Some pot holes still left on the road to EMU

The notion that EMU is a done deal has been the received wisdom for some time now, and in Ireland, at least, only two questions are seen to be relevant regarding monetary union: how quickly will Irish interest rates fall to European levels, and at what foreign exchange rate will Ireland enter EMU? Political events in Europe last week suggest that there may still be the odd pot hole to circumvent on the road to the euro, although events on the Dublin money markets point to a faster fall in rates than previously thought. Moreover, the Asian turmoil may mean a larger absolute fall in Irish rates, than currently anticipated.

As to the prospects for a smooth transition to an 11-country euro, four developments are worth keeping an eye on - all may come to nothing, but it is possible that the markets' current complacency on EMU could be premature.

The first development concerns the challenge to the euro in the German constitutional court, a case recently taken by a number of individuals, including a former Bundesbank council member. The case is that the euro will be weaker than the deutschmark (DM) because the Maastricht criteria are not being rigidly applied, which thereby undermines property rights as guaranteed by the German constitution.

Clearly this is a wild card, with any result possible. At a minimum the court may restate the need for parliament to have the final say, so bringing public opinion into the equation in what is an election year. This also makes the promised Bundesbank report on EMU (scheduled in late March) of increased importance, given the Bundesbank's standing amongst ordinary Germans. German federal elections are not scheduled until November, but Dutch elections are due in May, and political developments in the Netherlands have thrown up a second headache for European governments.

The Liberal Party, one of three in the government coalition, is reputed to be considering pulling out of the project rather than acquiescing to Italian membership, which is seen to weaken the euro. Indeed the current finance minister, a member of the party, stated his intention in the press to resign if Italy joined in 1999, although he subsequently denied this.

A third, less well publicised development, is in France, where it is believed that the constitutional court there thinks the Amsterdam Treaty is incompatible with the French constitution. Consequently ratification requires either a referendum or a 60 per cent majority in parliament, with the president deciding which is appropriate. Of course a referendum rejection of the Amsterdam Treaty is not a rejection of EMU, but it would push the EU into chaos and so threaten the euro. That said, it is by no means clear that a referendum will occur.

What is certain is that Ireland will have a referendum on the Amsterdam Treaty, probably in March. Again, this is not the Maastricht Treaty and on any known evidence it will be carried comfortably. But the debate could be messy, given that the state cannot openly support one side or the other, and the treaty contains some issues relating to defence, which may spark a debate on threats to Ireland's neutrality, perceived or real.

Overall, then, the next few months could generate enough uncertainty to at least cast doubt on the concept of a very broad EMU, including Italy. With Germany now likely to meet the deficit criterion, its political hand is strengthened, but the only obvious way to exclude the Italians is to play the debt card, given its debt ratio of 120 per cent.

Yet this hurdle would also preclude Belgium membership (with a debt ratio of 130 per cent) despite its close geographic, political and economic links to the German/French axis . Indeed that axis would also be strained, given the new French government's insistence on broad Mediterranean membership of EMU.

Whatever develops there is no doubt that Ireland will meet the criteria as set down by Maastricht, and the size of the economy is such that one doubts if any of our EU partners will object to Irish membership. So we are still left with the prospect of large interest rates cuts, even through the Irish economy hardly needs it.

Some months ago it looked likely that German rates by December could be as high as 5 per cent, so limiting the scale of Irish rate cuts to some one percentage point or so. Now, the expectation for German rates is 4 per cent and if the Asian turmoil broadens and deepens, this could decline further.

For now, the likely rate cut expected is over 2 percentage points at the short end of the money markets. Moreover, the fall in the value of the pound is prompting profit taking, which is pushing liquidity into Dublin and pushing short rates lower. So the quicker we reach the central rate, the quicker rates fall. One doubts if the central rate will be revalued now, but if so it will change little on the interest rate front. A 2 per cent revaluation would leave the currency where it is (and raises the question "why bother?") and a 5 per cent revaluation (to DM2.53) would require either a rise in the punt (so pushing liquidity into the system and rates lower) or rates to be lower than Germany's if the punt stayed below its new central rate.

We are left with the situation that - like it or lump it - rates will have to fall in Dublin unless the whole EMU project is derailed, even at this late date.

Dr Dan McLaughlin is chief economist at Riada Stockbrokers.