UK

The fiscal and monetary discipline imposed by the Maastricht Treaty on Economic and Monetary Union has ensured that Emu is unpopular across Europe. In the UK, where ironically, the economy is reaping the benefits of earlier fiscal consolidation, this unpopularity has reached depths unsurpassed elsewhere in Europe or even in the UK’s recent past.

The unpopularity of Emu in the UK relates, in part, to the eurosceptic position Conservative governments adopted in the past. Unlike those elsewhere in Europe, the Thatcher and Major governments of the 1980s and 1990s never sought to champion European integration back home and, arguably, used “Europe” from time to time as a scapegoat for domestic problems such as the mad cow disease fiasco in 1996. However, the luke-warm position of past UK governments was also a reflection of a deep-rooted scepticism held by the British public over further European integration.

Opinion polls in early 1997 suggest that around 60% of the UK public disapproved of Emu and as much as 40% questionned whether the UK should remain a member of the EU. For some in the UK, the issue of Europe is less about where Britain’s economic interests lie and more about atavistic post-imperial yearnings. For others, Europe represents over-regulated labour markets and an overbearing involvement of the government in business. Whatever the source of public distrust of “Europe”, that distrust is deep and threatens to bind the hands of any government in its future decision over Britain’s participation in a single European currency.

Emu and 1997 election pledges

During the campaign for the May 1 1997 general election the major political parties have competed with each other to be as uncompromising over British interests in Europe as possible. Many Conservative members of parliament, both backbenchers and a handful of ministers, tried to tap into this public scepticism by campaigning locally on election manifestos that were notably more eurosceptic than their party’s national manifesto. The campaign also forced Labour’s Robin Cooke to hint strongly that a Labour government would not take Britain into Emu before 2002. The resulting mixture of statements and campaign pledges made by both major parties at local and national levels make it politically difficult for the UK to be one of the founding fathers if Emu were to start on schedule on January 1 1999.

According to the JP Morgan Emu Calculator – which measures Emu expectations in each country by an examination of the behaviour of swap spreads in European and non-European markets- the market expectation in April 1997 that the UK participates in Emu in 1999 is around 40% and in 2002 is just over 50%. These market probabilities are the lowest for any EU state with the possible exception of Greece. See the chart below and refer to The Emu Calculator Handbook,published by JP Morgan, January 1997.

What happens if the UK lies outside Emu in 1999?

Monetary & Exchange Rate Policy

Following the UK’s ejection from the ERM on September 15 1992, the Major government switched from exchange rate targets to inflation targeting. The target for underlying inflation to be 2.5% or less at the end of the parliament, has been broadly achieved and the exercise has been hailed as a success. In the meantime, the exchange rate was allowed to sink below Dm2.20 in late 1995 and to rise above Dm2.80 in early 1997. If the UK were to remain outside of Emu in 1999, this policy framework is likely to remain unchanged. A new inflation target will be set and Britain will remain outside the ERM.

The monthly meetings between the chancellor of the exchequer and the governor of the Bank of England, nick-named the “Ken and Eddie Show” after chancellor Kenneth Clarke and governor Eddie George, are widely seen as less of a success. They have added an air of conflict and not transparency to the process of setting UK interest rates. If Britain lies outside the auspices of the ECB, potential reforms to the policy framework include the greater operational independence of the central bank with inflation and unemployment objectives laid down by government or parliament.

Sterling outside Emu

Sterling is set to experience a volatile, roller coaster ride if Britain lies outside Emu. Initially, the UK currency will be bolstered versus the Deutschmark and later the euro by the UK’s insulation from the turmoil and uncertainty surrounding the arrival of the new currency. There will be much uncertainty surrounding the future behaviour of the ECB and the appropriate value of the euro. Sterling should also be supported by higher interest rates in the UK than those in continental Europe as governments there hold on to restrictive fiscal policies in order to achieve and maintain the Maastricht convergence criteria. However, over time we expect the continental economy to recover, the euro to gain reserve currency status and the deep and liquid euro markets to become more attractive.

Moreover, the UK’s status outside Emu may make it a less attractive destination for foreign direct investment. In the past, the UK has been looked upon as providing access to the European market for US and Japanese corporates while offering a more deregulated environment in which to do business than in the rest of Europe. This has led the UK to become the first destination of foreign direct investment from the US and Japan. However, there is some evidence that a number of foreign companies are now anxious to diversify out of the UK into other European countries in order to avoid the cost of exchange rate volatility if sterling is not fixed to the euro. They are afraid of other costs as well. European countries have already threatened to keep British banks from having access to “Target”, the interbank settlements system, if Britain lies outside Emu. As a result, we expect sterling’s initial strength to prove short-lived and we expect a steep slide against the euro after the initial rally. This weakness, in 2000 and 2001 may trigger a reassessment of the government’s policy towards participation in the euro.

And if the uk participates in Emu?

Neither the Labour nor Conservative Parties ruled out entry in the May 1997 election and so it remains possible, if not very probable, that if Emu goes ahead the UK will join later, perhaps by 2002, just before euro notes are issued and participating European currencies are withdrawn, or maybe even sooner. The perceived wisdom is that a Labour government would find it easier to push Britain into Emu than previous Conservative administrations. The Labour Party favours Europe’s corporatist approach to employment rights, espoused in the Social Chapter, and the possibility of a European counterweight to the US in world financial and political affairs. Moreover, participation in a single currency centred around the Deutschmark would also help to reinforce Labour’s attempt to build credibility in the financial markets. The Conservatives arguably need this boost to their credibility less and they appear irreconcilably split on the issue of Europe. It is important to note that splits on a single currency are not absent in the Labour Party. Unity on Europe may be easy for a power-hungry opposition party to project, but may be much harder to achieve in government.

Sterling’s Emu conversion rate

If the UK wished to join Emu it is possible that the European Council would overlook Britain’s non-membership of the ERM, especially if sterling had been stable versus the euro in preceding months. If not, Britain would have to enter the ERM by the end of 1999 for it to be eligible for Emu before 2002- a full two years before. It is likely that the ERM central parity and the Emu conversion rate will be one and the same. The choosing of this rate will take on special importance given that the poor choice of sterling’s ERM parity is often blamed for sterling’s unceremonious ejection from the system in September 1992. The overvaluation of sterling’s ERM parity might then lead to a bias of undervaluation in the choice of sterling’s Emu conversion rate in order to avoid the same mistake being repeated. We believe a fair level for sterling, on a price competitiveness basis, is in the region of Dm2.50, more than 10% below the rate in April 1997.

The Emu calculator: Emu expectations