Introduction
The debate about UK’s entry into the Single European Currency will continue even though after all, Gordon Brown, the Chancellor of the Exchequer, is poised to announce that the five tests for British membership to the euro zone have not been met. Meanwhile, the exchange rate of the euro against American dollar has hit an historical peak. How long the UK will remain outside of the euro zone depends on to what extent the UK economy benefit from joining the euro. This essay will try to provide the answer from short and long terms, and gains and losses will be valued.
To begin with, it is inevitable to start this essay without introducing the euro. The Single European Act (1986) introduced Economic and Monetary Union (EMU) whose third stage began on 1 January 1999, when the euro was introduced as a legal currency to the 11 member economies. However, as is shown in the graphs below, the euro rose to $1.14, 36% above its low point of two years ago and within spitting distance of the rate of $1.17 at which it began life in January 1999 (The Economist, 8/5/2003). In relation to the sterling, the euro is relatively strong, reaching 0.7179 pound per euro (FT, 30/5/2003). And generally, as is illustrated in the graph, the exchange rate of the euro is very volatile.
Referring to the future of the single currency, The Economists (1/5/2003) forecasts a 10% increase in the euro over the next year or so. A much steeper rise is possible. Though it is too early to predict that the euro will replace US dollars as the most important currency in the world, economists believe that the Single European Currency will play a fundamental role in the world market.
Therefore, what makes the Chancellor insist keeping out from the euro temporarily? As Brown said, “the only consideration is economics”.
Short Term Effects
Philip Hall points out that the membership of EMU will reduce transaction costs for traders, with savings estimated at around £2 billion annually (Basic Economics). These savings come from not having to pay commission or maintain hedge funds to guard against currency instability. Peter Gumbel, analyst for Time Finance 26/5/2003), claims that having a single currency makes it far easier for businesses to shop around for suppliers and price their products attractively.
In addition, the abolishment of sterling brings exchange rate stability to the UK’s economy. This would encourage higher levels of trade, as exporters and importers realised that their profit margin could no longer disappear with an unanticipated exchange rate movement. The introduction of the euro has already led to a sharp rise in trade among its members. While Britains trade with Europe has gone backward. Germanys trade with the EU has leapt from 27.2 per cent of national output in 1998 to 32 % in 2001. Frances trade with the EU has risen from 28.0 per cent of GDP to 31.4 % (FT, 30/5/2003).
Consequently, the increase of trade will help to improve the balance of current account as the UK has a major trade deficit with the EU. In early May (Time, 26/5/200), the pound hit its lowest-ever level against the euro and that drop is presumed to boost U.K. exports by making British products more affordable to euro-zone purchasers. The static from FT indicates that 48% trade is with the EU, thus, the entry into the euro could better the performance of balance of trade. However, remember also that 47% of UK’s trade is not with the EU, and that the Euro itself has been unstable against other currencies. An appreciation of the Euro against the dollar subsequent to the UK’s joining would harm the UKs important trade with the USA.
Long-term effects
Britain in Europe campaign claims that by eliminating currency volatility and boosting investment, joining the euro would boost the UK economy by over £40bn in the medium term. Nonetheless, the Single European Currency may bring much more uncertainties. Therefore, the Five Tests were setup to assess the impact.
Sustainable Convergence
Interest rates are now much closer than in 1997. However, divergence also exists, especially in macroeconomics. Since the euro was introduced in 1999, British GDP growth has averaged 20% higher than in the euro zone. In March, unemployment in the U.K. stood at 5.1%-considerably less than the euro-zone average of 8.7% (HM-Treasury). In addition, the UK’s labour market is much more flexible than the European continent. Especially, the mortgage is most divergent from the euro zone and it will be discussed in flexibility in details.
Economic Flexibility
The graph shows that the housing market in the UK is the most volatile in Europe, and countries like Germany and France which together account for more than half of euro-area output develops steadily. Therefore, the European Central Bank pays little attention to house prices when it sets interest rates in the euro area.
Contrary to popular perceptions, mortgage rates in Britain are lower than rates in the Eurozone. Latest figures from the European Mortgage Federation showed that rates in Britain stand at 5.2 percent, compared to 5.87 in Germany and 6.2 in France. The EU average is 5.77. Britain’s low mortgage rates would be at risk if it entered the euro for the following three reasons.
Firstly, the UK long-term interest rates are set to stay lower than the Eurozone, according to the OECD. If Britain were to join the euro, it would be forced to live with a higher interest rate and this would then increase its mortgage rates. Secondly, Britain’s housing market currently enjoys far lower taxes than in the Eurozone. The European Commission’s drive to harmonize taxes would be a severe threat to Britain’s lower housing taxes. Thirdly, as is shown in the graph, British mortgage holders typically prefer variable rate mortgages whereas fixed rate mortgages are the norm on the continent. The lack of convergence in the housing markets means that Britain could not live with the one-size-fits-all interest rate that would be imposed upon it by the European Central Bank.
With house prices so volatile and property-backed credit readily available, the housing market drives the British economy to a much greater extent than occurs in the euro area. At present, for example, mortgage equity withdrawal—money borrowed on property but not invested in it—has jumped to 5.9% of household post-tax income, the highest since 1988. Without this injection of borrowed funds, the consumer boom would be running out of steam. A buoyant housing market is a principal reason why the British economy has weathered the economic setbacks of the last two years so much better than the euro area, therefore, losing the control of interest rate may result in a disaster to the UK economy.
Investment
The pro-euro economists claim that businesses will no longer have to worry about exchange-rate risk, therefore stability and certainty will encourage the potential investment. Britain was usually the most popular destination for oversea investment in the last decade, but its share fell sharply in 2002, according to preliminary estimates form the United Nations Conference on Trade and Development. Many of the big multinationals like Toyota, Ford, and Nissan have begun to warn that they only invested in the UK because they assumed it would eventually join the euro (Time, 26/5/2003).
However, staying out of the euro has not necessarily made Britain unattractive to investors-either in or out of the euro zone, said euro critics. In 2001, the U.K. received 24% of foreign investment into the E.U. Since 1997, net investment flows from the euro zone into Britain have increased almost fivefold-from 9 billion euros to 42.5 billion. In a 2002 survey, the German-British Chamber of Commerce found that 83% of German firms planned to continue investing in the U.K. whether it joins the euro or not (Time, 26/5/2003).
Concerns also come from the loss of independent monetary policy. The control of interest rate by European Central Bank (ECB) means that the UK could neither reduce interest rate to manipulate the level of investment domestically nor could it raise interest to make Britain a more attractive destination for oversea firms. The graph shows that the interest rate of Bank of England is always higher than the ECB, thus, provided that Britain joins the monetary union, its interest rate may no longer attractive to oversea investors.
Financial Service and the City
The economist argues that staying out has done the city no harm (9/5/2003). Latest figures argued by McConnell Sneddon of Wealth Management show that London transacts 32% of global foreign exchange turnover. Germany and France did 5% and 4% respectively. It is estimated that London accounts for around 70% of the specialist financial publications sold in London, Paris and Frankfurt combined and that London has about 70% of the banks and senior financial specialists in all three cities.
The Bank of England says that London’s role, as an international financial centre, does not primarily depend on whether the UK is inside or outside EMU. In fact, since the launch of the euro, all evidence indicates that London has increased its market share. Joining EMU would eliminate the sterling and the markets in which UK financial institutions have a competitive advantage. It is unlikely that joining EMU would be positive for the City of London.
Referring to the financial industry as a whole, the European currency is seen as beneficial by 63% of larger companies and 68% of British fund managers, in an annual survey for the information group Reuters. It also shows that for 42%, euro entry would enhance company valuations while 4% thought they would be reduced. Fund managers were bullish about prospects of improving sales and profits through the euro: 54% said joining would improve sales and 45% said it would help profits. In addition, the UK equities market has under performed other European markets and now accounts for less than 10% of a neutral global portfolio, therefore, Tempest, reporter for Reuters, argues it is difficult to see how the British market can stand alone.
Employment
The OECD is forecasting that Britain’s unemployment rate will be 5.4% of the labour force in 2003, compared with 8.8% in the euro area. Sneddon argues that the key difference is that the UK’s labour markets are far more flexible than those in the Eurozone, enabling it to reduce its rate of unemployment to lower levels than the EU, without igniting inflationary pressures. Therefore, the euro skeptics argue that entry into the euro will force the UK government introduce less flexible employment regulations and that will increase British labour cost, obliging firms cutting workers.
Another argument is that price transparency will promote competition, which could put British industry in a weak position and induce higher unemployment. Inappropriate exchange rate could deteriorate employment in the UK. According to Oxford Economic Forecasting, going in at too high a rate might cause U.K. industrial production to fall by 5.7% since too high a rate would mean a fall in exports, and thus less of a need for workers, unemployment could rise by 0.05%.
Conclusion
It is obvious that the biggest disadvantage of joining the single currency is the loss of independent monetary policy. A “one-size-fits-all” interest rate cannot be ideal for the UK whose economy is still divergent from the continent in mortgage market, trade pattern and employment flexibility. In addition, the example of Ireland, which drops its interest rates by 3% as soon as it entered the EMU, illustrates that the UK may suffer the same problem—high inflation. But joining the euro, Britain can avoid shocks from fluctuations in exchange rates, thus promoting stabilities inside the UK economy accompanied with higher levels of investment and increase in trade. However, by joining the euro, Britain may benefit from more stability, which may increase the level of investment and trade. Therefore, the question that to what extent might the UK economy benefit from the entry to the single currency remains how much sustainable convergence of Britain and Europe. The conclusion could be that as long as these two economies assimilate each other, the UK could benefit from the euro in a long term even though, if not, it could still gain price transparency and reduction of transaction costs in a short term.
Bibliography
Books
Beardshaw, J. (2001) Economics, London, Person Education
Begg, D. (2000) Economics, Berkshire, McGraw-Hill Publishing
Maunder, P. (2000) Economics Explained, London, Collins
Articles
Bloch, A. (1/2002) Should UK join the euro economically,
http://www.ilovephilosophy.com/articles/jan2002/articles.php?no=8
Hall, P. (2000) Should UK join the euro zone,
http://www.edinburghac.demon.co.uk/Subjects/Curricular/econ/euro.htm
James, J. (26/5/2003) Is the euro a no-go zone, Time Europe
Websites
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