Relief is tempered by doubts

Date: 16/11/1995

By Tim Jones

BANKERS are relieved that the European Union is at last on the verge of drawing up a detailed scenario for the transition to a single currency, but say the blueprint unveiled this week still leaves some questions unanswered.

A 48-page plan, released this week by European Monetary Institute (EMI) President Alexandre Lamfalussy, tackles most of the key issues facing the European currency project and paves the way for December's Madrid summit to adopt a binding transition plan.

The banking industry was keen to play down any differences over the report's conclusions, but it was clear many still have reservations about some of its recommendations.

It is the banking industry which will have to make immediate decisions about what will amount to a revolution in their business within three years - the Banking Federation of the EU estimates that its 2,900 members would have to invest up to 10 billion ecu in new computing systems, staff retraining and the marketing of new products during the transition.

Federation President Nikolaus Bömcke welcomed the report, saying it was “close” to his organisation's position, but added: “If there are differences, they are in emphasis or nuance.”

On the plus side, the report does set some dates. In early 1998, a summit will draw up the list of countries ready to join, based on their economic performance in the years up to and including 1997. According to Dutch National Bank President Wim Duisenberg, this will be Germany, France, the Netherlands, Belgium, Luxembourg, Austria and Ireland.

From the beginning of 1998, the European Central Bank (ECB) will be created and will assume the role of the EMI. Representatives of the chosen states will join the executive board while the remainder sit on a governing board. It will begin printing banknotes and will announce the date of their introduction and when national notes will cease to be legal tender.

From 1 January 1999, exchange rates will be fixed and the ECB will carry out all monetary and currency market policy in the new currency. For the next three years at most, only the national currencies will be legal tender while financial institutions can chose to use the European currency for their business transactions, and only new debt issued by governments should be switched.

“Private economic agents should be free to use the European currency. On the other hand, they should not be obliged to do so before the deadline set for the end of the change-over,” says the EMI report.

In January 2002, at the latest, the central bank will start to recall national currencies and replace them with the European currency. This will be finished by July 2002.

But commercial banks want the three-year transition to be limited to two years and as many financial transactions as possible to be switched into the new currency as soon as possible after January 1999.

“We see the time between the first step and the introduction of new notes and coins as a sensitive period which should be less than three years,” says Bömcke. “It is essential for credibility that a large range of activities switch to the new currency, and this means not just new government bond issues but existing stocks.”

After months of negotiations within the EU's various monetary bodies, officials were unable to come to an agreement over whether to insist that all member states convert their government bonds into the new currency from 1999.

German negotiators thought the swapping of existing debt, even if it was due to expire after 2002, was unnecessary. The EMI report left the question open, saying it needed further study.

Both the banking federation and the European Savings Bank Group warn that merely swapping new debt will be insufficient to give depth to the market for European currency bonds.

However, bond market data suggests this would not be a problem for long. It is true that at the beginning of the monetary union, if only new debt were converted, it would take time for a true bond market to develop in the new currency.

The total size of the bond markets in the seven front-runner member states is a colossal 1,120 billion ecu, but since the average maturity of these securities is 4.6 years, most of the debt will have been refinanced and converted over a three-year transition period.

With the management of the three-year transition to the European currency union sketched out by the central banks, German Finance Minister Theo Waigel stepped in last week to propose ultra-tight rules over how member states should behave once they are in it.

This is of vital importance to German companies. “We would like to have a single currency as soon as possible given the problems we have had with devaluations in Italy, Spain and the UK, but it must be stable,” says Hartmut Kämpfer from BMW's EU office. Waigel's proposals tighten the rules already set out in the Maastricht Treaty for countries within the single currency bloc.

The treaty called on bloc members to keep their deficits below 3&percent; of gross domestic product. But a substantial and continuous reduction towards 3&percent; after an “exceptional and temporary” overshoot could be accepted. Similarly, while public debt should be below 60&percent; of GDP, it could be enough to approach this level “at a satisfactory pace”.

The treaty does allow for sanctions if these targets are missed, but they are not automatic. Persistent overshooting can lead a member state to be censured, forced to meet deficit-reduction targets in a given time, lose European Investment Bank funding, pay a non-interest-bearing deposit and even fines.

“In principle, it's alright to toughen the rules of the treaty because they are cumbersome, unrealistic and take too much time to come to a decision,” said Ulrich Schröder, economist at Deutsche Bank. “What is missing in the Maastricht Treaty is some sort of automatic mechanism.”

It was to address this concern that Waigel called last week for all countries joining the bloc to sign up to a separate agreement to give teeth to the Maastricht Treaty's sanctions.

Under his proposals, the 3&percent; target would be a strict ceiling for deficits, only to be breached in 'extreme' circumstances. A European Stability Council would be formed, comprising the finance ministers of the member states inside the bloc, meeting twice a year to judge budgetary performance.

They would decide together when economic circumstances are 'normal' or exceptional. In normal times, member states should aim to reduce their budget deficits to 1&percent; of GDP. Countries with public debt above 50&percent; of GDP should agree to bring their deficit to 1&percent; of GDP.

Failure to comply with these targets would mean punishment. For every 1&percent; overshoot, the offending member state would have to pay 0.25&percent; of gross domestic product into a non-interest bearing deposit. After two years, this could be sequestered for the EU budget.

German business has reacted favourably to these suggestions, although economists are more sceptical.

“Asking a country which already has a budget problem to pay a penalty doesn't make much sense. It should be a little less stringent,” says Deutsche Bank's Ulrich Schröder.

Alison Cottrell, an economist at PaineWebber International, warns that far from creating stability, Waigel's proposals could make the single currency bloc more volatile.

“Different regions will have different credit risks. For example, the whole of Italy could be fined for overshooting its limit when the cause of the deficit was the southern part of the country. This will exacerbate regional divisions, increase secessionist pressures and so increase risk,” she says, warning a situation similar to that in the Canada's Quebec region could well arise.

The stakes are high with just two years to go before the decision to go ahead is taken. Yet, with the exception of the banks, Europe's largest companies still have to take a position on the currency.

One UK-based company with a direct interest in keeping agricultural currency volatility to a minimum was unaware of the EMI's report, Waigel's proposals or the decisions needed at the Madrid summit.

In the words of its spokesman: “We think the whole single currency enterprise is still very much a nebulous thing. In the immediate future, it will make little difference to the company.”