Bond yields suggest that EMU is a fair bet

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The Independent Online
Amid all the turmoil in the British political system about the onset of European monetary union, there is still a widespread expectation on this side of the Channel that it will never happen. This reminds me of the run-up to the launch of the exchange rate mechanism in 1979, when I was working as an economist in 10 Downing Street.

The prevailing Treasury view at the time was that the EEC would not be so foolish as to press ahead with such a half-baked scheme. Not only did the EEC surprise the UK government by doing so, but the scheme succeeded in holding together exchange rate relationships for the next 14 years, many of which saw Britain agonising about whether to join.

Instead of asking our esteemed diplomats what they think the chances may be of EMU being launched on time, it is instructive to observe what the financial markets are now saying about the odds.

Admittedly, the markets are subject to fads and fashions, and their mood might change without much warning. Never the less, we are at least observing the actions of people who have money to lose by making the wrong bets, so their views should be seriously held, if only for the time being.

Before the Madrid summit last December, the prevailing market view was that EMU would not start on time. There were doubts about the political will in France, and especially Germany, to proceed in 1999, and a strong feeling that the mini-recession which was beginning to envelop the Continent at the time, would make the budget deficit criteria in the Maastricht Treaty impossible to attain. The Bundesbank repeatedly talked of "strict" adherence to the criteria, which implied that it would oppose any attempt to use the many loop-holes deliberately left in the Maastricht framework to allow the politicians to go ahead with EMU, even if the precise criteria could not be achieved. Many thought that the opposition of the Bundesbank would prove the political death knell of the project in Germany. Some even believed that the central bank would deliberately kill the project by holding German interest rates high, thus creating instability in the currency markets and pushing the EU economy towards recession.

Admittedly, this cynical view was always more prevalent among investors in the United States and the UK, where the whole EMU concept tends to be viewed with disdain, than in the core countries on the Continent. But market prices suggested that it was the prevailing view overall.

The most direct way of assessing the probability of EMU from a single price in the financial system is to look at the relationship in the currency market between the ecu and its "theoretical" value. The theoretical price of the ecu is the value of the basket of national EU currencies of which it is comprised. The actual ecu should trade precisely at parity against its theoretical value if, and only if, the market believes that an event will occur at some time in the future to trigger a transfer between the ecu and its constituent parts at par. In the absence of monetary union, it is not obvious that such a trigger need ever take place, so the ecu can trade at a discount to its theoretical value. But if the market believes in monetary union, with one euro fixed to be equal to one ecu on the date of EMU, the terminal value of the ecu is tied down, and the currency will trade at parity.

Shortly after the Madrid summit, the ecu was trading at a record 3 per cent discount against its theoretical value, which implied that the market could buy a pound's worth of ecus for only 97p. Clearly, investors had lost confidence that EMU would ever take place, so the putative single currency was available at knock-down prices. But now that discount has halved to only 1.5 per cent, which implies that confidence is returning to the project.

This can be seen even more clearly from the bond markets. If there is a single currency in the future, new bonds issued in euros will all offer the same yield, give or take a small difference for the creditworthiness of different borrowers. National governments have similar credit ratings, so their bonds should all offer approximately the same return, with no differences being generated by variations in national inflation rates and other domestic economic "fundamentals".

One way of judging whether the market believes in EMU is therefore to observe whether forward bond yields in different countries all do in fact collapse to the same rate after the date at which the single currency is due to come into effect. Amazingly, that is exactly what we find for the core countries - Germany, France, The Netherlands and a couple of others - for the years after 1999.

From then on, the implied forward bond yields currently built into the market are virtually identical to each other, which means that the market is already treating them as if they were certain to be serviced and redeemed in a single currency. The same is not, however, true of the bonds issued by the non-core EU countries such as Italy, Spain and Sweden.

Although yields on this group of bonds have declined recently relative to those in Germany, there is still a long way to go before absolute credibility is attained.

Goldman Sachs has just published a paper that explains how to assess the probability of EMU membership from the bond yield differences between these countries and Germany. This relies on assessing what the yield difference would be if the market assigned either a 100 per cent probability, or a zero probability, to EMU membership. If the actual yield difference is somewhere between these extremes, we can use this fact to assess the probability attached by the markets to EMU membership.

Employing this method, we find that the market is virtually certain that the core group will go ahead in 1999, and that it attaches probabilities of some 20-35 per cent that Spain, Italy and Sweden will be in by 2001. For the latter group, probabilities have risen sharply in recent weeks, but obviously they still have further to go.

What about the UK? Not surprisingly in view of the politics of the issue over here, the market appears to attach a zero probability to membership by 2001. If it were to change this opinion, say with the election of a Labour government, then the difference between gilt yields and bund yields, currently standing at 190 basis points (1.9 per cent), would decline sharply.

In fact, for every 10 per cent increase in the probability attached to EMU membership, I calculate that long-term interest rates in Britain would drop by eight basis points.

If Gordon Brown wanted to ensure a good reception for Labour in the financial markets, all he would have to do is promise to take the UK into EMU in the first round in 1999 (if permitted by other members). But then again if he made that promise, it might prove so unpopular with the voters that Labour would not get elected in the first place. The markets are not stupid. They know that any politican, even on the Labour side, who promises to take the UK into EMU may not be around for long enough to redeem that pledge.

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