The single currency is still trading below its launch value, writes OliverMangan

The recovery of the euro continues on global foreign exchange markets but, in truth, what we have seen in recent months is a sharp slide in the value of the dollar. The euro soared above $0.98 for the first time in more than two years yesterday.

However, the US currency hit 30-month lows against the Swiss franc and 17-month lows against sterling. It has also fallen to a seven-month low against the previously out-of-favour Japanese yen. The sharp decline of the dollar has been driven by steep losses by US stocks, doubts about the sustainability of the US economic recovery and the widening US current account deficit. The US has been running a very large balance of payments deficit in recent years, as imports outstrip exports by a large margin.

This current account deficit has, however, up until this year been quite easily financed by large capital inflows into US equities and bonds. However, these capital inflows have been declining in recent months, most notably foreign buying of US equities.

Concerns over accounting standards, corporate governance and profitability against a backdrop of high price/earnings ratios on US equities have seen a sharp fall by US stock markets in recent months. This has frightened away investors, putting downward pressure on the dollar.

The situation has not been helped by a further rise in the current account deficit in the opening months of 2002. Put simply, the US is having great difficulty in attracting enough capital to finance a current account deficit that could hit $450 billion (€460 billion) this year.

It's an ill-wind that blows no good and the dollar's misfortunes have seen the euro gain more than 12 per cent against the US currency year to date. But these gains need to be kept in perspective. The euro is still trading 16 per cent below its launch value against the US dollar in January 1999.

Furthermore, the euro's gains have been much more modest against other currencies. It has risen by 2.4 per cent against the yen and fallen by 1 per cent against the Swiss franc year to date. The performance against sterling has been more impressive with the euro rising by 6.5 per cent against the UK currency since the start of the year.

The recent sharp currency movements should not have major consequences for the Irish economy. Exporters to the US will obviously suffer a margin squeeze where their exchange-rate exposure is not hedged. In regard to Britain, the present sterling/euro exchange rate of 0.65 is just 4.5 per cent higher than the average level in 2001. It is also still very low by historical standards.

A MUCH greater concern for the traded sector of the Irish economy is the high level of inflation, especially high wage and service sector inflation. From this point of view, the rise of the euro will further erode the competitiveness of the economy, and will not be welcomed by exporters

We do not believe the recovery of the euro will generate a marked fall in Irish inflation. The high Irish inflation rate of recent years is largely attributable to domestic factors - buoyant demand, a tight labour market and associated high wage inflation. In our view, while the recovery of the euro will put downward pressure on some prices, inflation in the Republic seems likely to remain high over the balance of the year and in 2003.

Another issue to be considered is whether the current uptrend in the dollar/euro rate will be sustained. The euro-zone economy is in poor shape and is lagging behind the US in the strength and timing of the upswing in activity. By itself, the euro-zone economy is unlikely to provide much support for the euro.

Thus currency markets are likely to continue to be driven by events in the US. Short term, the ongoing weakness of US equity markets is negative for the dollar. Hence, it seems likely to test parity against the euro before too long.

On a longer term view, however, the US is likely to continue outperforming the euro zone in terms of economic growth. We expect the economic upswing to prove sustained in the US, helped by the very relaxed stance of fiscal and monetary policy.

This should generate a rise in corporate profitability and see a recovery in US equity markets later this year. In these circumstances, the current downward pressure on the dollar could well abate as capital flows back into the US once again. Attention would then refocus on the euro and its underperforming economy.

Oliver Mangan is chief bond economist with AIB Group Treasury