Eurozone recovery over

To the extent that the Eurozone recovery ever really began, it now seems to be over. This is not only the message of the recent miserable GDP figures just released, where output was reported as rising just 0.3% on the quarter, but also the lead indicators, which generally continued to soften, and the fundamentals, most of which are deteriorating both within and outside the region.

One of those fundamental factors which is getting a lot of attention at present is the exchange rate. The euro has now broken out decisively from its trading range of the last few months, setting new record highs against the dollar since its inception in January 1999.

Indeed, over the past three months the euro has leapt 10% against the US currency and is now up a staggering 60% since its low in October 2000. So what is the likely impact of the currency appreciation on the Eurozone economy?

It is first of all important to note that it is the development of the trade-weighted euro that really matters for economic activity, rather than just the euro-dollar rate. Against a basket of currencies, the euro has risen by roughly half as much as it has against the dollar since it toughened four years ago and just 3%-4% over the last quarter.

This has obviously reflected the relative stability of the euro against most of the region's other key trading partners, such as the UK, Sweden, Switzerland and Japan.

Given that it is universally accepted that the euro was massively undervalued in October 2000, the effects are being examined from the beginning of 2003, when the euro-dollar rate briefly moved in line with most estimates of the Purchasing Power Parity rate, around $1.10.

Since then, the euro has been rising by around 11% a year in trade-weighted terms.

Using an export model to estimate the impact on year-on-year export growth, this move has enabled comparisons with what would have happened to exports if the euro had not appreciated.

At the moment export growth would be roughly 1% stronger than the current rate if the euro had remained stable at its Q4 2002 level.

The worry, however, is that the euro is set to appreciate further, or rather the dollar fall, as the market continues to focus on the US current account problem. The euro-dollar rate is expected to rise to $1.40 by end 2005 and it is possible that the move could easily be more aggressive than this and happen more quickly.

A key point is that while the European Central Bank (ECB), probably in combination with the Bank of Japan, may well try to reverse the currency tide by intervening in the market, it is unlikely to meet with anything other than temporary success. This largely reflects three factors.

Fundamental problems: history suggests that intervention rarely succeeds to turn a currency around, particularly when it is operating against the fundamentals.

The main issue undermining the dollar at present is the 5.5% of GDP current account deficit which, barring a US domestic recession, which is not replicated among its trading partners, can realistically only be cut by a big fall in the currency. In other words, the fundamentals point to further dollar weakness ahead.

No US support: given the above, it is not at all clear that the US Treasury (which is responsible for dollar policy in the US) would help the ECB in any future currency operations designed to stem the rise of the euro.

It is interesting to note that the US trade deficit with Western Europe (excluding the UK) is second only to the deficit with China and still rising.

Lacking reserves: the ECB has limited euro-denominated reserves that it could sell to weaken the currency. Total foreign exchange reserves amount to around €40 billion, compared with the $316 billion bought by the Bank of Japan in the 15 months starting from January 2003 to try and keep the yen from appreciating too rapidly.

It should also be borne in mind that the ECB is not permitted under its statutes to 'print money' in the same way as, say, the Fed or the Bank of Japan. The problem is that it is not backed by a fiscal authority, as most other central banks are.

The conclusion from this combination of strong euro, weaker global growth and income squeeze is an anticipated miserable 2005 for both exporters and more domestically oriented firms.

Having expected production to slow to zero by the end of 2005, it is now believed that an outright industrial recession is probable. Meanwhile, only modest growth is to be expected in the economy as a whole.

An analysis of the cyclicality of the individual Eurozone countries suggests that Germany and Italy are particularly vulnerable under these conditions and Spain the least. Italy also looks to be the most exposed when it comes to Chinese competition in third markets.

Eurozone inflation is expected to fall below 2% in early spring and growth prospects for 2005 look weak. Barring any surprises, this should lead the ECB to cut interest rates, although this is not expected until the autumn of 2005.

This report has been compiled by HSBC Bank Malta plc on the basis of economic research carried out by HSBC International Bank's team of economists and financial experts.