Euro needs more stability

The EU is expected to confirm that Germany breached the government budget deficit limit of 3% of GDP in 2003 this week, which would follow a statement last week requesting France to take measures to reduce its proposed budget deficit of 3.6% in 2004.

Tony Norfield, global head of FX strategy at ABN Amro in London, said that though several non-euro countries, including the US and UK, have looming budget problems, these breaches still represent a negative impact for the euro. "The argument against this having any impact is that the stability pact doesn’t make economic sense so it shouldn’t cause problems," he said. "However, it is a rule breach and therefore can damage investor confidence."

Chris Gothard, FX strategist at Brown Brothers Harriman in London, agreed. He said the breaches highlight the historically poor management of the European economy by both the EU and individual countries. However, "some also see this as a good thing, as both France and Germany are flirting with recession", and by ignoring the rules they are showing "a bit of common sense", he said.

The EU Commission statement on France, issued last Tuesday, delayed the deadline placed on reducing the budget deficit from 2004 to 2005. It is this move, in addition to the fact that 2003 already represents the third year of breaches for France that "makes a mockery of the pact" said Neil Mellor, currency strategist at the Bank of New York in London.

Mellor added that this is the first time the rules have really been tested, and the willingness by the EU to allow the breaches will encourage other countries -- such as Italy, which struggled to meet the restrictions at the start -- to follow suit.

The impact of the budget deficit limit breach has so far been limited by market focus on quarterly earnings announcements and on Japan. The background of the general US dollar sell-off over the past few months has also limited the effect.

More threatening for the euro is the effect this may have on the bond market, said Norfield. Foreign money inflows to the eurozone have been based on investment in the bond markets, over equities, and these breaches make bonds look less attractive, he said.