December 14, 1996

Europeans Report Breakthrough in Monetary Union Effort _______________________________________________________________

Common Currency, Uncommon Images
Kohl and Chirac Keep Veneer of Unity on European Currency (Dec. 10)
Infighting Erupts Over Single European Currency (Oct. 2)
Growing Fears in Britain of Single-Currency Isolation (Aug. 22)
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By EDMUND L. ANDREWS

DUBLIN, Ireland -- European leaders reached agreement Friday on how to overcome the biggest remaining obstacle to creating a full monetary union, paving the way to start replacing national currencies like the German mark and French franc a little more than one year from now.

After marathon negotiations here last night among European finance ministers, all 15 countries in the European Union agreed to a "stability pact" that lays out specific terms for enforcing tax and spending discipline on all countries that adopt the new currency, called the "Euro."

The pact resolves a deep philosophical and practical disagreement among European leaders who had threatened to torpedo plans for the Euro. At issue was how to enforce similar fiscal policies -- and staunchly conservative ones, at that -- on nations that have markedly different histories and still jealously guard their autonomy.

The result Friday was a compromise between Germany, whose leaders were determined to extend the rock-solid security of their beloved Deutsche mark, and most of the other countries in Europe, which wanted discretion to handle "special" circumstances.

The effort to forge a common currency represents the convergence of two goals: a political drive on the parts of Germany and France to lead the way to a united Europe and an economic effort to revive confidence and growth by making it easier to do business and raise money across national borders.

The plan may or may not work in practice, and it is still possible that the whole project might ultimately collapse before it gets off the ground. But the almost universal opinion among financial experts as well as political leaders is that the Euro probably will appear on schedule on Jan. 1, 1999, and that at least eight countries led by Germany and France will be among the founding members.

Indeed, European officials also unveiled the official design of the new Euro notes -- brightly colored bills that are the result of excruciating efforts to avoid "national bias." Indeed, the bills are so neutral that they feature no people, no words (except "Euro") and rely on images of majestic bridges and monuments that do not exist.

Largely at the insistence of the British, who have been reluctant to join the currency union but want to be sure that they can keep Queen Elizabeth's head on the bills if they do, there will be room for individual governments to print a small "national symbol" on the currency they issue.

But even the most hard-bitten currency traders now believe that the Euro is real, and the likelihood of its launch has gone from being a weak joke just one year ago to a very strong likelihood today.

Underlying that shift is a serious and dramatic shift in the economics of Europe itself. To an extent that would have seemed unimaginable a few years ago, most European countries have adopted fiercely conservative fiscal and monetary policies that are surprisingly in harmony with one another.

Even Italy, which had been famous for Latin American levels of inflation and haphazard economics, has brought its inflation rate down to 2.6 percent and is making a serious attempt to rein in its runaway debt to qualify for the monetary union.

"You can see the convergence of economic policy which is really quite remarkable," Alexandre Lamfalussy, president of the European Monetary Institute in Frankfurt, said at a recent meeting of European central bankers.

But it is the world's bond and currency traders who are providing the most concrete signals of the Euro's prospects, because they have methodically factored the likelihood of a common currency into their valuations on bonds sold by individual European countries.

As recently as a year ago, for example, France was paying a significantly higher interest rate on bonds than Germany -- a reflection of concern about whether Paris could maintain the strength of the franc. But on three-year bonds, which would come due after the Euro is slated to be launched, that risk penalty has disappeared, according to James S. Fralick, Morgan Stanley's director of European economics. The same risk premiums have all but vanished for most of the other countries considered certain to qualify for the new monetary union.

"A year ago, the European view was that the project was dead," said Norbert Walter, chief economist at Deutsche Bank, Germany's biggest bank. "All of a sudden last summer, people began to talk about it as almost inevitable."

Market analysts generally believe that eight countries will almost certainly take part in the new currency at its debut on Jan. 1, 1999. Those eight are Germany, France, Belgium, Luxembourg, the Netherlands, Finland, Austria and Ireland.

Three other countries -- Britain, Sweden and Denmark -- could probably meet the financial qualifications for belonging to the union but remain skeptical and have made it clear they will almost certainly not join at the start. Meanwhile, countries that nobody expected to meet the tough fiscal criteria -- Italy, Spain and Portugal -- have launched campaigns to qualify for entry that are far more credible than anybody expected just six months ago.

Under terms of the Maastricht treaty adopted in 1991, countries that want to be members of the monetary union must meet a series of tough benchmarks on things like the size of their government deficits, rate of inflation and currency stability prior to joining.

At issue at the summit meeting Friday was how the new European Monetary Union would enforce fiscal discipline on countries that met the entry requirements but later started to get sloppy.

Imagine, for example, if France's deficit abruptly ballooned to alarming new heights and the government increased its public borrowing so much that it threatened to undermine the stability of the Euro against other currencies. With no realistic prospect of throwing a wayward France out of the union, that might represent a frightening plunge toward instability for Germans, who would have already swapped their trusted Deutsche marks for Euros, and would no longer have their own central bank to rely on to keep inflation under control.

Germany initially pushed for huge fines on any country that allowed its deficit to rise above a ceiling set at 3 percent of its gross domestic product, and to have those fines imposed automatically. Most other countries wanted more political discretion, which became a demand for members of the European Council to allow reprieves for countries that slip into recessions.

The battle was over how clearly to defend the exceptions, and where to set the numbers. Several months ago, Germany demanded that only countries that suffered a recession where GDP plunged by at least two percent would be eligible for exceptions, though it later relaxed that demand to declines of 1.5 percent.

The compromise Friday sets stiff financial penalties -- fines of up to 0.5 percent of a country's gross domestic product -- on countries that run big deficits. But, in a carefully nuanced exercise in fudging, the plan also gives countries a chance to plead for a reprieve if their GDP drops by three-quarters of a percentage point. As a tradeoff to Germany for allowing more flexibility, the plan also calls on the European Council to publicly alert countries when they are liable for penalties, in hopes of shaming them into cleaning up their policies.

Though it was clear here today that many nerves were still raw and that Europe is far from bathing in the warm water of mutual trust, officials from all sides pronounced themselves satisfied with the compromise.

"It is more than I expected to get a year ago," said Theo Waigel, Germany's finance minister and the man generally described as the most isolated member of the European community. "The Euro will be as hard as the hardest currencies in Europe," Waigel said.

Market analysts remain skeptical, however. "An agreement will probably lead to a weaker mark and a stronger dollar," said Richard Davidson, the European equity strategist for Morgan Stanley in London.