Let's be franc, EMU is in trouble

France's travails threaten monetary union, writes Michael Prest

One of the better bon mots attributed to the journalist Claud Cockburn was: "Never believe anything until it has been officially denied." Cockburn was writing in the 1930s, but so it is today with the French franc.

A week of speculative activity against the franc and in support of the mark stirred from its August torpor a cast worthy of the Edinburgh festival. French prime minister Alain Juppe reassured us that there was no policy gap between Paris and Bonn, and the Banque de France has been intervening desperately. Hans Tietmeyer, president of the Bundesbank, Germany's powerful central bank, and his chief economist, Otmar Issing, soothingly hinted that their deliberations would not overlook France.

If that leaves you suspicious that something serious is afoot, you are right. European Monetary Union (EMU), on which Germany and France have staked all our futures, is in deep trouble.

Sterling, you may remember, has been on the sidelines since its ignominious exit from the Exchange Rate Mechanism on Black Wednesday in September, 1992. But EMU's British opponents will take heart from the prospect that the franc's slide could turn into a rout.

EMU's enemies, ever suspicious that monetary union is a cloak for German domination, will also feel vindicated by the onus falling once again on Germany to take the lead. All eyes are on Thursday's monthly meeting of the Bundesbank council to see whether Germany can ease the tension by cutting interest rates. One of the factors influencing the bank will be the German M3 money supply figures, due on Tuesday.

The manifestation of the tension is a flurry of speculative selling of the French franc over the past couple of weeks. In itself, this might not seem important. The franc fell from about DM3.40 to DM3.43 before easing back. At the same time, the value of French bonds slipped relative to German bonds, indicating that investors wanted a higher return from holding French government debt.

But none of this was supposed to happen. The gap between yields on French and German bonds had been narrowing. EMU calls for them to be virtually identical in the run up to 1999, the year in which the currencies that enter EMU will be irrevocably locked together.

Klaus Baader, senior currency economist at Deutsche Morgan Grenfell in London, said: "It's not quite time for policy makers to press the panic button." But he added: "The pressures in Europe are going to intensify."

The pressure causing the franc and the mighty mark to go their separate ways is concern that the two are failing to keep in step. French economic growth has been slower, and German growth faster, than expected.

This is crucial because the keystone of the infamous Maastricht Treaty is that converging economic performance will induce currency stability, which in turn allows currencies to vanish into EMU. France, Germany and any other country aspiring to participate in EMU has to cut its budget deficit to 3 per cent of gross domestic product to meet the criteria.

Unfortunately, France and Germany are running budget deficits well above this, and qualifying for EMU rules out several policy answers. For example, competitive currency devaluation is excluded by the requirement to keep within currency alignments allowed by the ERM.

Faster economic growth would help escape from the straitjacket. But France is not growing strongly enough at the moment. Revenue is running behind projections and spending is ahead.

The Cartesian maths is that for every percentage point French growth falls below target, the budget deficit mounts by another half of one percentage point. For Mr Juppe that means a budget deficit by the end of this year of 4.7 per cent or even 5 per cent instead of the forecast 4 per cent.

The only policy Maastricht then permits is to slash the budget. Yet French unemployment is 12.5 per cent, almost a record, and still rising.

No wonder Paris has been awash with rumours about conflict between the government and the Banque de France, now the independent central bank. President Chirac hinted in his Bastille Day speech to the nation last month that lower interest rates would be appreciated.

But Jean-Claude Trichet, governor of the Banque de France, relishes his independence and shows no sign of cutting interest rates and thereby accelerating the flight from the franc.

The upshot is that Bonn is in danger of losing control of European economic policy. The Bundesbank is well aware that pressure on the franc started after it failed to cut interest rates last month. But Germany is as firmly stuffed into the Maastricht straitjacket as France. Moreover, Chancellor Kohl has tried to ease public fears about the Euro, the planned European currency, by promising that it will be as strong as the mighty mark.

The market has characteristically decided to test the Chancellor's will. With the dollar a bit weak because the US Federal Reserve is taking a relaxed view of the robust American economy and keeping interest rates down, investors have flocked to the mark.

Mr Baader said: "The prospect of EMU is pushing the mark up and the franc down." So what next? Hopes for a solution lie in two directions: lower German interest rates, and faster French growth.

Neither looks very promising. The balance of market opinion is that the Bundesbank will not cut interest rates this week, although it may do so in September or October. Even then, however, the cut is likely to be small, say one-tenth of a per cent, and could be followed by increases next year if the German economy strengthens further.

Equally, French growth may accelerate but without being enough to escape from the straitjacket. And as the appointed date for EMU draws closer, the market will search for any weakness it can exploit. The central problem for France and Germany is whether currency relationships will be sufficiently stable and at the right levels to tie the knot. Gwyn Haache and Don Smith at HSBC Markets think the odds are they will not be in this happy state and that EMU will be delayed. According to a survey last week, a large majority of German business executives agree.

The problem is that if the markets really pounce, delay could become disaster.

Nor is the other main likely outcome much more palatable. Germany might squeeze its budget deficit to 3.25 or 3.5 per cent. France might be able to show reasonable progress in the same direction. Bonn and Paris could then declare the deal done.

But what of the "non-core" countries such as Italy, Spain and Portugal? They would probably regard a politically motivated bending of the rules by France and Germany as an invitation to do likewise.

EMU's troubles are only just beginning. The official denials are about to come thick and fast.