Slip in German Business Confidence Yet Another Euro Woe

IMF official says discussing intervention cannot be considered taboo.
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BERLIN -- Supporters of the beleaguered euro probably now understand why economics is know as the "dismal science."

German business confidence, as measured by the Munich-based

Ifo

institute, surged a few months ago on the back of a weakened euro as manufacturers of the world's third-largest economy figured they'd export loads of widgets as their goods became cheaper overseas. Wednesday, however, saw the euro test new all-time lows against the U.S. dollar, as the much-watched survey showed business sentiment had declined in August.

Ifo's reading for Western Germany, which makes up 90% of total output, only dipped to 99 in August from 99.1 in July. But this confounded the consensus expectation, which was banking on an improvement. After the report the euro slid to $0.8450, continuing its near 15% tumble vs. the greenback since the beginning of the year.

Even more ironic perhaps, business confidence is expected to tumble further in the coming months if the euro keeps sliding, as managers fear the

European Central Bank

will have to raise rates to contain the inflationary risk posed by the weakened currency. And as each cent is knocked off the euro's value, the risk of intervention in the foreign exchange markets by Europe's monetary authorities increases.

The "Ifo

survey and the euro are now reinforcing each other's tendencies in a distinctly unhelpful fashion," says Alison Cottrell, head economist for

PaineWebber International

in London.

The refrain in the currency markets has long been that it is more about a strong dollar than a weak euro, underpinned by expectations of continuing strong growth in the U.S. But now the ECB is haunted with the nightmare scenario: It may have to ratchet rates higher to contain inflation exacerbated by the weak euro -- a move that could simultaneously stunt the region's growth prospects. Highlighting just how "dismal" economics can be, that, in turn, could then send the euro lower against the dollar.

Aggravated by soaring oil prices, euro area inflation in August was 2.3% year on year -- above the ECB's defining limit for price stability of 2%, but down from 2.4% in July. The euro's weakness makes things even worse since products like oil are denominated in dollars.

"If

the euro continues to tank like it is, they'll have to do something at some point," muses one Frankfurt-based forex trader. Should the currency's slide persist this week, he believes officials will seriously have to discuss the possibility of supporting the euro at this weekend's

International Monetary Fund

and

Group of Seven

meetings in Prague.

But officials have been reticent to spend billions of the ECB's forex reserves merely to have the euro again turn tail and sink lower at the next convenient opportunity. Instead, the ECB has opted for what could be seen as confidence-building measures, such as when it chose to sell $2.15 billion in interest earnings made on foreign currency reserves last Thursday. Confidence in the euro lasted for about a day; then the slide resumed.

The ECB itself is thought to be far from sold on the idea of intervention and it would also have to concert any effort with the

Federal Reserve

and the

Bank of Japan

. American officials are generally thought to loathe intervening in the forex markets, but the Japanese have signaled this week they might be more sympathetic to the euro's plight and would be flexible in discussing possible action.

Also, IMF officials already in Prague have been voicing support for intervention on behalf of the euro. The fund's chief economist,

Michael Mussa

, opined if now wasn't an appropriate time for action there probably never would be, and IMF Managing Director

Horst Koehler

said discussing intervention cannot be considered taboo.

Whether the G7 will actually come up with the goods and decide to intervene when they meet this weekend is, at the moment, anybody's guess. Unfortunately for the euro, the risk remains high that the officials will simply issue a sternly worded communique addressing the euro's slide. And that will probably just help the currency continue moving south.