The euro is a bold, unprecedented move. What do the Americans make of it? Matthew O. Hughes reports.
Many articles have been written on the euro and the potential effects - both good and bad - to follow implementation. The goal of this article is to share general attitudes aired in the United States on the euro and how it will affect their business, not necessarily to rehash previously stated visions of the future.However, asked the two greatest news events to affect US business and finance, the answers will more than likely include two numbers: Year 2000 and a sustainable Dow 10,000. One would find the formation of a single European currency from 11 sovereign currencies further down the list, below perhaps the “Asia flu”.
Indeed, public opinion on the formation of the euro is difficult to find in the US. For those who have considered the business effects of the euro, general consensus includes short-term caution and long-term optimism.
Optimism results from beliefs common with those held in Europe and promoted by the members in the euro zone: that the single currency will promote greater competition, boost efficiency and lower costs of doing business. This optimism is simply magnified by the prospects of a fair and honoured World Trade Organisation emerging from the various rounds of international negotiations.
But it is in the short term where business executives from all sectors see a moment for pause. The reasons for this concern are widely varied, but most reasons can be traced to political and/or economic origins.
Politics is persistently cited as the greatest hurdle perceived for success for the euro. It is fairly accurate to say that a financial move like this has not been attempted, let alone successfully implemented, in history. Therefore it should not be surprising that many in the United States see this as at best a difficult endeavour from the beginning, and many feel the more difficult the endeavour, the more participating governments prefer to be involved. But certainly a degree of government participation and involvement is necessary.
The political nature of the transition is to many in the US perhaps best exemplified in the selection of the first members of the currency. The Maastricht Treaty stipulated many strict financial criteria an aspiring government would have to meet or surpass for accession consideration. The hurdles put in place in the Maastricht Treaty had very justifiable reason for being so stringent: to ensure the emerging currency is strong and stable. After all, without high requirements, there would be no incentive for a nation to dispel its sovereign currency, especially those nations, such as Germany and France, which had strong, reserve-grade currencies.
Unfortunately, it appears that the stringent measures have been “massaged”, as the time frame provided in the Treaty appears to have been too short for all nations but Luxembourg to achieve. “Deadlines” appear to be reinterpreted as “movement towards” or “goals”, especially when it was evident that the two cornerstone nations of Germany and France would also not completely make the bar. Still, while many argued the window between signing the Treaty and the actual birth of the single currency as too short, others argued the exact opposite, allowing exactly for the political manoeuvrings that some believe to have happened.
An additional area of political concern revolves around the new European Central Bank (ECB). In the run-up to the formation of the euro, debate emerged related to the nature of the ECB's powers. Would the Bank be a fairly independent institution familiar to the US Federal Reserve, or would its decisions, for example, on interest rates have to run through a series of approvals from the participating national governments, and all of the political issues involved?
Perhaps due to the nature of the US system, most opinions in the US support the former “EuroFed” model, with the latter option seen as a ready recipe for political and economic disaster. Fortunately for people sharing this opinion, it appears that indeed the ECB will have a high degree of independence.
However, though the ECB appears to have been established with autonomy in mind, a dispute arose which cast some concern on this. Prior to the official announcement of the 11 candidates for the single currency, it was determined that Wim Duisenburg of the Netherlands would take the first eight-year term as ECB head. However, the French government proposed its own candidate, Bank of France governor Jean-Claude Trichet. The civil but heated dispute originally ended with the French government announcing Mr Duisenburg had “agreed” to serve only the first half of his term, surrendering the second half of the term to Mr Trichet. Apparently since this unilateral announcement, Mr Duisenburg has announced he will serve his full term after all.
These types of political disputes are exactly the types of conflicts businesses in the US would rather not see occur, and certainly this desire is shared by many in Europe. But it does exemplify some of the difficulties and challenges potentially in store during the early years of the ECB.
As mentioned above, the two key elements where a strong euro can be helped or hindered are in politics and economics. Similar to the political situation, some in the US question the timing of moving to a single currency. The rationale for this concern is associated with the fact that, in the year prior to announcing the members of the euro zone in May 1998, the economies of a number of the prime candidates were in, or just showing signs of emerging from, a mild recession. Put simply, many felt it was not the most opportune time for such an attempt.
Thankfully, the economic situation with these countries has generally improved across the board. But it also pointed to a simple reality; while several nations were experiencing at least a few elements associated with recession, other candidates were experiencing a situation more similar to recovery or prosperity. This highlights a phase shift of economic cycles among the participants in the euro zone. The economies of the euro zone should converge their cycles over the midterm. But in the short term, it could mean that decisions the ECB takes on interest rates could have beneficial effects for some euro zone countries, while harming other national economies within the zone.
Another area dealing with the timing of the transition is purely coincidental, but nevertheless a key area of concern for US companies, and is another issue with numerous articles attributed to it: the infamous Y2k. The year 2000 is already straining technology and personnel, and the fear is the euro conversion will just exacerbate that strain.
Many of the issues related in this article are short term, with very few long-term concerns being investigated. Perhaps the one exception to this statement is what economic effects the euro will have on the US dollar, and the subsequent effects to exchange rates and interest rates in the US. While many business analysts believe the euro will not be in a position to challenge the dollar to any huge degree for at least five years, barring US economic recession, the end result they foresee is almost universal in agreement.
Unless something unexpectedly and drastically negative occurs with the euro or the European economies, most see a currency emerging eventually at reserve grade. This will create competition for the key reserve currency currently available, the US dollar. Competition will lead to the possibility that the dollar will come under exchange rate pressure, and the lower value for the dollar will cause imports to become more expensive, while lowering the relative cost of exports, among other things.
If the Federal Reserve decides to step in and defend deflation of the dollar, it will require a raising of interest rates. This will make financing business growth through debt issuance more expensive for companies in the US, and could have serious side effects on the apparently ever-rising stock markets in the US and abroad. Needless to say, this interruption is not awaited with much glee in the US.
One key economic element involves the convergence of interest rates within the euro zone. National interest rates are governed by two kinds of risk, currency risk and sovereign risk. The creation of a single currency and subsequent elimination of national currencies harmonises this part of the interest-rate equation. However, this still leaves sovereign risk, which will make complete interest rate harmonisation within the euro zone, at least for the short term, impossible.In general, most nations within the euro zone will see a decrease in national interest rates, though some key markets, such as Germany or France might see a small increase. What does this mean for insurers?
Insurance companies incorporated within the euro zone tend to weigh their asset portfolios relatively heavily with debt instruments, whether these are government bonds or corporate debt (the most apparent exceptions to this statement are Ireland and the Netherlands). While insurers in the US also utilise debt instruments, especially as a conservative stabilising force, they also rely equally heavily on other forms of investment.
Insurers in those countries where analysts predict a decline in rates should examine their portfolios to ensure asset-liability matching is not jeopardised. This is a crucial move because insurers will not be able to renegotiate terms of existing policies due to the “Continuation Clause”, a stipulation associated with the Maastricht Treaty ensuring contractual integrity during and after the move to the single currency.
A positive side effect could be felt by the stock markets in the euro zone, as some insurance companies and other financial institutions may need to seek investments with more aggressive returns. This could be beneficial in a number of ways: it would allow financial services companies another investment option to balance the weight of their debt portfolios, and would benefit companies in general by allowing them access to another option for raising capital. This possible move by financial institutions of all stripes could also contribute to greater liquidity in the equity markets, and talk has already been heard about the possibility of a massive “euro stock exchange”.
An area of subdued concern for insurers in the US is the speed of consolidation in the European industry. Many of Europe's largest insurers such as Allianz, AXA, Generali and Zurich, have been on a buying spree, and at least for the time being it appears the big will continue to get bigger. Equally interesting, there appears to be no insurer that is big enough to not be considered a target, as the acquisitions of BAT Financial Services and AGF have demonstrated. If anything, the arrival of the euro could accelerate the process, as there appears to be an unending list of targets, and a still insatiable appetite in the big insurers.A question these acquisitions have raised is how big is too big? In the days of national currencies and national customs borders, determining big in monopolistic terms was simpler than today, where the three generations of insurance Directives are trying to eliminate the commercial borders hindering true integrated trade. Thankfully a precedent was made during the negotiations of Allianz's takeover of AGF. During that business deal, it was determined that the resulting position Allianz would have in Germany after digesting AGF and its shareholding in the German insurer AMB ment that for the deal to conclude, Allianz had to agree to sell the shares in AMB.
There are numerous other issues for insurers to consider in the run-up to euro exclusivity in 2002, including those with accounting and technology themes, but for the sake of space these issues will not be pursued here.
Insurance: for US-owned operations
All of the above has caused US insurers with international interests to completely rethink strategy for Europe. Most US insurers already active in Europe have small operations, and are now being offered three key options, depending on how important a European presence is for the insurer's overall global strategy.Some companies will undoubtedly see Europe as an integral part of business. It should not be surprising to see these companies prepare plans to aggressively grow through acquisition. As mentioned earlier, there continue to be numerous candidates of various sizes for acquisition throughout Europe, though if the predictions related to the European powerhouses is accurate, the length of time this may remain true could be limited.
However, US insurers do not have a strong reputation for acquisition outside their home country. Indeed, when the acquisition route is chosen, it is usually exercised on smaller companies and in developing markets. Their record for M&A activity in Europe is quite limited.
US companies prefer to grow operations through internal means, by offering what they believe are competitive products and superb service. Growth through this process is understandably a long-term endeavour, and engaging such a strategy in light of the issues discussed here would imply that a European operational presence is of lower priority. In practicality, implementation of internal growth could force the insurer to remain a small niche player in Europe.The acquisition route obviously entails large infusions of capital - human and financial - up front, while the internal growth model is time consuming and offers shareholders little excitement. Additionally, neither path necessarily guarantees success. For acquisition, there are no assurances in operational integration nor in overall global strategy, while there is similarly no guarantee of a pot of gold at the end of the organic-growth rainbow.
In light of this, should a US insurer determine the effort does not justify the result, its management may decide to get out altogether, and refocus freed assets elsewhere. Judging by the small stature of many US-owned insurance operations in Europe, it should not prove too surprising if a number of these companies decide to divest.
There is at least one other facet the euro brings to US insurers and the US insurance industry. As previously mentioned, all signs are showing that Europe's biggest insurers are getting bigger, primarily through acquisition campaigns. As these purchases are digested and economies of scale offered by the larger size are experienced, the European giants are building large “war chests” of funds for further acquisitions.
Certainly some of this money will be earmarked for further European purchases, but some of this money is also being targeted for growth in foreign markets, including the United States. Indeed, some European companies, such as ING and Zurich Financial Group, have begun shopping sprees in the States, primarily targeting US life insurers and asset management companies.
Intensifying competition, from both foreign and domestic companies, is partly driving another phenomenon in the US, as mutual insurance companies, particularly the large life insurers, begin restructuring processes in order to become “capital markets ready”. The restructuring for the mutuals, whether through complete or partial demutualisation (the latter through a “mutual holding company”), provides mutual insurers with two key tools to prepare for more aggressive business practices. First and foremost, the reorganisation gives the formerly pure mutual access to cash through selling stock, an option unavailable to a mutual because of its structure.
This article primarily addresses the short-term concerns faced in the US, as short-term is the rage (Y2k, Dow 10,000). While the information above is somewhat pessimistic, two things are important to keep in mind. As mentioned above, the medium to long-term outlook from the US is optimistic. Second, the euro is here, and regardless of concerns, people expect it to survive, and one should expect all nations, the US certainly included, to do whatever necessary to ensure its success. Collapse of the euro is a much more frightening concept than competition for the US dollar on international markets.
A question which should be asked, however, is: Who should be concerned with the success or failure of the euro? Quite simply, almost every company has a vested interest. Whether or not the company has operational exposure, through physical plants or exports, should not be the determining factor. The world economy now has a greater degree of interdependence than ever before, and as evidenced by the Mexican peso crisis in 1995, what affects one country can have enormous ripple effects abroad. Multiply this effect by exponential levels and one will begin to approach the level of economic calamity possible should some disaster befall the euro conversion.
Of course, the nature of the insurance industry is to deal with negative situations, whether those situations involve auto accidents, house fires, cyclones, death, or some other galaxy of the catastrophe universe. If the some of all of the above sounds pessimistic, perhaps it is the nature of the insurance beast. But it bears repeating that the insurance industry is there to deal with the what-ifs: who knows if there is not someone out there developing insurance policies to prevent some of the possibilities mentioned above - or better yet, to promote the positive possibilities?
Matthew O. Hughes recently completed a secondment with the International Insurance Council (IIC), a Washington, DC trade association promoting free global insurance commerce. Prior to his appointment to the IIC, Mr Hughes accumulated over five years' experience with the international unit of a US life insurer with over $75 billion in assets under management, serving as a research analyst for Latin American and European expansion and support. Mr Hughes is also a Fellow of the Life Management Institute.