Issue No. 10 May 1998: SPECIAL EURO ISSUE Posted 6.V.1998
CONTENTS
Instead, I am taking the opportunity to devote this month's Issue
to something that, compared with the above, is a side issue but is going
to become increasingly important to the international investor: European
monetary union and the euro. The euro may become an international reserve
currency to rival the US dollar . . . or it may collapse in
chaos.Something to keep a close watch on. It is too early to come to any
conclusions, but here are my considered thoughts.
Unless there is some unexpected disaster, the new European currency
unit,the EURO(currency code = EUR), will be introduced on schedule on
January 1st 1999(although the introduction of Euro coins and banknotes
will not occur until later).
As a European by birth, and knowing that the success of monetary union
will inevitably result in a federal "United States of Europe", I have to
admit that I hope that it will be a total and resounding failure. Like, I
suspect, most people there, I do not want the proud ancient nation states
of the continent to be absorbed into the bureaucrat-ridden Tower of Babel
that is the EU. But, as aninvestor I have to ignore such feelings
and unemotionally attempt to assess what will happen. Hard currencies like
the D-mark and the Austrian schilling - there are not many around - will
disappear. Will the euro offer me a replacement hard currency for my
portfolio? Will the euro become a significant international reserve
currency (the implications are enormous)? Will it even be introduced
successfully? Or survive?
The initial "euro area" will include eleven countries. They are
Germany,France, Italy, Spain, Portugal, Belgium, the Netherlands,
Luxembourg,Finland, Ireland and Austria. With 291 million people, 19% of
the world's GDP and 18% of the world's trade, this economic unit will
easily rival the USA (268 million, 20%, 17%) in size and will push Japan
far into third place(126 million, 12%, 10%). When the remaining four
members of the EU (the United Kingdom, Denmark, Sweden and Greece) join in
a few years time the de facto "United States of Europe" will be the
biggest economy ever.
Those are facts. But to take those same facts and then conclude from them
that, as I keep reading "With the euro, the dollar will have serious
competition as the world's leading reserve currency" is a logical non
sequitur. It may, but the size of the euro area economy is not
the factor that will determine that. Size alone does not matter much:
compare the performance of the Swiss Franc with the US dollar during the
1970s and 1980s.
The period from now to the formal introduction of the euro on January 1st
1999 might be interesting. There is great potential for speculative
attacks on member currencies if the, essentially artificial and
political,pre-announced exchange rates of any member currency become at
odds with market value. The collapse of one or more of the member
currencies will have big implications, but is unlikely by itself to stop
the introduction of the euro on schedule. There will be a political
"fix".
But the period from the actual introduction of the new currency on January
1st to the total phasing out of the member currencies (scheduled for
2002)is the period of maximum danger. The member currencies will be fixed
at irrevocable exchange rates with the euro, and hence with each other.
Now where have we heard that before? I seem to remember that, only one
year ago in fact, there were a group of countries whose currencies had
fixed exchange rates with the US dollar (hence with each other) - Thailand
was one wasn't it, and a few others in Asia ... ? As was the case in Asia
last year, Europe is a region of strong but different economies growing at
different rates. They are at different stages of development - compare the
low income countries of the south such as Portugal with the high income
north such as Austria - and different stages of the business cycle.With a
system of floating exchange rates, the currencies move in response to the
differences. But once they are artificially fixed, stresses can build up
very quickly. Opportunities for speculative attacks on currencies will be
there, and the apparent belief of European politicians- despite very
recent lessons to the contrary - that they can ignore market forces and
fix exchange rates for several years by diktat boggles the mind. But
the big danger is that businesses and investors also assume that this can
be done, and thus that exchange rate risk between these currencies has
been eliminated. Businesses who do not continue to hedge their
intra-European exchange rate risks during this period might wake up one
day facing the same sort of problem as many Asian companies are facing
now. Investors should take these risks into consideration.
The strength of the Euro will be largely dependent upon three things:-
(1) The size and strength of the underlying economy,
(2) The remit and independence of the European Central Bank, and
(3) The gold and foreign exchange reserves held by the ECB.
Size does have some significance. The argument is that the more
transactions that are done in euros,the lower average transactions costs
should become. The lower the costs,the more incentive to use the euro in
business transactions, and to hold it as a portfolio component. Also bonds
denominated in euros have increasingly greater liquidity, leading to lower
costs and lower yields. Good for corporations and governments. These
things are all true, but are of small importance compared with many other
factors and the size of the euro area alone will have little to do with
the strength of the currency.
The strength of the underlying economy will be far more important, and
that is somewhat problematic. The economy of the initial "euro area" has
some real weaknesses which will chip away at the credibility of the euro
and weaken it. Under the 1992 Maastricht Treaty convergence rules there
were several strict fiscal criteria that every country had to meet to be
admitted.These were designed to ensure the credibility and strength of the
new currency. By early 1997 it was clear that few countries could possibly
meet them (other than the United Kingdom, which wasn't joining the first
wave anyway!). There was some talk of a launch with just a core group of
countries but it was apparent that not even the two key countries would
qualify without bending the rules - France fell short of the 3% public
borrowing to GDP requirement and Germany did not achieve the 60% total
public debt to GDP criterion. To get a 1999 launch would mean abandoning
the Maastricht treaty conditions for France and Germany, so obviously it
was politically impossible to exclude any other country that was able also
to "cook the books" (use accounting fictions) to at least be able to
pretend it met the agreed criteria. The launch should have been delayed,
but it was decided to "cook the books"instead. (A very powerful indication
of a future "soft' euro subject to political whim and legerdemain).
Considering that there isn't a nation on earth whose public accounts would
not constitute criminal fraud if offered up by a corporation in the USA,
Canada, or Europe, "cooking the books" has not required all that much
creativity. In the end, of the countries who wanted to join the first
wave, only poor old Greece ended up"undercooked" and was excluded.
Of the eleven "euro" nations only three (France, Luxembourg and
Finland) meet the important 60% public debt to GDP requirement! The
Maastricht Treaty has been 'interpreted' as only requiring that progress
is being made towards the 60% ceiling!
All eleven countries achieved the 3% public borrowing to GDP ceiling.But
France did it by using a one-off transfer from the France Telecom pension
fund to squeak through. Italy did it by adding an estimate to their GDP to
account for the underground economy - 20%! (Actually, provided that the
figure is reasonably correct, that is fine - the "underground economy" is
true wealth creating free enterprise.) Other countries changed their
corporate accounting rules in order to dishonestly massage their GDP
upwards, for example by restricting businesses' right to charge losses
against current income. The list goes on.
Certainly, public spending was reduced substantially in order to reduce
the public borrowing side of the required ratios. But what is to stop any
country allowing their spending to soar again now that they are
"in".Especially as the rest of the euro countries will be picking up the
tab. There is no mechanism to expel them - merely some rules that permit
withholding of EU funds and, in extreme cases, the ability to levy fines.
Here, once again,what began as sound rules have been undermined. At the
Dublin Summit in 1996, in the words of a Financial Times editorial
"the meeting was dominated by a titanic clash between the French and
the Germans over the terms of the Stability Pact for enforcing budgetary
discipline in the future euro zone, if necessary through draconian
sanctions. Kohl and Chirac, their faces almost touching, tore into each
other. After 17 hours of negotiations, the Stability Pact was renamed the
Stability and Growth Pact to take account of French demands that more
attention should be paid to job creation." We all know what that
means - more socialistic tax and spend. Given this watering down of the
public spending rules and the fact that the entry requirements have been
mostly thrown out of the window, the credibility of the measures has
become virtually zero.
The European Central Bank was intended to be a model of monetary
probity,like the German Bundesbank has been, with its primary objective
being price stability (i.e. fighting inflation):-
"In accordance with Article 105(1) of this Treaty, the primary objective
of the ESCB shall be to maintain price stability. Without prejudice to the
object of price stability, it shall support the general economic policies
in the Community with a view to contributing to the achievement of the
objectives of the Community as laid down in Article 2 of this Treaty. The
ESCB shall act in accordance with the principle of an open market economy
with free competition, favouring an efficient allocation of resources, and
in compliance with the principles set out in Article 3a of this
Treaty."
It was to be free from political interference:-
"In accordance with Article 107 of this Treaty, when exercising the powers
and carrying out the tasks and duties conferred upon them by this Treaty
and this Statute, neither the ECB, nor a national central bank, nor any
member of their decision-making bodies shall seek or take instructions
from Community institutions or bodies, from any government of a Member
State or from any other body. The Community institutions and bodies and
the governments of the Member States undertake to respect this principle
and not to seek to influence the members of the decision-making bodies of
the ECB or of the national central banks in the performance of their
tasks."
And to help both to ensure this independence and also stability of policy
and strategy, the bank's key people are to be appointed for a term of
eight years and they cannot be removed except under exceptional
circumstances:-
"In accordance with Article 109a(2)(b) of this Treaty, the President, the
Vice-President and the other Members of the Executive Board shall be
appointed from among persons of recognized standing and professional
experience in monetary or banking matters by common accord of the
governments of the Member States at the level of the Heads of State or of
government, on a recommendation from the Council after it has consulted
the European Parliament and the Governing Council.Their term of office
shall be 8 years and shall not be renewable.Only nationals of Member
States may be members of the Executive Board."
There is an interesting twist to this sordid event. In his xenophobic
determination to get a Frenchman appointed over the objection of every
other member of the EU (all of whom found Duisenberg acceptable) the
socialist President Chirac got a man, Trichet, who is known as being much
stricter on monetary discipline than Wim Duisenberg. Which is likely why
the market showed little reaction to what happened. But a very bad
precedent for the independence of the ECB has been established,
and we will have to wait a long time now to see just how well this
institution will be willing or able to protect the value of the new
currency.
We do not yet know much about this. With the most important "hard"currency
- the D-Mark - disappearing, the Japanese Yen being very weak,and gold
being unfashionable there is not much left but the USD.
As the whole point of holding foreign currency reserves is that you can
sell them if necessary to defend the home currency, too much reliance on
the USD doesn't make sense. Look at the situation in which Japan now finds
itself. Japan holds enormous USD reserves and is attempting to shore up a
falling Yen. But because of the situation in the USA, Japan cannot sell to
many dollars without weakening the dollar and driving up US domestic
interest rates. Totally counterproductive. So the reality is that Japanese
USD reserves do not function effectively to back the Yen. It would work in
a small nation whose total dollar reserves are not so significant, but the
euro needs huge reserves behind it - like the Yen does.
Presumably, the euro will be backed by some Swiss Francs, Sterling (at
least at first), Yen and a few other currencies in addition to dollars.But
the only answer that I can see that will offer any real strength and
stability is to hold significant gold bullion reserves. By
significant I mean 20%-30%. [This argument by the way is one of the
reasons that I recently changed my call on gold over at my Precious Metals
Website to 'cautiously bullish'.]
There was supposed to be an announcement about the makeup of euro reserves
at last weekend's summit but it did not happen. So we will have to wait
and see. This is a very big issue for the credibility of the new
currency.
Does size matter?
Over the weekend, the heads of government of the European Union met to
rubber-stamp formal approval of the eleven nations joining the first wave
of European Monetary Union, and to agree to the first, and as it turned
out also the second, head of the new European Central Bank.Will the euro survive?
The obvious answer is "probably, yes". But European monetary union is an
unprecedented experiment. I do not think there has ever before been a case
where monetary union has preceded political union. So Europe is sailing in
uncharted waters. Waters full of dangerous reefs.Will the euro be a hard currency?
The euro was intended to be a "hard" currency -stable and credible. Like
the German D-mark has been. At first this looked very possible. Today it
looks increasingly unlikely.The size and strength of the euro-area economy
The remit and independence of the European Central Bank.
[EXTERNAL
LINK] Full text of Maastricht Treaty.
A sound set of rules and principles. But in the very first action, the
appointment of the first head of the ECB, the politicians made a very
confidence damaging breach of the intent and spirit of the Treaty. Wim
Duisenberg has been appointed as head but had to "voluntarily" agree to
resign after only four years, when a French national Jean-Claude Trichet
will takeover (apparently for a full eight year term). "This is not a
fudge" said Tony Blair! What it is is what any Court of Law would know as
a legal fiction.The gold and foreign exchange reserves held by the ECB.
Will the euro rival the dollar as an international reserve
currency?
If it survives the transition period, and is proven a stable currency its
use as a major reserve currency may accelerate rapidly (especially in view
of the problems I have outlined above with the dollar). But the transition
period is fraught with such dangers that I do not see this process
starting quickly.