The march towards European Monetary Union now looks unstoppable. By early May the eleven countries which will join the first wave of monetary union on 1 January 1999 will have locked exchange rates and most of Europe will effectively be part of what will become a Deutsche mark bloc.
The whole evolution of EMU to date has been about bringing the rest of Europe into line with best practice in the German economy. The most remarkable aspect of what has been achieved is that, of the 15 member countries of the European Union, only Greece has failed to make the grade. The rest have all squeezed their budget deficits into the straitjacket of 3 per cent of gross domestic product required by the Maastricht treaty. The three hold-outs, the UK, Sweden and Denmark, all qualify on economic and financial grounds, but have decided to wait and see for domestic political reasons.
It will of course be pointed out that the large levels of national debt carried by countries like Italy, Belgium and Ireland mean they should never have qualified for EMU. However the markets have made up their own minds on this issue. The most stunning evidence is what has happened to the yields on government bonds within the prospective EMU area. Two years ago the gap between the yield on German government bonds, the least inflation prone of the European economies, and Italy, which has had the most erratic economic management, was 5.68 per cent. In other words it cost the Italian government and corporations almost 6 per cent more to borrow from the public than similar groups in Germany. Now the gap has shrunk to 0.38 per cent and is closing fast: investors in effect regard Italian paper as being almost as good as German paper since Italy has joined a Deutsche mark dominated currency bloc.
This was unimaginable even a year ago. In discussions among central bankers 12 months ago Wim Duisenberg, the Dutch central banker who will become the first president of the European Central Bank (ECB), was privately expressing doubts to his colleagues as to whether it would be possible for the project to go ahead on time.
One of the key macro-economic consequences of the new EMU bloc is that interest rates across the region will almost certainly be lower. Despite the Asian crisis the bigger economies grew by 2.75 per cent in 1997, the highest rise since 1995 and above the 2.1 per cent annual trend. With fiscal policy likely to be kept tight as a drum by the requirements of the stability pact, it should be possible in the early stages of locked currencies to hold interest rates and bond yields down. This will be particularly important for the inflation-prone EU economies, most notably Italy, Spain, Ireland and Portugal. Relatively low short-term interest rates could fuel consumer booms at home which will help reduce high levels of unemployment, especially if more flexible labour market practices are adopted.
In contrast the anchor of monetary union, Germany, may find the going much more difficult. German consumption will be partly hit by taxation in the pipeline, one of the consequences of squeezing to meet the budgetary target. And industrial restructuring, together with political uncertainties as Chancellor Helmut Kohl is challenged by the glamour politician of the middle-left Gerhard Schroeder, will affect consumer and business confidence. In addition German exports, largely in the heavy engineering and machine tools area, will be particularly exposed to the slowdown in Asia and potentially Russia.
The contrasting economic conditions between Germany and some of its economic partners could sow the seeds of the first monetary conflict within the new bloc as booms in Spain, the Netherlands, Finland and Ireland require higher interest rates to prevent them becoming unsustainable, just when Germany and France might need a looser monetary policy to stimulate sluggish output.
This partly explains why Tony Blair's government in the UK was reluctant to join the new currency bloc. It was feared that Britain's tendency to allow an unsustainable consumer boom to suck in imports, towards the end of an upswing in the trade cycle, could not cope with the current relatively low interest rate regime in Europe. The system of independently targeting inflation in the UK has not had enough history for the markets to be convinced that the UK could be a long-term member of the new currency system.
The consequences of being outside, however, could also be worrying. The two nations with the most tradeable European currencies outside the EMU bloc are already suffering. The rush of cash from southern Germany to Switzerland has pushed the ever solid Swiss franc higher on the foreign exchanges but is damaging a Swiss economy beset by stagnation and flat exports. Similarly, the strong pound has been hitting manufacturing in the UK and may contribute to a sharp slowing in growth in 1998, perhaps even by the third quarter.
Matters could get worse. There is still some concern that the euro will be weaker than the Deutsche mark because of the influence of the weaker economies on Europe's decision making. This may mean a weakening of the euro against the Swiss franc and the pound.
The situation of the dollar, so critical to the airline industry, is more difficult to predict. Theoretically the dollar is due to weaken as the US economy slows relative to its European counterparts. Moreover, in the early days, global fund managers will be seeking to acquire euro assets to rebalance their portfolios and this might put downward pressure on the US currency. However, in the initial days of the euro this may well be outweighed by the 'safe haven' effect. Investors like currencies they can trust and the dollar looks a more secure bet than a cobbled together euro which will spend its first few years on trial.
Source: Airline Business
