The financial markets are more optimistic than ever about the prospect of a broad Emu arriving on schedule. That is the verdict of the JP Morgan Emu calculator. The calculator is an analytical tool that reveals the market's view of the probability of individual countries joining Germany in a monetary union.
It has become very popular, gracing the desks of central bankers, investors and corporates. Its principal innovation is that it estimates expectations in real time. Users can see, blow-by-blow, the impact of political and economic events on market expectations. Being real-time, the calculator has generated a wealth of data that enable us to analyze the Emu process in ways not previously possible.
The Emu calculator derives market probabilities from the forward interest rate swaps market, in which investors swap future floating-rate interest payments for fixed-rate ones. The market's view of the probability of Italy participating in Emu in 1999, for instance, can be derived by comparing today's actual post-1999 spread between lira and Deutschmark swap rates, the zero level implied by Emu and the level to be expected if Italy did not participate in Emu. We estimate the non-Emu spread using the current level of Italian and German short-term interest rates and the past correlation between the lira-Deutschmark swap spread with similar spreads outside Europe. The error in these calculations can be estimated. Their impact is to bias our estimate of market probabilities by a modest ±5.0%.
The Emu calculator tells a story of rising Emu optimism over the past two years, ebbing now and then, only to flow strongly again later (see chart). In summer 1996 the market adopted the view that a narrow Emu would arrive in 1999 with some certainty. Expectations that Germany, France, Belgium-Luxembourg, the Netherlands and Austria would be in Emu rose to nearly 100%. Despite worries about fiscal deficits in Germany and France, the market's conviction that these six will be in Emu has hardly been shaken.
Once the market had fully priced in a narrow Emu, the focus of attention turned from whether Emu would arrive to whether it would be broad. Since September 1996, expectations Spain, Portugal, Finland and Italy joining Emu have climbed substantially. However, these expectations have been volatile. From September to December 1996 expectations rallied strongly, reaching a peak on December 14 1996 when European leaders signed the principles of a "stability pact" in Dublin. The pact was designed to ensure fiscal probity after Emu day with fines for countries that exceed a deficit-to-GDP ratio of 3%. The market agreed that if there was an agreement to keep deficits low after Emu day, there was less need to be strict about convergence beforehand. That meant it would be easier for Europe's formerly high-yield periphery to participate in Emu from day one. The stability pact is the key to expectations of a broad Emu.
No sooner was the ink dry on the stability pact than Emu expectations in the periphery began to soften. Between January and May 1997 expectations fell from 65%-75% to 50%-60%. Two factors contributed to this.
First, the Bundesbank became concerned that the haste with which some governments were bringing their deficits down to the 3% reference rate of the Maastricht convergence criteria was undermining the credibility of the putative euro. It began to introduce the "fifth convergence criterion", arguing that hitting the Maastricht reference rates was not enough - countries had to show they could "sustain" low deficits. The need for sustainability was seen then to reduce the chances of Europe's periphery making it to Emu on time.
At the beginning of 1997 the public debate on the euro in Germany was also starting to turn nasty. Germany reported record high unemployment in January 1997 and economic nationalism began to flower. Some politicians began to pander to the public's new Euroscepticism. When asked in an opinion poll in early June whether they backed chancellor Helmut Kohl's stand that EU countries should stick to the 1999 deadline, 82% of respondents said "no". The strength of this opinion began to undermine Emu optimism in the periphery.
In recent weeks, optimism has returned. This has largely been triggered by a realization that Europe's periphery is likely to turn in fiscal deficit-to-GDP ratios within a whisker of 3% and perhaps below levels in Germany and France. It will be increasingly difficult for Germany or any other country to deny Italy, Spain, Portugal and Finland a place.
Every rise in Emu expectations in periphery currencies has dragged the Deutschmark lower. Initially, rising Emu expectations were felt most strongly within Europe via a rapid narrowing of yield spreads and a sharply higher Italian lira and Spanish peseta. Between September 1995 and September 1996 the lira rallied 15% versus the Deutschmark. However, as Emu expectations continued to grow, "convergence" became more priced in and a broad Emu appeared more likely, the currency impact shifted out of the ERM. Today the currencies most sensitive to changing Emu expectations are the dollar and sterling. In part this is because there is little remaining value in European currencies. The lira and peseta would probably rally by less than 1% if their participation in Emu became a certainty.
Another reason why the dollar and sterling have profited from rising Emu expectations is that the market equates a broad Emu with a soft euro. There is a widespread conviction that a motley collection of European central bankers, unaided by a strong fiscal centre, overseeing an area with strong economic disparities and high unemployment, will be biased towards an easy monetary policy.
The main risks to the market are that Emu does not arrive or that it arrives and the euro is strong. The risks of a delay are not insignificant, especially given the tumultuous market implications, and lie somewhere between 15% and 25%. The German public is so far not warming to the idea of giving up the Deutschmark for a euro shared with Italy. The risk of a strong euro is the bigger risk. If the euro arrives it will be the currency of the world's largest economic bloc, largest exporter and largest importer. It will rapidly become an invoicing currency for trade and investment. This is the main requirement for becoming a major reserve currency.
As the euro gains reserve currency status, it could strengthen sharply. The dollar/Ecu rate is now in the region of $1.10. By 2002, when national currencies are removed and euro notes and coins are circulated, the rate will be closer to $1.50 than $1.
Avinash Persaud is head of currency research at JP Morgan Europe.