Euro facing new political uncertainties

 

The euro is now within 30 business days of its official launch on January 1st, 1999. Official preparations are well in hand and most Irish companies are engaged in preparations for the arrival of the new single currency.

However, the economic and financial environment in which the euro will be launched has changed considerably since the start of the final quarter of 1998. The old political order in Germany has been swept aside and its place has been taken by a new breed of politician who finds political soul mates in many other euro member states. The swing to the left, not only in Germany but also in Italy, has brought new uncertainties to the prospects for the euro currency and euro interest rates.

The debate about whether the euro will be a soft or hard currency has been a difficult one on which to adjudicate. Most central bankers within Europe believe that the euro will be a stable currency. This will come as good news to Irish companies, particularly as the UK will not be a member of the euro until about 2003.

However, recent political events may act to destabilise the euro in world financial markets. The euro economy will be a relatively "closed" one - a high proportion of its trade will be within the euro zone. The trend in the euro, therefore, against other currencies such as sterling, the US dollar and yen will be somewhat less important than movements in euro interest rates in influencing inflation within the euro economy. This is not to suggest that the European Central Bank (ECB) will neglect the new currency. This was made clear by the president of the ECB, Dr Wim Duisenberg, when he addressed the Institute of European Affairs in Dublin earlier this month.

Nevertheless, the ECB will not necessarily engage in a policy of active intervention in order to smooth the value of the euro on foreign exchange markets. It follows that we can expect that the new single currency will experience regular bouts of volatility against non-euro currencies. This will not come as any surprise, but the real question is how the euro will perform against sterling.

There had been a view that, with the euro anchored in a stability oriented monetary policy framework as operated by the independently established ECB, the new currency would appreciate against sterling. This would imply a rise in the pound against sterling from its current level of below 90p towards 95p in 1999.

This view was reinforced by the expectation that sterling would fall from its current level against the deutschmark as British interest rates were reduced. At a rate well above DM2.70, sterling was regarded as overvalued and a severe hindrance to British manufacturing industry.

The prospects of lower British interest rates are still very much on the cards in 1999. With sterling remaining very firm against the deutschmark as we head towards the end of 1998, the British economy will feel the negative impact on jobs and output. It is still expected, therefore, that sterling will ease against the deutschmark//euro in 1999.

The recent political attempts by the new German Finance Minister, Mr Oskar Lafontaine, to force a cut in German, and by implication, euro interest rates, have caused concerns about the independence of the new central bank. This could lead to a weaker euro in 1999.

The German government, in alliance with the French, believes that the European Central Bank should adopt a more pro-jobs stance in the conduct of euro monetary policy. Repeated calls for lower interest rates have been resisted and it is highly unlikely that the ECB governing council, which determines the course of official euro interest rates, would bow to political pressure.

The independence of the ECB is guaranteed by the Maastricht Treaty. However, with inflation easing in the euro area to an annual rate of about 1 per cent, the ECB may yet cut official rates based on the fear of deflation. If the ECB were to respond purely to political pressures in reducing rates, it is almost inevitable that longer term rates would rise as the financial markets responded negatively to the political interference.

This would jeopardise the prospects for stronger investment in the euro economy as most European companies borrow at fixed or longer term rates rather than at the short end or variable interest rates.

Any downward adjustment of euro interest rates in 1999 must be soundly based, otherwise the credibility of the ECB would be called into question.

This would not benefit Irish companies because the prospect of a lower and more stable interest rate environment was one of the main benefits of Irish membership of the euro.

For Irish corporate borrowers, therefore, it is possible that official rates could fall below the expected starting rate of 3.3 per cent but long term rates are unlikely to fall much below current levels.

The possibility that euro interest rates will move broadly in line with those in the UK and US in 1999 should prevent the euro from appreciating significantly next year.

This is particularly so against the US dollar but, with the British government adopting an ever more positive stance vis-a-vis the euro, sterling should lose ground against the new single currency. A move towards 95p, therefore, is a reasonable target in the course of the next 6-12 months. This should help to bring Irish inflation down closer to the euro average but it will also make life somewhat more difficult for Irish exporters to the UK at a time when British economic growth is forecast to slip below 1 per cent.

John Beggs is chief economist at AIB Bank.