The hardships of a single currency could scuttle the Continent's stock and bond rallies

For European investors, 1996 was the year falling interest rates finally put the bull back in bond and equity markets. But it's not the bulls, but the pols, who are patting themselves on the back for the markets' achievements. In the struggle between economic fundamentals and the political will to establish a single currency for the 15 European Union economies, you can definitely chalk up a triumph for politics.

But 1997 will be an even greater test than '96. Since this will be the key year for deciding whether a single currency will be born and who will be the first allowed to adopt it, the uneasy chemistry of European Monetary Union (EMU) will hang over politicians and central bankers. If they don't get the EMU formula right, the rallies of 1996 could quickly fizzle.

As the German Bundesbank cut interest rates to historic lows in 1996, bond yields around the Continent converged, once-raging currency markets went to sleep, and former spendthrifts Italy and Spain courageously pushed unprecedented fiscal restraint. The goal: to be among the inaugural group of countries when the single currency, dubbed the Euro, is created in 1999.

TRICKS. Only Luxembourg now meets the EU's stiff budget deficit, debt, and inflation criteria for entry. No matter. While economic fundamentals argue against starting monetary union on schedule,

Europols fear a delay would set back their integration agenda by a generation. So the politicians have sanctioned accounting tricks to burnish budget forecasts and watered-down German calls for strict measures to ensure the Euro will maintain the stability of the mark. That has led some economists to fret that the Euro will end up a pale imitation of the mark. Such an outcome could be a rude surprise for German savers: Rising bond markets have been moved by so much EMU happy talk this year there's little buffer for any shock.

There's no question that the Euro's No.1 booster, German Chancellor Helmut Kohl, aims to keep the new currency on track. But 12.6% unemployment will make it hard for France, an indispensable partner in any currency union, to muster the political courage for needed reforms. Kohl and French President Jacques Chirac appear to have potentially irreconcilable differences over the terms of monetary union and the nature of the new European Central Bank. Kohl wants a strong Euro rooted in strict monetary policy, while Chirac wants the bank to be more responsive to political influence.

If that already sounds contradictory, just think what will happen when the EMU meets Italy. A vise-like fiscal policy will help Italy push inflation close to 2% in 1997, a 10th of what it was in the early 1980s. But the economy is flat on its back. German bankers doubt Italy can shrink spending further to qualify for the Euro. Traders, however, have already raised expectations that the Italians won't be kept out and fueled a huge bond rally. If those expectations are reversed, Italian interest rates may soar.

More economic growth, of course, would help get the Euro off the ground smoothly. And the fall in rates over 1996 will certainly help get the Continent going. But the chance of more rate cuts may be

waning as growth prospects improve. If German recovery forces the Buba to reverse course and raise rates, bond and currency markets at home and in Italy, Spain, and France could face a grueling test.

In Britain, short-term rates have already risen 25 basis points recently in the face of improved growth, and stocks are 2% below their highs. But national elections are due by spring and John Major's Tories may lose despite a strong economy. Union Bank of Switzerland strategist George Magnus thinks it thus might fall to a new Labor government led by Tony Blair to push rates up another 100 basis points, to 7%, in a year's time. Blair also may levy new taxes--bad news for stocks. And don't expect Blair to put Britain into the Euro anytime soon.

By the time Europe's leaders show up at their midyear summit, they're likely to have a pretty clear sense of how individual budgets are shaping up for the big EMU test. More than likely, they'll move ahead with the Euro. Then a monetary union forged out of political goals, rather than economic realities, will face the ultimate test: the market.

By Bill Javetski in Paris


Updated June 13, 1997 by bwwebmaster
Copyright 1996, Bloomberg L.P.
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