Asian woes a boon for Europe's interest rates

 

There has been relatively little discussion about the impact which recent developments in south-east Asia and Japan could have on the European economy and on the move towards the single currency. This is because most analysts don't know the answer, which in turn is because it is still unclear how much more bad news might emanate from the region. However, one thing is very clear, the world economic outlook for 1998 has been damaged. Quite how much damage has been done will depend on how much further the crisis deepens and more importantly on how effective the official response will be. With world growth set to be pared back by between 0.5 of a percentage point and one percentage point, the implications for the European economy are not particularly good, but the implications for interest rates are.

The Japanese financial sector has been an accident waiting to happen since the early years of this decade. Now that the problem has finally come to fruition, the prognosis for the economy going forward is not particularly awe inspiring. The incipient recovery which was in evidence earlier in the year has now been blown firmly off course and subdued economic behaviour will be the order of the day for some time to come. The crisis afflicting South Korea and most other countries in that region is equally serious. Hyundai's decision to postpone its Scottish investment is just the tip of the iceberg and sets the scene for a period of corporate consolidation in the region. While the Asian tigers may not be about to leap into the abyss, they will now have to undergo a period of reflection and consolidation and "pussycat" behaviour will be their hallmark for some time to come.

The bottom line is that the engine of growth in the world economy for the past decade has now spluttered and anybody who believes that this will not adversely affect the European economy should take a good dose of reality. When intra-EU trade is stripped out, the Asian market accounts for just under 30 per cent of European exports, and sales to the region have been expanding at an annual average rate of 16 per cent over the past decade. The pace of growth is now set to slow quite sharply and the European growth performance will be affected. This is certainly not good news for a German economy which has been dragged out of the mire by exports over the past 18 months.

In recognition of this reality, the interest rate comments emanating from the French and the Germans have been undergoing a fundamental change over recent weeks. In Dublin recently, the governor of the Banque de France, Mr Jean-Claude Trichet, was quite adamant in his view that Euro interest rates will be determined by the `benchmark' countries - France and Germany - and that they will not be an average of market interest rates.

Put simply, there will be an onus on the other participants to get their rates down to the levels of the most credible countries. A number of Bundesbank officials have sent similar messages. This is a marked change from the attitude displayed during the summer when the suggestion was that interest rates for the euro zone would need to be quite high to accommodate countries like Spain and Italy and to establish the credibility of the new currency. There is now clearly a recognition that the developments in south-east Asia and Japan pose a threat to a fragile European economy which is still in the depths of an unemployment crisis.

Consequently, higher interest rates would be farcical in this uncertain environment and European central bankers will have to keep their powder dry. It now appears likely that the euro interest rate on "e-day" will be much closer to 4 per cent than 5 per cent.

This has very significant implications for Irish interest rates and we can now sit back and wait for market rates to decline by around 2 per cent over the coming months. That is of course assuming that information technology considerations and further turmoil in Asia do not force EMU postponement: this is probably a safe assumption to make at this stage.

This then raises the question of whether the Irish economy needs such an interest rate move, but whether it does or not is quite immaterial, as a smooth transition to EMU makes it unavoidable. When Mr McCreevy stands up on Wednesday to deliver his first budget, he will be very aware of this conundrum, but certain tax commitments have been given and will have to be delivered upon. If they are not delivered upon.

For the mortgage holder, a 2 per cent decline in market rates may not and most probably will not necessarily result in a similar decline in mortgage rates, because the lending institutions will have to take account of the depositors who outnumber the borrowers. Nevertheless, the prognosis for borrowers is good and brings to mind that old adage about ill winds.

Jim Power is chief economist at Bank of Ireland Group Treasury. The views expressed are personal.