Countdown to EMU: Huge questions still need answers on Europe's monetary `big bang'

In the first in a series of weekly reports `The Independent' assesses market perceptions of prospects for EMU; 365 Days to go

In just 656 days, European countries plan to lock their exchange rates, abandon their currencies and commence a great monetary experiment that will affect economies and financial markets across the developed world.

But huge questions remain to be answered. Who will be in and out? How strong or weak will the new currency be? Will it work in practice, or is it so badly designed that it could collapse under its own contradictions?

Each week the Independent will review these questions in the countdown to EMU. We will follow the changes in the financial markets, and publish the results of our regular poll of European analysts - the people who follow the week-by-week developments in most detail - on EMU's progress.

The graph (see right) that we will update each week shows the latest financial market views. Over the past two years traders have been betting on a broad-based EMU beginning at the end of the century.

Since 1995, long-term interest rates in Italy, Spain and Ireland have converged towards German interest rates at an astonishing rate. But the past few months tell a very different story. Rumours of delays and new jitters about the state of the Italian economy have increased the volatility in European bond markets. Moreover the trigger for a sudden change in the markets is as likely to be some new piece of economic data as it is a statement of intent from a politician or banker.

Bruce Kasman of JP Morgan said: "The German government has placed great emphasis on the Maastricht criteria partly to convince the German public that EMU will be strong and fiscally prudent, but also to draw a line between countries that should be in or out." As a result, European statistics which provide clues about how close each country will come to the Maastricht criteria have become extremely important to the markets. But it is no longer clear that the criteria will be enough to distinguish between Germany's preferences.

Stephen King of HSBC James Capel said: "The chance of Germany making the Maastricht deficit criterion has fallen." German unemployment figures last month increased fears that it would not be able to bring borrowing down, and might itself fail the Maastricht deficit test of 3 per cent. Should that happen, and should Spanish and Italian borrowing come in at a similar level, it will be politically much harder to keep Spain and Italy out.

However, letting them in - especially if they all fail the Maastricht tests - raises the chance of the German public rejecting the entire project, as well as making EMU a more risky economic project.

Spanish inflation this week was much lower than expected, leading Mr Kasman to conclude: "We think Spain will be in and Italy will be out."

But while confidence in Spanish entry has increased, analysts are more dubious about Italy. Italian bond and currency markets have been particularly jittery as a result.

Philip Chitty of ABN Amro said: "We expect that it will still be possible to draw a distinct line between the core European countries on the one hand and the Mediterranean countries like Italy and Spain on the other. We are far from convinced that Spanish and Italian convergence is sustainable."

Within the past two weeks, new data on the German economy suggests the economy is picking up after all, putting the Maastricht limit within reach.

Graham Bishop of Salomon Brothers said: "If Germany can't get its government spending down it will look as though it lacks the political will. And that could trigger a political crisis across Europe."

The political statements and the economic statistics of the next few months could have a huge impact on the direction in which Europe heads.