The impact of the Euro on European American Trade

An article by Paul de Ruijter
October 1998

“We lost almost 20% of our turnover after the Asian currency crisis”, that was the situation I found at a former Philips company earlier this year where I was asked to facilitate a scenario to strategy process. For me it was just a good way to illustrate the importance of scenario planning. For them it was a struggle for survival. “We never realised that we were so dependent on exchange rate fluctuations. Not only are we now too expensive to export to Asia, but Asian competitors are all of a sudden much more competitive in our European home market. We must be very happy that the dollar is still high.”

Now that they were to late to do something about the vulnerability of the company against currency fluctuations with Asia, the agenda was automatically set towards the logical next question: “Could the Dollar be next?”. Since the client produces in a European country the whole Euro-thing, especially related to the impact on exchange rates, became what we scenarist call a key uncertainty. In other words: “What would the dollar do after the introduction of the Euro?”.

We asked ourselves, is it possible that the Dollar would loose, say, half of its value in the next five years as a result of the introduction of the Euro? And if it is possible, is it also plausible? Armed with these questions I went to talk to people that “should know ” at the Dutch ministry of Finance and the Dutch Central Bank. But they did not see it as their business to speculate about the future dollar exchange rate with the Euro. They were introducing the Euro, but they did not perceived it as their task to evaluate the impact for exporting companies. Companies should do that themselves. I was very surprised that even organisations like the Dutch Federation of Exporters and the Employers Association had not given this question much notice. It seemed to me that there was a very solid belief that the euro would be a hard currency, and that a hard currency is good for business. Luckily a board level contact at ABN-Amro and some other banks did describe alternative views, which helped me to start a deeper research project.

To understand the possible impact of the melting of the currencies of eleven countries into to one European currency, the impact on the different functions of money need to be explored. Money is basically being used to facilitate trading transactions (its a lot easier than bartering), to store value, but a currency serves also as an underlying value to give other currency trust and value. This last function used to be primarily fulfilled by gold. But now central banks prefer the currency of another country’s central bank.

The most important use of a currency is of course in transactions between companies or people. And there the dollar is the main player. Wherever you go in the world, people will almost always accept the American dollar (and not only in the black markets). Even in remote places in the Himalayas locals know what a dollar look like. It is simply impossible to remember what all the different European currencies look like. Let alone to know what the exchange rates are. And because everybody uses the US dollar, the fees for converting it to the local currency are often much lower then for any other currency. For big companies there is another reason why they like to use the dollar for transactions. In an international transaction there are always currency risks and the dominant player normally imposes his or her national currency on the other. Until now European companies often used the dollar for international transactions since often the national currency is relatively unknown, but in the future it is more then likely that European companies will sent or pay their bills in their own currency. Many of the European companies are already preparing to send their invoices in euros starting January 1999, or will use the national name of the currency which in fact will be a euro. This will result in less use of corporate dollar accounts by European companies and their non-European trading partners. And so banks no longer need to exchange so many dollars to the local currency.

In the past the Dollar has been used by most central banks in the world to support the national currency. And the Dollar is still a favourite among central bankers, they amount to app. 60% of their reserves, whereas the different European currencies combined only amount to around 20%. And that while the output of “Euroland” and its trade are higher than that of the US. The reason for this is that the Dollar market is bigger than each of the individual currencies, making transaction costs when intervening with Dollars lower. But when all the separate European currencies melt into one on January 1st 1999, that disadvantage is no longer there. So it is not only impossible that the central banks in the world would start using more Euros, diversifying from Dollars. It is even plausible. To name just one example, the Chinese central bank already announced it is planning to do so. About 60% of the the Chinese $140 billion worth of reserves are currently held in US dollars against a mere 20% in European currencies. In the near future a 40%-40% is said to be favoured, resulting in $28 billion dollars being sold to buy Euros. Other central banks could well follow.

The same reason, the emergence of a very liquid Euro-market, could attract more people to use the Euro as an investment currency. Nowadays if a country or a company wants to issue a bond-loan they often do so in dollars, especially if the local currency is highly regulated, has a small marked or when the central bank is not trusted enough. Investors would then ask for a currency risk premium, something that can be saved if you issue your bonds in a trusted and often used currency, like the dollar. If we look at the bond market, most bonds are issued in dollars momentarily, but the Euro will become a good competitor all of a sudden. European institutions are already issuing EuroBonds at the moment, and the Euro might well be become a strong competitor to the dollar in those markets. Eventually, this could lead to an extra demand for Euros, and, again, a decrease in demand for dollars.

Adding all these possible shifts from dollars to Euros, this could mean a total shift of $,- to Euros. And that in turn could well lead to a fall of the dollar in the direction of 50 Eurocents. But all this is based on the assumption that investors trust the European Central Bank, the European Commission and the national governments. If, for instance, the ECB starts lowering the interest-rates, or starts printing money excessively this whole story would fall apart. In such a scenario the lack of trust in the Euro could even strengthen the position of the dollar. There are still a few European countries not in EMU, and they would stay out if confidence is low. To restore confidence would need higher interest rates, and this could even start strong arguments within the EC, undermining the confidence even further. But if the Euro is a success from the beginning, it could also work, as I said earlier, to a snowball effect, making the Euro as solid as gold used to be.

But this doesn’t help companies that are afraid of currency fluctuations. It would be easy if companies could financially hedge their currency risks, and they can. But these “insurance premiums” can be very high and are only effective in the short term, especially if the market starts feeling that turbulence is on its way. So the best option is to make sure that the organisation is “operationally hedged” as well as financially. This means that constructions need to be made to be able to make the most out of every situation.

In the scenario to strategy process for the company that initiated all this research, we came up with the idea that could work well whatever the Euro – dollar exchange rate would be. Rather than building an own sales and services network in the US, the company has now decided to work together with a distributor in the US that manufactures complementary equipment. So in the case of a high dollar, the exports go well, but if not, money can still be made by importing US equipment to Europe. At the same time both companies can focus on improving their products, making them less price sensitive. Now they no longer care what the Euro – dollar exchange rate will be…

* Many thanks to Nico Janssen, business and investment analyst, for his help with the research and editing