The beacon of European integration can never be turned off by a nation with Germany's history, as Herr Kohl has made clear in recent comments. But there is a dimmer switch - delaying the start of European economic and monetary union (Emu). Once that happens, the whole thing will unravel, and markets will return to looking at each country's individual economic merits.
Which brings me to the UK. There are two judgements central to portfolio investment in the UK. The first is whether UK financial assets benefit more from Britain being inside or outside the Emu system. The second is whether future UK economic policy will break from the mediocrity of the past and provide a disinflationary platform for gilts and strong corporate profits.
At present, European countries are judged by financial markets largely on the assumption that the third stage of Emu will happen, and whether or not a particular country is included. Ironically, the UK is one of only three countries likely to meet the Maastricht criteria for monetary union by the cut-off date of 1997. But markets assume that the UK will invoke its Emu opt-out, just as it has done with the social chapter. So it will be left out in the European cold to fend for itself against a strengthening family of continental European states, and so will be forced to devalue sterling to compete.
But a postponed Emu could sing a different tune. Then markets will start to judge the UK economy on its own merits, rather than on the risk of its being left out of the single-currency project. And markets will realize that the current risk premium built into the price of gilts and sterling is excessive.
Also, I think that the power of the markets to curb irresponsible and politically expedient policy means that the ugly days of boom and bust in the UK are over. While the rest of Europe remains caught in a straitjacket of deficit reduction, rising joblessness and growing social tension, the UK is quietly turning its old reputation on its head. Unlike the UK,
dirigiste France does not enjoy a supply-side, liberalized economy.
So when Emu is postponed, and France opts for growth and jobs by devaluing the franc, that will feed directly into French inflation and at least double the risk premium on French bonds.
By contrast, I think UK gilts are one of the few cheap bond markets in Europe, and yield spreads over German Bunds should narrow from 150 basis points (bp) today to between 70bp and 80bp. And if I am right about faster growth in Germany than the consensus expects and a reversal of the easing of interest rates by the Bundesbank, that would hit countries with high debt, as their servicing costs grow in line with rapidly rising interest rates. The UK, with forecast public debt below 55% of GDP in 1997, would look relatively good. The markets are still worried that increased UK growth could eventually feed into rising domestic inflation. But in the disinflationary environment of the 1990s, it's very hard to pass on cost increases to the con-sumer. And UK wages remain under control, with average earnings growing in line with prices, while the speculative housing market is still subdued. Moreover, the Conservative government appears to have resisted the temptation to go for unfinanced tax cuts that could mess up plans to cut the budget deficit. The 1996 budget errs, if anything, on the side of caution. And even with a change of government, I don't believe that "New" Labour would be fiscally irresponsible under the discipline of global markets. So a "cut-and-run" policy is what I expect to see only on the other side of the Channel
.There are longer-term reasons for looking favourably on the UK. These are based on the growing shift towards corporate globalization of trade and investment - a theme I shall return to in future pieces in this column. In the last 20 years, US corporates have migrated to big new markets and cheap labour areas, away from a relatively expensive domestic production base. Where the US leads, it seems, the UK follows. In 1993, the UK's stock of outward foreign direct investment was equivalent to 24% of GDP. That's more than twice the level in the US, Germany or Japan. This shift toward corporate globalization means that the UK equity market reflects more than just the domestic economy. It makes UK companies inherently attractive as global investments. And they're cheap.
Of course, the process of de-industrialization in the domestic economy means a lot of pain for the victims of rationalization. But the UK and the US have already completed this process. They no longer qualify as industrialized economies, as their domestic manufacturing sectors contribute less than 20% of GDP. Their service sectors predominate. In the UK, services are now almost as important an influence on overall employment as in America. The pain of de-industrialization has still to come in those countries, while the UK has had its catharsis.
However, what's good for the Anglo-Saxon corporate sector ain't necessarily so for the national accounts. UK corporate globalization and the rising share of GDP from services (traded far less than manufactures) will make it difficult for the UK to maintain a balanced current account and thus a strong currency. But because so much of UK corporate activity is glo-bal, currency fluctuations need not affect corporate competitiveness - or under- lying profit forecasts - too much.
Longer-term, achieving stable sterling will need a higher domestic savings rate. To get the savings rate higher, government must do its bit. But, as long as the UK government keeps chiselling away at its budget deficit over the next four to five years, the savings rate will probably rise, as I don't expect households or corporations to save less.
An efficient corporate sector has other benefits. As chancellor of the exchequer Kenneth Clarke has argued, when you invest in UK business you are now investing in a leaner machine than ever before. In gross terms, (dollar-denominated) manufacturing labour costs in the UK are 21% below those in the US, 44% below those in Japan, and half of those in Germany. Yet technology is on a par.
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