Risk of pact collapse reduces prospect of ECB rate cut

ANALYSIS: Reform of the Stability and Growth Pact could boost the value of the euro, provided that governments in the euro zone are prepared to adhere to some alternative form of fiscal discipline over the medium term, argues John Beggs

THERE was a great deal of surprise and indeed shock around the capitals of the EU and in the European Commission over the remarks on Thursday by the President of the EU Commission, Mr Romano Prodi, that the Stability and Growth Pact (SGP) was "stupid". He was referring to the rigidity of the rules regarding the 3 per cent deficit ceiling and the procedures for handling countries that breached the rules.

The pact is widely regarded by the EU Commission and by the European Central Bank as a key pillar in the stability of the euro currency on international foreign exchange markets.

Immediately following Mr Prodi's comments, all eyes focused on the Economic and Monetary Affairs Commissioner, Mr Pedro Solbes, who has battled to maintain a rigid interpretation of the SGP.

Mr Prodi's comments had a short-term negative impact on the euro. However, the euro also came under pressure due to the uncertainty surrounding the outcome of today's referendum on the Nice Treaty. The strong recovery in US equity markets over the past two weeks also supported the dollar, pushing the euro down towards $0.97. This came at a time when the latest economic data for the US were weaker than expected and should have pushed the dollar lower against the euro. The euro also weakened against sterling as the UK currency maintained its closer links with the dollar.

In more general terms, however, the euro-US dollar exchange rate continues to trade within a narrow $0.96-$0.99 range. The foreign exchange markets realise that not every government would agree with the EU president's remarks. His comments were music to French ears but Germany would have been alarmed, notwithstanding its current budget problems.

Mr Prodi's comments about the stupidity of the SGP are another reminder that the euro zone and the EU as a whole lack a coherent fiscal and monetary policy framework. The operation of the SGP has come under growing scrutiny because of its "pro-cyclical" nature. It has also been argued that it makes no allowance for a distinction between government current and capital expenditure.

Mr Prodi appears to have realised that the writing is on the wall for the SGP and that the pact is never going to work in the way intended in the face of a sharp downturn in the euro economy.

Economic growth in the zone has been below potential since 2000 and will remain so until well into next year. Furthermore, we are faced with a central bank that is bound up in rules around a single mandate of price stability. Official interest rates are too high in an environment where many sectors face deflation rather than inflation.

Mr Prodi seems to be proposing a trade-off between the rigid rules of the SGP and a more flexible approach, which would involve the Commission having more power to make decisions about the conduct of fiscal policy and the overall management of economic policy in the EU. In this regard, Mr Solbes may not be too upset by the president's remarks as he also favours greater powers for the Commission in the management of the EU economy.

There does not appear, however, to be any appetite to strengthen the role of the Commission in the overall conduct on economic policy in the EU. In the short term, therefore, Prodi's comments are unlikely to lead to any alternative structure being put in place.

Member-states such as France will avail of this opportunity to stretch the terms of the SGP to the limit.

What all of this means for currency markets is unclear. The foreign exchange markets see little value in a mechanism, such as the SGP, which was devised as a prop to the euro currency.

The dilemma, as the market sees it, is that the rigid adherence to the pact is hindering the recovery of the euro economy. In the US the authorities, faced with a sharp economic downturn, cut interest rates aggressively to 1.75 per cent and also loosened fiscal policy. This has been an important support to the dollar over the past year.

Reform of the pact, therefore, could boost the value of the euro, provided euro-zone governments are prepared to adhere to some alternative form of fiscal discipline over the medium term.

The ECB will be very unhappy with the uncertainty created by Mr Prodi's remarks, particularly in regard to the risks for the euro. It sees no reason to cut official rates from current levels, which are seen as "accommodative".

The risk of a breakdown of the SGP would reduce the chances of a rate cut in coming months as the ECB would see itself as the sole guardian of the external value of the euro. The irony is that the financial markets see the situation the other way. Lower interest rates and more fiscal flexibility would probably strengthen the euro and lead to the desired level of price stability that has thus far eluded the ECB.

John Beggs is chief economist at AIB Global Treasury