Everything to fight for in the benchmark war

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The Independent Online
European governments are arming themselves for the battle to provide the continent's benchmark debt market once the single European currency is introduced, preparing the ground for a game of "beggar-thy-neighbour" after 1999 and anticipating they'll have to fight harder for elbow room in international fixed-income portfolios once all their debt markets are denominated in the same currency.

The approach of monetary union has compressed the yield gaps between different markets in anticipation of currency risk disappearing, and as a reward for the tough economic medicine governments have been willing to stomach to ensure they qualify for economic and monetary union on 1 January, 1999.

After the European Central Bank becomes responsible for monetary policy on a continent-wide basis and currency differences are removed, the debt- market playing field will be levelled. The EMU member governments will find themselves in competition to win the top spot as the benchmark borrower in the new currency. And, while there's probably more national pride than money at stake, the race to provide the bellwether security for what will be the world's second-biggest debt securities market is heating up.

"The international prestige of being the euro benchmark is tremendous," said Brian Venables, senior bond strategist at ABN Amro.

The chief contenders for benchmark status in the EMU debt bloc are France and Germany. Both have been polishing their debt markets to enhance their post-1999 prospects as Europe's leading financial centre.

Germany is scrapping the elite circle of banks that has been setting the terms of its government bond auctions for the past 45 years. The Bundesbank decided its existing system, heavily weighted in favour of domestic banks, would undermine Frankfurt's competitiveness as a financial centre, so it is throwing the auctions open to a more international bidding group.

Germany also decided to group under one name a chunk of the debt it inherited from unification and from rebuilding its infrastructure after the Second World War. Unpalatable monikers such as the "Fund for Inherited Debt" or the "European Recovery Programme" will be dropped and the debt will all be traded in the name of the German government.

France, meanwhile, said it will become the first continental European country to sell inflation-linked bonds, widening the range of securities it makes available to investors. The UK, US and Canadian governments have had very successful programmes selling bonds, which pay higher returns if inflation rises.

"Innovation will be essential in an increasingly competitive environment," said French finance minister Dominique Strauss-Kahn as he announced the plan. He is rushing through parliamentary approval to ensure France is first in the market with euro-denominated inflation-proof securities.

"The competition for liquidity and investors' interest is accelerating," said Arnaud Mares, an analyst at Credit Agricole Indosuez. "Obviously this competition will provide us with a highly liquid euro market."

Belgium, meanwhile, made its pitch to stay in favour with investors by committing itself to a jumbo issue maturing in 2008. Its Treasury officials crafted a three-part issue denominated in Belgian francs, German marks and French francs, sold separately but with common interest payment and maturity dates to manufacture an issue with a trading size of more than $2.8bn (pounds 1.69m) once the three securities are redenominated into euros.

The harder governments work to boost the liquidity of their bond markets, the more attractive European debt is likely to become to global portfolio managers. "The battle is under way for the dominant euro financial centre and for the yield curve that will be the euro benchmark," said Graham McDevitt, an analyst at Paribas. "This is all good news for investors."

European investors who have typically stuck to their domestic debt markets, shying away from the currency risks of buying foreign bonds, are likely to take advantage of the opportunities the single currency will offer to buy the debt of new sovereign borrowers without exposing themselves to foreign exchange problems.

"We'll have to invest more in countries outside EMU," said Chema Caballero, manager at BSN Gestion in Madrid. That could cause problems for Belgium and Italy, both of which have debt ratios of more than 100 per cent of gross domestic product and are heavily reliant on domestic investors for funding.

The litmus test for which countries win and which countries lose out in the increased competition for investor cash, however, is likely to be how successful they are at balancing the needs of their domestic economies with the constraints imposed by the new Europe-wide monetary policy.

Federico Ferrer, vice-director general for external financing at the Spanish Treasury, told a conference in Paris earlier this month that sovereign issuers will be in competition with each other as "fiscal differences will remain for a certain amount of time", while governments continue to pursue domestic taxation policies.

"What's going to matter for me is whether countries really do stick to the rules of the euro," said Lars Appel, who manages DM20bn at Frankfurt- Trust.

"If products on offer become increasingly similar, there will be no reason to invest in any specific place. We'll have to see if economic policy does what it says it will."

q Additional reporting by Heather Harris, Francois de Beaupuy and Jeffrey T Lewis.