ECONOMIC VIEW: Markets lack faith in a single currency

The last few weeks have been full of the politics of European Monetary Union, and in particular the extent to which the Maastricht criteria might be relaxed so that some EU countries might be able to qualify in 1997, the reference year for a start date in 1999. At the moment it looks as though only Luxembourg and perhaps the UK will be able to do so.

This political argy-bargy has lead to some fall-out in the financial markets, for the greater the leeway on the criteria, the weaker the "euro" is likely to be. Fears that the "euro" would be a soft currency helped undermine the German auction of five-year bonds at the end of last week: these would be repaid not in marks, but in "euros" were EMU to go ahead.

It was not the only reason by any means - all bonds have been weak in the wake of the US market - but if the fear of being repaid in a weaker currency is now being cited as a reason for concern about investment in mark-denominated securities, this is bad news for EMU.

This sort of assertion is both unscientific and unsatisfactory: good ammunition for opponents of EMU, but nothing more. What investors really need is some way of measuring the view of the markets on the likely strength or weakness of the "euro", so that a rational price can be placed on the risks. Or rather, so one can see what price the markets are putting on the risk.

How might this be done? There is one way of making this assessment, and it involves comparing the actual exchange rate of the ecu, and the yields of ecu-denominated bonds, with the theoretical exchange rate and yields.

This may sound highly technical, but though the calculations are complicated the actual idea is very simple. Though the "euro" may not yet exist the ecu does.

This is the basket currency made up of 12 European currencies, weighted in proportion to gross domestic product and to their role in European trade, which has existed in different forms for many years. It was always intended as a precursor of a single European currency and will be exchanged one-for-one for "euros" if and when EMU happens. (The legal obligation for all ecu-denominated contracts to be converted is not absolutely rock- hard, but the European Commission has sought to reassure ecu-holders that this will be done.)

Now in theory the "euro" ought to be a harder currency than the ecu, for only the stronger European currencies will be allowed to join in EMU, whereas the ecu basket has some weak currencies in it. There is even a bit of drachma there, though not very much. So this possibility that the ecu might be translated into something better ought to make it more valuable than the basket of currencies on which it is based.

Not only should the ecu be trading above its theoretical value; interest rates on ecu-bonds should be lower than the weighted average of interest rates on the comparable national bonds.

Alas for Euro-enthusiasts, the reverse is true. Some of the best work on this has been done by Paribas Capital Markets, which has run off the two charts reproduced here. The chart on the left shows the performance of the ecu as a currency.

Back in early 1991 it was indeed above the level it "ought" to be; then for most of the period until the summer of 1994 it traded at about the right level, though with bouts of weakness during the periods of EMU turmoil in the autumn of 1992 and the summer of 1993.

But since 1994 it has deteriorated steadily so that on the market it is now worth nearly 3 per cent less than its theoretical value. As the graph shows, things have gone from bad to worse in the last three months.

Now look at the other graph. This shows the divergence between the actual yield on a 10-year ecu bond and the theoretical yield on a weighted-basket of bonds since the beginning of last year, the period when the deterioration of the ecu became most marked. It shows that the yield has been pretty consistently 0.4 per cent above the level it "ought" to be.

In other words, investors do not particularly trust the ecu - remember in theory they ought to be getting repaid in a better currency in 2006 than the currency in which their investment is denominated now - but at least their distrust has not increased in recent months. If anything it seems to have decreased.

Still the fact that there should be discrepancies between the actual and theoretical values of both the currency and bonds denominated in it ought to provide a wonderful arbitrage opportunity: a financial institution could borrow in a basket of currencies, stick the money in ecu-denominated securities of the same maturity, knock off transaction costs and still make a completely risk-free profit. The fact that they do not do so (if they did the gap would of course disappear) suggests that either they do not believe that the ecu will be converted one-for-one into the "euro", or that they don't think monetary union will happen at all.

It is difficult to give a wholly satisfactory explanation. Paribas thinks quite a bit of the problem is distrust of the one-for-one conversion. It went to the European Commission a week ago to ask about this, and understands that the conversion rate would be enforced by a council regulation, which is now being drafted and is scheduled to be implemented in 1997. But Paribas notes that the commission is concerned about the currency differential and wants to try to find a way of supporting the ecu.

Why the deterioration in the currency and not in the bonds? Not clear. There are a number of fairly technical explanations, such as the number of institutions making a market in the ecu; it is also true that most statements of support of the ecu have referred to the bonds rather than the currency. But the cold fact remains that uncertainty about EMU has not helped.

Looking ahead, things look like getting worse, as the markets take things into their own hands. We do not yet know the scale of the likely negative reaction to loosening of the Maastricht criteria, but past form would suggest that it would be received very badly.

Paribas does not explicitly reach this view, but the markets accept that the Maastricht criteria cannot be met. Both delay and loosening would worry them badly. Maybe - who knows - abandonment would become a relatively attractive option.