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NOVEMBER 28, 2001  SPECIAL REPORT: THE AGE OF THE EURO By Simon Smith, S&P MMS A New Note of Inflation? Widespread worries that businesses will use the euro conversion as an excuse to hike prices are overblown, according to S&P's experts In the mid-90s, British building societies (financial institutions that were effectively owned by their savings-and-mortgage account holders) were floated on the stock exchange, leading to large windfall gains for millions of British consumers. This amounted to an increase in take-home income of nearly 4% over three years, according to the Bank of England. But the consumer boom that everyone thought would follow failed to materialize. Similarly, at the start of 2000, the infamous millennium computer bug was meant to bring about worldwide chaos and recession. Again, it didn't materialize. In both cases (especially Y2K), the dire predictions were enough in themselves to ensure that consumers, central banks, and governments took the appropriate action. Now, with the launch of euro notes and coins just around the corner, the current phobia is that the conversion will fuel inflation. However, S&P MMS believes that these fears are likely to be, for the most part, unfounded. ROUND NUMBERS. The reasoning behind these concerns is that aesthetically pleasing prices in the domestic ("legacy") currency will look far less appealing in euros and, when possible, businesses will "round up" prices to the nearest whole euro. For example, a cup of java in a top Viennese coffee house will set you back around 40 Austrian schillings, or 2.90 euros. Far easier to call it 3 euros. Studies by various eurozone central banks have looked at thousands of prices in their respective domestic economies to assess the degree of vulnerability associated with rounding up. In Belgium and the Netherlands, the investigations suggest that the worst-case scenario is a price increase of around 0.6% over 2001 levels. The rounding-up argument is not as strong as often made out, however, and often cuts both ways. For any price that looks ripe for rounding up (2,000 Portuguese escudos is 9.976 euros), there's another that looks perfect for rounding down (60 Finnish markka is 10.09 euros). If companies did want to pass on price hikes to consumers, then they are likely to do so before E-day (Jan. 1, 2002). Blaming more expensive products on the weather or health concerns is easier for consumers to accept than blatant rounding up. Thus, by E-day, it is likely that most price adjustments will already have been made. Conversely, for companies wanting to lower prices to gain market share, E-day provides a very good peg. Evidence has already emerged of some budget retailers in Austria and Germany preparing to round down prices on the changeover -- and the weakening eurozone consumer climate could well lead to more such initiatives. The outfits most likely to do so will be producers with flexible pricing (predominantly retailers, especially food sellers) operating in competitive markets, which create the incentive to increase market share. COSTS VS. SAVINGS. Still, those businesses with little competition will be more likely to push through increases and/or round up prices, especially around the yearend period. If that coffee house in Vienna has to go to the trouble and cost of reprinting its menus for January, then why not charge 3 euros instead of 2.90? There have been reports that bus and subway companies in Italy are looking to boost prices by up to 30%. What about the business costs of the changeover, such as the mechanisms for handling the new kind of cash? Again, estimates suggest that despite the concerns, the expenses are not that significant. A wide-ranging survey by Belgium's central bank calculated them to be just 0.29% of the private sector's annual turnover. Furthermore, it suggested that most costs had already been passed on to consumers in 1999 and 2000 as businesses invested ahead of the event. This needs to be weighed against cost savings from the euro introduction, such as reduced cash-conversion charges for businesses operating across the borders of member states. So far, the changeover's mechanics suggest that overall, eurozone prices will not rise dramatically, with the majority of increases having already been seen. While difficult to estimate, it's probable that a proportion of the increase in eurozone inflation earlier in 2001 (peaking in May at 3.4% year-on-year) is because of changeover costs being passed on, together with some rounding up ahead of time. DEFLATIONARY FORCES. There is one concern, however, that could stall Europe's current inflation downtrend. The eurozone has varying limits on the amount of legacy-currency cash that can be converted to euros without authorities being notified. There are no such limits to spending it, however, and this is generally more satisfying to people who prefer to be discreet about their cash hoard. Some evidence suggest that this may be happening. In October, data showed private car registrations in the EU up 8.3% vs. the previous year. In August, the same measure was recording a 1.6% decline. Also, there's anecdotal evidence of greater demand for property in parts of Southern Europe. It remains likely, though, that any further inflationary pressures will fail to stand against the tide of deflationary forces. Lower commodity prices, slowing consumer demand, and the euro's steadier course of late are pushing prices lower. In November, 2001, eurozone consumer prices were expected to grow almost 2.1% year-on-year. If it wasn't for the introduction of euro notes and coins, inflation would probably come in below the European Central Bank's desired limit of 2%. By the middle of 2002, inflation is likely to sink to around 1.5%.  Smith is managing analyst at S&P MMS in Europe Standard & Poor's MMS real time analysis of the global fixed income, forex and emerging markets is available on the Web at www.GLOBALMARKETS.COM Get BusinessWeek directly on your desktop with our RSS feeds.  Add BusinessWeek news to your Web site with our headline feed. Click to buy an e-print or reprint of a BusinessWeek or BusinessWeek Online story or video. To subscribe online to BusinessWeek magazine, please click here. Learn more, go to the BusinessWeekOnline home page  | | NOVEMBER |
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