Opinions on the likely strength of the euro have varied over the past few years as the genesis of the single currency progressed. Until about mid 1997, the skeptics - those who expected the euro to become a weak currency - had the upper hand.
They pointed to a likely loss of confidence in the euro that would arise should EMU be established (1) at the same time that a number of founding members would have failed the convergence test, or (2) to the risks that an inclusion of the peripheral countries would pose to the external value of the single currency.
Others pointed to the preference of some governments, especially the French, of using the external value of the euro as a means to foster economic growth. Nonetheless, around the middle of last year, sentiments with respect to the euro changed. This shift had little to do with the Amsterdam Summit, in spite of the fact that the Growth & Stability Pact was finally signed. Also, the sentiment shift was in sharp contrast to the ever growing chances of participation by several of the so-called peripheral countries.
In retrospect, the emerging confidence in the euro as a strong currency was the result of three critical developments: the combination of an on-going marketing effort by almost all of the would-be participant member states' senior politicians and their central bankers, the continuing progress made in the preparation for the introduction of the euro and the upturn in European economic growth.
In addition, there has been growing recognition with respect to some of the institutional aspects and market forces that could underpin the Euro. For example, the surplus on the Euroland current account of the balance of payments looks promising in comparison with the structural deficit on the US current account.
Moreover, over time, Euroland's ec-onomic clout will increase as more countries are granted admittance. That clout will undermine the US dollar's status as the world's predominant re-serve currency, although many expect this to be a slow process. Finally, the euro's role as a vehicle currency would be more significant than the deutsche-mark's role in that respect.
We suggest tempering that optimism at present. For example, the European Central Bank has no ex-change rate targets. Its only goal is to ensure price stability. Although currency trends could be important for policy, the reasoning is that structurally low inflation - which guarantees the internal value of the currency - will automatically lead to a strong external value of the currency. This we expect to be true if we compare Euroland's low inflation economy with an inflation prone economy like the UK. Nevertheless, in comparison with the low inflation economy of the US, the policy is no guarantee for a strong euro vis-à-vis the US dollar.
We would not be surprised to see a disappointing start of the euro in its initial years, despite continual low inflation on the Continent. First, the positive interest rate gap between the US and Euroland is probably going to remain for a considerable time, even if the ECB would nudge up the repo rate a bit in early 1999.
Secondly, we expect to see the peak in Euroland's business cycle around mid -1999, after which the economic outlook will deteriorate somewhat. Although this does not necessarily have to put to test the provisions of the stability pact, the possibility that a number of governments will break the 3% threshold in their budget deficits could depress the euro. Alternatively, should governments stick to the 3% ceiling, latitude for counter cyclical policies will be limited at best, thereby putting more emphasis on continuous easy monetary conditions in Euroland.
Thirdly, comparing structural strengths and weaknesses between the US and Euroland economies, it should be clear that Europe is lagging the US in doing its homework. Whereas in the US, both trend growth and the business cycle point to a continuation of strong growth, in Europe the structural deficiencies in for example labour markets and social security systems tend to keep a lid on trend growth for the time being. All in all, Euroland will need the help of a competitive euro to ensure sufficient growth while transforming its economies.
As inflation trends in the US and Euroland will probably not determine the strength of the euro in coming years, the euro's performance will be primarily driven by relative growth. Europe is not ready yet to show a consistent outperformance in this respect over the US economy.
Bernard Walschots is head of financial markets research at Rabobank International in the Netherlands.