Emu: No More Ifs Or Maybes
Until recently, it was still fashionable in some European circles to voice doubt about whether monetary union would really happen in 1999. Last week, Germany's central bank put an end to all that. When the Bundesbank raised short-term interest rates and four other central banks instantly followed suit, it was a strong signal that EMU is already a reality in the minds of Europe's financial powers. And the Buba made clear that it will call the shots as financial union approaches. Until a new European central bank is created in 1999, the Bundesbank will be its proxy. "This is the European central bank in operation," says Allison Cottrell, an economist with PaineWebber International (UK) Ltd. in London.
Corporate Europe is already positioning itself for the new reality. In May, governments will announce which countries can enter the new union and set preliminary exchange rates. Between now and then, Continental financial markets will start to radically restructure, as investors and executives anticipate a more level playing field in everything from interest rates to corporate debt ratios to price-earnings multiples in national stock markets.
Meanwhile, greater financial transparency under EMU will reveal inefficiencies once disguised by exchange-rate differentials. New competition, lured by the prospect of a huge, unified, deregulated market, is severely pressuring Europe's banks and insurers, formerly coddled and protected. Hence the spate of European financial megamergers, with some $40 billion in deals announced in mid-October.
Many investment strategists now think the prospect of monetary union will push key elements of financial integration forward by May, well ahead of EMU's official Jan. 1, 1999, kickoff date (table). In the debt markets, it's already happening. As bond investors have come to believe in EMU, 10-year yields in most European countries have converged around Germany's 6% level, even in nations that may not be allowed into EMU at first.
TEMPTATIONS. Clearly, investors like the idea of a new monetary order in Europe, administered by a new central bank that's as hawkish on inflation as the Bundesbank. The bank admits that it weighed "international" factors, as well as domestic economic concerns, in setting German rates. Translation: The Buba wants to stamp out inflation in every potential EMU partner, not just in Germany, between now and May.
It's a tempting environment, and one that's bringing sophisticated new financial players to Europe, especially from the U.S. They are already pressuring traditional European lenders to be more innovative. Nearly 60% of European corporate borrowing is bank debt, but alternatives are springing up. In March, Germany's Siemens issued its first syndicated debt in 25 years, a $1.2 billion, three-way deal denominated in Dutch guilders, German marks, and French francs that shifts into a single euro-denominated issue in 1999. The concept, pioneered by J.P. Morgan & Co., is designed to give borrowers a Europewide investment base ahead of EMU.
And with Bankers Trust New York Corp. leading the way, a Continental junk-bond market is developing for the first time. Companies have done a dozen junk issues, worth about $1.4 billion, so far this year. "That market is going to expand dramatically," predicts Michael Dee, a London-based Morgan Stanley & Co. managing director.
For companies, the benchmarks for financial performance will get tougher. In core EMU countries, exchange rates are starting to move in tandem. As that happens, creditworthiness rather than exchange-rate risk has become portfolio managers' central preoccupation when they evaluate debt issues. Strategists also predict that stock market valuations, such as price-earnings ratios, will converge. At the same time, as EMU forces governments to cut their budgets, Europe's stock markets could keep booming. "The optimistic case is that one can draw parallels between Europe now and the U.S. in the mid-1980s," says Peter Sullivan, European equity strategist with Goldman, Sachs & Co.
With the financial markets already anticipating EMU, the next big shifts are likely to come from governments. EMU-related austerity measures contributed to Italy's budget crisis and are straining Chancellor Helmut Kohl's German coalition. But the biggest squabbles are yet to come. If interest rates come up too quickly, Europe's still fragile economic recovery could choke. And conflicts seem certain when European governments meet next May to decide which countries get into EMU in the first round. But given the financial momentum behind EMU, it looks as if by next spring there'll be no turning back.