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Euro Remains Strong Despite Budget Deficit Controversy - 2003-11-27

There was an uproar in European financial circles this week, when France and Germany evaded punishment for breaking rules governing the euro currency. But the euro remains very strong, despite the controversy.

The euro recently hit an all-time high value of $1.20. That is a striking increase from a value of just 88 cents when the euro first became a hard currency last year.

The euro has risen, despite slow economies in the countries that use it, and despite budget deficits in its two most powerful countries, France and Germany. Their deficits have exceeded the three percent limit for the past two years, with no sign of improvement next year.

Experts offer several reasons for the euro's strength.

One is what former president of the German Central Bank Hans Tietmeyer calls the collective structure of the eurozone, which gives it protection. He says, in the past, an economic slowdown or large budget deficit in one country would have hurt its currency. But with 12 countries sharing the euro, problems in one or two countries can be compensated for by strengths in the others.

"With their own currencies, they would be punished," he said. "That was the case in previous times. And that was the case that the pressure from the market came, and they had to do their job. Today, there is no pressure from the market."

Other reasons for the euro's strength include the weakness of the U.S. dollar, due to a slow economy and low interest rates in the United States, and a new trend in many Central Banks around the world to hold euros as part of their foreign currency reserves. Economist Daniel Gros, director of the Center for European Policy Studies in Brussels, explains.

"Foreign central banks have not used the euro to the extent that I would have anticipated, especially central banks in Asia, and that has certainly been a factor behind the strength of the dollar on average still over this period," he said. "That seems to be about to change. Now it will not change overnight and very quickly. But if the new trend one has seen over the last year continues over the next years, then I think that would mean that, slowly, the preeminence of the dollar as the sole global currency will be eroded."

Mr. Gros warns that the euro countries need to enforce their own rules, if the euro is to continue to be strong and in-demand. In particular, he says, France and Germany must be forced to abide by the budget deficit rules - rules that Germany insisted on imposing.

"The problem we have right now is that the weakness is in the core, in France and Germany, and these two countries both have excessive deficits, and agree, basically, among themselves, that they will not punish each other," he said. "Then it is not possible to actually implement sanctions and the measures foreseen in the stability pact. I do not think that will last forever, because France and Germany will see that if they continue to have large deficits, then they lose power within the European Union."

Another problem for the euro countries is that their strong currency makes their exports expensive.

"It is now too strong for our business," said Ralph Wiechers, chief economist of the German Engineering Federation, the largest industry branch association in Europe, representing 3,000 companies, many of which export industrial machinery. "We have a relationship of about $1.20 to one euro and it is too high for our export business. And in the long run, we had an exchange rate around $1.10. So, this is the borderline where it becomes more and more difficult for a lot of companies to compete on export markets."

Mr. Wiechers says exporters in the euro zone have been saved by strong demand from China, which has compensated for reduced orders from the United States and other countries, where importers do not want to pay the high euro prices.

Despite such problems, economist Daniel Gros says, the euro and the countries that use it are in a strong position for the future. "We know that currency markets are extremely difficult to predict, that currencies sometimes go down and up for no good reasons," he said. "And a bit of that happened to the euro during the first years. The euro area economy seemed so weak compared to the U.S. economy that people thought, 'Oh, we can just buy dollars, and it will always be a good bargain.' But now, people see the euro area might be slow, slow in terms of growth. It might have some problems with fiscal policy. But it is not about to disappear. And it has one advantage over the U.S., which is that it does not have a very large current account deficit [includes budget and trade deficit]. So, people start to think maybe the euro is a boring currency, but is a pretty safe bet over the long run."

Meanwhile, the euro is slowly becoming a more important currency in the world economy.

Mr. Gros estimates that foreign central banks have about 10 percent of their foreign currency reserves in euros. He predicts that during the next decade that could increase to 50 percent, which would put the euro on a par with the dollar as one of the world's most important currencies.