Europe Steps Back From Currency Chaos
Finance ministers decided to allow currencies to trade in a broader band around the deutsche mark
YESTERDAY'S decision to dramatically loosen European currency exchange rates is being met with a mixture of relief and regret.
Relief, in that recession-burdened countries such as France finally have the freedom to lower interest rates and stimulate their tired economies. Regret, in that the goal of the single European currency envisioned in the Maastricht Treaty seems farther away than ever.
After a marathon meeting brought on by last week's near collapse of the European exchange rate mechanism (ERM), European finance ministers and central bankers decided early Monday to drastically expand the flexibility of the ERM, rather than abandon it altogether.
The ERM is a 14-year old system closely linking European currencies. Its purpose is to provide European importers and exporters with stable, reliable exchange rates. But German unification and European recession have thrown the system out of whack, with member currencies straining at their allowed trading floors. French, Belgian, and Danish currencies traded to record lows yesterday.
Last September, downward pressure on the British pound and Italian lira forced them to leave the ERM. The threat of a similar scenario for the French franc was what led to the decision early yesterday to increase the allowed fluctuation of ERM currencies to 15 percent up or down from a central exchange rate, which is determined in large part by the deutsche mark. The previous fluctuation band had been a narrow 2.25 percent (6 percent for Spain and Portugal). The decision "is a very good solution," says J oachim Fels, economist at Goldman Sachs in Frankfurt. "Monetary policy can now reorient itself to domestic needs." Market forces, not artificial relationships, will take over, he says. German priorities
The problem with the previous setup was that countries were being forced to follow the lead of the German Bundesbank - whose policy was out of step with the rest of Europe due to its unique circumstance of unification.
French Prime Minister Edouard Balladur blamed high interest rates in Germany as being responsible for the current crisis. While other nations have been wanting the Bundesbank to drastically lower its leading interest rates - so that they can follow - the German central bank has been keeping them relatively high to restrain inflation and growth in the money supply.
When the Bundesbank failed to drop its key interest rate before breaking for the summer holidays last Thursday, money traders dumped the currencies of France, Denmark, Belgium, Spain, and Portugal.
But, as a result of yesterday's decision, "I think the turbulence is over," says J. Paul Horne, economist for Smith Barney, Harris Upham & Co. in Paris. "The turbulence was caused by fixed markets," and now that policymakers have moved the ERM to as broad a band as 15 percent, currencies are essentially floating freely on the exchanges, he says.
Mr. Horne expects countries such as France to lower interest rates and predicts that the franc will drop in value about 5 percent to 8 percent - nowhere near the new limit of 15 percent. If true, this should be a relief to central bankers who are obligated to spend billions to prop up currencies whenever they reach their floors. Last week, for instance, the Bundesbank alone spent 60 billion deutsche marks [US$35 billion] to defend the franc.
Analysts also expect stock markets, anticipating lower interest rates, to pick up in all ERM countries except the Netherlands and Germany. Both of these countries have decided to maintain tight currency ties and, for the moment, their currencies are moving upward - a development which will hurt their exports. Loss of momentum
While economists praised the new ERM flexibility for allowing countries to tailor monetary policy to domestic needs, some European governments expressed regret. Instead of Europe's monies moving closer toward an eventual single currency, they are being allowed to diverge from each other. "Today is a very sad day for Europe," said Dutch Finance Minister Wim Kok of yesterday's decision. German Economics Minister Gunther Rexrodt said Europe would have to take a "breather" from the goal of a single European currency, although he maintained the goal itself was not in danger. However Britain's Prime Minister John Major called the prospect of a single European currency unrealistic.
Finance ministers emphasized that the ERM's new 15 percent band is only temporary. German Finance Minister Theo Waigel said that it will be reviewed Jan. 1. Economist Horne maintains it is too early to pronounce the ERM dead. "The old parities are dead, but the ERM will be resurrected," he says. The reason is that the European Community "has a need for predictability in exchange rates." By the time next winter rolls along, he predicts, a new set of parameters will have been established that may even allo w the lira to return to the ERM.