EU growth rates to promote interest rate convergence

The European economy is growing far faster than many commentators had predicted and, far from the perceived image of a continent in almost perpetual recession, the EU is set to grow faster than the US over the next year.

In fact, according to the recent EU Commission forecasts, the average rate of growth in the EU next year will be 3 per cent.

This has implications for the beginning of the single currency. First, it now seems unlikely that many countries will fail the budget deficit test of 3 per cent and even those who do will not do so by much. Only France, whose deficit is predicted to be 3.1 per cent and Italy, which has spent a lot making concessions to the government's left-wing allies, are in any conceivable danger of breaching the 3 per cent guideline.

The higher growth rates - and 3 per cent is not to be sneezed at for a mature economy - may well mean that interest rates may be higher than many commentators have been predicting up to now.

According to the Commissioner for Economic Affairs, Mr Yves Thibault de Silguy, conditions "had never been so favourable" for monetary union to take place.

Next year is likely to be the best year for European economies since 1989. Ireland remains the best performer, with Britain expected to be worst, with growth there estimated at only 2.1 per cent after 3.3 per cent this year.

The average growth rate of the 10 or 11 countries expected to be in the single currency is around 3.2 per cent, compared to the US which is estimated to grow at 2.5 per cent or less.

The Irish position is, as we have now come to expect, even more favourable. The Irish economy is expected to grow by 8.6 per cent this year and 8.1 per cent the year after, in terms of GDP.

Even these optimistic forecasts may prove to be understating the final position. This year, many commentators now expect growth of closer to 10 per cent while the significant boost which we can expect next year could mean that 1998 may not be far off 1997's likely record.

After all, the economy will receive a stimulus next year from the likely fall in interest rates, some exchange rate boost as the currency falls towards its central rate against the deutschmark and a fiscal stimulus from expected large-scale tax cuts.

Even a revaluation of the pound is likely to mean some exchange rate boost, while it now seems that the Minister for Finance, Mr McCreevy, will have to deliver around £500 million in tax cuts in this December's Budget - despite his noisy protestations.

There is still a question mark, however, over the likely size of the interest rate cuts. The Commission's forecasts point to even more rapid interest rate rises in the run-up to 1999. Indeed, it seems that the Bundesbank is already thinking about trying to instigate most of the rises before the decision in May next year on which countries will be participating in monetary union. Dr Hans Tietmeyer, its president has already hinted as much.

Most commentators are already pricing in German rate rises to around 4.5 per cent. However, with continued growth and the first signs of inflation picking up, it is likely that the risk is that German rates and hence those of most other European countries will rise even faster. These rises will be seen here as hastening us down the road to convergence. After all, German and Irish rates will have to be very close to one another as soon as monetary union begins. But the farther they rise, the less Irish interest rates will have to fall.

With German rates at 4.5 to 4.75 per cent by the second half of next year, Irish rates would have only just over 1.5 percentage points to fall and not the two or even three percentage points which many had been hoping for.

With the economy booming, that should still be stimulus enough to keep growth running strongly next year.