With just seventeen months to go before the official birth of the euro, the financial markets have started to focus seriously on what sort of currency it will be. It is quite clear that the conclusions which are being reached are not exactly positive.

Few in the markets appear to believe that the euro will be able to compete with the dollar and it is already being written off as a soft currency which will lack the sort of credibility which the markets so desire. This conclusion may be a little pre-mature.

The strength of the euro relative to the yen and the dollar will be determined by a number of factors. These will include the economic fundamentals of the single currency area, relative interest rate levels, official policy towards the currency, demand for the currency by the world central banking system, the new grouping's share in world trade and economic output and the credibility which the markets will attach to the European Central Bank (ECB).

A key reason why the deutschmark has fallen so heavily over the past year is that the markets have concluded that the German currency will be subsumed into a basket containing a number of currencies, most of which are inferior to it. In other words, the new currency will be as strong or as weak as its inherent parts.

As it looks increasingly likely that the euro will initially be a broad based arrangement containing eleven currencies, the markets are sceptical. The convergence criteria were put in place to ensure that only those countries with impeccable track records could participate.

However, poor economic growth across the continent has resulted in a situation where rigid adherence to the criteria would actually prevent its launch and the powers that be have intimated that a generous interpretation will be applied in order to keep the project alive.

It may be incorrect to focus in on countries like France and Germany and conclude that just because their budget deficits will be a few tenths above the three per cent target, the euro will automatically be weak. What is much more important is the sustainability of the convergence.

Countries like Spain and Italy become a cause for concern when looked at from that perspective. Italy, in particular, has performed all sorts of manoeuvres to ensure that it satisfies the various criteria, but the big test will come a couple of years down the road.

There is a fear that the Italians may find it difficult to live within the rigours of the single currency and the lira could become a source of instability.

The jury is still out on this and only time will tell but, in the meantime, the markets will remain sceptical. There would be much more confidence in the ability of the six core countries to initially form an economic and monetary union, as they have effectively had that situation for some time.

They trade heavily with each other and their exchange rates have had a close relationship for some years. It is when the group is broadened, that the doubts surface. The markets also fear that the ECB will lack the authority and credibility of the Bundesbank.

With the French pushing to have a strong political counterweight to the ECB, these fears seem justified. There is a suspicion that future monetary policy decisions will be heavily influenced by political considerations rather than considerations of sound monetary policy.

For as long as the Bundesbank exists it will continue to fight this battle and has already intimated that euro interest rates could be high from the beginning in order to establish the credibility of the new currency as a low inflation vehicle. The logic here is flawed, because Europe's economic growth performance is likely to be still quite subdued in 1999, and certainly its unemployment level will still be unacceptably high.

Consequently, the markets are likely to regard a high interest policy as totally inappropriate to economic conditions, and the euro would suffer as a result. Far better from the euro's point of view would be a level of interest rates consistent with economic stability.

The above mentioned factors are the main reasons why the markets have concluded at this early stage that the new currency will be inherently weak. However, it will not be one way traffic. It is important to remember that the EU accounts for about 31 per cent of world output and 20 per cent of world trade, compared to 27 per cent and 18 per cent respectively for the US.

The dollar's share of world financial transactions far exceeds its economic weight and the share of the EU currencies is significantly below their economic weight. The likelihood is that once the euro zone is created, this monetary gap between the US and the EU will close and the euro will gradually become a more widely used currency.

This will result in a significant diversification of official and private portfolios. In simple terms, private investors will gradually replace dollar investments with euro investments and the world central banking system will run down dollar reserves and replace them with the new currency. These portfolio shifts will create strong demand for the euro and selling of the dollar.

Furthermore, an integrated EU capital market will be become much more liquid, broad and deep, and will significantly outweigh the US market in terms of size.

It is very difficult to quantify just how large the portfolio shifts will be and how quickly they will happen but, provided the ECB pursues sensible policies which are consistent with economic stability and that EMU does not turn out to be an unmitigated disaster, the process should occur quite quickly.

Of course, a strong currency is not be the be all and the end all and we have got ample evidence in Germany in recent years of how damaging an over-valued currency can be. It will be interesting to watch how the official currency policies of the three trading blocs evolve over the coming years.

Competitive currency policies will not end with the birth of the euro and there may well come a day when Europe will be crying out for a weak currency rather than regarding it as a burden.

Jim Power is chief economist at Bank of Ireland Group Treasury. The views expressed here are personal.