Taking care of business . . .

Analysis: Europe faces only

modest gains if yen nightmare ends

 By Brian Love

European Economics Correspondent  

PARIS (Reuters) — Europe's dream of a stronger yen may soon be fulfilled, helping its exporters to defend their global leadership, but gains for the continent's economy as a whole will probably be modest.

If the Bank of Japan raises interest rates in earnest — a process that could begin when the central bank meets this week — this may start reversing a trend in which the yen has lost close to 50 percent against the euro in the past five years.

Europe's carmakers, which employ 2.2 million and face full-on competition in world markets, would perhaps benefit most of all from a yen revival. But the effect on Europe's economy overall would be more like stopping a hemorrhage than providing an infusion of new blood, and other factors are at play.

The value of Japan's currency is part of a growing Asian challenge to Europe as the world's leading exporter. This is led nowadays as much by China, with its vast pool of cheap labor and a currency that is state-controlled, unlike the yen.

Also, just when the yen may be about to reverse course, the dollar is also showing ossible signs of becoming a weakling, slipping in recent days to levels that cause concern in Europe, from about $1.30 per euro upwards.

Analysts stress that a yen revival is no cure-all for the European economy. Morgan Stanley's chief Europe economist, Eric Chaney, calculated that a 20 percent yen rise would add just 0.2 percentage points to euro zone gross domestic product.

European exporters need to look further than exchange rates to remain competitive. "Japanese car makers sell their hybrid-engine vehicles in the U.S. market like hot cakes," he said, adding that European carmakers missed this opportunity because they focused on diesel engines.

 "In the end, currency rates are no substitute for innovation, even in the car industry," says Chaney.

 Sleepless nights?

Nevertheless, Societe Generale did a few calculations recently that might keep European Central Bank chief Jean-Claude Trichet awake at night, wondering if the bank should keep raising interest rates in its anti-inflation drive — hikes which tend to push up the euro.

The euro's gains over 2002-2006 reduced exports by 20 percent in France, Italy and Spain from what they would have been had the rise not happened, the bank estimates. That equates to four percent a year in the euro zone's second, third and fourth largest economies. It also reduced exports of Germany, the bloc's biggest member, by 15 percent, or 3 percent a year.

"As the world's leading exporters of manufactured goods, the Europeans have paid a high price for the breakthrough of Asian goods into the world market," the bank said in a research note.

This damage has been masked by the best economic growth the world has seen in decades during precisely the same period, making the pie bigger for all.

The euro has risen about 50 percent against the yen and China's yuan in the last five years, and 36 percent against eight Asian currencies that Societe Generale used for its study.

"The issue of Asian exchange rate policies can be considered to be of utmost importance for Europe, as a major exporter, (and) moreso than the U.S., an importing country above all." 

Marco Annunziata, chief economist at UniCredit bank, stressed the importance of the auto industry and a few other sectors. "They are probably the only ones where Europe can hope to maintain some competitive advantage, while all the lower value-added sectors get gradually lost to lower-cost emerging markets producers," he said.

German Economy Minister Michael Glos recently singled out his country's auto sector as a victim of the weak yen, but Japan's car industry sees nothing untoward in the exchange rate and no reason to expect any rapid change.

Yen levels "basically reflect economic conditions and are not unnatural," said Fujio Cho, head of the Japan Automobile Manufacturers Association and chairman of Toyota Motor Corp.

It is not just Europe's car industry that hopes 2007 will be the year of the rising yen. French luxury goods group LVMH fared better than most with record profits last year, but CEO Bernard Arnault said the gain would have been 19 percent rather than 16 percent if it had not been for exchange rate trouble.

"I expect a rebound of Asian currencies and the yen, and I believe the exchange rate will follow the trend of interest rates," he said, adding that the opposite would be unfortunate.

With rockbottom interest rates and a weak currency Japan has had its longest spell of growth since the 1960s, allowing the world's second largest economy to recover gradually since early 2002 from the stagnation of the 1990s.

ECB'S fault?

While the Bank of Japan has raised rates only once in recent years, the ECB has moved six times since late 2005. For some euro zone politicians the point is simple. If the ECB eased off on rate rises, the euro would be less attractive to yield-hungry investors and thus less strong, helping the exporters. 

 But even if the ECB held its fire, the BOJ remains way behind. It nudged its key rate from zero to 0.25 percent in July, which compares with the ECB rate of 3.5 percent. All eyes are now on a possible hike at the BOJ's February 20-21 meeting.

"The cheap yen focus is also a convenient way for EU politicians to indirectly put pressure on the ECB," said Annunziata at UniCredit. "It is a way of pointing out that other central banks set policy with an eye to growth, whereas the ECB's hawkish stance then translates in widening interest rate differentials and an exceedingly strong euro."

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