Another day, another record high for the euro-dollar.

This has been a pretty much constant theme in the currency markets over recent weeks and one that is triggering growing angst among industry and political leaders within the region.

What needs to be quantified is the threat posed by the currency to Eurozone exports. We also investigate whether there is any merit in the argument that a stronger euro could boost consumer spending by cutting inflation.

Is it more a case of dollar weakness than euro strength?

It is important to make this distinction as the euro has been far stronger against the US currency than it has against most others - indeed the move against the dollar explains about one half of the trade-weighted rise, even though the US only accounts for one seventh of eurozone exports.

This relationship has become even more extreme recently as the euro has hardly risen on a trade-weighted basis over the past seven months, while it is up a further 9% against the dollar. This reflects the euro's stability against sterling and the fact that it has softened against the likes of the yen and the Australian and Canadian dollars.

The result of all this has been to leave the euro around 15% above its purchasing power parity rate against the dollar. This is the highest it has been since 1997, although still well below the levels seen in 1991 and 1980 when the synthetic currency was overvalued to the tune of more than 30%.

According to the lead indicators of Eurozone export/industrial activity, the euro is apparently posing no problem whatsoever for companies, which are predicting a veritable boom this year. The best example is German IFO expectations, which is as high as it has been since November 1994 - apparently consistent with 8% industrial production growth. OECD lead indicators have also shot up in most Éurozone countries over recent months.

There are however reasons to be sceptical about the strength implied by these surveys. In particular, the improvement in IFO expectations is not being backed as strongly by demand as one would have expected by now. An enormous gap has opened up between expectations and manufacturing orders growth, just as it did in 2002 when surging expectations provided a misleading impression of the eventual strength of the recovery. In trying to quantify the impact of the euro through an equation for exports, which includes world trade and the exchange rate, the results of so doing reveal the estimated hit to year-on-year export growth from the rise in the currency.

The model suggests that a 10% appreciation of the euro knocks just over 2% off the level of exports, with the full effects taking around 18 months to be felt. We estimate that the euro's appreciation to date will eventually reduce the level of export by 5%.

If the euro were to remain unchanged at current levels, the maximum hit to year-on-year export growth has now passed.

On the basis of our currency forecasts (which envisage a rise in the euro-dollar rate to $1.35 by end-2004 and an 8% trade-weighted appreciation in the year to December 2004) export levels will be 3% lower than would otherwise have been the case come the fourth quarter of this year. Half of this reflects the impact of the previous appreciation and the rest the expected further rise in the currency.

The ECB is becoming increasingly concerned about euro strength but will struggle to get US support for any action ahead of the US election. Its best bet is to cut rates, which, given our growth and inflation views, we expect in September and December.

This report has been compiled by HSBC Bank Malta plc on the basis of economic research carried out by HSBC International Bank's team of economists and financial analysts.