Last year was the first year of the common European currency -- the euro. Eleven of the countries in the European Economic and Monetary Union (EMU) gave up their own currencies and adopted the new currency. They are: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain.
The values of participating currency units have been irrevocably fixed against the euro by the EMU.
However, the euro's value has fallen by 16 percent against the US dollar and a whopping 29 percent against the Japanese yen since it hit the market with so much fanfare early last year. That the euro fell by such large margins after it had been tipped by many as a promising currency is an indication of how unpredictable the foreign exchange markets have become.
Facing these undulations, not only do Taiwan's financial authorities need to be prepared and on the alert, but local businesses should also learn the lessons of the euro and use financial instruments to reduce risks.
The introduction of the euro symbolizes the notion that nations can do away with egocentric ideologies and conduct economic affairs in a spirit of unification. The euro may even enable a closer cooperation on the political front. Therefore, the euro generated much enthusiasm and anticipation around the world before its introduction. The world expected the euro to ride on the European Union's strong economic and trading power and become a strong currency and a major tool for pricing in international trade and finance, challenging the dominant position of the US dollar.
However, the actual development was rather different from the vision originally outlined. The euro did not become a strong currency. Investors who boldly chose the euro as their set currency for revenues and assets have suffered losses.
It is difficult to explain the euro's devaluation over the year in terms of economic fundamentals. For example, last year's US economic growth was stronger than that of the EU. However, already at the peak of its business cycle, the US economy stands a good chance of a downturn. In contrast, the EU's economy is now in a state of recovery and may enter a period of strength in the future. In fact,with inflation standing at only 1.4 percent, the EU's economic strength was no weaker than the US last year.
More importantly, the EU's current account surplus is more than US$100 billion, a stark contrast to the mammoth US$300 billion deficit the US is now running. Against such a background, it is rather puzzling how the EU has weakened so much against the US dollar. This also shows that there is a limit to which economic fundamentals can be used to explain or forecast changes in exchange rates.
In fact, the euro's weakness was caused by capital flows to the US and Japan due to investors anticipating bull markets there. It is estimated that the value of currency trading around the world has reached US$1.5 trillion daily. More than 90 percent of this is generated by financial investment and less than 10 percent by actual commodity or service trading. Along with the quick fall in trading costs and the prevalence of equity culture, stock assets have become the prime area of international portfolio investment. In other words, short-term capital flows caused by stock market investment have become the major driving force behind currency rate fluctuations. As Taiwan plans to lift all its restrictions on foreign capital investment in the local stock market, the financial authorities and businesses here would do well to be sensitive to the changing factors behind currency markets.
Hwang Jyh-dean is an associate professor in the international business department at National Taiwan University.
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