Currency Profiles: Guide to Developed Countries Currencies

European Union

Economic Overview

The European Union (EU) was developed as an institutional framework for the construction of a united Europe. The EU consists of 15 member countries; Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, The Netherlands, Portugal, Spain, Sweden, and the United Kingdom. All of these countries share the Euro as a common currency, except for Denmark, Sweden and the United Kingdom. They are known as the European Monetary Union (EMU). Aside from a common currency, these countries also share a single monetary policy dictated by the European Central Bank or (ECB).

The EMU is the world's second largest economic power, with GDP valued at over US$6Trl in 2002. With a highly developed fixed income, equity and futures market, the EMU has the second most attractive investment market for domestic and international investors. The EMU is primarily a service-oriented economy. Services in 2001 accounted for approximately 70% of GDP, while manufacturing, mining and utilities only account for 22% of GDP.

The EMU is both a trade and capital flow driven economy. Unlike most major economies, the EMU does not have a large trade deficit or surplus. In fact, the EMU went from a small trade deficit in 2001 to a small trade surplus in 2002. EU exports comprise approximately 19% of world trade, while EU imports account for only 17% of total world imports. Because of the size of the EMU's trade with the rest of the world, it has significant power in the international trade arena. International clout is one of the primary goals in the formation of the EU, because it allows the individual countries to group as one entity and negotiate on an equal playing field with the US, who is their largest trading partner.

The EU's growing role in international trade has important implications for the role of the Euro as a reserve currency. It is important for countries to have large amount of reserve currencies to reduce exchange risk and transaction costs. Traditionally, most international trade transactions involve the British Pound, the Japanese Yen, and/or the US Dollar. Before the establishment of the Euro, it was unreasonable to hold large amounts of every individual EU national currency. As a result, currency reserves tended toward the dollar. At the end of the 1990s, approximately 65% of all world reserves were held in US dollars, but with the introduction of the euro, foreign reserve assets are shifting in favor of the euro. This trend is expected to continue, as the EU becomes one of the major trading partners for most countries around the world.

Monetary & Fiscal Policy Makers

The European Central Bank (ECB) is the governing body responsible for determining the monetary policy of the countries participating in the EMU. The Executive Board of the EMU consists of the President of the ECB, the Vice President of the ECB and four other members. These individuals along with the governors of the national central banks comprise the Governing Council. New monetary policy decisions are typically made by majority vote, with the President having the casting vote in the event of a tie, in biweekly meetings.

The EMU's primary objective is to maintain price stability and to promote growth. Monetary and fiscal policy changes are made to ensure that this objective is met. With the formation of the EMU, the Maastricht Treaty was developed by the Union to apply a number of criteria for each member country. These criteria were developed by the Union to help them achieve their objective. Deviations from these criteria by any one country will result in heavy fines. Listed below, are the EMU criteria. It is apparent based upon these criteria that the ECB has a strict mandate focused on inflation and deficit. Generally, the ECB strives to maintain annual growth in HCPI (Harmonized Consumer Price Index) below 2% and M3 (Money Supply) annual growth around 4.5%.

The EMU Criteria

In the 1992 Treaty on European Union (the Maastricht treaty) the following criteria were formulated as preconditions for any EU member state joining economic and monetary union (EMU).

  A rate of inflation no more than 1.5% above the average of the three best performing member states, taking the average of the 12-month year-on-year rate preceding the assessment date.

  Long-term interest rates not exceeding the average rates of these low-inflation states by more than 2% for the preceding 12 months.

  Exchange rates which fluctuate within the normal margins of the exchange-rate mechanism (ERM) for at least two years.

  A general government debt/GDP ratio of not more than 60%, although a higher ratio may be permissible if it is "sufficiently diminishing".

  A general government deficit not exceeding 3% of GDP, although a small and temporary excess can be permitted.

The primary tools the ECB uses to control monetary policy is the following:

Open Market Operations: The ECB has four main categories of open market operations to steer interest rates, manage liquidity, and signal monetary policy stance. These categories are main refinancing operations with average maturities of two weeks, longer-term refinancing operations with average maturities of three months, fine tuning operations done ad hoc to manage liquidity and structural operations such as the issuance of debt certificates or reverse transactions.

ECB Minimum Bid Rate (Repo Rate): This rate is the key policy target for the ECB. It is the level of borrowing that the ECB offers to the central banks of its Member States. This is the rate that is subject to change at the biweekly ECB meetings. Since inflation is of high concern to the ECB, they are more inclined to keep interest rates at lofty levels to prevent inflation. Changes in the ECB's minimum bid rate, has large ramifications for the EUR.

The ECB does not have an exchange rate target, but will factor in exchange rates in their policy deliberations, as exchange rates impact price stability. Therefore, the ECB is not prevented from intervening in the foreign exchange markets if they believe that inflation is a concern. As a result, comments by members of the Governing Council are widely watched by FX market participants and frequently move the EUR.

The ECB publishes a monthly bulletin detailing analysis of economic developments, and changes to their perceptions of economic conditions, which is important to follow for signals to changes in the bias of monetary policy.

Important Characteristics of the Euro

  EUR/USD cross is the most liquid currency

The Euro was introduced as an electronic currency in Jan 01, 1999. At this time, the Euro replaced all pre-EMU currencies, except for the Greece's currency, which was converted to the Euro in Jan 2001. As a result, the EUR/USD cross is now the most liquid currency in the world and its movements are used as the primary gauge of both general European and US strength/weakness.

  Euro risks as a new currency

Since the Euro is a new currency, there are number of factors that need to be considered as risks to the Euro that are not factors for other currencies. Namely, the ECB is frequently considered an untested central bank, due to its short history. This short history does not give market participants a good gage to how the central bank would react under different economic and political conditions. In addition, since the Euro is the currency for 12 member countries, it is highly sensitive to political or economical instabilities in any one country.

  Spread between 10Yr US Treasuries and 10YR Bunds can indicate Euro sentiment

The ten-year government bonds serve as an important indicator of future euro exchange rates, especially against the US dollar. The differential between the 10-year US government bond and the 10-year German Bund rates can provide a good indication for Euro movement. If Bund rates are higher than treasury rates and the differential increases, or the spread widens, this implies EUR bullishness. A decrease in the differential, or spread tightening is EUR bearish. The 10-year German Bund is typically used to represent the Eurozone.

  Interest rate differentials are use to predict Euro area money flows

Another useful interest rate is the 3-Month Interest Rate, also known as the Euro interbank offer rate or the Euribor rate. This is the rate offered from one large bank to another on interbank term deposits. Traders tend to compare the Euribor futures rate with the Eurodollar futures rate. Eurodollars are deposits denominated in U.S. dollars at banks and other financial institutions outside the United States. Because investors like high yielding assets, European fixed income assets become more attractive as the spread between Euribor futures and Eurodollar futures widens, in favor of the Euribors. As the spread narrows, European assets become less attractive, whereby implying a potential decrease in money flows into the Euro.

Important Indicators for the Euro

All of the following economic indicators are important for the Euro. However, since the EMU consists of 12 countries, it is important to keep abreast of political and economic developments such as GDP growth, inflation, and unemployment for all member countries. The largest countries within the EMU are Germany, France and Italy. Therefore, in addition to the overall EMU economic data, the economic data of these three countries are the most important.

  Gross Domestic Product (GDP)

  Individual Country Budget Deficits

  IFO Survey

  Harmonized Index of Consumer Prices (HCIP)

  M3

  German Unemployment

  German Industrial Production

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