc and the Deutschmark abolished, bouts of currency speculation, which led investors to buy and sell currencies, stocks and bonds to benefit or avoid losses is a thing of the past.
The fact that regional trade imbalances in Euro-zone no longer have significance for currency traders since the national currencies that would be affected have been eliminated illuminates why the Japanese yen has not risen against the dollar. Even though Japan has a huge trade surplus with the US, and has suffered from deflation for years, the yen declined 14% through November 2005. Economics 101 states a country with a large trade surplus and low inflation will have a rising currency. That ‘law’ seems to have been violated. However, Japan, in effect, acts as if its economy is dollar-based. As long as Bank of Japan maintains that stance, the yen may not rise, just as it will not matter for the euro if Germany has trade surpluses with France for years to come.
While currency risk within Euro-zone has been eliminated, the growth of cross-border investments has increased the overall currency risk institutional investors have. That risk is substantial. Although the euro was born at $1.17 and traded at $1.17 in December 2005, suggesting currency returns ‘wash’ in the long-term, that impression is totally wrong. The DM and the euro have moved in large trends in the past decades. And the euro has not moderated fluctuations against the dollar. The euro’s value changed by more than 7%, up or down, in six of the past seven years. In four of them, it changed by more than 10% – enough to wipe out or double the average annual expected long-term return of equities.
The euro’s volatility is equivalent to that of the Deutschmark’s. In the past seven years, the euro/dollar rate changed by 2%, or more, in 49% of those months, while the DM had monthly changes that exceeded 2% in 46% of the months in the seven years that preceded the euro.
Although currency risk has been eliminated in Euro-zone, the globalisation of investments coupled with an unchanged level of currency risk between the euro and other currencies, means that the use of currency overlay programmes, designed to manage currency risk effectively, will continue to grow. And, currency as an asset class that can provide great opportunities for alpha will likely grow even faster.
Simply stated, the fiduciary responsibilities of trustees and investment professionals require that all currency risks are assessed and managed to protect investments against unnecessary currency losses. The euro has not changed that imperative.