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Another Blow To Europe's Recovery


Everybody knows Europe's sluggish economy is recovering from three years of recession and stagnation far more slowly than America's. So why is the euro climbing against the dollar and threatening to douse the faint spark of recovery? After fluctuating between $1.11 and $1.15 for most of the summer, the single currency surged back above its 1999 launch value of $1.17. By Oct. 8, it was hovering around $1.18. That's 20% more than a year ago. Most economists and traders believe it's not done rising: They expect the euro to continue gaining on the dollar, albeit sporadically, for the foreseeable future.

The phenomenon is due mostly to concerns about spiraling deficits in the U.S., statements by government officials trying to "talk down" the dollar, and spillover from rigid currency regimes in Asia. Merrill Lynch & Co. (MER) currency specialists predict that the euro will top $1.20 by December this year and hit $1.33 by the end of 2004. J.P. Morgan Chase & Co. (JPM) expects a rate of $1.45 shortly after that. Of course, some currency strategists, such as Citigroup's (C) Steven Saywell, say the dollar could rebound next year as the U.S. economy accelerates. But they are in the minority. "The trend is set to continue, despite intermittent signs of a U.S. recovery relative to the rest of the industrialized world," says Ashraf Laidi, chief currency strategist at MG Financial Group in New York. "The euro is not expected to undergo any severe backtracking."

That upward trend is bad news for many euro zone businesses and the region's economy. A stronger euro makes it harder for European companies to sell their goods and services overseas. It also reduces the euro value of earnings generated by foreign subsidiaries. Analysts at UBS (UBS), the Swiss bank, estimate that a 10% increase in the euro lops an average of 5% off the profits of Europe's 300 largest listed companies. It also squeezes nominal gross domestic product growth by a full percentage point. "Dollar weakness is transferring nominal growth to the U.S. on a massive scale," says Ian Stewart, a European economist for Merrill Lynch.

To make matters worse, some euro zone companies that tried to hedge their currency exposure assumed the euro would rise slowly to no more than $1.15 by December, 2003. Heineken (HINKY) Chief Financial Officer Ren? Hooft Graafland said last month that the strong euro cut the company's operating profits for the first half of 2003 by 7%, to $693 million, because Heineken hedged 96% of its dollar inflows based on an estimated dollar-euro exchange rate of $1.10. He warned that the situation will worsen next year, when only about half of the company's dollar exposure is hedged. "The full impact of the weaker dollar will not be felt until 2004," Graafland told journalists.

The euro is mainly being driven higher by the twin U.S. trade and government deficits, both of which, economists say, are now unsustainably large. The currency markets are narrowing America's $550 billion current-account deficit -- and, indirectly, the projected $500 billion budget deficit -- by devaluing the dollar. That makes it easier for U.S. manufacturers to boost exports and, in turn, generate more taxable revenue to fill government coffers. Merrill Lynch economist Yiano Kontopoulos notes that 20% of total U.S. corporate revenues, from subsidiaries as well as exports, comes from abroad. So a weaker dollar boosts overall earnings and pushes up tax payments. That's one reason U.S. Treasury Secretary John W. Snow effectively signaled the end of Washington's "strong dollar" policy at the Group of Seven meeting in Dubai last month. The euro has since risen more than 3%. On Oct. 6, European Central Bank President Wim Duisenberg told a Spanish newspaper that a weaker dollar was "inevitable," promptly spurring more euro buying.

A stronger euro wouldn't be so bad if Asian currencies were also gaining ground against the dollar. But they're not. That's giving Asia's companies a big pricing advantage over European rivals. China keeps its yuan pegged to the greenback, and Japan is intervening in the currency markets in an effort to hold the yen down against the dollar. Although the yen has risen to three-year highs against the greenback, it has fallen against the euro. The result is that the euro bears the brunt of the exchange-rate correction, even though 20% of the U.S. current-account deficit originates from China and an additional 50% from the rest of Asia. "From a European perspective, the Dubai communiqu? is a failure," says David Gilmore, a partner at Foreign Exchange Analytics in Essex, Conn.

HEDGING STRATEGIES

It gets worse. Euro zone policymakers are increasingly concerned the dollar could take a precipitous dive and drive their economies back into recession. Several euro zone finance ministers, such as the Netherlands' Gerrit Zalm, have indicated that while an exchange rate for the euro as high as $1.20 might be in line with economic fundamentals, anything above that would put real stress on European exporters. Duisenberg was frank about his concern, saying on Oct. 6: "I hope and pray that the [dollar's] correction will happen gradually and slowly."

European companies are working on strategies to further protect themselves. One technique is to switch to dollar-based accounting. Companies that have done so include Novartis (NVS), the Swiss drugmaker, and Astra-Zeneca (AZN), its British rival. Although neither is headquartered in the euro zone, the rising euro gives them increasing euro costs and declining dollar revenues. Another company now doing its books in dollars is STMicroelectronics (STM), the Italian-French chipmaker. Of course, dollar accounting doesn't change the fact that most of ST's costs are in euros while revenues are mainly in dollars. "Plus, the shareholders are mainly from the euro zone and think in terms of euro," says one London-based investor.

Another popular strategy to blunt the impact of a stronger euro is hedging. New Volkswagen finance director Hans Dieter Potsch says that the company will increase the proportion of the $5.9 billion net foreign-currency exposure that it hedges from 40% to two-thirds. The company was hit by more than $900 million of currency losses in the first half. Other companies, such as Germany's Siemens, plan to establish "natural hedges" by borrowing money in dollars next year on the grounds that it will be cheaper to repay in the future once the euro has strengthened even more. "It gives us more flexibility," says Siemens (SI) CFO Heinz-Joachim Ne?burger.

But hedging can't protect a company over the long term against a sustained currency slide. If the euro continues its sharp rise, a budding European recovery may well be its first victim. By David Fairlamb in Frankfurt


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