Tuesday 24 October 2017

Core of eurozone starting to crack under pressure

Far from the turmoil on Greek streets, a series of subtle developments on European markets this week struck terror into the core of the eurozone and recalled -- in particular for France -- an era of speculative pressures that was only overcome by a decade of hardship ahead of the launch of the euro.

It is as if all the sacrifices of the past were being called into question before a crucial EU summit at the weekend could even consider the future.

An exasperated President Nicolas Sarkozy has raised the spectre of the destruction of the eurozone and protested that France cannot cope on its own.

French frustration is partly due to perceived foot dragging by Germany. The EU summit was already delayed until this weekend so that a "grand bargain" could be struck to deal with the euro crisis -- now Germany is saying we should not expect too much.

The G20 asked for a decisive and "comprehensive plan" to be set before its summit in two weeks -- now Germany is saying the search for an end to the crisis will continue into next year.

Slow progress

Progress is slow and France's ability to influence the outcome is eroding. Any plan that emerges at the weekend will be Germany's.

French policymakers are also unnerved by a regular report from Moody's credit-rating agency, which casts doubts on their "triple A" status.

It said a lower outlook for growth could undermine France's budgetary strategy.

Moreover, there is mounting concern about the size of the contingent liabilities that France might face from potential losses in its banking system (when Greece defaults) and the prospect of increased lending to eurozone countries (should the crisis spread further).

Moody's is essentially saying that France may not be able to play a full part in resolving the crisis -- at least not without greater sacrifice at home (which is very unlikely ahead of an election).

All this has highlighted an inherent danger in the current approach: should France lose its "triple A" rating, the potential size of the European rescue fund would shrink, and the capacity to contain the crisis in the periphery would diminish.

Then, the crisis could spread more vehemently to countries like France at the core and further undermine its capacity to act -- and its "triple A" rating.

France has suddenly realised that in order to prevent this potentially devastating feedback loop from setting off, the eurozone's assistance to the periphery must be big and fast. But it may already be too late.

This concern is driving a wedge between the interest rates on German and French bonds that, this week, reached its highest level since 1992 -- the year the Maastricht Treaty set a timetable to establish the euro.

French 10-year bonds are now yielding around 3.1pc per annum, compared to a return of 2pc on German bonds, and are in danger of moving higher.

Although the amounts may seem small at first, a single percentage point spread on such bonds means that their current values -- their relative prices -- have diverged by 10pc.

And such losses send bond traders running for cover -- inviting further speculation and further divergence.

In 1992, the United Kingdom crashed out of the Exchange Rate Mechanism (ERM) in a speculative frenzy that precluded its participation in the eurozone.

France itself barely survived, of course, and the crisis was just the penultimate episode in a string of such events that saw France expend enormous resources -- and withstand serious economic hardship -- in order to prove it had the capacity and the tenacity to participate in a monetary union with Germany. It was a costly ordeal.

Success in that endeavour was measured in interest-rate spreads and, now, the ghosts of the past are back.

European monetary union was founded on the notion that France would have an equal say in formulating strategy and would enhance its policy credibility by association with a stronger Germany.

This would lead to financial integration and a convergence in interest rates. Germany, on the other hand, would benefit from being able to export more easily to its European neighbours and -- by sharing its strength -- would not cause resentment as its economic power grew.

Now, with interest rates diverging and French credibility on the wane, Germany is increasingly dismissive of French proposals.

German lead

Moreover, European institutions are being gradually left behind as Germany alone charts a path for the future of the eurozone.

And this gave rise to an extraordinary pre-summit warning from Mr Sarkozy that "those who destroy Europe and the euro will bear responsibility for the resurgence of conflict and division on our continent".

So, make no mistake, the stakes are about as high as they can get this weekend.

Jean-Claude Trichet will attend his last summit as head of the ECB and it will be a particularly distressing event for him.

The man who valiantly led "the battle of the franc" in the late 1980s and early 1990s -- and finally succeeded in getting French interest rates and credibility into line with Germany -- could be a lonely witness to the unravelling of his life's work.

Gary O'Callaghan is Professor of Economics at Dubrovnik International University. He was a member of the staff of the IMF and has advised numerous governments on macroeconomic policies.

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