The irrevocable fixing of exchange rates for currencies entering European monetary union (Emu) is much too important to be left to the markets. That is the conclusion of most policymakers looking at the task the EU has set itself between now and January 1 1999.
But can these learned folk come up with a better solution? If they have, they're keeping it to themselves. The debate on how to fix these parities is going right up to the wire, inviting the very market turbulence governments would like to avoid.
Meanwhile, the speculators are gathering forces and studying the literature. Would it be surprising if they attempted one last big trade against this political white elephant? The politicians know from the bitter experiences of 1992 and 1993 that any weakness in their decision will be punished mercilessly, first by a handful of hedge funds, then by the rest of the market. Market forces can only be kept in equilibrium if they are pitted against themselves.
The Emu politicians have a problem. They are saddled with a Maastricht Treaty that stipulated the single currency (since dubbed the euro) will be exchanged for the Ecu one for one. But the Ecu is a basket of currencies, some of which will not be in the first wave of Emu. This means that fixing the parities of the Emu currencies early, as some have suggested, will not determine the external value of the Ecu/euro, until the non-Emu currencies are thrown out of the basket.
Any suggestion that the Ecu basket should be amended as soon as the non-Emu currencies are known - sometime around May next year - is dismissed because it would mean rewriting the Maastricht Treaty. The Ecu basket was frozen from December 1994. Although it would technically be possible to amend the treaty, politicians fear that would open a Pandora's box. With that avenue closed, all other proposals seem second-best, possibly with terminal flaws.
One is to announce by May a formula by which rates will be fixed, or will converge on their central rates in the exchange rate mechanism (ERM). The formula for pre-fixing could be an average of the last three years' rates within the ERM - the so-called Lamfalussy rule. Or it could be a move to the central rate. Or, a popular proposal is to lock the bilateral rates of the Emu currencies as early as May 1998.
Each of these proposals invites some level of speculation. Even the three-year average would probably see turbulence early on, as currencies moved to their average rate, and possible manipulation later as some governments tried to lower the average value of their currency before Emu entry, for competitive reasons.
Central parities are not ideal, since some currencies, the Irish punt and the Finmark are well off their central rates today. A final realignment of these two currencies might be possible, without violating the Maastricht Treaty. In a recent research document, Goldman Sachs advises: "...with the punt above its ERM central rate the possibility [of realignment] does suggest one trade to hedge against this risk...to go long the Finmark against the punt." Note the term "hedge" not "speculate". Yet speculate is surely what some leveraged players will do if they sense that the punt cannot go into Emu at its present central rate.
Fixing bilateral rates in May would aim to reduce speculation in the Emu candidate currencies. But there are two objections to this. First, there could be increased speculation in the non-Emu currencies - possibly sterling, lira, Danish krone - that are still part of the Ecu, since they will effect the external exchange rate of the basket Ecu against the dollar and the yen, right up to the moment of its conversion one-to-one to the euro. Unless Emu central banks have a firm commitment to intervene to stabilize these currencies there is likely to be big speculation over the starting value of the euro. Without the European System of Central Banks (ESCB) in place, and the Target payment system, it could be difficult.
Without ESCB and Target it might also be difficult to prevent anomalies occurring in the money market and payments systems, creating differences in short-term rates between supposedly fixed currencies. That again could be punished by speculation as punters attempt to create a, theoretically risk-free, shortage of one currency, or set of financial instruments, for delivery against another. Unlikely, says Chris Golden at Nomura International in London: "The one thing that Bernard Connolly and the EMI [European Monetary Institute] agree about is that you can't speculate against credibly fixed bilateral rates," he says. (Connolly's book The Rotten Heart of Europe ridiculed attempts to govern exchange rates within the ERM.)
Certainly, concerted speculation against the Schilling/Deutschmark rate in August 1993 failed because of the utter commitment of the Austrian central bank. Provided the politicians have a credible commitment to maintain fixed exchange rates from May onward until the single currency, experts see little danger of big speculation. But that credibility has to weather the German election in autumn 1998.
Time is passing. The EMI, which should be masterminding a policy to take currencies into the euro, is strangely silent. Is this because it has a cunning plan, part of which is to keep speculators in the dark as long as possible?
Let's hope so.