A SUPPLEMENT TO EUROMONEY
Ecu From Basket to Core Currency The Ecu has played a central role in the history of European integration and the drive towards a single currency. The Ecu was initially defined in 1978 as an open (revisable) basket. Its external value was determined by the EEC currencies, weighted on the basis of the relative importance of each national economy. The composition of the basket was revised twice: in 1984 when the Greek drachma was included and in September 1989 with the inclusion of the Spanish peseta and the Portuguese escudo. In its present definition the Ecu is a closed basket made up of twelve of the fifteen EU currencies. Since the first Ecu bond was issued in 1981 the Ecu bond market has seen times of prosperity but also of gloom. European optimism in the early 1990s was defeated by the ERM crises in the summers of 1992 and 1993. Despite recent enthusiasm, even last year confidence in Emu was running low. In the bond market, spreads of Ecu benchmark bonds widened to their theoretical yields towards the end of 1995. Similarly, in the foreign exchange market the value of the private Ecu to the basket, as measured by the Ecu parity divergence, fell sharply, as can be seen in graph 1. The Madrid summit in December 1995 marked the turning point. The EU heads of state agreed on a strategy for changeover to the single currency and the name Ecu was replaced by the name euro. It was recognised that, at the start of stage three, the Ecu basket would cease to exist and that Ecu contracts would be converted into euros at a rate of 1:1. The Summit gave the European Commission the task of drafting a regulation for the euro to that effect, to be completed by the end of this year. The EC now proposes to base the legislation that provides for the legal continuity of contracts (including the 1:1 convertibility of Ecus into euros) on Article 235 of the Maastricht Treaty. The main advantages of this approach are that it can be implemented before the participating member states are identified and that it applies to all EU member states, whether or not they participate in Emu. Perhaps the most important impacts of the Madrid Summit were the confirmation of the strong political will for Emu and the return of confidence in the single currency in financial markets. Governments improved economic fundamentals in an attempt to meet the convergence criteria and investors made up their minds as to who would be included in phase one of Emu. The Ecu also benefited from this, with benchmark bonds starting to trade through their theoretical yields from the second quarter and with the Ecu parity divergence narrowing. There is one crucial difference between Ecu and the other EU bond markets. When the 1:1 conversion into euros is confirmed, Ecu assets automatically will become part of the euro market. Thus, the Ecu has represented the most certain Emu convergence play. Actual Ecu bond yields have long been compared to their theoretical yields to identify relative cheapness. However, it is unlikely that all twelve countries whose currencies constitute the basket Ecu will participate in Emu from the start, which is when the conversion from Ecu bonds to euros takes place. For that purpose Paribas, which has calculated Ecu theoretical yields on a daily basis since 1990, developed new tools of analysis last year: the EC5 and EC7 theoretical yields. These are the theoretical yields of the five and seven currencies that are believed to have the greatest chance of participating in Emu when it starts. The four currencies (from five countries) used for the EC5 theoretical yield are the Deutschmark, French franc, Belgian franc, and guilder (the Austrian schilling is not part of the basket Ecu). The EC7 theoretical also includes the Danish krone and Irish punt. Graph 2 shows that, taking the Ecu benchmark and theoretical curves in isolation, Ecu bonds are now more expensive than the theoretical. Comparing the Ecu benchmark curve to the EC5 curve reveals that there is still about 30bp to 45bp room for convergence if Emu were to start off with only a small group of core countries. The performance of both Ecu bonds and the currency hinges on market confidence in Emu, on Emu going ahead on time and on the countries that will participate in the first wave. As our base scenario is that the monetary union starts in 1999, we project Ecu bond yields to start trading flat to the core European markets of Germany and France. Apart from the gravitational pull of Emu on Ecu yields, we expect there to be a continued shortfall in supply. We also project the Ecu currency parity divergence to trade back to par, but the Ecu currency will remain more sensitive than bonds to Emu sentiment. Mary Bloem, Ecu/Emu bond strategist Graph 1: Ecu Parity Divergence Graph 2: European yield curves |
