First the UK’s new Labour government dropped hints that it was gearing up to join Europe’s single currency earlier than expected, and before the full launch in 2002. Then it seemed to pull back and suggest that UK entry would not happen in the five-year life of the current parliament. That’s made for continued uncertainty. Financial markets want to know when.
In October 1996 I argued that the UK would eventually have to join the European Union’s monetary union if the new system went ahead. Ever since, I have been advising clients to go long gilts as a spread play to Bunds, and UK equities. The mixed signals coming from the Labour government do not change my view. The UK will join, and ultimate convergence will put its government bond yields below those in France and Germany, and sterling close to Dm2.50.
There are sound economic reasons for the UK to sign up to the single currency. Outside a weak euro area, the UK would lose competitiveness on over half its exports. So jobs would be lost. Outside a strong euro area, the UK would suffer high interest rates – the penalty of a risk premium for living in a financial twilight zone. So there would be a big mortgage and consumer credit burden on households from high interest rates, and there would be low growth in the corporate sector.
Also, there are political forces pushing towards UK entry. Prime minister Tony Blair is an ambitious, charismatic leader who needs a wider European stage to fret and strut the next 20 years upon, selling the hot, new, conservative brand of left-wing politics. The timely death of most of Europe’s elder statesmen will provide just that opportunity. But you can’t be appointed leader of the euro club without first joining it.
We know the UK will certainly not be on board the euro train on January 1 1999 – if it starts then. But there are also many political obstacles in the way of achieving entry by 2002. First, there is the division in the cabinet between finance minister Gordon Brown’s Emu-today thinking and the Emu-tomorrow stance of Blair and foreign secretary Robin Cook. The government’s recent statements of “clarification” have only papered over that split. Second, there is the difficulty of timing and then winning any referendum, in the teeth of opposition from an anti-European tabloid press.
Economically, fast-track convergence for the UK by December 1998 would entail having the same short-term interest rates as Emu candidate states (about 5.2% by then, or 200 basis points below where UK short rates are today). Sterling would also have to get back to between Dm2.50 and Dm2.60 (from Dm2.83 today), which would be a sustainable exchange rate for ERM/Emu participation. Easing monetary conditions so much so quickly would blow the UK’s already overfast economy out of the water.
But there’s nothing to stop Blair announcing Emu membership as a goal of his government – subject to the outcome of a referendum. And public opinion polls reveal how pragmatic, rather than how viscerally anti-Emu, the British are.
With a little more time, the pace of economic growth in the UK should slow and enable it to enter Emu more smoothly. Sterling will fall back against European currencies. Downward pressure on the pound will come from a widening trade deficit as import growth continues to accelerate, while exports fade. Additionally, pre-emptive monetary tightening by the Bank of England and slowing consumer spending will bring real GDP growth down to an annual rate of 1.5% by the end of 1998. So the Bank of England will keep interest rates stable at a time when faster growth in continental Europe forces up interest rates there.
UK retail inflation will subside accordingly, while inflation accelerates in Germany. Thus the relative inflation differential will narrow, and with it the yield spread between UK gilts and German Bunds – to 60bp by the end of 1998 even if the UK stays out of Emu.
Sterling will weaken to Dm2.60 by the end of 1998. That’s because the trade and current accounts will deteriorate further over the next years and the UK’s short-term interest rate differential over Germany will narrow.
Sterling began to appreciate sharply in late 1996, supported partly by an improved trade account. However, the deficit stopped narrowing this spring. Since then, import volume growth has turned up and export volume growth has slowed. Consequently, the trade deficit has begun to surge again, putting downward pressure on sterling. The UK’s services surplus will deteriorate as consumers spend windfall gains from the flotation of mutual building societies on overseas holidays. On my calculations, all these factors should push the current account to a 1.6% (of GDP) deficit in 1998.
The other factor that led to a strong pound was the widening differential between UK and German interest rates during 1996 and early 1997, as the UK grew and Europe stagnated. But economic activity in the UK has now peaked. Consumer expenditure is still strong, with retail sales volumes up 5.6% year on year in August. That pace of expansion is unsustainable. I estimate that retail sales growth of only 3.5% would be consistent with past gains in employment and real wages, as measured by real labour earnings growth. The rest comes from £36 billion ($58 billion) in one-off gains from the demutualization of building societies.
The Bank of England has tightened monetary policy by 100bp since the general election in May. Nominal interest rates are now at a five-year high. That should tempt consumers to save windfalls or reduce borrowing, thus hitting consumption growth. Furthermore, the impact of a strong currency and high short-term interest rates has dampened manufacturing production. It managed only 1.8% year-on-year average growth in the first half of this year. Business confidence is now negative.
Once the UK economy is seen to be slowing, financial markets will begin to price in a lower interest rate spread for the UK over continental Europe, where interest rates will be rising. At current three-month rates, the spread between the UK and Germany is 370bp. I expect that to narrow to 170bp by the end of 1998. That will encourage investors to switch funds into Deutschmark cash – although uncertainty over Emu may diminish that trend. As a result, UK gilts will outperform German Bunds as consumer inflation rises faster in Germany than in the UK. Retail prices may be growing at 3.5% annually in the UK, but deregulation and competition have kept underlying prices stable.
The economic risks of staying short of sterling are low. If GDP growth were to slow more than we expect, the trade account would not necessarily improve. First, import volumes will not slow immediately because of the lagged effect of past sterling appreciation. Secondly, import prices would rise as sterling declined, and the J-curve effect would kick in to drive up import values. If GDP growth were to be sustained, then the trade deficit would widen anyway as the import bill rises.
That brings me back to where I started. The other risk of staying short of sterling is Emu. Sterling has benefited from the weakness of Deutschmark as the consensus expects a broad-based fudged Emu.
But the Emu timetable is not certain. German savers will not tolerate replacing their Deutschmarks with a currency that incorporates the Italian lira (with all the public debt and political volatility that implies). The German electorate will vote next September for whichever political party pledges to protect their savings. So political expediency may force the ruling coalition in Germany to delay Emu, or to insist that Italy is left out when Europe decides on first-wave membership next May. That would create a much stronger euro than markets are currently pricing in. If that happened, sterling’s safe-haven status would evaporate.
David Roche is president of Independent Strategy, a London based research firm.
