The Finance Vigilantes Are Closing InBill Javetski
Depending upon whom you talked to, the European aftermath of Mexico's peso crisis was either a triumph or a disaster. At their monthly meeting in Brussels on Jan. 16, Europe's finance ministers congratulated themselves on how well their currency markets had weathered the storm. French Economy Minister Edmond Alphandery even said optimistically that the European Union could achieve monetary unity on schedule by 1997.
Meanwhile, in London, Swiss Bank Corp.'s head of global foreign exchange thought just the opposite. After watching the financial markets hammer Spain, Italy, and Sweden--calming down only when the U.S. announced it would bail out Mexico--Andy Siciliano saw worse to come for the EU. "Bringing together Europe's disparate economies will never happen," he said flatly.
Indeed, the recent turmoil seems to prove that the financial vigilantes are closing in on Europe's economic weaklings. As they did during the currency crises of 1992 and 1993, traders are piling into the mark and fleeing weaker currencies. But this time, instead of simply attacking overvalued currencies, they are voting against high levels of public debt and stagnant fiscal policies in Europe's more profligate nations. The demands are clear: Unless heavily indebted countries such as Italy and Spain begin addressing structural problems and easing inflationary pressures, investors will desert them, causing another currency meltdown. Says Peter Praet, chief economist at Generale de Banque in Brussels: "What the market is telling European governments, and what is not being understood, is that it wants the welfare state reformed."
Liberal spending on social programs, from unemployment benefits to health care, is a time bomb for all of Europe--even Germany. After years of taking ever bigger bites of workers' paychecks, governments will find it much more difficult to tax their way out of their budget problems. About 45% of gross national product in France and Germany already goes into taxes, and many Italian wage earners see less than half of their paychecks. So the markets are cracking down on countries that can't or won't stop living beyond their means.
WIDE GAP. As investors continue to favor the most solvent and reform-minded countries, the threads that hold together the EU's crowning achievement--its single market--could begin to unravel. Over time, chronic currency and bond weakness could even split Europe into two ranks of countries: those that adapt to and thrive in an open global economy, and those whose balance sheets classify them with the emerging markets.
Already, investors are demanding fat risk premiums from countries whose policies foster inflationary spending. Long-term money in Italy and Spain costs almost 500 basis points more than in Germany--nearing the 600-point spread between Mexican government bonds and U.S. Treasuries.
The gap between European haves and have-nots is likely to get even wider soon. With Germany's economic recovery further along than its neighbors', most analysts believe the Bundesbank will raise interest rates by midyear to keep inflation at bay. That will put pressure on the other EU nations to keep up. But raising rates in countries that are only now emerging from recession could choke off growth --and pump up the deficits of Spain, Italy, and Belgium even further.
Besides pressuring interest rates, sinking currencies are having an instant effect on Corporate Europe. As Italian and Spanish exports get cheaper and cheaper, they force the entire trading bloc into a price war. Prices in Germany and France are "adapting themselves to the lower prices in Spain and Italy," rather than the reverse, complains Jean-Franois Phelizon, chief financial officer at French glass and building materials maker Saint-Gobain.
SCRAMBLING. Italy may be the most dramatic example of a country pushed to the brink. A crisis of political confidence drove the lira to a historic low against the German mark before the naming of an emergency technocrat government on Jan. 16 calmed the markets down. Now, Acting Prime Minister Lamberto Dini is in a race against time to overhaul Italy's costly state pension scheme and rein in the 1995 budget deficit. Although trade unions and the business community applaud his agenda, former Prime Minister Silvio Berlusconi could make it tough for Dini to push debt-busting measures through Parliament before another election is called.
Other European governments, from Lisbon to Helsinki, are scrambling to improve budget numbers. Sweden in early January unveiled a four-year budget program intended to cut $15 billion, or 7% of gross domestic product, from annual state outlays to stabilize state debt. In Spain, the scandal-wracked government of Prime Minister Felipe Gonzlez on Jan. 13 approved a belt-tightening package intended to cut $1.1 billion in spending. Madrid also bowed to market pressure by announcing it would immediately begin planning the 1996 budget, months ahead of schedule.
But such steps fall far short of the spending cuts the markets are demanding. As a result, the costly 365-basis-point spread between Swedish and German bonds is likely to grow, figures Bo Engstrom, Stockholm analyst for James Capel & Co. He also thinks Swedish bonds and the krona will get pummeled again as the minority government tries to push the package through Parliament. And while Ford Espaa Managing Director Alain Batty calls the Spanish government's plan "important," he worries that it "won't change the overall environment," which he characterizes as "a lack of confidence" in governments around southern Europe.
In this environment, Germany looks more and more like a safe haven. Its budget deficit this year will fall to 2.4% of GDP, roughly its level five years ago. By comparison, France's deficit has swelled to 5% of GDP, nearly three times its 1990 level. Yet serious action on addressing the French deficit is on hold until after the May 7 final round of presidential elections. Prime Minister Edouard Balladur, the almost certain winner, has promised to encourage hiring by reducing employee health care and welfare charges that companies pay.
DELICATE PHASE. But one official at carmaker Peugeot dismisses as "campaign talk" Balladur's claim that he'll balance the cost of picking up those payments--at least $2.5 billion in the first year--by trimming government spending. Instead, this official thinks Balladur will try to hit taxpayers again. That's sure to be counterproductive, threatening the delicate consumer phase of what has so far been an export-led recovery. The result: a "very bad" second half of 1995, says the official, who sees growth in Western European car sales slowing to 3% this year, down from 5.9% last year.
Slower growth could get downright dangerous. Lehman Brothers Inc. analyst Keld Holm estimates that if the EU's GDP growth averages 2% per year for the remainder of this decade, its budget deficit will actually be 10% higher in 2000 than it is today. As a result, he says, "it won't take a recession but only the signs of a slowdown" for markets to push up the risk premium for much of Europe in what he says will be a "nightmare scenario" of lower revenues, higher debt, and rising interest rates in some weaker EU members.
At that point, European governments will have no choice but to reach for an old-fashioned remedy--inflating their currencies--to reduce their debt burden. That might kill once and for all the idea of a broad monetary union in Europe. Between the two versions of reality offered by Europe's politicians and the global capital markets, there's no doubt where the odds lie.