The first year of the euro was a pretty difficult one for those who make a living out of forecasting exchange rates, but for companies with an exposure to currencies the pain has been much more profound. Those who advocated Irish membership of EMU without sterling crossed their fingers and hoped that the British pound would behave itself in a stable manner against the fledgling currency and eventually become part of it. Even if it did not behave itself, a correct hedging strategy would protect against adverse currency movements, or at least so the argument went. Hence at the beginning of last year many Irish companies in receipt of sterling believed the pundits and sold the currency forward to guard against downside risk, while those who needed to buy the currency also believed the so-called experts and didn't bother buying sterling forward. As we now know, the pundits were by and large very wrong and Irish exporters to the UK who sold sterling forward have suffered a massive opportunity lost or profit forgone.
On the other hand importers who didn't buy the currency forward are now facing considerably higher import bills. There is a number of lessons to be learned from this experience. One is that sterling outside EMU has the potential seriously to negate the potentially positive impact of EMU membership for the Republic, and another is that exchange-rate forecasting is mostly an activity with a poor track record in terms of accuracy. Of course exchange-rate forecasters are not the only ones that have had their reputations seriously tarnished over the past year. What about equity analysts who were recommending buying the banks late last year at levels that many investors would now kill to see again? The reality is that forecasting financial variables is not an exact science and is fraught with danger. Forecasters can look very good in an environment where a strong trend is evident or where variables are behaving in a predictable manner, but they are rarely good at recognising paradigm shifts. In a sense, the reasons why exchange-rate forecasters have been so bad recently are quite similar to the reasons why many equity analysts have got it wrong. Namely, they failed to anticipate and react early enough to the global investor shift toward "new-economy" thinking. The performance of the technology-laden Nasdaq over the past year has been truly remarkable, but has only recently started to feature in the thought processes of mainstream forecasters. Observers of the Nasdaq were prepared for too long to write off the phenomenon as a bubble that would burst with damaging ferocity, and then life would return to the normal pattern of "old-economy" thinking.
One can argue that the euro's performance since its launch was entirely consistent with the cyclical economic and interest-rate factors that forecasters know and love. This line of thinking suggests that the currency weakened because the US economy outperformed the euro zone, and the consequent alteration of interest rate expectations had a predictable impact on the currency. However, one might have thought that by the end of last year the dollar had a lot of good economic and interest-rate news built into its price and that once the euro-zone outlook started to improve, the euro would regain at least some lost ground. This has not happened. Despite another bout of high expectations at the beginning of the year, the euro is still failing to realise what many believe is considerable upside potential, despite clear signs of recovery in its economy and changing interest rate expectations. In the last couple of weeks the currency has hit new lows against the dollar and the markets are ignoring good economic news out of the zone. European Central Bank (ECB) figures show that in the first 11 months of last year, net portfolio investment outflows from the euro zone totalled #28.3 billion and net outflows of foreign direct investment amounted to #120.6 billion. These capital flows totally swamped the current account surplus and in turn swamped the euro. The controllers of global capital flows are shunning the euro zone at the moment. Europe is suffering from a perception that it is well behind the US in the technology stakes, that its monetary authority is divided on most issues and that shareholder value is not a concept that permeates the boardrooms of Europe to any great extent.
Furthermore, there is a perception that unlike the US, Europe does not have a services sector of any note. I recently spent a half-hour trying to battle my way through the checkout in a German supermarket, and a lunch hour trying to find a restaurant open in Luxembourg. I came away from both experiences lamenting the lack of a services sector culture in Europe. Quite simply, the US is regarded by investors as new economy, while Europe is regarded very much as old economy. Until these perceptions change, investors are likely to continue to steer away from Europe and the euro will fail to realise its alleged potential. Of course it is also apparent that European officials do not want a stronger euro. A couple of weeks back when the euro edged up through parity against the dollar, the ECB vice-president, Mr Christian Noyer, stepped into the breach with a comment that sent the currency back down again. This has been a familiar pattern in recent months.
A weak euro is obviously good for European growth, but it is probably also the case that European officials recognise the risk that at some stage the US equity bubble might burst and then the balance of payments deficit would become a key issue for the dollar. So if the dollar is eventually to suffer a serious correction, the stronger the level against the euro from which it suffers such a correction, the better for Europe. Consequently, as long as investor perceptions of Europe remain so negative and as long as Europe resists a stronger euro, the currency is likely to remain in the doldrums. Incidentally, the consensus view among economic forecasters is that the euro will appreciate to 1.1260 against the dollar by January 2001. Be warned!
Jim Power is chief economist at Bank of Ireland Treasury
