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spikegifted - The UK and the "Euro Decision" (June 9, 2003)


The UK's love-hate attitude towards the Euro...

On June 9 2003, the UK government delivered its latest assessment on the UK's entry to the European Union's common currency - the Euro. As usual, for anything that is related to the European Union, this was a heavily contested political point-scoring occasion. Out of the three major political parties represented in the UK parliament, only the smallest of the three was completely united in favor to joint the Euro. The other two major political parties are completely split with relations to the Euro. Lots of politicians are making lots of political noise, but this should not be the case. For the UK, the decision on whether to join the Euro should strictly be an economic one.

When the Labor government was elected into office, the Chancellor of Exchequer set out five economic tests (or conditions) which would be used to determine whether the UK is economically ready to join the Euro. Furthermore, by outlining these five tests, the Chancellor has isolated the economic issues from the political issues, which have the tendency to bring all kinds of unnecessary emotions to the debate. The announcement from the government, based on the assessment of whether the UK has satisfied these five conditions is therefore purely an economic one. Since I am not a politician and I try to present my arguments from an economic perspective, the prevailing political debate will not be addressed.

So what are these five economic tests? These tests deal with the convergence, flexibility and competitive position of the UK economy relative to the Eurozone. In all, they deliver a view of whether the UK, upon jointing the Euro, is in a position to maintain its economic and commercial positions within the Eurozone, both in the short- and medium-term. The five tests are as follow:

1) Convergence with the Eurozone;
2) Flexibility to adapt;
3) Impact on jobs and economic growth;
4) Impact on the financial services sector; and
5) Impact on investment.

Convergence with the Eurozone
The first result of joining the Euro means that the Bank of England will no longer have the power to set the interest rate in the UK, the power will be transferred to the European Central Bank (ECB). The ECB bases its interest rate decisions on the overall economic health of the Eurozone with particular emphasis on keeping inflation low. Despite many years of prudent management of monetary policy in the country, the UK inflation rate is still higher than that of the major Eurozone countries - France and Germany. However, countries like Ireland and Portugal are enjoying far superior growth in comparison with other EU countries and their inflation rates are higher than that of the UK. Given that the ECB sets on interest rate that applies through the Eurozone, its decision is always made based on the economic development throughout the Eurozone. Currently, and this has been the case for the past few quarters, the Eurozone interest rate is too high for slowing economies like France and Germany where the relatively high interest rate is stifling investment. On the other hand, this same interest rate is too low for fast expanding economies and is failing to slow down the expansions to a more manageable and sustainable pace. Given that the UK will be joining this single interest rate environment, UK's economy has to be 'in sync' with the majority of the Eurozone economies and if the UK interest rate environment is significantly different from that of the Eurozone, this will put terrible stress on the economy. Over the past few years, the UK interest rate environment has been moving closer to that of the Eurozone. However, one significant difference remains - mortgage or more precisely - the housing market's sensitivity to interest rate changes. The UK has the highest property owner occupation rate in the EU. However, unlike the majority of the Eurozone (and the US, for that matter), the UK mortgages are typically variable rate mortgages, which leads to this sensitivity. There are both political and economic consequence to this sensitivity. The political side is due to the negative sentiment from the borrowers, while on the economic side arises due to the reduced spending power of these borrowers. Since the end of the recession in the early 1990s, the Treasury and the Bank of England have together done a excellent job in guiding the UK economy to a relative position of health. However, structural reform of the housing market has not been carried out. Without this reform, the UK will not achieve the necessary degree of convergence with the Eurozone and without that the long-term prospect of economic growth cannot be secured under the single currency environment. This condition has not been met.

Flexibility to adapt
In joining a single currency, and hence a single interest rate environment, the UK will be put into a position where decisions of the ECB may not be compatible with the needs of its domestic economic development. Incompatibility will lead to stress and strain in the economy. It is therefore essential that the UK economy and its economic policies have the flexibility to adapt to these incompatibilities. Based on economic theory, one of the requirements to achieve low unemployment is a flexible labor market. Since the 1980s, the UK labor market has been gradually liberalized, to the extent that it is significantly more flexible that those in the Eurozone. If the evidence in existing EU members is taken into consideration, reforms in the Eurozone labor markets are proceeding slower if at all. This should provide the UK with a strategic competitive advantage. However, as always, there is an Achilles' heel and again it is the housing market. Again, the UK housing market does not exhibit the kind of flexibility required to withstand an incompatible interest rate regime dictated by the ECB, which in turn put great strain on the UK economy. Until the behavior of the UK mortgage borrowers changes, the UK will not have the kind of flexibility required to thrive in the single currency environment. This condition has not been met.

Impact on jobs and economic growth
The very existence of the EU is the result of desire to create an European common market, where trade barriers are removed and hence promote economic activities between member states. The breaking down of trade barriers can only ease cross-boarder activities to a certain extent since the transaction cost of converting from one currency to another remains. The constantly fluctuating exchange rates between various currencies within the common market did not encourage cross-boarder competition either. The introduction of the Euro removed the most significant hurdle which hindered the expansion of inter-state economic activities. Apart from the 'Euro-sceptics', who base their arguments largely on emotional and political grounds, there is little disagreement with regards to the long-term economic benefit of the UK adopting the Euro. Although there exist a large difference of opinion as to how much benefit is directly attributed to the act of joining the Euro, most economists agree that it will be 'significant' as oppose to 'negligible' or 'dramatic'. This is the result of increase cross-boarder activities between the UK and the rest of the Eurozone. Higher trade means higher economic activities, which in turn translate to higher earnings and an improved skill base within the country. All this is good news for the UK, however there are some short-term stresses and strains which, if not overcome quickly, will lead to continual structural problems in the UK economy. If the UK were to join the Euro today, without achieve a sufficiently high level of economic convergence (including inflation, interest rate, economic and business cycles and the housing market) with those already in the Eurozone, interest rate in the UK will be dropped to the significantly lower level set by the ECB. This would lead to a surge in the housing market and a consumer boom which in turn could lead to a bust somewhere down the line. This was the case for the UK in the late 1980s and early 1990s, during the 'EMU experiment' - home owners found their interest rates were rising at a time when the UK economy was slowing down. Higher borrowing rates (mortgage and loan rates) led to lower disposable income at a time when homeowners needed it most. The UK was in need of lower interest rates to lessen the effects of a housing crash but was not able to deliver due to the lack of independent monetary policies. The result was a long and deep recession. The government's own assessment that one-off economic events can have prolonged impact on the country's economy. The effect on the labor market would mean a sharp rise in unemployment which can persist for many years. As the current situation stands, the UK economy is not sufficiently adapted to handle these kinds of stresses and strains. Moreover, the current interest rate setting procedures of the ECB and the EU's 'Stability and Growth Pact', which limits a government's ability to borrow, do not provide the UK government the tools necessary to deal with the shock of joining the Euro. This condition has not been met.

Impact on the financial services sector
The financial services sector is a significant contributor to the UK's economy which is why the UK government has singled out this sector as part of its five economic tests. On the wholesale sub-sector, the UK has a leading position in Europe all the major indicators - cross-boarder bank lending, foreign equities turnover, foreign exchange trading, etc. What is key is that, according to the Treasury's study, there would be little or no negative effect on London's position as Europe's leading financial center. On the contrary, by joining the Euro, London may be able to consolidate its position as investments that are being withhold due to uncertainty on the UK's position in relation to the Euro will be removed. On the retail side of financial services, there is little impact on whether the UK remains outside the Eurozone or not, as customers already have the ability to have access to invest in assets outside their 'home' currency. However, by joining the Euro, psychological barrier of a national currency will be removed. Based on the government's own studies, the Eurozone is so diverse that real cross-boarder competition is often hampered by a range of cultural, regulatory and political barriers. Finally, there is one area that will certainly benefit if the UK were to joint the Euro - policies. Although the UK already has a strong influence on EU financial services policies thanks to the size of the London market, being part of the Eurozone may enhance the UK's ability to influence EU policies. On the whole, London has demonstrated its ability to compete successfully outside the Eurozone and the act of joining the Euro will have little or no effect on the UK's financial services industries. This condition has been met.

Impact on investment
In comparison with their Eurozone counterparts, British companies invest relatively little into the domestic economy as percentage of GDP. Debt is the main investment financing vehicle which drives investment. While the large British companies already have access to the deep Euro investor market, small- and medium-sized enterprises (SME) are restricted by the small investor base of the sterling market. On entry into the Eurozone, the large SME will be able to tap into that very same investor base which is currently only available to the large companies. Additionally, the Euro entry will remove the significant currency uncertainty which SME, which rely on Eurozone import and export to survive, are not in position to fully hedge out. By removing this currency risk, the act of joining the Euro could signal a surge of investment into the domestic market as investment decisions would be made purely on economic grounds and not having to worry about currency uncertainty. In the long run, the UK economy will benefit from the additional investment and hence improve the overall efficiency of the economy. However, joining the Euro will not diminish British companies' exposure to volatility to the US dollar and other US dollar-linked currencies and that is a significant factor as a significant portion of UK export is to those countries. All the talk of creative an attractive investment environment when the UK joins the Eurozone will have little effect if the UK's economy has not achieve a sufficient level of convergence with the Eurozone. If the UK were to join the Eurozone at a time when convergence is not achieved, the single interest rate environment will bring higher level of economic volatility (see Convergence with the Eurozone condition) which in turn will make the UK less attractive for investment, both foreign and domestic. Additionally, the prospect of lower long-term interest rates is not an argument that currently holds much water as there is little evidence that long-term interest rates in the Eurozone will be lower than that of the UK. In the end, how much the UK can benefit by joining the Euro will depend on the level of convergence with the Eurozone as well as the exchange level at the time of joining. If the decision is taken at a time when both of these are favorable to the UK, then its economy and its ability to attract investment will benefit. However, if the decision is taken without the necessary convergence and the exchange rate too high or too low, the UK economy will suffer for a long time thereafter. This condition has not been met.

So, with four out of the five conditions not met, there is little argument on whether the UK is ready to enter the Euro. However, the Chancellor of Exchequer has promised to revisit these tests again in a relatively short time-frame - between 12 to 18 months. Given that the reasons for the UK economy not meeting these conditions are deep-seated structural ones, it is unlikely to have change significantly over the next 12 to 18 months, even with wide-ranging policy changes promised to encourage the economy to change and adapt. It is unrealistic for the Chancellor to expect the UK economy to change overnight (on an economic time scale) and it is even more unlikely that changes on the European side to happen any quicker. Given that the five economic tests are set to determine the UK economy's readiness to join the Euro and the economy is clearly not achieved the level of readiness required to handle the shock of Euro entry, the UK is clearly not ready to join the Euro for the foreseeable future. It is, therefore, of little significance for politicians to argue about the Euro, since political argument is irrelevant until the UK is economically ready.


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