What’s next in EMU after Greece deal?

March 26, 2010

Jane Foley-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

The European Union has finally agreed that an Economic and Monetary Union member country in serious fiscal difficulties will be able to receive bi-lateral assistance from its Eurozone partners as well as draw support from the International Monetary Fund.

Following weeks of discord, it had become politically important that there be a show of unity on how to deal with fiscally errant members.

In this sense the announcement of an agreement was an important step in the right direction.  The proof of the pudding is in the eating, however.

Greece still has to sell a significant amount of debt in the open market this spring and the EU will be hoping that Greece, never mind Portugal or Spain, will not have to tap its EMU partners for a loan.

Greek bond spreads tightened in response to news of the support mechanism, though the initial move in the longer end of the curve was half-hearted with the 10 year still yielding over 300 bps over bunds.

Similarly while the euro performed well after the announcement, EUR/USD has only retraced a small part of its recent falls.   The Greek debt office will almost certainly have to announce another bond sale in the coming weeks.

Not only will this sale be a crucial test for Greece but it will set the scene as to what happens next in the EMU.

A poor response to the sale will raise the likelihood that Greece will be forced to ask for financial assistance and Germany, despite recent protests, is likely to be the biggest contributor under the new support plan.

Poor results in the next Greek bond sale would also increase the risk of contagion to Portugal and this could intensify the pressures on the new support mechanism, on EMU and on the EUR.

Whatever happens in the forthcoming Greek bond sale EMU countries will have to acknowledge that their fiscal Stability Pact is inadequate.

The formation of “economic governance” to more stringently police the fiscal management of member nations has already being flagged.

For many years EMU successfully sidestepped the long-standing argument that monetary unions in general could prove unsustainable without fiscal union.

Doubts as to the integrity of EMU have recently been gaining more momentum and not purely as a result of the problems in Greece.  Germany is also being blamed as being partly responsible for adding to the pressures within EMU.

By maintaining downward pressure on wage growth and conservative fiscal policies (which have contained domestic demand) Germany has built up trade surpluses which are now considered potentially destabilising for EMU.

In order to match Germany’s competitiveness, a country could cut wages or it could devalue.  Alternatively, Germany could sour its competiveness by revaluing which would relieve some pressures on its struggling Eurozone neighbours.

Clearly the options of revaluing/devaluing are not available to a Eurozone country.  This turns the focus on wage costs.

The Irish last year cut some civil servant nominal wages by 20 percent.  This has boosted the country’s deficit cutting credentials and reined in the cost of funding for the Irish debt office.  Clearly, slashing wages is not an option which would be swallowed everywhere.

Almost certainly many Greek, Portuguese and Spanish workers would rather accept a devalued national currency.  If toeing the EMU line on fiscal policy proves too tough it is still possible that EMU may move forward with a different list of members.

EMU politicians have finally shown some accord over support for struggling members but there may be further hurdles to overcome.  The EUR is not out of the woods.

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