EU states tinker with rates as uncertainty prevails

Following last weekend's EU summit on monetary union, the way is now paved for a clear progression to the new single currency bloc on January 1st. The unseemly row over who will head the new European Central Bank provided the major interest for what should have been a celebratory weekend for heads of state. But a key question now is what will be the trend for European and Irish interest rates over the balance of the year.

The ECB row between the French, Dutch and Germans was eventually settled in a compromise, which turned out to be where the negotiations had begun.

It has now been settled that Dutchman, Mr Wim Duisenberg, will head the ECB for around four years, when he will "voluntarily" retire at a time to be decided only by himself.

Despite the difficulties over the process, the summit has formally put the euro on track and has answered any doubts over which states will participate. It has also copperfastened the bilateral exchange rates between the participating currencies. Although neither of these decisions came as a surprise, the very fact they have now been taken gives the markets a good deal of extra security.

Initial predictions that the compromise could lead to a wave of sterling buying as the deutschmark fell even further in value turned out to be wide of the mark. Indeed, the opposite appears to have happened. Traders decided that the ending of uncertainty means sterling lost some of its value as a "safe haven" currency. And ironically the row over who would get the new job was simply seen as copperfastening the Bundesbank's determination to raise interest rates and thus prove its mettle, even in the dying days of its influence.

And it is this focus on interest rates which is likely to dominate much of the markets and indeed much of the public's thinking on the euro over the coming months.

In the immediate aftermath of the EU summit, the Spanish cut rates by a quarter of a percentage point, while the Danes hiked rates. Both of these are symptoms of what is happening in the wider euro bloc economy. While the Danes will not be part of the new currency, their rate rise underlines the likely direction of German rates over the rest of this year. The Spanish rate cut, on the other hand, was seen as an attempt at purely technical convergence with far lower German rates, a process Ireland will also have to complete.

Most of the peripheral countries (Ireland, Finland, Spain, Italy and Portugal) have far higher rates than those prevailing in the core countries. According to Dr Dan McLaughlin of ABN Amro the average rate among the peripheral countries is now 5.5 per cent, while the average among core countries is 3.6 per cent.

Until recently, many economists had assumed that German rates would rise only a little over the rest of this year and then only as a response to domestic growth. However, with Italy in particular a member of the euro zone and one which makes up 22 per cent of EU gross domestic product it is now possible that even the Bundesbank will have to pay some attention to its monetary needs when setting interest rates.

For Ireland this could mean smaller rates cuts over the balance of the year than many had been predicting. At the moment Irish rates at just over 6 per cent are the highest among all 11 countries. And the Central Bank is officially saying it will leave any cuts until as late as possible. One of the reasons for this is that it is as yet unclear by how much and how quickly the Germans will raise their rates.

There is also a possibility that the new ECB may be more prone to raising rates than previously assumed. An examination of the composition of the executive board reveals that the core countries end up with nine votes, two for Germany, two for France, two for Holland, one for Belgium, one for Luxembourg and one for Austria. The peripheral countries, on the other hand, end up with eight, two for Italy, two for Spain, two for Finland, one for Ireland and one for Portugal.

And, as Dr McLaughlin points out, it is also possible to count the two Dutch votes in this latter bloc, as their inflation rate is running close to 2 per cent and growth is a strong 4 per cent. This is likely to mean a bias to higher interest rates from the ECB than prevail now in Germany.

It is also possible that the in-fighting at the summit may have predisposed the Bundesbank to hike rates. It is understood that it was Mr Tietemeyer along with German finance minister, Mr Theo Waigel, and foreign minister, Mr Klaus Kinkel, who revolted last weekend, refusing to countenance any date to be put on Mr Duisenberg's departure.

The row means that the ECB and hence the euro is built on less solid foundations than many hoped would be the case. And many believe that the response of the hardline or hawkish new central bankers will be to favour interest rates rises and press for some help from the national central banks over the second half of this year in achieving a higher starting interest rate level for when the euro zone comes into operation next January.

While the ECB comes into existence on July 1st, it does not have any responsibility for monetary policy until the currency is formally launched on January 1st next year. As a result its interest rate intentions will not be clear for some time, while the national central banks retain some indepenence, albeit severely curtailed.

For Ireland, the implications for rates over the rest of the year have yet to de decided. But it does seem likely that they will be watching the Germans before making any move. After all, there would not be much point cutting rates, only to find them hiked again by a determined German or European Central Bank. As one insider noted, it is still a case of playing it by ear.