Between a rock and a hard place

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French prime minister Lionel Jospin wants to increase government spending. But the Bundesbank won't let France into Emu if its budget deficit rises. Unless one gives way, Emu is off. By David Roche.

Life under the euro

Financial markets are betting that European economic and monetary union (Emu) is still on track after France's new socialist prime minister, Lionel Jospin, accepted German chancellor Helmut Kohl's terms on the Stability Pact at the recent intergovernmental conference in Amsterdam. That convinced markets of the irresistible force of their combined political will to achieve Emu, despite the Paris-Bonn spat over "job creation" versus "sustained fiscal stability".

If Emu is indeed destined to go ahead on time, short-term interest rates will converge completely for first-wave members at the single discount rate set by the European Central Bank (ECB). Long bond yields will continue to converge to equilibrium spreads over Germany. And the euro (and the Deutschmark before it) will be a weak currency. This is what the market consensus seems to believe, and it's why financial assets continue to perform as if Emu is a done deal.

But I think this view could be dead wrong on two counts. First, the French may have signed up to "fiscal stability", but they have denounced "austerity". And their budget deficit looks set to overshoot the Maastricht criterion by some way. But chancellor Kohl has no room to accept any French dilution of fiscal stability. He needs to convince his electorate that if the Deutschmark is abolished it will be replaced by a euro that will be strong, because it is supported by sustained fiscal discipline in France as well as Germany. But that's precisely what is in doubt, because the French socialists are pledged to boost jobs and growth, at the expense of Maastricht targets on government deficits and debt.

Second, regardless of whether Emu is launched on time in 1999 or not, the business cycle is accelerating in Europe. By the first half of 1998, core Europe will be growing at a 3% clip. Germany and France will be in the midst of a sustained export- and investment-led recovery. So the Bundesbank will be intent on tightening monetary policy. Other countries will follow its lead. Higher short-term rates will damage equity market valuations more than long-bond yield convergence will help.

The future of Europe's monetary union is now bouncing between the proverbial rock and a hard place. The hard place is Jospin. He's a conviction politician who wants to put people before finance. He believes there is a soft European economic option: a Europe of jobs, not Maastricht masochism. His vision for Europe and France is one of regulated markets and Keynesian demand management. The fact that the model was tried in the past - and failed - matters little.

Jospin is also honest. He is not posturing on the European stage just to force concessions out of the Germans. He knows that president Jacques Chirac called the election because the French 1997 budget deficit is closer to 4% of GDP than 3%. But Jospin does not intend to cut spending. He will increase it. This combination of conviction and honesty could be fatal for Emu.

Furthermore, Jospin is in a hurry. He knows he has only a year before the president can call another election. So he must show that he can provide a happier economic alternative to Emu for the French people. He will not stick to the Stability Pact if French unemployment stays high. His vision is that, as France is creating no jobs (an evil he puts down to a lack of demand which a dose of Keynesian reflation could cure), the government should be allowed to have a huge budget deficit and still qualify for Emu. Otherwise there will be no Emu because France cannot and will not qualify under the present rules.

President Chirac has sided with his socialist prime minister because he cannot afford the unpopularity of being associated with the inhuman, mechanical view of Europe (and in order to allow Jospin a year to hang himself with silly policies, he hopes). So expect no alternative policy on Emu from the French president to override what Jospin is doing.

The rock for Emu is not Kohl. It is Germany's most popular political institution, the Bundesbank. It will not allow Emu to happen unless the Maastricht budget deficit criterion is met by all Emu member states, fiscal stability is supported to the letter, and the European Central Bank is as independent as the Bundesbank itself.

The Bundesbank has just forced Kohl's government to take its hand out of the cookie jar to cut the budget deficit by revaluing gold reserves. The Bundesbank may well decide again to jerk the politicians back into reality at any time. It has three means to do so. It could call a press conference and denounce the whole Emu thing at a critical moment (perhaps when politicians try to fix currency parities well ahead of the Emu start date). Second, it could appear as expert witness to the German constitutional court on one of the many anti-Emu cases that are surfacing. Third, it might rebel when called to give its opinion to the German parliament when it votes on Emu in spring 1998.

So Kohl is caught between the French government and the Bundesbank in his own backyard. He is now almost unelectable. He wants to be the chancellor who united Germany and Europe. But he has no platform to run again without Emu getting done. And he has no room for manoeuvre to get it done. The vengeful Bundesbank waits in the wings.

A controlled Emu-delay strategy is dead. Gimmicks - such as starting Emu with no countries in it, or stopping the clock - are allowed by the treaty, but won't work. Any delay now will be based on deep ideological differences and visibly nasty disagreements.

The consensus view of a broad-based Emu is nonsense. It is a premise based on correct analysis (France and Germany are not going to make the deficit criteria without resorting to accounting fudges) but the wrong conclusion (any country that doesn't meet the criteria should be allowed into Emu at the start). The correct conclusion is that, if either France or Germany fail to meet the criteria, the Bundesbank will blow the whistle and Emu won't happen. So Emu will be narrow, strict and pure - or it won't happen on time.

If Emu is delayed, what would that mean for European interest rate convergence and financial markets?

Countries with established anti-inflation credentials would see their currencies soar. The principal winner would be the Deutschmark. France, Belgium and the EU periphery (notably Italy) would see their currencies fall. And so would those with currencies presently perceived as "safe havens" (sterling and the Swiss franc). In the middle would be those countries with above-average GDP growth prospects and big currency account surpluses (Finland and Ireland). But Emu delay would not necessarily mean Emu abandonment. So central banks in weak-currency countries would respond by raising interest rates. That way, exchange rate mechanism stability could be sustained.

In the past, German real interest rates have risen by almost 50 basis points for every one percentage point expansion in real GDP. I expect a 400bp expansion in the German economy by the end of 1998. That means real interest rates will have to go up by 180bp. Adding in a mild acceleration of consumer price index inflation to 2.2%, nominal rates in Germany could rise by 250bp by end-1998.

By mid-1998, Ireland, the UK, Portugal, Spain and Scandinavia will have been growing - and filling up idle capacity - much faster than the core of Europe, where unemployment remains comparatively high and on an upward trend. Cyclical inflation pressures would be building. Central banks in these countries would be keen to raise interest rates in order to douse the inflationary fires of domestic demand. High-debt, high-growth, peripheral countries would raise short-term interest rates the most.

For equities, the impact of Emu delay - at least in the short term - would be relatively small. Much more critical would be the effect of tighter monetary conditions and the drying up of liquidity - especially as the uncertainty would drive capital away from Europe.

Rising long-bond yields would make equity markets look stretched relative to dividends and earnings. And with German short-term interest rates heading back towards long-run average levels, equities in core Europe would no longer look attractive relative to cash.

Equities will suffer across the board in continental Europe - most in high-spending countries where interest rates go up most. That's why I think the UK is the one consistently attractive equity market.

David Roche is president of IndependentStrategy, a London-based research firm