The euro is, yet again, coming under pressure on the foreign exchange markets. It fell sharply in Far Eastern markets yesterday morning, dropping below 94 cents at one stage, before recovering later to trade in New York last night around 97 cents. Opinion is now divided among market analysts about the outlook for the currency. The latest turbulence in the foreign exchange markets was sparked by figures published late on Friday, showing that the US economy grew by an annualised 6.9 per cent in the fourth quarter of last year. This rate of growth in the US is remarkable; the largest economy in the world is, however briefly, experiencing growth as rapid as the Republic. This is drawing international funds into the US and thus into dollars, with investors also attracted by the prospect of a further rise in US interest rates next month.
The main European economies, meanwhile, are recovering, but so far growth rates remain well below the US. The European Central Bank is also having to work to establish its credibility in the financial markets. Investors are still not sure of its attitude to currency management and to interest rates, while its US counterpart, the Federal Reserve Board, has worked for years to develop confidence in the markets. Does this mean that the euro will remain on a downward track for the foreseeable future? Probably not. On most measures, the euro is now looking "cheap" relative to the US dollar. Most forecasters believe that it will recover in value. But they diverge sharply on when this will happen. EU finance ministers, meeting yesterday in Brussels, tried to give the impression that they were not overly concerned with the currency's fall. Europe's senior ministers and central bankers are well aware that markets are volatile, that they can undervalue a currency for a prolonged period of time and that the worst thing to do in the face of selling pressure is to give any sign of panic. Privately, however, they would certainly prefer if the euro was putting in a stronger performance.
The European Central Bank (ECB) could, of course, increase interest rates in an attempt to shore up the currency. Higher interest rates generally increase the demand for a currency by pushing up the return available to investors. However the risk for the ECB is that by raising interest rates in the near future it would be seen to be responding directly to the pressure on the currency. Also, if investors believed that higher borrowing costs could choke off recovery in the main EU economies, then higher interest rates might prove counterproductive and actually lead to further selling pressure on the currency.
Europe's policy-makers - both central bankers and finance ministers - need to present a united front to the currency markets. There are fewer loose comments now than was the case last year, but the markets have still been confused recently about varying policy signals coming from different officials and politicians. However the most important job of EU governments is to focus on the factors which will build productivity and support long-term economic growth. This means addressing issues such as the efficiency of tax and public spending structures and developing new policies to spur development in high-growth areas, such as telecommunications and technology. If the euro is to develop into a strong and stable currency in the long term, then the euro zone must develop as a vibrant and growing economic area.