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S. Harikumar

AFTER its mega launch in January 1999, the euro quickly lost turf against major global currencies. However, it has now made a turnaround, though more due to the relative weakness of the US dollar than the strength of the European economy. At the same time, two significant developments are happening in the EU area. The enlargement process, to add another 10 countries, is on track and, more interestingly, Britain is revisiting the option of entering the Eurozone.

The Maastricht treaty set the roadmap for European Monetary Union (EMU), but Britain has always been a reluctant fellow traveller in the journey. In 1990, Britain hesitantly entered the Exchange Rate Mechanism (ERM), the precursor to the euro. Soon, the country was beset with recession and unemployment and could not get the `expected interest rate cut relief' from the ERM anchor currency economy — Germany, which too was suffering from unification woes.

Sensing the vulnerability, George Soros made a ferocious speculative attack that resulted in the pound exiting the ERM; obviously Britain became more cautious about the single-currency concept.

In this context, in 1997, the Chancellor of the Exchequer, Mr Gordon Brown, introduced an economic study based on five tests to analyse the possibility of Britain joining the euro and the resultant failure to fulfil the test requirements that had kept Britain away from the euro launch in 1999.

The success of the euro and the political victory of the Labour Party in England in 2001 rekindled the euro entry idea, leading to a second, more comprehensive study. This time too, four of the five tests failed. However, there was great optimism in the Chancellor's policy statement as well press as the briefing of the Prime Minister, Mr Tony Blair (June 9-10, 2003), underscoring the fact that Britain's entry into Euro would no longer be a distant dream.

The core of this highly comprehensive and complex study is five economic tests that address the following aspects: Convergence; flexibility; investment; financial services; growth, stability and employment.

The most critical among the five is the test of cyclical and structural convergence — analysing whether the UK business cycle is moving in tandem with Eurozone and can sustain the trend in the long run. In relation to 1997 there has been greater convergence of both the economies.

In Britain and Eurozone, the inflation rate is now around 2 per cent while short-term interest rate difference after the recent interest ECB cut is 1.75 percentage points, almost half the 1997 level. However, the greatest concern for the Treasury is the typical characteristic of British housing mortgage market.

Britain has large mortgage debt — to the tune of 60 per cent of GDP — in comparison to the relatively low continental average. Almost 80 per cent of these mortgages are linked to short-term floating rates. Hence, any minor change in the short-term interest rate will have great repercussions on the economy, both in consumer spending as well as on the inflation front.

In the recent past, the Bank of England has resisted offering an interest rate cut to the sagging manufacturing sector due to overheating of the housing segment. The best way to tide over this problem is to encourage the household to switch over to fixed mortgage pattern, and this will be the issue the Treasury will be addressing seriously in the days to come.

The test of investment focusses on how a single currency will improve the prospects of the UK economy. The entry into the Euro will reduce the currency risk and augur well for profit and performance, particularly for UK's export firms. In fact, more than 50 per cent of UK trade is with the EU, while it is around fifteen per cent with the US.

Moreover, this will help Britain compete effectively with other European economies in attracting FDI and also will help the domestic small and medium firms to economically capitalise on the benefits of a deep and liquid Euro capital market.

Though the Treasury is upbeat about investment prospects of EMU it concludes that entering the will be detrimental to macroeconomic stability unless the convergence and flexibility tests are met.

The relatively less significant test, and the only one to be passed on both occasions, is the test on financial services. The City of London has a pre-eminent position in the wholesale financial service sector and could retain its dominance even four years after the euro launch. This has allayed the fears of possible erosion of its competitive position. The fifth, and final, test assesses whether joining the Euro will improve growth, stability and employment. The positive effects of the Euro on GDP is now incontestable as Eurozone has already started reaping the benefits. However, test results caution that achieving convergence and flexibility is prerequisite for success of the final test. On the exchange rate front, the present surge in the price of the euro is leading to a pound exchange rate at which Britain wants to lock into the euro, once the expected referendum is passed.

It is assumed that around Euro 1.40 against a pound sterling will be an ideal value of conversion that will not hurt exporters, domestic industries and other Eurozone economies.

In this context it is worth examining the European Union enlargement process.

The enlargement has gained momentum in the beginning of the year, with 10 more economies (Estonia, Latvia, Lithuania, Poland, Hungary, Czech Republic, Slovakia, Slovenia, Malta and Cyprus) systematically progressing towards meeting acquis communautaire, the euro legislation that the member countries has to implement and abide by, and will be ready for joining the Union by 2004.

To enter the single currency, countries must, apart from fulfilling the Maastricht convergence criteria on deficit, national debt, inflation and the existence of an independent central bank, remain in the new ERM with a +/- 15 percentage band against euro for two years.

Britain has a strategic geographical location by lying between two major economic regions of the world — the US and Europe. Though Britain's obsession with national identity and transatlantic political affiliation is quite apparent, it cannot ignore the economic opportunities lying across English channel.

The British Prime Minister, Mr Tony Blair, has remarkable skill to navigate his ideological ship to desired destinations amid the worst storms, as is evident from the Iraq war. The Euro case will, no doubt, be no different, as he means `business'.

(The author, a post-graduate in management and political science, is doing an MSc programme at the School of Business, University of Reading, UK. The views are personal.)

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