The weakness of the Euro's exchange rate since 1999 when the currency was launched has been against general expectations. With the introduction of Euro notes and coins this year, the following is an assessment of the Euro's future exchange rate performance.

I. The Euro's Performance in Retrospect

The Euro's exchange rate has been persistently weak since its introduction. Comparing with early 1999, the Dollar (U.S.)/Euro rate at the end of 2001 has fallen by about 24%. During the period, the largest decline registered was almost 30%.

The Euro's weakness was particularly significant after its introduction. According to the IMF, the "synthetic" Dollar/Euro rate (the weighted averages of the legacy currency rates) began to follow a downward trend after 1990-1992 when it stabilised around 1.20-1.40. It mainly fluctuated around 1.05-1.30 during 1993-1998. Since the Euro's introduction in 1999, the Dollar/Euro rate declined further, moving around 0.82-1.17. Since 2000, it has mostly stayed below 1.0. Although it has not reached the record low of 0.70 in the 1980s, it has already declined substantially from the peak at above 1.40 in early 1990s.

II. Long-term Factors

Quite a number of explanations have been put forward to account for the Euro's weakness. Nevertheless, considering the long-term trend of the Euro, fundamentals still play a dominating role. Besides, as the Euro is a relatively new currency, insufficient confidence in its operation and problems in the cooperation among major member countries also affect its exchange rate.

1. Economic Fundamentals

In the past decade, economic performance of the Euro Zone was inferior to that of the U.S. ?During 1991-2000, the average annual economic growth rate of the U.S. was 3.3%, while that of the Euro Zone being only 2.0%. Particularly in 1996-2000, average annual growth of the U.S. economy reached 4.3%, much higher than the 2.5% of the Euro Zone. Also, higher economic growth in the U.S. has not ignited inflation. Such performance was particularly outstanding.

Statistics from the OECD show that U.S. labour productivity has gradually surpassed the Euro Zone in the 1990s, reversing the trend in the 1970s and 1980s. Average annual labour productivity growth of the U.S. traded sector rose from 1.0% in the 1970s to 4.6% in the 1990s, while that of the Euro Zone fell from 4.0% to 2.9% in the same period.

Euro Zone Economic System Relatively Inflexible ?Economic system has much influence on productivity. The market economic systems of Europe and the U.S. have different orientations. Major members of the Euro Zone, including Germany, France and Italy, have put much emphasis on social cohesion, having created more protective measures favourable to labour and the public. These measures, nevertheless, have reduced the flexibility of their economies.

Single Market Needs Further Progress ?As early as 1987, the European Community, predecessor of the E.U., already decided to implement the "Single Market" in 1993. The "Single Market" refers to a regional economic zone which allows internal free flow of goods and services, as well as labour and capital. The creation of the single market ought to be a pre-requisite for the launch of the single currency. The reason is that without exchange rate adjustment, free flow of factors of production has to play a major role in economic adjustment, harmonising the business cycles of member countries. On the other hand, while further abolishing internal economic and trade barriers, the single market can add growth impetus.

However, when the single market was implemented, E.U. member countries had not adopted all single market directives in their national laws. By November 2001, the proportion of directives not yet adopted by all member countries was still at 10%. Besides, there have been obstacles in the enforcement of the directives, dampening the effectiveness of the single market. During August 2001, single market infringement proceedings under progress reached 1,477, substantially higher than the 27 cases during 1997. Furthermore, nearly 40% of the proceedings are related to the three major members.

Price convergence is another indicator of market integration, particularly for tradables. Nevertheless, a survey by the E.U. in 1999-2000 suggested that there were quite substantial price differentials among member countries, with the largest difference for some food prices reaching about 200% (compared to the lowest). Price differences in electronic products among members were in the range of 30-50%, higher than the national differences of 10-20%.

The launch of the Euro has brought about a single currency financial market for the 12 countries. With increased market scale and no exchange rate risk, liquidity should be much enhanced and transaction costs can be reduced. Integration in the stock, bond and money markets should come about, fostering the development of financial services and creating a more favourable financing environment for corporations. Yet, progress in financial market integration has been below expectations. According to the European Central Bank (ECB), rapid integration progress has only been evidenced in the unsecured money market, but not in others. Reasons for fragmentation include the existence of different supervisory bodies and standards, different stock exchanges and divergence of sovereign risks (due to the "No bail-out" clause concerning government finance) among member states.

Still Some Accomplishments ?Despite the above obstacles in reform and integration, progress made in recent years has been rather substantial. The proportion of single market directives implemented has actually been much lowered from over 30% in mid 1997. The implementation of the single market has brought about liberalisation measures, e.g. in electricity market. The competition policy has also made member countries relax control and reduce state aids. Tax reform is another major development. Major E.U. members such as Germany, France and Italy have been pursuing tax reform. Germany's reform has already begun while the Italian government also pledged to reform when they took office last May.

Another area worthy of attention is employment. The 1997 Amsterdam European Council identified employment as a "matter of common concern". The purpose is to foster labour market reform that replace welfare measures for the unemployed by preventive measures (including training, strengthening market integration and encouraging the unemployed to seek for work). Progress can be reflected in the falling unemployment rate in recent years. In 2001, the unemployment rate remained steady at 8.3-8.5% amid economic slowdown, demonstrating that some structural improvements have counteracted the negative impact from the economic bust.

Progress of stock market integration can also be found, mainly in the merger and acquisition of stock exchanges and clearing houses. For example, the French, Netherlands and Belgian stock exchanges merged in 2000 to form Euronext, the second largest exchange in Europe. Euronext subsequently succeeded in taking over Liffe. The German stock exchange Borse is also buying 50% equity of the clearing house Clearstream. In 1999, the E.U. put forward the "Financial Services Action Plan" to boost financial market integration. In early 2001, it further appointed a wise men committee led by the former president of European Monetary Institute to study for ways to foster the implementation of the Action Plan. The committee suggested splitting the progress into two parts: concentrating legislative effort in core principles and leaving to specialists the details of implementation.

2. Risk and Confidence

Although the Euro is not the first currency union in history, the overall scale of participating economies is the largest, including major European countries Germany, France and Italy (also members of G7). Such broad participation, together with the diversities in culture and nationality, and also the 1992-93 ERM crisis, did make some people sceptical about the smooth cooperation among major member countries and hence take a wait-and-see attitude towards the success of the single currency. Indeed, there has been divided opinions about monetary policy between major member country and ECB Board members. Market confidence in the Euro has really been insufficient. According to the E.U.'s survey, proportion of residents considering the Euro would bring more ills than benefits still reached 40% by at the end of 2001.

Such a situation may continue to pose negative influence on the Euro. Yet, some positive developments can contribute to sustain people's confidence in the Euro. The first is the introduction of Euro notes and coins, with those of the legacy currencies being withdrawn from circulation gradually. Although full circulation of Euro notes and coins carries more symbolic meaning (because the launch of the Euro in 1999 has already replaced the legacy currencies), it would still generate rather significant positive psychological impact on the public.

Secondly, the willingness to place international foreign reserves in Euro is increasing. In early 2002, the Chinese Finance Minister indicated in public the suggestion for the People's Bank of China to increase foreign reserves in Euro. He pointed out that the Chinese government cares much about the development of the Euro and expects the currency to attain equal international status as the U.S. dollar. Earlier, the Hong Kong Monetary Authority has already converted a portion of foreign reserves into Euro. Mainland China and Hong Kong SAR possess the second and fourth largest volume of foreign reserves in the world respectively. Although the increase in Euro reserves will probably be a gradual process, official affirmation of the Euro's status can serve to consolidate market confidence, thereby offering support to the currency.

Confidence in the Euro's operation would also be affected by the possible conflict among Euro member countries and the potential repercussions of admitting over 10 Eastern and Southern European countries into the E.U. Considering the cooperation among member countries, divergence of economic cycles would be the major source of conflict. Nonetheless, it should be noticed that convergence of economic cycles between Germany and other member countries since mid 1990s has contributed to the success of the Euro. After the introduction of the Euro, only Ireland experienced more rapid growth and higher inflation among the member countries. Performance of the German, French and Italian economies have been similar. Inflation differential among members has mostly been within 1.5 percentage points. Although the possibility of divergence in future cannot be ruled out, further progress of the single market should be favourable for sustaining convergence. As for the E.U.'s plan to admit new members in 2004, it does not imply immediate Euro membership. The E.U. still requires members to satisfy the conditions in inflation, long-term interest rate, exchange rate and government finance before joining the Euro, so as to maintain good foundations for the currency.

III. Official Exchange Rate Policy

The primary objective of ECB's monetary policy is to maintain price stability. This implies that exchange rate will only be a matter of concern should it threaten inflation. After ECB's inception, it has only intervened to support the Euro when the Dollar/Euro rate dropped to 0.82. In the recent year, inflationary pressure has subsided amid global economic adjustment and lower oil prices. Together with the rebound of the Dollar/Euro rate, the ECB has paid less attention on exchange rate. While low exchange rate has appeared to have boosted exports and can encourage import substitution, member countries should be willing to accept it.

The crucial thing is how would the ECB or member countries perceive the future trend of the Euro? Most likely, the ECB still does not favour the Euro's fall back to the lows after its introduction, for fear of possible inflationary pressure. The ECB and member countries will certainly accept the gradual appreciation of the Euro in future, particularly if it reflects the improvement of the Euro Zone economy, or it is due to the success of reform that attracts overseas capital or the repatriation of domestic capital. Besides, rebound of the Euro exchange rate can also enhance the reputation of the ECB or the E.U. A normal Euro exchange rate should be more favourable for encouraging the U.K., Denmark and Sweden to join, as well as sustaining the confidence of East European countries in joining the E.U. and the single currency in the long run.

International factors also play a part. Obviously, the most significant is the attitude of the U.S. Though pursuing a strong dollar policy in recent years, the U.S. probably does not expect the U.S. dollar to rise continuously. The U.S. will certainly accept exchange rate adjustments in line with economic fundamentals.

IV. Is the Euro Undervalued?

A number of studies have shown that the Dollar/Euro rate is below its "equilibrium". The "Hamburger Index" by the Economist, that signifies the simplest form of purchasing power parity (PPP), indicates that the Dollar/Euro rate is undervalued by 11%. The practical relevance of such simple PPP analysis, however, is much impaired by its strong assumptions, e.g. ignoring non-tradables, productivity changes and etc. Nevertheless, studies by some international organisations, which employ more sophisticated techniques and take into consideration more factors, e.g. interest spread, productivity, oil price and government finance, also conclude that the Dollar/Euro rate has been undervalued. These studies indicate that the equilibrium rate should be around 1.10-1.20, implying that the current rate is undervalued by about 20-25%.

Estimates of Equilibrium Dollar/Euro Rate

V. Conclusion

To sum up, it can be considered that economic fundamentals of the Euro Zone are on an improving trend. Although the pace of improvement would not be fast and it is not certain whether the reform will meet market expectations, some economic benefits can be expected. Besides, with the introduction of notes and coins as well as the affirmation of the Euro's role by official authorities, international confidence in the long-term sustainability of the Euro can be boosted. Also, considering that the Euro is staying at relatively low levels, its moderate rebound due to fundamentals should not arouse strong reaction from major countries. Therefore, despite market fluctuations from time to time, we can still be cautiously optimistic about the moderate rebound of the Euro in the medium to long-term.