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Euro bonds go off boil as big two simmer

The strain of trying to keep European monetary union on track for its planned start in 1999 is beginning to show for its two leading proponents.

In Germany, the government has picked a fight with the Bundesbank over plans to re-calculate the value of gold and foreign exchange reserves. The move is designed to release a wind- fall of about Dm20bn (pounds 8bn), that would help Germany meet its economic target to qualify for a single currency.

In France, the government faces being booted out by an electorate tired of the belt-tightening needed to whip the French economy into shape in the run-up to EMU.

The result? European bonds are starting to look a lot less attractive than they did a couple of weeks ago. Not only do investors tend to steer clear of markets which smack of political uncertainty, they're also beginning to anticipate that the euro, which is set to replace existing currencies in 1999, will be weaker than the mark.

The German government plans to recalculate the central bank's 95 million ounces of gold and billions in foreign currencies at a value which more closely reflects market prices, rather than the post-Second World War prices currently used.

The Bundesbank warned that the plan "goes against German tradition, as well as the intentions of the Maastricht Treaty governing central bank independence". Various Bundesbankers slammed the government for undermining investor trust in the euro before it has been introduced.

Germany has been here before. In 1990, the Bundesbank was overruled in its objections to allowing East Germans to swap their ailing currency for marks at a one-for-one exchange rate, leading to the resignation of then-Bundesbank President Karl Otto Poehl a year later. Politics, not economics, had the final say. Bundesbank President Hans Tietmeyer had to deny rumours last week that he, too, was about to resign.

European bonds took a dive last week with the yield on benchmark 10-year German government bonds, which set the pace for European markets, rising five basis points to 5.93 per cent. Investors are betting that the politicians will call the shots, ignoring their central bankers.

"The new euro currency bonds in 1999 will not possess the same market credibility as bunds, thus 6 per cent bund yields look too low," said Oliver Mangan, chief economist at AIB Capital Markets Primary Dealer Unit in Dublin. "European bonds should carry a risk premium because of a fudge on Maastricht."

The Bundesbank said it anticipates "negative effects" upon the selection of countries for the common currency. In other words, the German government's actions leave other countries free to use creative accounting in their efforts to qualify.

As Matteo Fini, who manages bonds at Caboto Gestioni in Milan, puts it: "The Germans were hard on the Italians for accounting tricks. Look at them now!"

German bonds have lost some value relative to their US counterparts in the wake of the Bundesbank's statement. Benchmark 10-year German annual yields are 96 basis points below US yields, down from 99 yesterday. The narrower that gap, the less value investors perceive in the German market.

"It makes things difficult for EMU to go ahead under the terms of the original criteria, so there's a further layer of fudge which increases the uncertainty about value in European assets," said Ian Dickson, a fund manager at Henderson Investors. "It deters buying of European securities."

Dickson said the weighting of European bonds in his portfolios is neutral compared with indices against which fund managers measure performance.

The Bundesbank's spat with the government is seen as propping the door open for countries who might otherwise find their economies aren't up to snuff in the eyes of the German central bank.

Ireland, for one, is likely to be better off. "It would mean a broader- based single currency, and we'd be in with our own type, like Italy, rather than being put in an uncompetitive situation, with just core EMU currencies," said Joan Henry, an economist at Bank of Ireland Treasury.

The UK markets could benefit, as investors look for markets which won't be affected by the German fracas. With Germany having to raid reserves to shore up its chances of getting its budget deficit down to the 3 per cent limit, the Bundesbank is left with little ammunition against its fellow transgressors - and the more weak countries are able to join the new currency, the less value that currency is likely to have.

"No one can doubt that the integration of countries such as Portugal, Spain and Italy will weigh on the strength of the euro," said Arnaud Laforge, head of bond investments at Caisse Centrale des Banques Populaires.

With the French government taking a beating from the electorate at the ballot box, and the German government assailed by its central bank for playing fast and loose with its beancounting, European bonds could be in for a rocky summer.

"Germany's plan to use proceeds to reduce its deficit has harmed the credibility of the government and the euro, which has weighed on the mark," said James McKay, an economist at PaineWebber International. Bunds will come under renewed pressure, and yields will go up in the core European countries." Copyright: IOS & Bloomberg