New EU agreement behind fall in euro

THE euro fell against the dollar last week, partly because of rising US interest rates, but also due to an agreement struck by EU finance ministers last weekend.

Consensus has finally been reached on the reform of the stability and growth pact (SGP) which governs the spending and borrowing of Eurozone member states.

Under the old SGP, member states were required to keep budget deficits under 3% of national GDP, with limited exceptions.

If a member’s budget deficit exceeded this limit, the commission had the power to impose penalties, although such action has never been taken, despite the fact that several members ran excessive budget deficits in recent years.

Reforms agreed last weekend proposed that such members ought to be allowed an extra five years (penalty free) to correct deficits in future, and in a potentially more serious development, finance ministers also agreed that certain spending costs relating to the ‘unification of Europe’ ought to be excluded from deficit calculations.

This is a clear concession to Germany, which has struggled in recent years under the burden of Eastern unification costs, but it leaves the door ajar for other member countries to petition for spending exemptions. Italy, for example, might in future argue that spending in its underdeveloped southern regions should count as ‘unification’ spending.

So what does it all mean? It’s clear that currency traders disapproved of the proposed amendments, since the euro weakened when the measures were announced, but the longer-term implications of looser fiscal policy across the eurozone are serious.

If governments are set to spend and borrow more, then Eurozone credit conditions might suffer as a result. Our interest rates are historically low, partially due to the existence of the SGP, and the reassurance it gives to bond market creditors (that inflation is unlikely to rise sharply in an environment of controlled spending).

Essentially, if governments are about to increase their spending by borrowing more in bond markets, then the Eurozone’s money supply will accelerate, and inflation will rise. And the ECB has previously voiced its opposition to any dilution of the pact, so these amendments, if approved, could bring forward the timing of an inflationary preemptive ECB rate hike.

Predictably, the ECB has muted its criticism of the politically brokered amendments to the pact. However, other commentators have been less reserved. Last Friday, the Governor of the Bank of England, Mervyn King, claimed it was clear that the ECB was ‘dismayed’ by the proposed pact reforms.

Pact reform was inevitable, since in its previous form, the pact was hindering the economic recovery of an entire continent. However, the reforms agreed early last week give too much spending leeway back to governments, and wrestle too much control away from fiscally prudent bankers. Higher interest rates will almost certainly follow as our Central Bank struggles to offset the inflationary impact of increased spending, and we now look for rates to rise to 2.50% by year-end.

The views and opinions expressed in this article are those of the author and do not necessarily correspond with those of Ulster Bank or any other member of the RBS Group.