The Trouble With Europe

Baldwin Louie — Mon, 09 Oct 2000 15:00:00 -0700

When the euro was introduced nearly two years ago, it was supposed to make business in Europe easier. But today, the common currency is so anemic that it's causing companies headaches and raising concerns about the future health of Europe's economy.

The euro's precipitous fall - it's down 24 percent against the dollar since its January 1999 launch - has prompted an extraordinary intervention by European and American central bankers, who hope to at least stem a further decline of the currency. For Europe's nascent Internet Economy companies, many of which rely heavily on technology and equipment from the U.S. that has to be paid for in dollars, stability is critical. And any further drop in the euro could force central bankers to raise interest rates, slowing development across the board.

"The new economy demands aggressive investing," says Abe Golkowitz, chief global strategist of Deutsche Banc Alex. Brown (dossier). "And that's hard to do where the currency is weakening, inflation is worsening and it's all confounded by oil prices."

For many U.S. companies, Europe is looking less like a land of opportunity and more like a danger zone. Intel (INTC), for example, cited sluggish business in Europe when it warned of weaker-than-expected revenues last month; the company gets 27 percent of its revenues from Europe. Oracle (ORCL) says the weak euro may affect its earnings, and printer manufacturer Lexmark says the euro knocked $43 million off this quarter's revenues.

While few U.S. Internet companies are yet big enough in Europe to break it out in their earnings reports, they are clearly being affected as well. Net Perceptions (NETP), a marketing software company, and Sitel, an Internet business software company, warned last week that slow sales in Europe would hurt third-quarter earnings.

It's true companies love to blame business troubles on macroeconomic factors outside of their control. And investors often overreact to currency-related fluctuations, which aren't a good barometer for the overall health of company. Still, the math is brutal: When the euro is falling, even stable profits and sales shrink in dollar terms. That has led some companies to start reporting European sales figures in euros (or in the local currencies that are tied to it).

"The continued weakness in the euro affected us more before when we reported only in dollars," says Glenn Manoff, director of marketing for GTS, which runs a broadband network in Europe. "Wall Street would look at the dollar figures and say 'You aren't growing quickly enough.' We were, but it was understated because of the foreign exchange translation effect."

For European politicians and business leaders, the euro troubles go far beyond the impact on quarterly earnings. The euro, which dictates the value of currencies of 11 countries and is scheduled to replace those currencies entirely by 2002, is a crucial tool for economic and political integration across the Continent. But countries that have declined to join the euro - notably the U.K. - are now all that much harder to persuade. Just last week, voters in Denmark rejected a referendum on Denmark's adoption of the beleaguered currency. Denmark has long opposed the euro, but the vote, coming on the heels of the euro's extended slump, could further erode confidence in the unified currency.

A weakened euro is not all gloom. It makes imports from European countries cheaper, potentially lowering costs for companies in the U.S. and elsewhere and benefiting U.S. consumers. It also lowers the costs of setting up a business in Europe, which may narrow the losses for firms just starting out there.

But other clouds are forming on the economic front that could make for a stormy passage for Internet companies heading into Europe. Rising oil prices could mean higher inflation, which could in turn prompt a jittery European Central Bank to raise interest rates and dampen investments. The Organization for Economic Cooperation and Development expects inflation in countries tied to the euro to rise 2 percent in the second half of 2000 and 2.2 percent in the first half of 2001 - the latter figure is higher than the European Central Bank's requirements.

The European central banks have traditionally been far more worried about inflation then the Federal Reserve, a tendency aggravated by the strong influence that Germany's central bank, Bundesbank, holds over the European Central Bank.

Bundesbank officials, still mindful of the trauma of the rampant inflation under the Weimar Republic in the 1920s, are notoriously tough on inflation. Wim Duisenberg, governor of the European Central Bank, is also an inflation hawk. During the years he ran the Dutch central bank, Duisenberg closely followed the Bundesbank's anti-inflation policies.

If European central bankers raised interest rates in an attempt to bolster the euro it would likely weaken investment sentiment all around.

Such a skittish macroeconomic climate is hardly what Internet companies need to flourish in Europe. Investments in European startups have already lagged behind those in the United States, where tolerance for risky Internet ventures has historically been higher.

A recent study by Credit Suisse First Boston (dossier) found that investment in information technology was 4.2 percent of Europe's 1999 GDP, lower than the U.S.'s 6.8 percent and the 6.3 percent booked in Japan. Europe would need to boost its tech investments by 40 percent, or $228 billion, to match the U.S. ratio.

The competitive edge that U.S. companies have built up has come from investments in cost-saving technologies that boost productivity. Europe's edge, in part, has come from a weaker euro that makes European goods cheaper in overseas markets.

"If the euro does stay this weak it takes pressure off European companies to invest in technology," says Julian Callow, chief continental European economist for CSFB. "Europeans have acquired competitiveness because they got it through the currency and not because they invested in technology."

Higher European interest rates would only strengthen the tendency to withhold from tech investments, further slowing demand for U.S. technology exports.

The euro plight is a far cry from the optimism that surrounded its launch in January 1999. Back then, the unified currency was hailed as a way to promote investment and economic growth. And many hoped the currency, which began trading at $1.17, would soon rise against the dollar.

Some analysts are expecting a rebound next year for the euro, which is currently trading around 88 cents. But few expect it to reach parity with the dollar, let alone rise to its original value.

One factor that may bolster the euro is the return of capital that fled Europe for the raging U.S. stock markets. "There was a first-quarter anxiety to pile into U.S. companies," says Andrew Smithers, who runs London-based economic consultancy Smithers & Co. "The effect since then has been a singed bull."

Smithers and others expect investors to eventually take money out of the U.S. markets and plough it back into Europe and euros. One possible home for the returned capital: telcos participating in auctions of airwaves to bring the Internet to a new generation of mobile phones. Many of the companies didn't raise capital before the auctions and may need to sell equity to do so now.

Despite any near-term troubles that might be caused by a weak currency or rising interest rates in Europe, the longer-term promise of the Internet won't be derailed. And those who can withstand immediate pain may end up best positioned to reap rewards later.

"There is a tremendous opportunity to buy financial assets in Europe now and set up businesses because long-term expectations in Europe are strong," says Robert Mundell, the Nobel Laureate economist who is known as the godfather of the euro. "The rate of return should be a gold mine."

In the meantime, many involved in Europe's Internet industry will be counting on a stabilization of its currency. "If the euro rises, then god bless everyone," says Dan Niles, an analyst at Lehman Brothers. "But the main point is for it not to get any lower."

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The Trouble With Europe