"The euro will be weak" has been the mantra of the currency markets this summer. Most traders think the single European currency will be nowhere near as firm as the deutschmark, which has risen for most of the past 25 years. As the deutschmark is traded as a proxy for the euro, they have been selling the German currency.
It dropped 5 per cent against the dollar in July, hitting eight-year lows, and has revived only in the past fortnight. But the markets may be wrong: the euro could be as hard as the deutschmark. The "weak euro" argument rests on three pillars. First, the market expects European monetary union to be "broad", with up to 11 founding members in January 1999, including such historically weak currencies as the lira, peseta and escudo. The entry criteria for EMU would probably be blurred, letting entrants run high budget deficits, thus softening the euro.
The second argument is that Europe has structural economic problems. Economists say it pays out too much social security, creating high unemployment and low growth. The third point: the euro will have no pedigree. Central banks want to hold the dollar and deutschmark because these currencies have proved strong. As the euro will have no history, central bankers will convert their deutschmark reserves into dollars rather than euros.
But the euro could have some classic economic fundamentals making for a strong currency. The countries expected to join EMU have a total current account surplus of about $100 billion.
Europe has become "banker to the world", says Mr Peter von Maydell, senior currency economist at UBS in London. Any economy that exports more than it imports should find demand for its currency exceeds supply.
Then there is the independent European central bank. Currency strategists expect it to kick off by taking a tough line on inflation. "Whoever is running the bank will be an inflation hawk from Day One," says Mr Kit Juckes, currency strategist at NatWest Markets in London.
That means rising interest rates. The high yields should draw investors to fixed-income assets in euros, boosting the currency.
The European central bank will be relatively free to raise rates, says Mr Avinash Persaud, head of global currency research at J.P. Morgan in Europe, because the EMU economies should be recovering by January 1999. France may want the bank to go easy on rate rises, but the bank's statutes should enable it to resist politicians, currency strategists say.
Mr Persaud adds: "You are talking about a culture of central banking today which is very conservative in Europe, from Germany to Italy." Mr Antonio Fazio, governor of the Bank of Italy, "is arguing about pockets of inflation in a country with an inflation rate of 1.5 per cent. He's a tough man".
Already, the inflation rate in the putative EMU zone averages only about 2 per cent. That bodes well for the euro.
With monetary policy tight, EMU members will have to stimulate their economies by cutting taxes. That should enhance economic growth, another plus for a currency. Taxes are high all over Europe this year, to reduce government deficits.
But Mr Von Maydell says: "These are the tightest budgets we will ever see in Europe". Further, says Mr Persaud, many European countries and companies are cutting social security spending. That should boost growth.
Lastly, many central banks will want to hold large euro reserves, says Mr Persaud. He rejects the view that central banks seek to hold strong currencies as reserves.
Were that the case, he says, bank vaults would be full of Swiss francs, Dutch guilders and Japanese yen. In fact, the dollar is the most popular reserve currency. Central banks like the dollar because it has tended to fall. They know it is unlikely to soar, forcing them into devaluations.
Much international trade is paid for in dollars. The euro should assume a similarly dominant role in world trade, says Mr Persaud. So there are reasons to think the euro will be firm. For the euro, Mr Juckes says, the only way is up.
