Attention focuses on inevitable fall in Irish rates

Dublin's money market was briefly jerked from its summer lull this week by "news" that the Irish Central Bank had cut official interest rates. Alas, the news agency report proved erroneous, although it has re-focused attention on the timing of the inevitable fall in Irish rates and the likely scale of that fall.

The re-emergence of Russia as yet another potential emerging market basket case, this time on the EU's doorstep, also raises the prospect that Irish rates will converge to a euro rate level that will be lower than previously envisaged, so making the gain to Irish borrowers much greater.

One-month cash in Germany is currently trading at 3.5 per cent, with rates in all but four of the other euro members trading at similar levels. The four are: Spain, Portugal, Italy - the so-caled Club Med countries - and Ireland. Rates in Spain and Portugal are some 1 per cent higher than in Frankfurt, in Italy the difference is 1.5 per cent, with Ireland out in left field at 2.75 per cent.

By January, short term interest rates across Euroland will be identical, so further convergence is required. But to what level?

Six months ago the financial markets were betting that euro interest rates would start next January at 4.25 per cent, but the expected figure has since fallen sharply, with onemonth cash - the benchmark short-term interest rate - now expected to trade at around 3.6 per cent in January.

This would imply a marginal upward move in official German rates (currently 3.3 per cent).

But with post-war record levels of unemployment and a sub 1 per cent inflation rate, the domestic case for a rate hike in Germany is hardly compelling. Indeed, the upcoming Federal elections would make any near term rate move politically sensitive.

Yet the whole point of euro rates is that they represent the most appropriate rate for the euro region, as opposed to the requirements of individual states, and the obstinacy in cutting rates shown by "Club Med" and Ireland implies that Europe's central bankers disagree about what that euro rate should be.

For example the (weighted) average one-month interest rate in Euroland is currently 3.9 per cent so the peripheral countries would probably welcome higher rates in Germany, to minimise the required monetary easing in the periphery.

In Ireland's case 4 per cent euro rates in January would still imply a 2.25 percentage point fall in Dublin rates over the next four months, but a 3.5 per cent starting rate would mean a 2.75 point decline, despite double digit GDP growth and pronounced house price inflation.

So we have a stand-off between the domestic requirements of Germany (accounting for 31 per cent of Euroland GDP) and Club Med plus Ireland (also 31 per cent).

Against this backround the Russian crisis adds a new dimension and probably tilts the balance in the German direction. The recession in Asia will cut EU growth by some 0.6 per cent over two years, which is not negligible in a region struggling to grow by more than 2.5 per cent per annum.

Russia adds a further disinflationary element, and although it is not a large recipient of German exports (Eastern Europe as a whole takes around 10 per cent of German exports) German banks are disproportionately exposed to Russia; industry estimates put the total at $30 billion, against $1 billion for British banks.

Although most of these loans are trade related and ultimately guaranteed by the German state, the financial cost is potentially large, and a collapse in the rouble would risk runs on some other east European currencies, so pushing rates in the region higher and thereby precipitating company bankruptcies and debt defaults.

Russia's decision to declare a moratorium on some short term debt will also raise the external cost of borrowing across the region, hence hampering economic growth in eastern Europe.

Although the financial crisis in Russia is not on the same scale as that in Asia it is another factor dampening European growth, so putting further downward pressure on inflation via lower commodity prices.

All consumers benefit from lower inflation and Irish borrowers will also gain, as the current fragile state of financial markets, in turn a response to events in Asia and Russia, means euro interest rates may start at very low levels, so increasing the size of the fall in Irish interest rates over the next four months.

Dr Dan McLaughlin is Chief Economist at ABN AMRO Stockbrokers