A weak euro is not a weak EMU

The European currency may be heading south but there are signs that markets have great faith in monetary union
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The Independent Online
THE ONLY explanation for the sharp fall in support for joining the euro - last week's ICM poll showed 62 per cent against, the highest in four years of polls - is that the public are up to their old tricks of judging a currency by its testosterone. A few years ago some economists tried to see whether any economic indicators explained changes in support for the government: almost nothing seemed to work. Not incomes, consumption, industrial production, or unemployment. The only factor which appeared to have any explanatory power was the strength of sterling. As sterling rose, so did government support. As it fell, so slumped the polls.

Since that study was done before the pound's exit from the exchange rate mechanism in 1992, and the subsequent fall from grace of the Conservative government, the link would probably look better than ever. Therefore there is a very simple equation in British public opinion: weak euro equals bad currency, equals no thank you, Jacques. The only problem with this simplicity - for the anti-euro campaigners - is that what goes down may also go up. Francis Maude, the shadow Chancellor, is already carefully preparing the ground for the coming rise of the euro by saying that of course his opposition is nothing to do with a little temporary droopiness.

After all, the main reason for the euro's weakness is the sharp rise in growth expectations for the US, and hence expectations of interest rates. US GDP growth forecasts for 1999 averaged 2 per cent in November last year, and nearly 4 per cent in May this year. At the same time, the eurozone forecasts were shaded down a little, although the change was not so dramatic. Even so, the euro is still trading just 3.3 per cent down on the end of last year measured by its trade-weighted index, and at about the same level as the summer of 1997. The dollar, however, is up a trade-weighted 4.9 per cent.

The euro may well head south for a while yet, simply because that is the way of the markets. The trend is my friend, until another trend gets chummy. I would not be at all surprised to see the euro worth, say, 90 cents. But this will not make it any less silly to judge a currency by its external value as opposed to its internal value. The Maastricht Treaty sets out a clear objective for the internal value - it wants price stability, which the European Central Bank has defined as inflation in the range of 0 to 2 per cent - but there is no target whatsoever for its external value.

That is for a very good reason: the external value of a currency principally affects the internal value through the impact of a change in import prices. A falling currency pushes up import prices measured in that currency, and boosts inflation. It also makes exports more competitive, and thus increases growth.

However, these effects become smaller as the economy as a whole becomes bigger. Big economies like the United States, Japan and the eurozone trade only about half the amount relative to their GDP as medium-sized economies like Britain simply because they are more self-sufficient. Indeed, the trade share in GDP of the eurozone countries averaged nearly 25 per cent before the euro, and just 11 per cent after it. A 10 per cent fall in France's currency used to add 2.5 per cent or so to import prices. Now it just adds 1.1 per cent or so - and then only after a time lag of maybe two years or more.

Indeed, the insulation which the euro provides from volatile currency markets is a very important reason for supporting it. It has created a zone of monetary stability for its participants which means that they are much less vulnerable to sharp shifts in the exchange rate. This does not just affect their trading sectors. It in turn means that domestic interest rate policy does not have to be geared - as it has so often been geared in Britain - to dealing with exchange rate crises regardless of how appropriate such interest rates are for the domestic economy.

This is an advantage which can be expected to grow in a world where prolonged and serious misalignments of currencies are increasingly common. The first example of such overshooting during the post-1973 floating rate period was the Swiss franc in the late-Seventies, followed by sterling in the early-Eighties, and the dollar in the mid-Eighties. (The German mark fell against the dollar from about 55 cents in 1980 to just 29 cents in 1985, a fall of very nearly half. The dollar then collapsed back to where it started within three years).

A fall in a currency should only become worrying to the monetary authorities if it looks as if it may become self-perpetuating and ignite inflation.

The real test is internal credibility, and that is easily measured by the yield (fixed interest payment divided by the market price) on long- term government bonds. If the markets expect inflation to rise, the fixed interest rate on long run government bonds will be worth less, and the bond price will fall. That in turn will push up the yield on the bonds.

Yet the yields on ten-year government bonds in the eurozone, although they have edged up a little, continue to be sharply lower than the yields on the equivalent government bonds in the United States or Britain: on Thursday, the 10-year German bund yielded 4.73 per cent against 5.2 per cent for the UK and 5.68 per cent for the US. The euro is clearly expected to deliver lower inflation in the long run than either sterling or the dollar. On this key test of credibility on the euro's internal value, the new European Central Bank is just as credible if not more so than rather more elderly institutions like the US Federal Reserve and the Bank of England.

The particularly low British yields on 30 year bonds are an aberration: they are actually lower than the yields on 10 year bonds, which goes against the normal market rule that requires an extra premium for the extra risk of a lengthy term.

This is caused by the combination of a thin market - less than 1 per cent of all Britain's national debt is outstanding at this maturity - and by the UK debt managers' stubborn refusal to supply the recent increase in institutional demand for particularly long-date paper on the grounds that they do these things only once a year, and do not want to surprise the market.

If the euro's weakness against the dollar were a symptom of wider worries about monetary union, as some have argued, then the markets would signal that concern with rising long-term bond yields which would be higher than the alternatives in the US. That is not the case. The markets would also signal fears about a break-up of EMU by treating the bonds of countries which are unlikely to have such sound anti-inflation track records in any post-EMU world (Italy, Spain) much less favourably than the bonds of countries whose track record is likely to remain sound (Germany).

In fact, the extra risk premium paid by the Italian and Spanish governments is remarkably low and suggests that the financial markets think EMU is extremely strong. If you invest in 10 year Italian bonds, you will currently enjoy a yield of 4.93 per cent, only 0.20 percentage points more than the German rate even though Italy's public debt is nearly double that of Germany as a proportion of GDP. (It is also, by the way, rather lower than the rate at which Britain can borrow despite our superior public finances). A weak euro does not mean a weak EMU.

Christopher Huhne, founder and head of the sovereign team at the ratings agency Fitch IBCA, has just been elected as a Liberal Democrat MEP.