Will the Euro start a price war ?

 

Valérie Simonnet*
 
In this crucial year leading to the largest monetary "upheaval" yet to be experienced on a European scale, there is a wide spread tendency amongst Consumer Product companies to focus more on the technical, IT implications of the Euro, (companies will need to upgrade their IT and accounting systems to accommodate the new currency and the period of dual currency) than anticipating its real market impact .

If we base our predictions on previous, lower key monetary conversions such as the "big-bang" introduction of decimal currency on February 17th, 1971 in the UK and Ireland we learn from economists that the cumulative effect of rounding-up prices was a significant rise in inflation. On that occasion consumers were left deeply suspicious of retailers. The degree of suspicion was probably an exaggeration of reality, but it provides a useful indication of consumer behaviour in a conversion context. Hence, the key question in this eve of the Euro is will its introduction follow historical precedents and lead to higher prices?

All indicators to date point in the opposite direction. The scene is set for a price war, with one clear winner "the consumer" and a number of clear losers. So what will make the Euro conversion different from previous conversion experiences? In a nutshell - retail behaviour. Major retailers are already anticipating an increase in their cross border sourcing due to the increased ease in comparing bids from diverse geographical sources but they have also started to anticipate consumer reactions to the Euro, a phenomenon at the origin of mounting concern. Retailers fear that the loss of all monetary bearings, disillusionment with promotions that have lost their impulse appeal, confusion over the price benefits of private label brands, growth in cross border purchases and all this compounded with an inherent suspicion of being cheated by the retailers in the rounding exercise (particularly during the dual pricing period), will lead inexorably to reduced consumer spending.

Their retort, to avoid a drop in spending ,will in most cases be "rounding down", rapid alignment to more aggressive competitive retailer prices and determination and re-determination, in the light of the competitive context, of overly attractive new Euro psychological price levels. All the mechanisms will be set to trigger a price war, exacerbated by the fact that in the absence of a fixed conversion date, conversion timing will prove a highly coveted source of competitive advantage. Yet it seems unprobable that retailers will bear the financial brunt of such an aggressive pricing strategy. To maintain their margins, they are likely to exert pressure on major European manufacturers to align their prices, not to the pan-european average, but to their lowest European price. There is also a likelihood that retailers will oblige manufacturing partners to participate in the costs of dual labelling, dual checkouts… Major European manufacturers will hence find themselves squeezed on all fronts.

Let us first delve a little deeper into the factors contributing to retailer’s fears of reduced consumer spending. Initially consumers will lose all bearings when confronted with the new currency consisting of 8 coins (1,2,5,10,20,50 cents and 1,2 Euros) and 7 notes (5, 10, 20, 50, 100, 200 and 500 Euros). They will suffer from "Monetary Illusion" which will be more or less pronounced in different areas of the community, since each country is starting from different national units. Spaniards who previously paid Pts 1237 will now pay 7.40 Euros, and all but the most adept at mental arithmetic will find it difficult to compare the two values. Most will simply start judging values from scratch in the new units. Other community members may continue to compare the Euro with their old currencies. The Irish consumer will pay 7.40 Euros instead of Ir£ 5.90 and might simply imagine that everything has become ‘more expensive’. Germans, tempered by foreign travel may be capable of converting from DM 14.60 to 7.40 Euros, or may be led to believe that prices have gone down by the lower nominal values. In each case, consumers will need time to adjust properly to a new system of value. Most currencies will seem to lose ‘resolution’ which in theory opens the door to the introduction of the 1 and 2 Euro cents into member states that to date are not accustomed to this currency form. Italians and Spanish who have hardly bothered with anything other than integer prices in the past will be surprised by the concept of 1,2, 5,10, 20 and 50 cents and their combinations. And even the French accustomed to the 5 centime coin ( although rarely used) are likely to hesitate over the minutiae of the 1 and 2 Euro. In the UK, where the penny and two-penny piece are more common fare, due to psychological price points of 99 and 49 pence, the 1and 2 cents should have a more positive reception. Thus during this adjustment period consumers will search for new monetary bearings and it is feared that their purchase propensity will decline.

This decline will be exacerbated by the fact that whilst consumers get used to the new monetary system, promotions, an important purchase trigger will lose their appeal. Promotions operate on the basis of embedded price points in a consumer’s mind. Consumers are familiar with the standard price for an article and when they perceive promotional activity in a retail environment their unconscious reflex is to compare the promotional price with the familiar standard price. Promotions in Euros will not initially relate to a specific Euro price point for consumers which will temper purchase impulses. Additionally, the gap between the promotion price and the standard price in Euros will be less pronounced than in national currencies, making promotions even less attractive. This homogenisation by the Euro of price differences has a number of other implications.

The Euro smoothes out differences between private label and branded price positionings which could lead to a drop in private label consumption. The deodorant category, for example, currently has a price structure in the realm of 21F40 for manufacturer’s brands, 13F20 for private label and 7F80 for discount brands. With the new Euro pricing structure differentials will be 3.31, 2.04 and 1.21 Euros for manufacturers brands, private label and discount brands respectively. In the FF structure the perceptible gap between branded and private label price positionings is striking, yet in Euros, the numbers used to express prices are much closer. To ensure that private label sales remain buoyant, retailers are likely to exert pressure on their suppliers to maintain a competitive offer. In the short term, however, consumer identification risks to be more strongly aligned with national brands.

The price transparency inherent in the Euro facilitates cross border product and price comparison. France alone shares its borders with Spain, Italy, Germany, Belgium ,Luxembourg and Switzerland. In these border areas, consumers are already used to purchasing in the country where prices are most advantageous, despite the need for currency conversion. The question mark surrounding the impact of the Euro is how many more consumers, now free of conversion hassles, will be tempted to cross borders to check out price differentials and how many more will defect to new retailer stores spending less in the home market? Manufacturers are keen to help retailers with marketing strategies to hinder direct price comparability such as modification of standard or promotional pack sizes, introduction of novel multi-pack configurations, formula enhancement, or conversion to different packaging materials . A second, more short term consequence of the increased level of cross border price comparison is the likelihood of consumers postponing certain purchases until they can buy at a more favourable price level in a neighbouring country (this behaviour already exists for some products brought back to the UK from France).Both the purchase postponement phenomenon and the potential defection of consumers to foreign retail stores nourish national fears of a drop in consumer spending.

An important supplementary factor predicted to contribute to reduced consumer spending is the additional time retailers fear consumers will spend hesitating in front of shelves for their regular purchases, estimated at 5 times longer by some sources, reducing the time for impulse buying behaviour (consumers will spend approximately the same time in the store) .The negative consequences of this buying behaviour is not to be underestimated.

Finally retailers are sensitive to the fact that consumers will fear that they are being cheated in the rounding exercise. Legal requirements are that the 6-figure conversion rate is applied, the new figure obtained can then be rounded to 2 decimals either up or down, whichever is the closest, but what happens to the 0.505 cent? Alerted by the press to the fact that in the past, conversions have lead to price increases, they will be well versed in "rounding mechanics" and initially slightly less prone to purchase. Customers loyal to a specific retail store are likely to " shop around" to ensure that their retailer is offering a fair deal and certain, informed customers unhappy with pricing dynamics might investigate other , new purchasing channels such as home delivery. Retailers that have already started the build up to the Euro using a slightly higher conversion rate than the actual rate (with the resulting impact that Euro prices appear lower) will also be confronted with the introduction of higher Euro prices than those initially featuring in catalogues (assuming the current rate remains stable up until the official date of determination on May 2ndt 1998).

The factors detailed above fuel the fear that an overall reduction in consumer spending will follow the move to the Euro. Retailers cannot afford to take such a risk, and are expected in most cases initially to round down prices to reassure consumers and ensure that all their prior efforts to increase loyalty are not wasted. Considering the highly competitive nature of the retail environment and the brand new Euro context, if retailers perceive a drop in consumption there will be an ongoing alignment of Euro prices to competitor levels.

Rounding games alone, however, will not suffice in the new Euro era. Existing psychological pricing barriers will become defunct leaving the door open to the definition of new psychological price levels. The psychological prices of 13F90, and £1.99 for example, will need to be reviewed when converted to 2.10 and 4.46 Euros respectively. Retailers are likely to aim at psychological price levels below those of pure converted prices, and to further realign with competitors that introduce more appealing price points if consumption appears to be tailing off. This form of pricing dynamics is likely to set off a downward pricing spiral.

The risk of deflation is further compounded by the legislative environment. The six month co-habitation period of national and Euro currencies from January 1st to June 30th 2002 and the " no compulsion no prohibition principle" opens the door to competitive tactics between retailers Either they all agree on a mega-bang, all converting to the Euro together over a limited period, or they adopt a more progressive, strategic approach, each retailer attempting to create competitive advantage through electing different conversion dates from January 1st 2002 to 30th June 2002. The consumer confusion that could arise from the introduction of psychological Euro pricing in one retail store whilst psychological national currency pricing exists in a nearby competitive store is easy to imagine. This, in likelihood, compounded with reactive pricing behaviour, one retailer aligning to the lowest competitive price displayed in national currency and another aligning to the lowest competitive Euro price can only contribute to an ongoing price slide.

But who will pay for this aggressive pricing strategy? Margin reductions have strong implications for the manufacturers of consumer goods. If most retailers round down prices but wish to retain their own margins, then their suppliers will have to bear the loss in revenue. This could amount to as much as 2% of turnover for FMCG companies. A number of retailers have already announced that their own cost of gearing-up for the changeover could be as high as 1,8% of turnover. Some of these costs are inherent to the changeover to the Euro: changing coin-operated caddies to accept Euros, training staff, informing consumers, upgrading IT systems. Yet a high percentage are due to the cohabitation period : cash tills adjusted to handle 2 currencies, dual price labelling, dual price displays….

We can anticipate that most retailers will want to share these costs with their suppliers, and add a cut in margins on top. Such pressure will be difficult for national manufacturers to bear, yet european manufacturers face a supplementary margin pressure. In the new era of price transparency, retailers are likely to exert pressure upon pan-european operators not merely to align their prices to the pan-european average, but to the lowest european level. On the basis of 2 well known pan-european brands, this drop could range from 20-35% for products in certain countries. This pressure for alignment fails to take into account the different historical margin structures that exist throughout Europe and the different national VAT, social and legal frameworks as well as diverse national competitive environments.

Lastly it is feared that the introduction of the Euro could adversely impact the small, neighbourhood retailer, unable to compete in the new price war and to assimilate the on-cost of dual pricing, dual payment facilities and dual currency invoicing.

Thus, if the 6 month transition period is upheld (as opposed to a much tighter time span), if consumer spending drops prior to and during the transition period, and if most retailers in consequence implement an aggressive pricing strategy we have all the ingredients for a price war to take place. To try and ease the situation an "E-weeks" move to the Euro, which the European Commission is now considering, coupled with extensive co-operation between retailers and manufacturers could help mitigate the widespread economic squeeze. This alone will not prevent the deflationary mechanism triggered by the Euro which will be more or less pronounced depending upon how long industrials take to realise the benefits inherent in the introduction of the Euro into a liberal economy. The Euro provides companies with an "enlarged" market and a means to improve both financial and organisational productivity. On the financial front, internal transaction costs will drop, as will the costs of covering exchange risks. The Euro should also lead to a reduction in financing costs, due to the fact that it can be used as a stable currency in the place of the dollar. From the organisational standpoint the streamlining of finance, treasury and accounting functions on a pan-European basis should induce savings in general and administrative costs. Yet uncertainty reigns over whether these compensatory benefits will indeed balance out the effects of the price war and over what time period. The European community, hence, faces the serious challenge of reconciling deflation and market forces to ensure the longevity of the Euro…

 

19-06-98
 

 

* AssociatePartner, Andersen Consulting - Paris


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