|
Why the Euro will be a strong currency As the European monetary union (Emu) deadlines grow nearer, there have been increasing doubts from, among others, the German population, about the wisdom of entering into Emu. Much of it is an opposition of principle. The average German does not object to the concept of Emu so much as its practical implementation and the effect that this would have on the value of his or her savings. We believe these concerns are not valid. Furthermore, bond markets are now fully pricing in the early advent of Emu and perhaps are not giving full consideration to the many uncertainties that remain about Emu’s bond market implications. The root of fears about the future value of the Deutschmark lie in the observation that the Dm/Ecu exchange rate has fallen by about 10% over the last five years. In other words, if the Deutschmark is part of Emu, it will be replaced by a currency that is much weaker than itself. A secondary aspect of these worries is that the European Central Bank (ECB) will not be as vigilant about maintaining price stability as the Bundesbank has undoubtedly been and that real bond returns have once again become uncertain. The problem with the fear that the Ecu is an unworthy successor to the Deutschmark is that this belief is based on comparing apples with oranges. The Ecu that has fallen so much in value against the Deutschmark over the last 5 years is a basket currency. Among the twelve currencies included in that basket are a number that are hardly renowned for their strength, such as sterling, the lira, the peseta, the escudo and the drachma. Between them these currencies only account for up to some 23% of the current weighting of the Ecu, but as the accompanying chart clearly shows, they are responsible for 100% of the depreciation of the current basket Ecu against the Deutschmark since 1990. When Emu takes place, the currency that would replace the Deutschmark will not even be called the Ecu, and it would differ in a number of crucial and fundamental ways from the currency that we now call the Ecu. The Euro will no longer be a basket currency at all, but the legal currency of a number of countries; and the Maastricht criteria are there precisely to ensure that only the strongest countries in Europe are included in that group. As a result, the Euro that the Deutschmark would turn into would have little, if any, of the weakness associated with the current basket currency Ecu. A ‘”strong basket”, consisting only of the Deutschmark, the French franc, the Dutch guilder, the Belgian and Luxembourg Francs, the Danish kroner and the Irish punt, would have depreciated by an average of less than 0.2% per annum, or a total of just over 1%, since January 1990 when the Ecu was last recomposed. In the six-and-a-half years since then we have witnessed episodes of huge tension within the ERM, particularly in September 1992 and August 1993, yet the Deutschmark value of the “strong basket” never deviated by even as much as 2% from the value of the Deutschmark. Even more surprising to those who have blindly accepted the arguments of Emu opponents, the “strong basket” has spent over 80% of the time since January 1990 being stronger than the Deutschmark. Only episodes of extreme speculation against the ERM have prevented this “strong basket” from tracking the value of the Deutschmark even more accurately. What does all of this mean? In a nutshell, neither the German investor nor the German population has any legitimate reason to fear the conversion of the Deutschmark: the Ecu that is talked about as having depreciated by some 10% against the Deutschmark over the last five years is not the Euro proposed for Emu. The “strong basket”, which is the closest approximation we can construct for the post-Emu Ecu, has in fact behaved much benignly and should not be held up as a dangerous successor to the Deutschmark. (It is worth noting as an aside that the Ecu’s composition was frozen when the Maastricht Treaty was ratified in early 1992. Hence the currencies of the three currencies which have since joined the European Union – the Austrian schilling, the Swedish krona and the Finnish markka – will never be part of the Ecu basket.) While worries about the Euro’s value are not founded on any correct analysis of recent history, past performance is, of course, no guarantee of future behaviour. This brings up the second concern about Emu: that the ECB will not have the same control over the Euro that the Bundesbank is widely believed to exercise over the Deutschmark. The external value of the Deutschmark is not actually part of the Bundesbank’s responsibilities, but its price stability certainly is. The general structure of the ECB is known, and the Bundesbank was instrumental in designing it in the months of work that led to Maastricht. The Bundesbank’s view about the results is contained in its 1991 annual report. Just a few months after the Maastricht conference the Bundesbank’s verdict on the proposed ECB was quite clear: “The Bundesbank too, is of the opinion that the provisions of the Treaty, and the Statute of the future….ECB, largely meet the requirements of monetary policy geared to the goal of price stability. In some respects….. the provisions of the Treaty actually extend beyond what is included in the Bundesbank Act. In addition, the Statute of….the ECB affords better protection in legal terms than the Bundesbank Act.” Of course it is not just the structure of the institution which will actually determine whether or not the ECB is successful in maintaining price stability, but structure is a crucial component and it is impossible to speculate on the other important factors. We do not know how the ECB will react to political pressure (which will never be direct), or how it will resolve internal disagreements at a council level. These are questions that cannot be answered in advance, but they are also questions we could ask about the Bundesbank. Perhaps it would have been better to leave the previous system alone, in the post-war era when the Bundesbank was founded, on the grounds that we did not yet have answers to these questions. Or was it right to take a risk then? No-one can tell what will happen in the council of the ECB, or whether the monetary policy adopted in the age of the Euro will be optimal (or even just good). All we know is that the most independent experts on central banking think that the framework is right; and if that is what the Bundesbank thinks, we should be willing to take the risk. In addition, Theo Waigel, the German finance minister, has helped to focus the debate on post-Emu economic policy by insisting that the Maastricht criteria be maintained beyond the introduction of the Euro. In fact it has always been the case that the criteria would continue to apply, both for countries using the Euro, and those which have not yet adopted it, but Waigel’s insistence on the matter is welcome. He has also suggested tightening the deficit criterion, pointing out that 3% should be a maximum, not an average. This suggestion has not yet been approved by the EU’s Council of Ministers, but it is sure to be a topic of debate during the inter-governmental conference which began on March 29 and will run for the next year or so. It should be noted that Waigel’s suggestions for penalties against countries that persistently breach the Maastricht limits are actually already contained in the Maastricht Treaty , and therefore do not need any further approval. But it is always helpful for a politician to underline the fact that countries will remain under close scrutiny even after Emu. The antagonism to Emu expressed by the popular European press is not evident in the market performance of Ecu bonds, as the chart above shows. Not only has the spread between actual and theoretical narrowed to parity, but also the government market spreads of many of the most likely, and some of the most unlikely participants in Emu have converged dramatically. The bet in place: political will to overwhelm popular worry. The road to Emu must surely hold a few surprises which will arise from the disparity between popular and political views, and a few shocks for bond investors. Fundamental questions surrounding harmonization and implementation of economic and monetary policy severely limit our ability to simulate a post-Emu bond market environment. There is no true comparison for government markets whose only point of differentiation is their credit standing. History offers no parallels. The opportunity and diversification benefits across markets, and the development of these over time, remain shrouded by the uncertainty of details not yet debated or agreed. This uncertain background and its political nature should command a higher risk premium, a higher compensation for volatility than is currently evident in the government securities markets of the most likely participants. By Chris Golden and Con Keating, Fixed Income Research Fixed Income Research Chris Golden 171 521 2006 Bonds Sales Management Mark Goldman 171 521 2036 Sandy MacKenzie 171 521 2161 Mark Tate 171 521 2052 Nomura International plc, Nomura House, 1 St Martin’s-le-Grand, London EC1A 4NP Nomura International plc is regulated by the Securities and Futures Authority and a member of the London Stock Exchange |
