A SUPPLEMENT TO EUROMONEY
Spain
Central Hispano
On the right track to Emu in 1999
Spain’s chances of joining Emu in 1999 increased significantly in 1996, underscored by the sharp decline in the 10-year yield gap with Germany (to 145bp in November from 367bp in January). Lower inflation, a reduced budget deficit and expectations of further improvements in 1997 make it likely that Spain will meet the Maastricht conditions (see graphs).
The outlook for inflation in 1997 is quite good. Headline inflation was running at 3.5% in October 1996, well below the 5.2% registered after the April 1995 turmoil. Several factors are contributing to this fall, including the better international climate. The increased rate of household savings, the Bank of Spain’s full autonomy and growing credibility, the lack of demand pressures, the peseta’s strength, lower money supply growth and a tighter fiscal policy, are all contributing factors which curb inflation further.
Morever, the decline in some government-administered prices, particularly in energy and telecommunications, and the measures approved by the government in June 1996 partially liberalising professional services, electricity, telecommunications and urban land will also help to reduce inflation. Central Hispano’s Research Department believes inflation will dip below 3% in the first months of 1997 and drop to around 2.5% at the end of the year. The yearly average (the Maastricht yardstick) will be 2.8%, below the qualifying ceiling estimated at about 3%. The main risk to this convergence comes from excessive growth in labour costs.
The budget deficit target of 3% of GDP in 1997 can be achieved if the government adheres strictly to its plans. The deficit in 1996 is expected to fall to 4.4% of GDP from more than 6.5% between 1993 and 1995. Public spending in 1997 is set to rise by only 1.7%, a 1% reduction in real terms. The brunt of the cut is to be borne by reduced subsidies to state companies, public investment, a wage freeze and a tougher hiring policy. Welfare spending, however, will grow by more than the average increase in expenditure. Revenue is forecast to increase 6%, in line with nominal GDP growth, with the tax burden remaining unchanged. The revenue increase is based on a moderate upturn in the economy (3% growth as against 2.3% in 1996), and small tax changes.
Central Hispano estimates real GDP growth in 1997 at 2.8%, basically in line with the government’s forecasts. Private consumption will grow by around 2.5%, thanks to a rise in employment of some 2%, a small decline in the savings rate and improved consumer confidence. This is based on lower interest rates, enhanced job creation and better prospects of Emu integration. Investment in capital goods will consolidate the recovery that began in mid-1996, fuelled by lower interest rates and the pick-up in Spain’s main trading partners.
The risk of a budget deficit overrun looks limited, and is linked to slower growth and optimistic revenue projections. Central Hispano estimates that the overrun would fall below Pta300 billion, which would lift the deficit to 3.4% of GDP. The government’s overriding policy priority is to meet the convergence criteria, backed by a broad social and political consensus on the need for Spain not to be left out in the cold and join Emu right from the start in 1999. Therefore, if the budget were to overrun, the government would most likely take the necessary offsetting measures. In our view, there is ample scope for these mid-year adjustments.
Meeting the overall budget deficit goal would reverse the upward trend in public debt (lowering it to 67.2% of GDP from 67.5% in 1996), thereby complying with a generous and widely expected interpretation of the debt requirement .
All EU countries managed to narrow their 10-year yield gap with Germany in 1996. By the middle of the year the differential for mediterranean countries was in the neighbourhood of 250bp. Since September the gap has narrowed much further to well below 170bp. These expectations indicate that financial markets are increasingly betting on a large Emu from the start (around 12 countries). These expectations have gathered new momentum with the re-entry of the Italian lira into the exchange rate mechanism of the EMS. This optimism is shared by the European Commission’s latest half-yearly report. The report predicts that under current policies 14 countries will meet the inflation requirement in 1997 and 12 the budget deficit condition.
Emu expectations will strengthen during 1997 as inflation and budget deficits come down. This will trigger further cuts in central bank intervention rates and an additional narrowing of the 10-year yield gap with Germany. Long-term interest rate differentials will increasingly depend on the fixed parity envisaged for each national currency against the Deutschmark in Emu, because with parity of interest rates, differentials principally reflect appreciation or depreciation expectations (and credit risk premiums).
Emu will have a common monetary policy designed by the European Central Bank, with a single official interest rate, although executed through national central banks. Until then, short-term interest rates will tend to converge at the levels of the most stable countries. The speed at which this happens will depend above all else on the market’s expectations of the irrevocable parities in Emu.
Consequently, interest and exchange rate forecasts in Spain are closely linked to the assumptions on the peseta’s possible parity against the Deutschmark in Emu, which, in turn, will depend on the method agreed upon to set the definitive parities. The method must fulfil at least three criteria: be compatible with the Maastricht Treaty and the euro’s legal framework; prevent speculative pressures in the currency markets and strong tensions between countries; and attain exchange rate levels in line with each country’s fundamentals. One possible method that seems to meet these requirements reasonably well is the setting of market exchange rates with a prior indication by national central banks that the current central parities are deemed adequate for Emu.
- Stability of market exchange rates in a narrow band around central parities could indicate that the markets consider them adequate and sustainable. And the requirement of exchange-rate stability for two years before Emu would be fulfilled.
- The central parities appear to reflect correctly the fundamentals of each economy, without introducing unjustified biases in competitiveness.
- Their transparency could avoid the necessary tensions between countries that could arise in a negotiation.
Using a narrow peseta band of 1.5% on either side of the current central parity with the Deutschmark would give a rate of between 84 and 86.5/Dm. Indeed the peseta has moved in the lower part of this band (84/Dm) for most of 1996. Therefore the peseta could be irrevocably converted into Euros at a rate within that bracket.
The peseta’s move towards the expected parity with the Deutschmark in Emu and the gradual confirmation of convergence progress would trigger a further narrowing of the 10-year yield gap with Germany. By the middle of 1997 the differential could be down to 100bp and 75bp at the end of the year (see graph). During 1998 it could slide to 40bp to 50bp, a level reflecting the differences in the credit risk premium and one which would tend to stabilize in Emu. At the same time, the Bank of Spain’s key intervention rate could decline to 5.5% at the end of 1997 from its current 6.75% and converge with the German repo rate in the first half of 1998.
Spain is in sight of the finishing line but it still has to make a final sprint.
Inflation differential with the three best countries, %
General government deficit target (% of GDP)
Favourable prospects on Spanish interest rates
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