FEATURE - Pre-EMU forex speculation no grave concern
01:01 a.m. Mar 10, 1998 Eastern
By Pratima Desai
LONDON, March 10 (Reuters) - Economists across Europe dismiss as small
the chances of a market onslaught on currencies joining economic and
monetary union (EMU) between May this year and January 1999 when the
project is due to be launched.
Fear of central bank intervention and their ability to monopolise
forward rate markets, alongside political determination for a timely
start to the project, will keep markets under control, they say.
''The likelihood of speculative attacks on currencies joining EMU is
very low,'' said Luca Mezzomo, economist at Banco Commerciale Italiano
in Milan.
European Union finance ministers decided last September to announce
bilateral conversion rates among participating currencies on May 2,
eight months before the planned launch of the euro.
The conversion rates are expected to be based on the central parities of
the Exchange Rate Mechanism (ERM).
''They will announce the rates in May, and in practice they are not
committed to them until January but the threat of announced rates being
enforced will be enough to bring markets into line,'' said Mezzomo.
Speculative risk arises from the fact that the rates to be announced in
May are not legally binding under the Maastricht Treaty.
The chosen rates are a statement of preference and there could be a
problem if a currency was to trade at a different level from its pre-set
conversion rate on the last day of trading at the end of December 1997.
''Central banks can manipulate markets and ensure their preferences are
met. On the last trading day of 1998, there may have to be significant
intervention,'' said Michael Lewis, senior currency analyst at Deutsche
Morgan Grenfell in London.
''But it won't be necessary. The markets will have anticipated and
arbitraged away this eventuality.''
MARKETS HAVE DISCOUNTED EMU
Over the past two years volatility in the mark's European cross rates
has slowed to a trickle as rates converged close to their central ERM
parities.
Pricing in the options market also reflects the market's conviction that
EMU will go ahead without major upheavals in the remaining months.
Implied volatilities on options on the mark's crosses have dwindled,
with mark/French franc volatility at historic lows of not even one
percent compared with more than six percent two years ago. Options allow
the holder to buy or sell currency at a given date at a preset rate.
The lira has strengthened by more than 20 percent since March 1995 to
around 983 per mark amid growing expectations that Italy will be a
founder member of EMU. Its central ERM rate is 990 per mark.
Over the same period the yield difference between 10-year Italian bonds
and German bonds has dropped by more than six percent to about 0.30
percent.
Expectations are for EMU to go ahead with 11 countries. The core group
-- Austria, Belgium, France, Germany, Luxembourg and the Netherlands --
is expected to be joined by Finland, Ireland, Italy, Portugal and Spain.
''Markets are now focusing on the contribution of a country to the
economy of the euro-11 rather than on differences between them,'' said
Stephen King, chief European economist at HSBC James Capel in London.
CENTRAL BANKS COULD FLEX MUSCLES
Faced with the combined reserves of all 11 central banks, analysts doubt
whether currency markets will have the courage to start a protracted
battle before the start of EMU.
''My estimate of the reserves of the 11 is in excess of $200 billion,''
said Ray Attrill, director of analysis at 4CAST in London. ''The markets
are very unlikely to test their collective might.''
Interest rate convergence, expected to occur in the second half of this
year and essential for currency convergence may cause some anxiety.
''The period between May and January could be more comfortable if rates
had already converged,'' said Herve Goulletquer, chief economist at
Credit Lyonnais in Paris.
Convergence between French and German interest rates has already taken
place. The repo rate in both countries is 3.3 percent.
But between Ireland, with interest rates at 6.75 percent, and Germany,
interest rate convergence is still to come.
Attrill said the rate of convergence -- to the ERM central rate --
between the lira and the mark will be dependent on the pace of
convergence between their interest rates.
KEEPING AN EYE ON FORWARDS
Yield differentials between those countries hoping to be founder members
of EMU can be seen in the forwards market, where currencies can be
bought or sold for delivery at a future date.
One mark will buy around 3.3525 French francs -- near the ERM central
parity at 3.3539 -- whether the delivery date is tomorrow, next week, in
May or at the end of December.
But the Irish punt, trading about 2.4850 marks, is almost three percent
higher than the ERM central rate at 2.4111.
For early May or end-1998 one Irish punt will buy around 2.4750 marks or
2.4580 respectively. Both forward exchange rates remain significantly
above the ERM central rate because of the yield differential to be
gained by holding Irish punts.
But despite some remaining divergence there is little to be gained for
speculators, analysts said.
''Governments could take the lead in offering to buy and sell forward
contracts for end-December to ensure they get the rates they want,''
said Lewis. ''Who is going to bet against them?''
Another pointer for a smooth transition to EMU is the financial turmoil
in Asia and its impact on the mark's crosses.
King at HSBC contrasts the relative stability of mark crosses since the
Asian turmoil started with the Mexico crisis in December 1994.
''Then investors bought marks causing problems for the more volatile
European currencies,'' King said. ''There has been no safe-haven flow
into marks over the past few months.''
Probability of turbulence could rise if the dollar fell significantly.
But analysts said the correlation between the U.S. currency and mark
crosses is not as strong as it used to be. Moreover, the dollar is well
supported by the strength of the U.S. economy.
''For example, dollar/mark would have to drop to 1.35, before mark
crosses became volatile,'' Lewis said.
A possible source of turmoil may be verbal expressions of
dissatisfaction with agreed conversion rates.
''It could be a starting point because if taken seriously then the whole
process of negotiating conversion rates would have to start again,''
said Gerhardt Grebe, chief economist at Bank Julius Baer in Frankfurt.
But Grebe saw a minimal chance of this happening given that all
conversion factors have to be agreed unanimously. ((London newsroom, +44
171 542 2737, fax +44 542 5293, uk.forex.news+reuters.com)) |
