A harsh verdict from the fiscal vigilantes

Last week Alfredo Pastor, Spain's economy minister, was speaking to investors in the City of London. He wanted to convince a critical audience that his government was determined the Spanish economy would meet the criteria to join a European monetary union before the 1999 deadline.

Mr Pastor said: ``Any kind of monetary arrangement is a means to an end. For us, the end is the political project of European union.'' Spain would undertake whatever economic reforms were needed to reach this goal, he said.

International investors have delivered their verdict on the Spanish economy's prospects of joining the EU first division. The peseta was forced into a 7 per cent devaluation late on Sunday night as financial markets pushed it through the floor of its allowed band of variation against other European currencies.

This was the fourth devaluation since Spain joined the exchange rate mechanism (ERM) in June 1989. The EU's monetary committee met in its second- ever emergency session for 11 hours before announcing the decision.

The previous embarrassments occurred in September 1992, when Italy and Britain fell out of the ERM, November 1992 and May 1993. In August 1993 Spain opted for wide, 15 per cent, bands of fluctuation against other member currencies rather than its previous plus or minus 2.75 per cent.

Last year the foreign exchanges were unusually quiet. They have made up for it with a vengeance since the New Year. The peseta's latest troubles have taken place against a choppy background of a sharply falling dollar and inexorably rising German mark and yen.

Yesterday Javier Solana, Spain's foreign minister, blamed this turbulent environment for the peseta's upset. When there is a tempest on the high seas, it can easily shipwreck small vessels.

There is some truth in this defence, but overseas investors have plenty of doubts about Spain itself. It shares a number of problems with other ``peripheral'' European countries - including Italy, Greece, Portugal and Sweden, all of whose exchange rates against the mark have dived this year.

These include high unemployment and higher inflation than the EU average. But the most serious problem, as far as the financial markets are concerned, is the big government budget deficit and a high level of existing government debt.

Spain's deficit last year amounted to nearly 7 per cent of national output, more than twice the limit set by the Maastricht treaty. Government debt has risen sharply to a level equivalent to 64 per cent of national output, just above the Maastricht limit. The Spanish government protests that these ratios are nowhere near as bad as Italy's - 10 per cent and 123 per cent respectively - but they are still too high for the peace of mind of financial disciplinarians in the markets.

Doubts about whether the governments can achieve the spending cuts they need to bring deficit and debt ratios down to acceptable levels boil down to questions of politics. In Spain's case, big cuts in the welfare budget will be required. In Italy, the pension system needs profound reform, yet the government cannot get the most basic budget package passed. Investors do not believe that either government is strong enough to reform public finances.

The currency markets are acting as fiscal vigilantes. If they don't like the look of your budget, watch out for your exchange rate.

Unfortunately, the markets react in minutes but budget deficits take years to bring under control. And meanwhile the market reaction generally makes it much harder to make the fiscal improvements. The Spanish government will pay more debt interest and face higher inflation after this weekend's devaluation.

A few dealers in the markets imagine that the discipline they impose through their dramatic votes of no confidence actually helps governments to get their economies in order. In reality, another two pfennigs off the peseta makes not a halfpennyworth of difference to the political outlook in Spain.

At the same time, the devaluation has dealt a serious blow to Spain's hopes of participating in the grand project of the European single currency. It is widely believed that French and German politicians are keen to keep unstable, inflationary, peripheral countries - along with Britain, perhaps - out of the monetary union. The Maastricht convergence criteria - low- enough deficits and debt, and inflation and interest rates near the EU average - are meant to screen out undesirables.

In theory Spain could still scrape over the Maastricht hurdles by 1999, the final deadline. In practice, the financial markets are clearing the decks for an early race into the single currency by the core countries of the Union.

If there were any doubts about whether Spain would match up to the high standards of the core, they have been resolved. It does not. International investors have cast their veto.

There is now every incentive for the committed northern EU countries to move to the single currency on their terms. Their reaction yesterday indicated no softening of the timetable or terms for monetary union to deal with turmoil in the ERM. The chances are that the Germans and French will use the currency instability to argue in favour of speeding up the process, especially with the markets eyeing the French franc as their next target.

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