Emu Country Analysis: Introduction

A SUPPLEMENT TO EUROMONEY

Introduction
ABN AMRO

Markets anticipate a political decision on Emu

Recent developments in the financial markets show there is widespread confidence that the single currency union will go ahead as scheduled with a larger than initially expected number of countries participating. In recent months, bond and currency traders have become increasingly upbeat about the prospects for a broad-based Emu in 1999, including weaker EU economies such as Spain and perhaps Italy. Markets have placed a substantial bet on these countries achieving their goal, encouraged by the prospect that, following the announcement of their 1997 budgets, both Italy and Spain could reduce their fiscal deficits to the 3% specified in the Maastricht Treaty. Financial markets already awarded these countries stronger currencies and lower interest rates.

Interest rate convergence in EU bond markets

Interest rates have converged at an astonishing speed in recent months. Within the hard core group, almost complete convergence has already been achieved. The French spread over Bunds fell to zero, while the Dutch spread has been negative for some time. This development is not surprising as for these hard core currencies Emu is already a near certainty.

The distance between the ‘core group’ and the ‘Med group’ countries has narrowed markedly as Italy, Spain and, in their slipstream, Portugal have seen their yield spreads over Germany fall at a dizzying pace. Yield spreads on Italian 10-year paper have fallen to a historical low of 176 basis points versus German Bunds, from 325bp early September and more than 500bp at the start of 1996. Italian yields even fell below those in the UK and a further drop is expected in the near term after the lira re-entered the ERM-grid. Spanish yields narrowed to 124bp from 244bp and Portugal’s spread fell even further to 121bp. The exception was the Swedish market. It showed poor performance as it became clear that Sweden probably won’t be part of Emu in 1999.

Growing currency stability

The improved market sentiment is also mirrored in the ERM-grid, where confidence that the Emu will come caused high-yielding currencies to strengthen versus the hard core. The peseta, but also the less closely-watched escudo, have recently tested new highs against the Deutschmark and now are amongst the strongest currencies in the grid. But the lira gained strength in recent months on growing belief that Italy could meet the convergence criteria. This has smoothened the path for the recent re-entry of the Italian currency into the ERM after four years’ absence at a parity level of L990 to the Deutschmark.

Correction on the financial markets

Notwithstanding the present Emu euphoria, it is far from certain this process of broad-based currency and interest rate convergence will continue. The market’s favourable sentiment towards Emu contrasts with the mood among monetary officials, who are skeptical of broad Emu despite the political will showed by the Med group countries. These fear being penalized by the financial markets and paying higher interest rates when they stay out. Even Greece is pursuing austere fiscal policies.

Some say convergence might have gone further than reality and ask for a significant reversal. Political uncertainty as to the 1998 decision date may cause correction in the financial markets mainly for the Med group countries.

These fears have strengthened since the Bundesbank and EMI underlined fears that an Emu involving the high yielding countries would risk undermining the strength of the euro and destabilizing the whole Emu project. The currency and bond markets will therefore behave as a barometer of Emu progress and of the state of economic and monetary convergence in the EU member states.

State of economic and monetary convergence

It is still far from certain which countries will participate in Emu from the start. Certainly, convergence progress in the EU is advancing. According to the 1996 Convergence Report of the European Commission, virtually everyone will meet the inflation target, and only Greek bonds are above the bond yield reference value. After the inclusion of the Finish markka and the lira, 10 out of 15 EU countries now also meet the exchange rate criterion. Results on fiscal and state debt criteria however are not so rosy. Most member states have not yet achieved a sustainable fiscal position. Only four countries could qualify on the basis of 1996 figures: Ireland, Luxembourg, Denmark and the Netherlands. Even Germany, last year ripe for Emu entry, has fallen out of this select group. The EMI said in its recent report that the drop in budget deficits thanks to one-off measures is no guarantee of structural consolidation. Given these comments there is growing doubt about the sustainability of southern Europe’s sudden conversion to the fiscal rectitude of the hard core group, reducing chances for these countries to enter Emu in 1999.

Still currency risk?

The present hard core group currencies will not lose their present stability. It should not be ruled out, however, that the French currency might come under pressure, especially if markets become more skeptical in 1997 of France’s ability to meet the Emu criteria. It is a different story for the Emu-hopefuls. These might show more nervousness in the market until the official announcement in 1998. Any renewed doubt in the viability of Emu could cause investors to move into the Deutschmark as a safe haven. The Bundesbank might counter this by further interest rate cuts. As soon as it becomes clear which countries are Emu-fahig, their currencies will be more pegged to the Deutschmark. This can be seen now with the guilder, the Belgian franc and the Austrian schilling.

Forex markets could put the outs under pressure. Some fear that these currencies will be penalized and forced to devalue their currencies or defend them by high real interest rates. The EMI is now investigating a beefed-up EMS-II system, where the currencies of the ‘not-yet-Emu’ countries will fluctuate against the Euro within a narrow band. Not only will this counteract speculation, but it could prevent competitive devaluation by the Emu outsiders.

What conversion rates?

A point of uncertainty for the currency markets is at what rates the currencies will be fixed. Financial markets will speculate on the level of these conversion rates, as the Maastricht Treaty is not very clear. Worries about some countries’ striving for a lower rate for competitive reasons could grow, especially after recent comments by former French president Valéry Giscard D’Estaing that the French franc should depreciate. The most commonly-accepted scenario is that European authorities will set an objective for the conversion rates well before the start of Emu, during the course of 1998. Exchange rates would thus converge according to the rate at which Emu’s credibility increases. One may reasonably assume that the present EMS central rates will play an important part in this or will indeed constitute the effective rate.

Stability pact

Another problem is the slow progress towards the stability pact, a key part of the German government’s campaign to gain acceptance for replacement of the Deutschmark by the euro. This pact is a prerequisite and a guarantee for Emu-wide fiscal discipline. This issue is particularly important for guaranteeing that the euro is strong. Tensions over Emu might rise if EU countries cannot reach agreement on this pact at the Dublin summit.

In case of a failure in Dublin, Germany might block decisions on the EMS-II proposals aimed to prevent fluctuations between the Euro and currencies remaining outside Emu. This might damage confidence in the attainability of Emu in 1999. A possible delay in the planned start of Emu could unsettle financial markets and one may see pressure on the weaker currencies.

Med group bond yields in for reversal?

While the hard core group already has reached almost complete convergence, the spreads of other countries against the Deutschmark are still considerable. This indicates that there remains a risk that has to be compensated by a higher yield. There are too many uncertainties to create almost complete convergence in interest rate spreads versus Germany. It is far from certain that the Med group countries will be allowed to enter Emu in 1999. The markets are very sensitive to negative comments on Emu. Any time Germany takes a hard line approach to Emu, it puts doubt into the market. And it is expected that the Bundesbank will intensify its attacks, taking a hard line against the countries that ‘window dress’ their budgets to meet the criteria for Emu.

These uncertainties might trigger a significant reversal in bond yields. Markets could realize that the budget deficits in Italy and Spain are set to overshoot their targets this year, making it more difficult for these countries to meet the 3% target. Investors are likely to be quite keen to take profits once the reversal has begun, after huge price gains in recent months. This could lead to growing spreads versus Bunds as a consequence of lesser prospect of early Emu membership. But growing fiscal discipline in these countries in recent years, with inflation well under control and the prospect of Emu participation two years later, will prevent the spread of Med Group countries’ bonds going back to their initial highs. Italian bond yields may rise to as far as 250bp over Bunds, while Spanish 10-year bond yield spreads could be reversed to around 220bp (Portuguese paper: 215bp).