Which way for the euro?


Published on:

The initial membership of Emu is decided, as is the board of the European Central Bank (ECB) and the exchange-rate parities for converting Emu participant currencies into the new euro on 1 January 1999.

The noise has been deafening about the interference of politicians in the appointment of the new ECB president. Many observers argue that it indicates that the ECB will not be independent in running Emu monetary policy. But anyone who looks at the personalities on the ECB board should be in no doubt that they will exert their authority pretty quickly. The governing council of Europe's new central bank will resist any attempt at political interference. Its monetary policy decisions will be directed solely at maintaining price stability.

The toughness of the ECB's monetary policy in the weeks after Emu starts is not the problem. The real problem is that low interest rates in the run-up to Emu are overcooking Europe's peripheral economies. Inflation in these countries will surge. So corporate competitiveness will be eroded and jobs will be lost. Peripheral equity markets may outperform in the short term.

The ECB will respond to overheating by tightening monetary policy more aggressively than the consensus expects. That will drive the euro up in its infancy, but it will also cause bonds and equities to plummet.

As interest rates rise, public finances will deteriorate in the highest-debt economies. The risk of fines being imposed, under the terms of the Emu stability pact, will grow. Investors will penalize regions with the poorest economic fundamentals. And the threat of expulsion from Emu - the ultimate sanction - will widen sovereign credit spreads further. Growing political uncertainty will also undermine the euro in the medium term.

The ECB's basic weapons against inflation - the cudgel of interest rates and the axe of exchange-rate adjustment - are woefully short on finesse. The core countries (Germany, France, the Netherlands, Belgium, Luxembourg and Austria) will dominate Emu economically and politically. But in the second half of 1997 they were growing at a ponderous 2.6% a year. In contrast, real GDP in the hangers-on (Italy, Spain, Portugal, Finland and Ireland) had accelerated to 3.5% by the end of the year (4.4% excluding Italy).

As long as growth rates are so different, a "one-size-fits-all" Emu monetary policy won't work. Peripheral countries' interest rates will have to fall to core levels, revving up their economies even further. And governments there won't want to inflict more fiscal pain to offset this monetary boost after an extended period of abstinence to qualify for Emu. Take Italy. Its 1999 budget makes just 0.7% of GDP worth of net spending reductions and targets an overall deficit of 2% of GDP, yet surpluses of at least 2% to 3% of GDP should be the order of the day at the peak of the business cycle.

By early next year, the peripheral economies will be growing at close to 5%. As demand rises, so will sellers' pricing power and their profit margins. Wage demands will soar. And inflation will rear its ugly head. Ireland is already showing the stresses. Eventually, the ECB will have to stop pandering to the slow-growing core. It will be forced to raise interest rates to protect the euro.

And there's a much more powerful effect in store. Corporate bond issuance in Europe today is equivalent to just 4% of GDP. That compares with over 20% of GDP in the US. Regional and municipal borrowing is similarly underdeveloped. With currency risk (largely) eradicated, Europe's bond market is set to develop in depth and breadth. A more diversified capital market will allow investors to penalize local authorities in regions with relatively high inflation, high debts and low growth prospects. In extreme cases, the risk of expulsion from Emu will also get factored into sovereign credit risk.

And there's another body blow ahead. Although inflation rates have converged in Europe, there's been little in the way of price convergence. The euro bulls argue that Emu will expose these disparities and competitive pressures will drive prices down to the lowest prevailing levels. But if that's the case, a lot of uncompetitive producers will go out of business. Corporate profit margins will get squeezed. And unemployment will jump in the least competitive countries.

Labour-market deregulation could help to limit the most damaging side-effects of a wage-price spiral. However, the dirigiste economic model still rules in euroland. France and Italy have already legislated for workers to be paid more for every hour of work they do, by reducing working hours without loss of pay. And Germany's chancellor-in-waiting, Gerhard Schröder, not only believes that shareholder value should play a subservient role to job creation. He's also quite happy for the state to hold golden shares in corporations to ensure that management lives up to this ideology.

All the signs are that Europe's politicians will continue to seek the easy way out. The ECB will be pressured to "go for growth" and to turn a blind eye to inflationary risk. So the euro's long-term fate is to be a weak currency, not a strong one.

David Rocheis president of Independent Strategy, a London-based research firm.