Chances of the single currency dream crumbling? About 40%
The two views that continental interest rates are rising and the euro will be a soft currency are mutually inconsistent
Thursday 07 August 1997
It is the kind of discussion that makes the rest of us wonder whether participants in the financial markets live on the same planet as the rest of us. The German economy needs higher interest rates like a hole in the head. The speculation about a rate increase co-exists with the widespread conviction that because of the need for a lavish application of fiscal fudge for European Monetary Union to start on time, the single currency will be a "soft" currency. This is the explanation analysts give for the weakness of the German mark and strength of the pound, which is expected to stay out at first.
Whatever planet the currency traders come from, it is not Mr Spock's logical Vulcan. These two views - continental interest rates are rising, the euro will be a soft currency - are mutually inconsistent.
Of course, it is unfair to pretend that the same people hold both simultaneously. There is a difference of opinion in the market about the outlook. But if enough people come round to the idea that the Bundesbank might just start raising interest rates some time in the next six months if the economy picks up a bit more and the mark stays very weak, and more importantly, to the realisation that the new European Central Bank will be just as tough as the Bundesbank, there could be a sudden readjustment of currencies.
When that happens, sterling's fall will prove as dramatic as its ascent. Britons travelling abroad this summer should make the most of the 10-franc, 250-peseta pound.
Predicting timing is foolish and dangerous if you are not paid to do it, so I won't. But the correction could be sudden. There are straws in the wind. The newly published monthly EMU publication from investment bank Paribas warns that euro interest rates are likely to be well above current German interest rate levels, and warns: "The market as a whole may be in for a nasty surprise."
Paribas economist Paul Mortimer-Lee argues that interest rates across the Continent are artificially low to compensate for the extremely tough government budget policies in the increasingly futile effort to hit the Maastricht target for deficit levels. After the start of EMU, governments will no longer have to keep tightening fiscal policy to the same degree year after year.
This will coincide with the new central bank taking over the responsibility for setting interest rates. No matter how narrow or wide the membership, whether those lax Italians are out or in, the cost of borrowing will be set by an unelected, unsackable collection of central bankers who can set their own inflation and monetary targets. Whatever the politicians want, it is difficult to see why the European Central Bank would allow the new euro to be a soft currency.
However, even as more people in the financial markets come round to this way of thinking, there remain some fundamental problems in assessing the outlook for the single currency and how to price financial assets accordingly. This autumn will mark the start of a crucial phase politically, and the uncertainties are huge.
It is hard to find any expert who is really certain that they know how it will all turn out. Which countries will be in, which left out, and what the repercussions will be. Whether the start date will be postponed, and whether a postponement would be credible or seen as a dressed-up abandonment of the project. Whether it might be abandoned anyway. What the result of regional German elections next spring and Federal elections in the autumn of 1998 will be - as the chart shows, public opinion in Germany is among the most Eurosceptic there is. In the face of all these unanswerable questions, there is a new flurry of interest in scenario planning, assigning probabilities to different outcomes and figuring out what the implications would be.
A new book* by the respected journalist David Smith looks at the broad economic picture, of which EMU forms only a part. He concludes that the most likely outcome is that the EU will muddle along successfully, with a core single currency which is gradually broadened. He puts the likelihood of this outcome at just over one in three, with a small chance that the economic outlook is rosy if the highest hopes for the single market and single currency are realised. However, that means that the probabilities of the less attractive outcomes, ranging from a two-track Europe which might break up to total economic disaster, add up to more than one in two.
David Marsh, European analyst at the investment bank Robert Fleming, assigns probabilities to three types of outcome in a recent client circular: EMU starting on time; a constructive postponement; and an indefinite postponement. The first option gets only a 25 per cent rating, with a narrow EMU slightly more likely than a wide EMU. He sees a 35 per cent chance of a delay that is politically acceptable and believed by the markets, with EMU starting in 2001-2002. However, the chance of the project crumbling in various ways is highest, at 40 per cent. He sees either lack of credibility in the markets, a Franco-German row or a wide EMU collapsing under the economic strains soon after it starts in 1999 as the most likely reasons for the ending of the single currency dream.
Of course, these scenarios can help financial markets in deciding how to rate the separate currencies now. But even the pessimists who think EMU more likely to collapse than to go ahead will have to carry on brooding about it and planning for it. When Europe gets back from its summer holidays (no doubt cursing the hordes ofBritish tourists, flush with cash thanks to the exchange rate), German electioneering gets under way, and the political horse-trading becomes really serious, the uncertainties will increase before they start to diminish.
`Eurofutures' by David Smith, Capstone pounds 18.99.
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