The Economist

FINANCE AND ECONOMICS

European interest rates

THE European Union’s plans to create a single currency, the euro, on January 1st 1999 have brought a bonanza for bond investors. Since the start of 1995, government-bond markets in Italy and Spain have soared as yields have tumbled into line with those on offer in Germany. But yields on shorter-term paper are still wide apart: in Germany, three-month interest rates are 3.3%; in Spain 5.4%; and in Italy 6.8%. A single currency requires a single short-term interest rate. But for some would-be members of the single currency, getting from here to there might not be easy.

The bond markets offer some clues (see chart). They are betting that German interest rates will rise sharply in the run-up to monetary union. The Bundesbank has not changed its official rates for a year, and so far has had no cause to raise them: the German economy has long been in the doldrums, one German worker in nine is in want of work, and inflation has been subdued. But now the economy is picking up: in the second quarter, industrial production grew at an annualised rate of 4.3%. Inflation is twitching too: consumer prices rose by 1.9% in the year to July, the highest since June 1995.

Other European economies are also beginning to speed up. According to The Economist’s latest poll of forecasters, the Danish, Dutch and Spanish economies should all grow by 2.9% this year. Economists at Goldman Sachs reckon that once this year’s sharp depreciation of Europe’s currencies against the dollar is taken into account, pan-European monetary policy is at its loosest for 20 years.

Next year, the Bundesbank will in effect hand over the task of setting European interest rates to the future European Central Bank (ECB). Given the Bundesbank’s impressive record of fighting inflation, it will not want, as its last act, to saddle the ECB with a super-loose monetary policy. At some point, therefore, German rates will surely have to rise. That could make life awkward for both Italy and France, Germany’s closest European partner.

Currently, the markets expect Italy’s rates to fall a bit by 1999, but to stay above Germany’s. The Banca d’Italia would love to see its rates fall to converge with German ones. Italy finances much of its huge debts by borrowing at short maturities. If it could pay less interest on this, it would increase its chances of squeezing its budget deficit for this year below 3% of GDP, one of the criteria for joining the single currency.

But some economists reckon that Italy in fact has little scope for cutting rates. Investors demand higher Italian rates than German ones because they are not yet convinced that Italy has shed its profligate past. The currency markets might greet an Italian rate cut by dumping lire, which would wreck Italy’s hopes of joining the single currency in 1999.

Of course, Italy might yet be persuaded to delay adopting the euro. That would suit the Bundesbank, which likes to point out, indelicately, the problems of “large, heavily-indebted countries” joining the single currency at the outset. Alternatively, Italy might be forced out. If, say, German interest rates climbed steeply and Italy was forced to raise its own to maintain the lira’s stability, its budget deficit would rise. The risk that Italy might not qualify for the single currency straight away partly explains why the market still predicts a gap between Italian and German rates in 1999.

As for France, its short-term interest rate is close to Germany’s, at 3.4%. If Germany raises it rate, the French would have to follow to keep the D-mark/franc exchange rate stable. But the French government desperately wants to keep interest rates as low as possible for as long as possible. The country’s economy is among the most sluggish in Europe, and its recently elected socialist government has promised hundreds of thousands of new jobs. Its chances of cutting its budget deficit to below 3% of GDP are already slim. In the past, France and Germany have been the closest of allies in the EU: German interest-rate rises, however, would furrow French brows.

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