Markets put their faith in EMU

Date: 11/04/1996

Traders are putting cash on the line and basing transactions on the belief that economic and monetary union will occur. Thomas Klau looks at the sudden boost in the single currency's credibility.

N their increasingly uphill struggle to achieve economic and monetary union within less than three years, European governments can now count on the impetus provided by the most powerful force in modern economies.

For the first time ever in the history of the project, there are strong indications that financial markets are putting their money on the assumption that monetary union will happen in January 1999.

Leading analysts in London and Frankfurt say the current infinitesimal gap between rates on French and German ten-year government bonds is clear evidence that traders expect both currencies to merge before the bonds mature.

For the time being at least, traders, these experts say, have turned their back on years of entrenched EMU-scepticism.

As late as in the autumn last year, the prevailing market attitude was one of disbelief in monetary union. Eurosceptics seized on this as further evidence that the EMU plan was economically unsound.

But analysts such as Graham Bishop from Salomon Brothers in London, and Thomas Mayer from Goldman Sachs in Frankfurt say that for the last few months, traders have been basing their calculations on the belief that monetary union - including, amongst other countries, France and Germany - will happen.

“If you ask the average trader (whether he believes EMU will take place), he will hem and haw,” says Bishop. “But the ten-year bond rates and the forward rates for the franc and the mark (the rates to be paid on money bought or sold now, but cashed in later) show that the market is now factoring it in.”

According to these experts, several factors have concurred to bring about this change of attitude. Germany's and France's oft renewed public and private commitment to the twin goals of EMU and economic convergence in the face of economic and political adversity has finally made an impact, they say.

The same goes for the smooth progress of the preparatory work being carried out by the European Monetary Institute in Frankfurt and other institutions.

Analysts say traders also noted with interest the total failure of Germany's main opposition party, the Social Democrats, to enhance their electoral appeal by campaigning against EMU in the regional elections last month.

In the rich south-western state of Baden-Württemberg, where the Sozialdemokratische Partei Deutschlands (SPD) first tested this strategy (despite much internal criticism), voters sent the party packing, giving the SPD a mere quarter of the vote in its worst-ever result in the region.

But in an apparent paradox, the decisive boost for EMU's credibility may well have come from the German economy's disappointingly sluggish recent performance.

Cries of pain from export-oriented German entrepreneurs losing international market share because of the strong deutschemark have led to an increasing clamour for fixing exchange rates and bringing monetary union about at any reasonable cost - and certainly at the price of a more lenient interpretation of the Maastricht Treaty's requirements for the start of EMU.

As one of Germany's senior and most orthodox economic commentators, the Frankfurter Allgemeine Zeitung's Hans Barbier, recently pointed out in a disapproving editorial, a growing body of opinion in economic, industrial and banking circles in Germany is now balancing the risks that may arise from relaxing some of the stability requirements against the real dangers of postponing EMU beyond 1999.

Voicing an opinion previously rarely ever heard in Germany (but widely held in France), leading economists and industrialists now publicly doubt the wisdom of making the start of EMU conditional on a strict fulfilment of all the Maastricht Treaty's convergence criteria. “The price of non-EMU is beginning to dawn over the mark,” says Bishop.

And while the call for flexibility has yet to be taken up by the government, Mayer believes “there has definitely been a shift in the economic debate”.

“The discussion in Germany is now no longer over whether the Euro will be as stable as the mark, but whether the Euro will help us against the mark's overvaluation. If the answer is yes, the Euro will help to preserve jobs, and this will help us to persuade the population.”

In a further boost to the pro-EMU camp, market expectation that monetary union will indeed happen as scheduled is increasingly becoming an economic factor in itself, since any decision to postpone the start would now “introduce new parameters into the market”, as Mayer explains, and “increase the risk of currency instability and further upward pressure on the mark”.

In other words, the longer the expectation that EMU will happen on schedule dominates the market, the more disruptive the consequences of a postponement might be.

German readiness to agree to a more relaxed interpretation of the Maastricht Treaty's two debt criteria has been further strengthened by a growing awareness in Bonn that Germany itself will in all likelihood fail to keep its 1997 deficit below the ideal upper ceiling of 3&percent;, as laid down in the Maastricht Treaty, unless the economy finds its way back to a much stronger growth than is generally expected.

This would in effect strengthen convergence with France, as a comparatively poor German performance on the deficit criterion would bring Germany more in line with the result expected for the French budget.

If both countries were to form a monetary union with a deficit of between 3.5 and 3.9&percent; of GDP, the overshooting of the initial target of 3&percent; would be much easier to sell to a sceptical German public than if a special provision had to be made for France alone.

An interesting side-effect of a less rigorous application of the Maastricht Treaty would be to boost the early EMU membership chances of countries such as Spain, which stands no chance of bringing its deficit under 3&percent; by 1997, but might possibly manage to keep it just under 4&percent;. Spain might thus become a serious candidate for early EMU participation if a more relaxed interpretation of the criteria prevails early in 1998.

The growing realisation that governments will, in two years, probably face an unpalatable choice between postponing the currency merger and agreeing to a relaxed reading of at least some of the Maastricht participation requirements, is causing increasing anguish for some of the senior officials who participated in the treaty negotiations.

“Our original plan has not worked,” says one. “The idea was to compel governments to lower their structural deficit enough to make sure that the 3&percent; limit would, at worst, be only marginally overshot even in a cyclical downturn.

But governments have not done their homework.”

Some officials, pointing to the real progress achieved on the other stability goals, argue for EMU to proceed regardless and warn against any scrapping or renegotiation of the treaty.

But others suggest the treaty's sometimes less than precise wording allows sufficient scope for creative interpretation to ensure the launch of EMU could be postponed without the treaty needing to be formally breached or renegotiated, as the Commission maintains officially.

“One might imagine a scenario where the Council decides no country is ready for EMU yet,” says one official.

“This would mean that EMU would be postponed, without the treaty needing to be formally breached. But from January 1999 onwards, member states would be under the formal obligation to start with EMU as soon as possible.”

Others point to the treaty's article 109j, the fourth paragraph of which stipulates that “if, by the end of 1997, the date for the beginning of the third stage has not been set, the third stage shall start on 1 January 1999”.

But while the wording is regarded by some as ambiguous, the fathers of the treaty insist they were clear in their minds that this was only meant to allow a

start-up of EMU before 1999, and not a postponement.

“We had a discussion about it at the time, and thought that the wording was clear enough, once you took it in context,” said one official.

“Obviously, we were wrong. But I don't think it would be a good idea if the Council were to agree (in 1998) to an interpretation of the treaty which all of us rejected at the time. Legally speaking, that would not be very sound.”