Against the tide - The UK and Emu: the sixth test

by David Roche

UK entry into European economic and monetary union (Emu) is becoming less likely. There’s scant evidence of cyclical convergence with the eurozone economies. Interest-rate differentials are widening. And the weak euro has increased the political risk of holding a referendum on membership.

A successful campaign for Emu entry will have to wait at least until after the next general election in 2001. And unless popular support for the project recovers, it may not happen at all.

Shortly after the Labour party’s landslide election victory in May 1997, chancellor of the exchequer Gordon Brown spelled out the circumstances under which the UK would join Emu – sustainable economic convergence, flexibility, continued inward investment into the UK, no obstruction to UK financial services, and Emu participation boosting employment. His five economic tests were designed to pacify the doubters but left the door for British entry into Emu ajar.

Most of the tests are intrinsically quite ambiguous – more qualitative in nature than anything else. The only really verifiable test is the degree of cyclical economic convergence between the UK and the euro block.

On that test, there’s little evidence to suggest that the growth gap is closing. Nor, for that matter, are inflation or unemployment rates converging. Unsurprisingly, short-term interest rates are miles away from the benchmark in the eurozone too. Both in real and nominal terms, the spread is around 2%, compared with zilch in France. That presents a major dilemma for the UK government. Once in Emu, the Bank of England would have to cede monetary control to the European Central Bank. The implied 200 basis point cut in real interest rates, to bring the UK into line with the eurozone, would wreak havoc.

But I think there’s also a sixth test – the political one. And it has assumed paramount importance in the wake of the June 1999 European Assembly election. UK attitudes towards – or rather against – Emu, are hardening. Indeed, the success of the Conservative opposition-led, anti-Emu pitch was overwhelming. As a result, prime minister Tony Blair has had to back away from announcing the referendum he’d promised on Emu.

That a plebiscite won’t be held in this parliament is no great surprise. But the possibility – even probability – that there’ll be no push into the eurozone even in the next one would change the political landscape in the UK and Europe. It would also have major repercussions for sterling and UK gilts.

There are two ways the Emu issue can unfold. The Labour party currently has a massive, 179-seat majority in the House of Commons. The 1997 election represented a one-off, anti-Conservative backlash, after 18 years of Tory rule. Yet many of these seats were won by relatively small margins. Next time round, many of these “freak” results are likely to be overturned. And with the new Scottish and Welsh assemblies elected on a proportional representation basis, the Conservatives have a great chance of reducing Labour’s majority to 30 to 50 seats at the next general election in 2001-02.

That could have a major impact on Labour’s Emu strategy. Sure, the government would have the security of a second term. And it could clearly set out the economic rationale for Emu entry – lower long-term interest rates inside Emu than out, more affordable housing, cheaper investment and higher growth. What’s more, the UK’s (for which read, Blair’s) political influence would be enhanced inside a unified Europe.

But a much-reduced Labour majority could just as easily be interpreted as a kick in the teeth for the Emu-advocates.

William Hague, the current Conservative leader, is absolutely clear why the UK should stay outside Emu and why his brand of pro-British Euro-scepticism is the clearest way for the Tories to differentiate themselves from Labour. At present, the electorate seems to agree with him. In the latest ICM poll, 62% declared themselves decisively against Emu membership. And that number is growing, driven by concerns over cronyism in the European Commission and euro weakness.

In the meantime, there are encouraging signs of a recovery in the UK’s economic fortunes. The flirtation with recession is over. The housing market is heating up. Consumer confidence is buoyant. Even manufacturers seem to be coping with a robust currency. Add to that the strong equity market and it’s easy to see why the feel-good factor is back.

However, it means there’s little justification for further Bank of England interest-rate reductions. And the growing risk of UK self-exclusion from Emu means the pound is well supported, despite some modest slippage on the current account. But although the outlook for the pound has improved, UK gilts look more vulnerable. As economic recovery and Emu-exclusion are priced in, spreads over German Bunds could easily double.