Just over a year after the launch of the single European currency, the prognosis is good. But if the euro is to thrive, governments must think long term, says Michael Blanden.

The euro tree has taken root. That may be hard to credit given the nature of most of the comments on developments in Euroland. Inevitably, these have focused on short-term issues. First, there was the potential trauma of the introduction of the new currency and the switchover from the 11 national units of the member countries.

There is still some way to go before the process is complete, with the introduction of euro notes and coins in 2002, and there is still work to be done on the infrastructure of the euro-zone markets. Attention has concentrated on the monthly interest rate decisions of the European Central Bank (ECB), the frequent - sometimes delphic or apparently contradictory - public statements of ECB president Wim Duisenberg and other members of the Bank's board. Discussion has been dominated by the sharp drop in the value of the euro on foreign exchange markets, particularly against the dollar.

Less obvious has been the dramatic and lasting impact that the existence of the single currency has had on European capital markets and on the structure of European industry. The arrival of the euro has at a stroke eliminated exchange risk in cross-border deals and created an enormously larger pool of capital resources compared with the previously fragmented national markets.

It has been an important element, along with associated financial deregulation and single market legislation, in spurring an unprecedented round of consolidation both in the financial services sector and in industry more generally. This has included a previously unheard-of round of hostile bids in once protected markets. As financial institutions and the corporate sector come to terms with a wider and more integrated Europe, that process will be taken much further. It may not be long before the already powerful potential of the European single currency area is extended further.

Among the four European Union member countries still on the outside, Greece, the only one excluded perforce rather than by choice, has shown its determination to qualify by the start of next year with its most recent move a 3.5 per cent revaluation of the drachma's central rate within the European Monetary System. Of those which chose to stay out, both Sweden and Denmark are heading towards a change of mind.

Only the UK is still dithering, as Tony Blair's New Labour government tries to keep both the pro- and anti-Europeans happy. Meanwhile, though the City of London has so far demonstrated considerable resilience in maintaining its role as the leading financial centre in the European Union, concerns are beginning to grow that it cannot expect to sustain that position forever as an outsider.

There are, it is true, some worrying signs of a resurgence of nationalism even in countries which are firmly committed to the European ideal - including for example the success of Jörg Haider's far right Freedom Party in Austria's recent election (see page 28). And there is concern over attempts by national governments to retain their control over domestic industry and their freedom to provide effective subsidies to what are regarded as "flagship" companies.

For all the short-term doubts, the European single currency area has to be accepted as here to stay. As Wim Duisenberg said in his Per Jacobsson lecture at the IMF and World Bank annual meetings last year: "Long ago European integration reached the point of no return. There is no alternative but to continue down the path of integration. Economic integration has generated its own dynamics."

The evidence of the impact of the single market is already there. One aspect is the boom in mergers and acquisitions activity in the European area - though admittedly that includes the historically dominant UK. Figures from Thomson Financial Securities Data show that last year the European M&A market totalled $1,213bn, up by 105 per cent from the previous year, in the biggest leap ever witnessed (see page 63). Europe made up 37 per cent of the global market. "With 21 deals with a value of more than $10bn, 1999 will be a record breaker whether the Vodafone offer for Mannesmann succeeds or not."

In the financial services sector, the growing concentration was illustrated in a special article in the January issue of the ECB Monthly Bulletin. The number of "monetary financial institutions" in the euro area dropped 4 per cent from 9856 to 9443 in the period from end-1998 to November 1999, with the number of credit institutions - banks - down almost 5 per cent at 7906. The process has been going on for some time, but is being accelerated as a result of the single currency. Most dramatically, the impact of the single currency is demonstrated in the capital markets.

Figures from the Bank for International Settlements, quoted by ECB vice-president Christian Noyer in a speech during a visit to the US last month, underline the point. "According to this statistical source, in the first three quarters of 1999, euro-denominated gross international issues of money market instruments, bonds and notes accounted for 38 per cent of total issues, just slightly below the share of the US dollar (41 per cent). By comparison, in the first nine months of 1998, the combined share of the former euro area national currencies and the ECU [European currency unit] was only 24 per cent of total gross issuance."

Figures compiled by Capital DATA demonstrate the full impact last year. In 1998 the euro was already beginning to show; total issues in EMU currencies came to the equivalent of $312bn, including $18.4bn in ECUs and $62.6bn in euros. Last year the EMU total soared to $603.3bn, with a tiny amount in D-marks. The $602.5bn-equivalent denominated in euros topped the $573.8bn issued in dollars (see page 17).

Christian Noyer's comments concentrated on the international impact of the euro. He again highlighted the sheer size of the euro-zone, with 11 states which, at least in this context, have become one economy. "Although the largest single country in the euro area accounts for slightly more than 4 per cent of world GDP, the euro area as a whole accounts for 15 per cent. This is less than the share of the United States, at 20.5 per cent of world GDP, but around twice that of Japan, at 7.8 per cent.

Moreover, the euro area has the highest share of world trade, with a ratio of area-wide exports to total world exports of 19.5 per cent, well ahead of the shares of both the United States and Japan, at 15 per cent and 8.5 per cent respectively." Mr Noyer pointed to three areas which he felt were crucial in relation to the euro's international role: · The use of the euro by the business community as an investment and financing currency in the global financial system; · The new role played by the euro area in the process of international co-operation; · The importance of the euro for the process of regional integration in Europe and Africa, and the role that this process may play with regard to possible integration in other regions of the world. He drew three main conclusions. "First, although it is not the end of the process, the introduction of the euro can be considered to be a major milestone in the long process of integration initiated by the European Community more than 40 years ago. Moreover, the euro can be confident that it rests on extremely solid foundations.

"Second, the international use of the euro and the role of the euro area in international co-operation are likely to develop further, in line with the relative position of the euro area in the world economy and the institutional and political integration of EU member states. "Finally, the original formula as a result of which Europe operates as a regional organisation may become a point of reference with regard to possible integration in other regions of the world, although it has to be acknowledged that specific historical and cultural factors determine the European integration process." There remain shorter term preoccupations. In the foreign exchange markets, the euro has continued to be relatively weak. In early December, it briefly dipped below parity with the dollar during the day and by the third week of January was hovering just above $1.01. This compares with a peak of $1.1877 reached soon after the euro was launched in January last year. Wim Duisenberg addressed the issue of the euro's value in response to a question at last month's regular ECB press conference.

"We were, to say the least, not surprised that the exchange rate of the euro in the first few months of 1999 came down from the high level it started at. I was somewhat surprised, although it is explicable, that the exchange rate then went down further, through the level which had persisted throughout 1997 and 1998 and came close to so-called parity with the dollar.

"I am pleased that in recent weeks, and especially in recent days, the euro has moved away from that level again. And then, when I say we were somewhat surprised, -- with the benefit of hindsight, of course, one can explain everything - it is not really surprising that the very different cyclical situations prevailing in Europe and the United States did cause the exchange rate to move in the direction it did. Moreover, now that we see that cyclical developments in the United States and Europe are converging, we will not be surprised that our expectation, which we have expressed time and again, that the euro has a strong upward potential will become reality."

The ECB, with its overriding priority of controlling inflation, has taken care to distance itself from the day-to-day fluctuations in the euro's exchange rate. The only significant cause for concern is that a low value for the currency can itself contribute to inflationary pressures; in particular, the rise in oil prices coupled with the weakness of the currency have been part of an increase in the cost of imports for the euro-zone. This is seen as among the potential dangers to price stability. The ECB commented in its January Monthly Bulletin: "The risks to price stability over the medium term mainly depend on the reaction of wages to these short-term developments in consumer prices."

The annual inflation rate for the euro-11 edged up to a provisional 1.6 per cent in November. The euro-zone economy, as Mr Duisenberg indicated, is meanwhile showing increasing signs of renewed growth in line with global trends. The ECB reported: "Eurostat estimates for real GDP growth in the euro area indicate that economic activity significantly accelerated in the third quarter of 1999. Survey data for the industrial sector point to continued solid output growth in the final quarter of 1999 as well. In general, available indicators point to an improved business climate."

That is good news, and the growth in Europe could itself contribute to a better performance by the euro. There are dangers as well. In particular, expansion in the money supply has been accelerating, with M3 growth on a gradually rising trend since the beginning of 1999. At a three-month average of 6.0 per cent in September-November, the increase remained around 1.5 percentage points above the reference value of 4.5 per cent.

The ECB needs to remain watchful. Yet on the broader perspective the central bank and the governments of the EMU member countries should feel some satisfaction that the single currency has established itself, perhaps more quickly than might have been anticipated, as a major international instrument.

It has taken root. But it may be a little too early to start to gather the fruit.

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