Nov. 26 (Bloomberg) -- Europe may face the threat of higher interest rates after Germany and France won permission to violate budget-deficit rules, prompting the European Central Bank to warn of ``serious dangers'' for the euro. Germany and France, the two largest of the 12 countries using the euro, overrode objections from four countries including Spain and blocked calls for further savings at a meeting of European finance ministers in Brussels yesterday. Both countries plan to cut taxes to boost their economies. ``A conflict between a majority of finance ministers and the ECB raises the risk that a first ECB hike may come a little earlier than otherwise,'' Holger Schmieding, an economist at Bank of America in London and a former adviser to the International Monetary Fund, said in a note to investors.
ECB council member Nikos Garganas said yesterday higher interest rates will be among ``the first symptoms'' of the EU decision to give France and Germany an extra year to rein in their deficits. Rates at a half-century low are helping the region's economy to recover after shrinking in the second quarter. Investors expect the ECB to boost interest rates toward the middle of 2004, futures trading shows. The yield on the three- month contract maturing in June is 2.52 percent, compared with a money-market rate of 2.15 percent.
Test for Trichet
How the central bank responds will pose an early test for its new president, Jean-Claude Trichet, who said five days after taking over from Wim Duisenberg on Nov. 1 that the budget rules were already stretched ``to the limit.'' As French central bank chief, Trichet built his reputation on persuading President Jacques Chirac to pursue the low-inflation, low-deficit policies needed to win a spot in the monetary union when it began in 1999. Yesterday Trichet summoned the 18-member policy council onto a conference call to warn that the Brussels deal ``risks undermining the credibility of the institutional framework and the confidence in sound public finances.'' To be sure, the consensus-seeking central bank is unlikely push up borrowing costs before the end of the year because the dollar's drop to record lows against the euro may sidetrack the recovery, analysts said. The bank next meets to set interest rates on Dec. 4. Widening deficits haven't so far undercut the euro, which reached a record of $1.1978 last week. The dollar has fallen on concern about the U.S.'s ability to finance growing budget and current account deficits. The euro bought $1.1807 at 7:40 a.m. Frankfurt time.
Threat of Sanctions
The $8 trillion economy will grow 0.4 percent in 2003, the European Commission estimates, the slowest pace in a decade. It predicts growth of 1.8 percent in 2004, less than half the 3.8 percent pace expected in the U.S. Backed by six countries, Germany and France blocked calls for tougher austerity measures and won permission to keep their deficits above the legal limit of 3 percent of gross domestic product for the third year in 2004. Threats of sanctions leading to fines were put in ``abeyance'' for Germany and France, the ministers said in a statement. The non-enforcement puts the EU's stability pact in the ``in the refrigerator,'' said Gerrit Zalm, Dutch finance minister. Zalm is planning 10.9 billion euros ($12.9 billion) of spending cuts next year to staunch a widening deficit in the Netherlands. Now the rules are ``seriously amputated,'' said Gunnar Lund, international economics minister from Sweden, where the debate over double standards for big and small countries contributed to voters' rejection of the euro in September.
Pensions, Welfare
Germany and France argued that their deficits are being pushed up by the short-term costs of overhauling the pension and social welfare systems, saying public finances will be all the healthier in the long run. France won permission to cut next year's deficit by 1 billion euros, less than the 6 billion euros demanded by the commission. Germany stood by previously announced cuts of 13 billion euros, less than the 17 billion euros called for. Both will be over the deficit limit of 3 percent of gross domestic product for the third year in 2004. ``We have changed from a rule-based system to a political- based system,'' EU Monetary Commissioner Pedro Solbes said after his recommendations were thrown out. He spoke of ``far-reaching consequences'' for the enforcement of the rules.
`Risk Premiums'
Differing interpretations of the rules by the commission and governments may be dissuading bond investors. The extra return demanded by investors for holding German instead of U.S. 10-year bonds rose today by 5 basis points to 23 basis points, the widest since July 11. ``It casts doubt on the credibility of fiscal policy, and it will lead to risk premiums,'' said Ulrich Kater, an economist at Dekabank in Frankfurt. The chairman of yesterday's meeting, Italian Finance Minister Giulio Tremonti, responded: ``I don't see the problem.''
All euro governments originally promised to get their budgets ``close to balance'' by 2002. Only seven of them --Belgium, Spain, Ireland, Luxembourg, the Netherlands, Austria and Finland -- met that goal. ``The first symptoms will be an increase in interest rates and weakening of the euro,'' Garganas said in Athens. Violations of the budget rules ``will put the cohesion of monetary union at risk.''//www.bloomberg.com