Emu: The outside view

The popular perception that the European Central Bank (ECB) will be as tough and even tougher than the Bundesbank is giving way to fears of sluggish economic growth in Europe and the likelihood of weak aggregate demand and a weaker euro. The growing possibility of Italy and Spain joining Emu in the first wave adds fuel to the weak euro view.

"In the long term the euro is likely to be a weak currency, to create growth," says John Shepperd, chief economist at Yamaichi International in London. "But short-term the European Central Bank will keep the euro strong, to establish credibility." The Deutschmark, because it is a major currency in Europe but small by the standards of the dollar and the yen, tends to get driven artificially high on occasions, notes Kenneth Courtis, senior economist at Deutsche Bank Group Asia Pacific. Because it would be a broader-based reserve currency than the Deutschmark, the euro "wouldn't be bounced around in the same way", he says.

A clue to how the ECB may behave lies in a comparison between the US as a trading bloc and the external trade of the Emu bloc after monetary union. Patrick Artus, chief economist at Caisse des Dépôts et Consignations in Paris, notes that a high proportion (between 45% and 70%) of the external trade of EU nations is with other EU members. Depending on how many join Emu, the value of exports by these countries outside the Emu block could be as little as 11% of their combined GDP. US exports account for around 10% of GDP (see chart page 114). So, argues Artus, while the Bundesbank has always been concerned about the external value of the Deutschmark, the ECB will be less concerned and is likely to behave more like the US Federal Reserve ­ pursuing internal price stability, but largely indifferent to the impact of the exchange rate on foreign trade.

Europe will become more of a large, closed economy, rather like the US, affirms Barry Eichengreen, professor of economics and political science at the University of California at Berkeley. "There will be less of a preoccupation with the external value of the euro." He notes that foreign exchange markets can see great movements in the dollar, as much as 3% a month, month after month in the same direction. "The same could be true of the euro against the dollar."

US fears of Fortress Europe

US concerns in general have been more about the single European market than about Emu. There was huge interest from the US at the launch of the single market in 1992, but Emu has been greeted largely with indifference. "Most Americans have not heard about Emu, and those who did could not care less," noted a Deutsche Bank Research report this summer. "Even among the intellectual elite, Emu is more associated with the big bird roaming the Australian outback than with monetary union," wrote the report's author, Mieczyzlaw Karczmar. "Since then I haven't changed my view," he told Euromoney last month.

There are US concerns about the development of a protective trading bloc ­ Fortress Europe. Courtis at Deutsche Bank notes that for the last 15 years there has been an increase in intra-European trade at the expense of a "substantial decline in trade with the rest of the world". Economic stagnation among Emu countries ­ caused by the efforts to conform to Maastricht criteria and the strictures of German finance minister Theo Waigel's proposed stability pact ­ could lead to protectionist trade measures, warn some US observers. This is possible, admits Eichengreen, but it wouldn't be like the 1930s. "Today there are institutions, such as the World Trade Organization, to mediate trade conflict," says Eichengreen. Moreover, a more flexible and more deregulated European economy should make for better market access, he believes.

Every year someone in the US warns about Fortress Europe, says Peter Kenen, professor of economics and international finance at Princeton University, "but it ain't there".

And a diminished dollar

Kenen dismisses another US concern that, after Emu, the European system of central banks will find itself with excess reserves and start disposing of dollars. "There will be an automatic contraction of reserves," says Kenen. "The Deutschmarks which account for 25% of the reserves of other European countries will become euros and no longer count as reserves." Moreover, he points out, Germany and Japan have for years held excess reserves because they don't want to depress the dollar. And the euro is likely to undergo gradual depreciation, not appreciation, making it less attractive as a reserve currency.

Worries about the reserve status of the dollar are "a tempest in a teapot", says Eichengreen. Such a status is a function of history, he points out: sterling is still important as a reserve currency on the basis of 19th-century trade flows. Only in eastern Europe could the euro quickly become the preferred reserve currency because of newly established trading patterns ­ but that is already happening with the Deutschmark. "One can imagine a day in the 22nd century when the euro will rival the dollar," says Eichengreen.

Central Europe out in the cold

A more general worry ­ shared with the British Eurosceptics ­ is what happens to the European countries outside Emu, and to the dream of a wider EU that embraces Hungary, Poland, the Czech Republic and other former eastern bloc members. "I'm concerned for countries which are not in the first wave," says Charles Dallara, former US executive director of the IMF and now managing director of the Institute of International Finance (IIF) in Washington. "Will they face a challenge of credibility? Will it create a schism such as we almost saw four years ago when the lira and sterling were forced out of the ERM [exchange rate mechanism]? There is a long-term risk in leaving the Czechs, Poles and others outside the net for too long."

Emu's inflexible structure

Dallara also questions the fundamental precept of Emu: "Is it part of the structure that will create jobs and wealth in Europe?" He sees shortcomings in the Maastricht criteria: "They were structured without any reference to flexibility in the agriculture and labour markets, or privatization." They omitted one important aspect ­ "structural change".

What happens to G7?

As a former multilateral official Dallara wonders about the geo-financial effect of Emu: "What is the framework of [international financial] coordination? Does the G7 become the G3 or G4?" Some officials are already referring to the "Quad" ­ the US, Canada, Japan, and Europe.

Will Emu stimulate trade?

Kenen sees the impact of Emu being not external but mostly internal, where it will "remove barriers to internal transactions". There is good quantitative evidence, he says, that trade between the US and Canada is much smaller than it should be, probably because of the exchange rate barrier.

European companies would argue that they are more used to trading in a multi-currency area. Unless Emu is extremely wide they will still have six or seven European currencies to deal with.

Swiss concerns

"Switzerland should be worried about practically everything," says Kenen at Princeton. It seems that, whatever financial-economic strategy it adopts, it will lose out from monetary union. If investors continue to regard Switzerland as a safe haven then the upward pressure on the Swiss franc will murder the country's competitiveness in manufacturing. If investors lose their appetite for Swiss franc assets then the country will experience a decline in one of its most important sectors, private banking and fund management.

A recent study concluded for the Swiss National Bank outlines the dilemma for management of monetary policy. If the franc tracks the euro too closely and explicitly then it risks losing the 2% interest rate differential that it enjoys at the long end of the yield curve. If the franc stays too independent it will appreciate against the euro, with dire effects on Swiss competitiveness.

Exchange controls?

The study offers several strategies to steer a middle course, but it warns that whatever the Swiss National Bank (SNB) does, the markets will want to test how far it will support a range for the Swiss franc/euro rate.

Intervention by the SNB using foreign currency "can hardly influence the exchange rate", the report says. A dual exchange rate is considered ­ applying different parities for balance-of-payments and capital-account transactions; but that is quickly dismissed as contrary to free-market principles.

The idea of applying varied pricing according to economic entity is explored and likewise dismissed. An example is quoting prices in Italian lire, lower than Swiss franc prices, in Ticino (the Italian-speaking canton of Switzerland), for the benefit of Italian tourists.

Lower rates, but not minus rates

Given the extreme delicacy of the Swiss situation, with an overvalued currency and very high production, labour and social costs, Josef Marbacher, chief economist at Bank Julius Baer, was shocked when the SNB raised short-term rates to 2.5% three months ago.

He was mightily relieved when the rate was lowered again in October to below 2%, assisting the 5% fall in the currency against the Deutschmark over the last three months. "This shows they have the intention to have a weaker Swiss franc," says Marbacher.

But he draws the line at negative interest rates, which Switzerland tried in the 1970s to discourage capital inflows. He was at the Swiss National Bank at the time. "It's such a nonsense," Marbacher says. "It's absolutely impossible with today's options and futures markets."

Ahead on structural reform

Marbacher doesn't share the pessimistic view of Switzerland; he says it is ahead of the rest of continental Europe in Thatcherite structural reform, and that explains the "bad mood" prevailing in the country: "Switzerland is far behind Europe in GDP growth, with stagnation for six years now," he says. "Switzerland must make enormous efforts to destroy the historical structure ­ it's the most cartelistic system in Europe ­ and we need an open economy. But we have a great advantage ­ it's similar to what Thatcher did in the UK, destroying the structure with shock therapy. Of course there's a bad mood [in the country], and that's the main reason why consumption isn't working. But compared with Germany, Switzerland is in a better position." Although Switzerland is in the heart of European trade flows, its future is not within the European Union or Emu, he believes.

Sweden's dilemma

Nils Gottfries, professor of economics at Uppsala University in Sweden, was a dissenting voice in a recent study that recommends Sweden should wait until its economic stabilization programme and its labour market were better able to face the asymmetric shocks of Emu membership. "I said these arguments against joining Emu are also relevant in the long run," says Gottfries. "We should continue with a floating exchange rate." But the consensus among the panel of Sweden's leading economic academics, headed by professor Lars Calmfors of Stockholm University, was that once Sweden has stabilized its economy, it should join Emu. They concluded that there were political advantages in joining early, because Sweden would have more influence in the EU in general.

Norway tracking at arm's length

Neighbouring Norway is preparing itself for life outside Emu, although its strategy depends closely on what Sweden is doing. A central question is the parity of the Norwegian krone. It was pegged to the Ecu, but it was floated in December 1992 after the ERM had blown apart. There was a 20-month period during which the krone operated under no clear guidelines. In May 1994 the king's council approved a policy to peg the krone to "European currencies", which most understand to mean a European basket close to the Ecu. From January 1999 there is a question: should the krone be pegged to the euro, or to a new basket? "The euro wouldn't reflect Norway's trading patterns, but wouldn't make a big difference, considering that the ERM II countries will also follow the euro," says Jan Qvigstad, chief economist at Norges Bank, the central bank. Norges Bank governor Kjell Storvik warned on October 11: "Even though we have chosen to remain outside the EU, we cannot allow Norway to become an "outsider" as regards economic policy." But he discounted any fixed link with the euro or any plans for coordinated intervention. "Whatever system Norway chooses," continued Storvik, "Norway's monetary policy will be heavily influenced by the monetary policy conducted by the future European Central Bank, even though there is not necessarily a one-to-one relationship between Norwegian and European interest rates in the short term." He pointed out one difference ­ Norway's heavily commodity-based and dollar-dependent export sector ­ which means that economic cycles and monetary policy would and should not be in lock-step with Emu countries.

Aiming for a wide Target

Norway, Switzerland, Sweden and the UK want their major banks to be members of Target, the planned pan-European payment system for the euro. Some countries in the hard core of the Emu project want Target to operate only in Emu countries, as Fedwire does in the US.

But Norway's argument is that as a member of the European Economic Area, and as part of the single market, it should have access to the single market's payment system. It depends, says Jan Qvigstad, chief economist at Norges Bank, whether the European Monetary Institute, which is designing Target, sees it narrowly ­ as a system to transmit monetary policy ­ or more broadly ­ as a system to serve the single market. "We argue that ­ in the latter case ­ if our companies want to make payments in euro, our banks should have access to Target," says Quigstad.

The Swiss National Bank's study notes: "If possible, Swiss franc-based companies should not face higher transaction costs than those in the euro area, because of the smaller size and greater competition in the Swiss franc market. A precondition for Swiss banks to make efficient cross-border payments in euros through the Swiss Interbank Clearing System is that the Swiss National Bank should be a member of Target."

Japan's-eye view

Emu seems remote from Japan's major concerns, its own economy and the 78% of its external trade that is done with Asia/Pacific countries. Readers confined to the Japanese press won't learn much about the Emu debate in Europe, says Richard Ku, chief economist at Nomura Securities: "Most people are very sceptical that something like Emu can actually happen." Investors have mostly been avoiding the European continent and looking at US treasuries and UK gilts, he says. But in the last six months, and more intensively in the last few weeks, some investors have been betting on convergence and debating hotly whether the euro will be strong or weak.

"Until six months ago," says Yamaichi's Shepperd, "the consensus in the US and Japan was that it wouldn't happen. But now there is increasing concern about how the euro will trade and the outlook for Europe post-Emu."

Tending towards the strong euro belief "some Japanese are continuing to invest on the basis that European rates are converging, and are increasing their foreign bond holdings in Deutschmark and French francs, with some investment in Italy and Spain", says Keith Edmunds, an economist at IBJ International in London. The Japanese ministry of finance gives a breakdown of the country's investment in major European currencies but not in Italy or Spain, which makes volumes difficult to ascertain.

To some banks in Japan the question of Emu is too remote to bother about. "Just now, I don't have much idea," guffaws the chief economist of a major bank in Tokyo. "I haven't really thought about it."

Asian focus

Singapore, Hong Kong and Beijing have given Emu more thought than Japan, says Courtis at Deutsche Bank in Tokyo. He notes that Asians are broadly sceptical: in general "they can't believe that sovereign governments will give up so much economic power to a centre ­ Brussels ­ without a proper political structure". But, as the possibility of Emu gets stronger, investors in those Asian countries, such as Thailand and Singapore, whose currency is pegged to a basket that includes the Deutschmark have quite a focused interest in the future performance of the euro, he suggests.

Fear of failure

Outsiders, particularly in the US, worry that trouble is brewing between the single-market concept and what might be an exclusive Emu club. "How stable politically is variable geometry?" asks Eichengreen at Berkeley. The eventual outcome for the UK, in the single market but outside Emu, might be to quit the EU. On the other hand, "wait until sterling goes up to 1.80 or higher to the dollar", says Courtis. "Maybe that will bring them running into Emu." Another area of doubt is the Waigel stability pact and its future if either France or Germany itself fails to meet the minimum criteria. Yet so much is now riding on the inclusion of Spain and Italy in the first wave of Emu that there are bound to be market repercussions if and when these countries finally fail to qualify.

Bert Ely, consultant on central banking and monetary affairs in Virginia, US, fears there are so many unresolved issues that, even if Emu happens, "it will come unglued. My sense is it will be a very messy process."