Test 5: Will the city thrive?

What impact could entry into the economic and monetary union (EMU) have on the competitive position of the UK's financial services industry, particularly the City's wholesale markets?

The assessment of the financial services test examines the costs and benefits of EMU entry for the UK financial services sector as well as those associated with remaining outside euroland. The assessment is based on the evidence of four years' operation of euro financial markets since the start of EMU and the City's relative performance, and the detailed analysis of longer-term trends in the EMU study.

Inside or outside the EMU, the competitive strength of the City should mean that the UK continues to attract a significant level of wholesale financial services activity. The international nature of the City's markets and the foundations of its competitive position imply that the achievement of sustainable and durable convergence to safeguard stability in EMU is less of a determinant of the likely success of wholesale financial services activity than it is of other aspects of the UK economy.

Entry might strengthen London's position as a leading financial centre. To the extent that the euro proved to be a factor in the location of wholesale financial services activity, entry would remove any unease firms might have about being in a financial centre outside the euro area.

Entry could also improve the UK's ability to compete for the new, contestable business that can be expected to arise from EU enlargement, an ageing EU population and the continued development of euro financial markets. Changeover costs arising from entry for the sector would not be significant. Entry would improve the competitive position of the UK's retail financial services sector if other barriers are also removed. Benefits to the retail financial services sector from entry would include lower costs on euro area transactions, the possibility for a more optimal allocation of investment portfolios and potential scale economies for investment funds. Assuming markets are competitive, these benefits should be passed on to consumers and offset the one-off changeover costs for the retail financial services sector that would arise from entry.

The dynamic effects of the single currency can be expected to be gradual. With other changes, the euro will encourage integration of retail financial services in the single market over the longer term and, importantly, greater competition in the sector.

The business case for greater cross-border merger and acquisition activity could strengthen as retail financial services firms seek to make the most of new opportunities in a single market with no currency barriers.

Compared with wholesale financial services activity, realisation of these gains for retail financial services is more conditional on the achievement of sustainable and durable convergence and the safeguarding of stability, just as it is for other UK business sectors that serve the domestic market.

The UK's influence over EU financial services policy should remain strong whether inside or outside the euro area.

The overall conclusion of the financial services test is:

Over the four years since the start of EMU, the UK has attracted a significant level of wholesale financial services business. The strength of the City in international wholesale financial services activity should mean that it continues to do so, whether inside or outside EMU. Entry should enhance the already strong competitive position of the UK's wholesale financial services sector by offering some additional benefits.

Again, while the UK's retail financial services sector should remain competitive either inside or outside the euro area, entry would offer greater potential to compete and capture the effects of greater EU integration that would arise from the single currency and other efforts to complete the single market, in particular the financial services action plan (FSAP) - benefits that are postponed while the UK is not in EMU. Overall, the financial services test is met.

Ongoing efforts are required to increase EU financial services integration through the FSAP and other measures. In the longer term, this should add to competitive pressures in the UK financial services market.

The financial services test asks: what impact would entry into EMU have on the competitive position of the UK's financial services industry, particularly the City's wholesale markets? Compared to the 1997 assessment, this assessment has the benefit of more than four years' experience of the euro on which to draw. The 1997 assessment concluded that EMU offered considerable benefits to the UK financial services sector, whether the UK was inside or outside the euro area. However, the benefits and the opportunities would be more easily tapped from inside the euro area than outside.

The UK's wholesale markets were expected to remain competitive after the introduction of the single currency whether or not the UK joined, because the City held a number of significant competitive advantages relative to other EU financial centres. Prospects for the UK retail financial services sector were also generally positive. Compared with other European markets, the UK sector had undergone early and significant structural reforms, with consumers feeling the benefits of innovation stimulated by competition.

The financial services sector continues to play an important direct role in the UK economy.

In 2001, financial services accounted for 5.2 per cent of UK output, compared with 5.6 per cent of output in 1997. The financial services sector provided more than a million jobs in 2002, a level largely unchanged since 1997. The sector is a significant source of overseas earnings for the economy. In 2001, financial services net overseas earnings (including insurance) amounted to about £13.2bn. In 1997, the surplus was about £9.7bn. The large surplus suggests the UK continues to hold an important competitive advantage in financial services activity relative to its competitors. The financial services sector also has an important wider role in the UK economy.

An efficient financial sector contributes to increased investment, productivity and growth - issues that are at the core of the investment test and the growth, stability and employment test.

The importance of the financial services industry to the UK economy and its dynamic nature mean that there are no grounds for complacency in this assessment. The severity of the global equity market downturn since 2000 has created a level of uncertainty not seen in the financial services sector for many years, and there are as yet few signs of a rapid recovery in market sentiment. Other significant long-term forces are also shaping the sector - the EMU decision adds to the already complex environment for the UK financial services sector.

It has some direct and, perhaps more importantly, indirect effects on existing trends, with potential long-term implications for both the UK's wholesale and retail financial services sectors.

Technology should continue to influence the structure of the financial services industry and where financial services activity is located. As competitive pressures in the financial services sector increase, retail financial services firms in particular can be expected to take advantage of the opportunities offered by technology to relocate lower value-added activities to lower cost locations. In some cases, this may mean locating activity outside the EU altogether.

Some reversal of the trend towards building financial services conglomerates may be seen as firms focus on core activities and buy in services where they lack expertise or sufficient market presence to compete. Consolidation should continue in domestic markets, particularly in the retail banking sector where average bank size in many member states remains small compared to that in the UK.

To assess the costs and benefits of EMU entry for UK wholesale markets, it is important to establish first the current position and the reasons for it. The UK remains by some distance the leading financial centre in Europe, largely due to the very high levels of wholesale financial services activity in London. Scottish financial centres also make an important contribution to the UK's position in wholesale financial activity through their significant presence in institutional asset management services. Scotland is now the sixth largest institutional equity management centre in Europe.

The EU study on the location of financial activity and the euro uses economic geography and economic history to identify a number of common themes that help to explain London's competitive position in international wholesale financial activity. These include clustering forces. London's key attractions are the critical mass of wholesale financial services activity present in London and a large pool of skilled labour drawn from both domestic and international labour markets.

[There is also] a supportive public policy framework. The UK's flexible labour markets, its approach to financial services regulation and a competitive tax regime create an attractive business environment for wholesale financial activity; and [in addition] the UK has a long history and reputation for providing international wholesale financial services.

While London faces challenges, the presence of these attractions means that the UK is still viewed as a competitive location for international wholesale financial activity.

In assessing the impact of EMU entry on UK wholesale markets, two direct short-term costs to the UK's wholesale financial markets, and some potentially more significant long-term implications, need to be considered. While London currently enjoys a strong competitive position, and should continue to do so inside or outside the euro area, the dynamic nature of financial services means that a financial centre's competitive position cannot be taken for granted.

There would be short-run changeover costs for wholesale financial services firms and markets arising from a UK decision to join EMU. Operating systems would need to be adapted to cope with the changeover to the euro. Short-run changeover costs would not be expected to undermine the long-term competitive position of the UK's wholesale financial services sector.

If the UK were to join EMU, and assuming entry was under the right conditions, the positive perception of the UK as a full participant in euro financial markets should continue. Entry might strengthen London's position as a leading European financial centre, provided it did not undermine - or was not perceived to undermine - London's other advantages.

Given the high levels of foreign ownership in the City, perception effects may be important. Many international wholesale financial firms are mobile. The high level of foreign ownership in London's and Scotland's wholesale financial centres may have made them more sensitive to changes in the relative attributes of locations.

To the extent that the location of wholesale financial services activity might be based on membership of the single currency, then a decision not to join the single currency might imply an adverse perception for future location decisions. However, the first four years of the euro have not produced any evidence of such concerns affecting location decisions.

A further effect of a decision to join the single currency might be to encourage wholesale financial services firms that had not already done so to concentrate more on their euro-related wholesale operations in London.

As already stressed, an ageing EU population, greater use of market-based instruments by euro area firms and investors, and the forthcoming enlargement of the EU are all likely to be important sources of new business for UK wholesale financial services.

There might be some additional benefits if firms use the strategic opportunities resulting from growing euro financial markets as well as the growing international use of the euro, and transact any increase in business flows through their wholesale operations in London. But inside or outside the euro area, the UK's wholesale financial sector would expect to capture its fair share of new business resulting from any increase in demand in the euro area because of its strong competitive position.The UK retail financial services sector is well developed, offers a very wide range of retail financial services products and has a high level of innovation. The assessment of the costs and benefits of EMU entry must take this into account. The retail banking sector has been through an intensive period of restructuring and consolidation in the past two decades and the sector is dominated by four large institutions.

There are few signs that the single currency has made any significant impact on the UK's retail financial services sector. The reasons lie in the structure of the EU's retail financial services sector and remaining obstacles to the cross-border provision of retail financial services in the EU. These mean that EU markets remain segmented along national or even regional lines, limiting any benefits from greater single market integration that the single currency might encourage.

The short-run costs of entry into the single currency would be significant for retail financial services. The changeover costs incurred would be dependent upon the approach taken by each institution, the type and age of IT systems and the composition of the customer base.

While most of the cost would relate to IT changes, for example accounting infrastructure and automated cash machines operated by banks in their branch networks, other costs would include: short-term cash handling costs when the move to euro notes and coins took place; marketing and information campaigns to inform customers about changes to their bank accounts as well as euro products and services; staff training costs to service customer needs and manage the changeover; and opportunity costs as other change programmes were deferred and management focused on the changeover period.

Against these short-run costs, some longer-term benefits might arise through investment in upgrading IT systems to handle the euro. These could hasten efficiency gains for the UK retail financial services sector, providing the opportunity for organisations to rationalise and upgrade their product ranges and introduce improved customer service and working practices.

Over the longer term, a number of dynamic benefits would be captured from EMU entry that would outweigh the short-term costs. Compared to wholesale financial services activity, realisation of any gains for retail financial services is more conditional on the achievement of sustainable and durable convergence and the safeguarding of stability, just as it is for other UK business sectors that serve the domestic market.

The extent to which these benefits would be realised depends on the degree to which the single currency can in practice encourage the right business models to develop.

The single currency may have its greatest long-term effect on cross-border mergers and acquisitions activity. Retail financial services firms can be expected to take increasing advantage of the business opportunities presented by a single market without currency barriers. Thus far, the business case for cross-border mergers and acquisition activity has been weak, given the low levels of cost savings that can be achieved compared to domestic mergers - an important reason why, to date, most bank mergers in the EU have been in domestic markets.

As these domestic opportunities become exhausted, and as rules permit them to do so, euro area firms may increasingly look across borders for their expansion plans.

The large size of many UK institutions relative to their euro-area competitors would put them in a good position to take advantage of any such opportunities.

The impact of a decision to join EMU on the other business models might be expected to be more limited, especially in the short run. Entry would improve the competitive position of the UK's retail financial services sector if other barriers were also removed. Benefits to the retail financial services sector from entry would include lower costs on euro area transactions, the possibility for a more optimal allocation of investment portfolios and potential scale economies for investment funds. Assuming markets are competitive, these benefits should be passed on to consumers and offset the one-off changeover costs for the retail financial services sector that would arise from entry.

[In conclusion], the dynamic effects of the single currency can be expected to be gradual. With other changes, the euro will encourage integration of retail financial services in the single market over the longer term and, importantly, greater competition in the sector. Being outside the euro area would mean that these effects would be more muted in the UK sector although the barriers are regulatory and legal rather than related to currency.

The business case for greater cross-border merger and acquisition activity could strengthen as retail financial services firms seek to make the most of new opportunities in a single market with no currency barriers. Outside the euro area, the business case for UK retail financial services firms to capitalise on these opportunities could be weaker.

A complex issue to assess is the long-term development of policy towards, and affecting, financial services in the EU. It has been argued that the UK EMU decision could affect the UK's ability to influence the course of these developments.

Some areas will clearly remain unaffected by the question of the UK's entry decision, such as the UK's ability to determine its own approach to tax policy.

Other more specific examples suggest that the UK's influence on EU financial services regulation should remain strong. For example, a significant proportion of euro business is done in the City. This creates a powerful argument for the UK to be fully involved in all discussions relating to regulatory or financial markets issues. One example is the UK's success in negotiating cheap and efficient access to Target, the eurosystem's wholesale cross-border payments system.

Also, there is significant input from the Financial Services Authority (FSA) and the Bank of England to regulatory, supervisory and financial stability discussions in the EU.

The UK's influence over EU financial services policy should remain strong whether inside or outside the euro area.

Concerns before the start of EMU that the UK's influence would diminish outside EMU have not been realised. Using its strong influence, the Government will work with the UK's financial services sector to ensure that the UK's competitive advantage in many retail and wholesale financial services activities is safeguarded and, wherever possible, enhanced.

Over the four years since the start of EMU, the UK has attracted a significant level of wholesale financial services business. The strength of the City in international wholesale financial services activity should mean that it continues to do so, whether inside or outside EMU. Entry should enhance the already strong competitive position of the UK's wholesale financial services sector by offering some additional benefits. Again, while the UK's retail financial services sector should remain competitive either inside or outside the euro area, entry would offer greater potential to compete and capture the effects of greater EU integration that would arise from the single currency and other efforts to complete the single market, in particular the FSAP - benefits that are postponed while the UK is not in EMU. Overall, the financial services test is met.

THE IMPACT ON FINANCIAL SERVICES

* The City of London should continue to attract new wholesale financial services business, whether inside or outside EMU.

* EMU entry should enhance the already strong competitive position of the UK's wholesale financial services sector.

* While the UK's retail financial services sector should remain competitive inside or outside the euro area, entry would offer greater potential to compete.

* Overall, the financial services test is met.

BACKGROUND PAPER: THE CHANGEOVER

Euro notes and coins could be circulating in the UK within three years of the Government making a decision on a referendum, the Treasury's national changeover plan made clear yesterday. The plan, the third published since Labour came to power, states that there should be only a two-month dual currency period in Britain when the pound and euro can be used side by side.

Four months after a government decision that conditions were right, a referendum would be held and 20 months later euro financial services would be available electronically. Ten months after that would come the UK's so-called "E-day", held not on 1 January as at the euro's launch but on 6 April. Two months from then the pound would cease to be legal tender.

The changeover plan means that, on the most optimistic assumption of a decision being made by the Government in July next year, the euro would be legal tender in the UK by August 2006 at the earliest.

After closely watching the performance of the 12 nations that joined economic and monetary union (EMU) on 1 January, 2002, the Treasury has decided that there should be only a two-month dual currency period in the UK. The Treasury has also revised the number of coins it would have to mint from between 13 and 14.5 billion to 10 billion. Two billion notes would be printed.

"The Government has developed, and progressively refined, an outline timetable and the logistics that would be necessary for a changeover in the UK," the Treasury document said. "A phased approach to a changeover would help minimise costs, operational risks and the overall length of a changeover."

By Paul Waugh

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