Hamish McRae: Turbulence ahead for sterling in run-up to euro referendum

We might get the bad aspects of euro membership without the benefits
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As one campaign ends another starts. The sharp fall in sterling this week signalled the start of the debate as to whether Britain should join the euro.

As one campaign ends another starts. The sharp fall in sterling this week signalled the start of the debate as to whether Britain should join the euro.

The pros and cons will be batted back and forth until we are thoroughly fed up with the whole business. So no words about that here right now. But it is worth outlining some of the practical issues that the business and financial communities will have to face during the run-up to a referendum. That fall of sterling was just one early sign of ructions to come, for it raises the key issue of what the right level for sterling should be.

The first thing to be said here is that there is no "right" level for the pound. There are extreme levels that would be clearly wrong. Sterling was clearly too cheap after the pound was ejected from the Exchange Rate Mechanism in 1992, when it slumped to around 2.30 German marks. It was clearly too high when it neared DM3.40, but within a broad band of say, DM2.50 to DM3.20, you can make a case either way.

How so? Well it depends on which bit of the economy you are looking at. Much of manufacturing industry is thought to be competitive only at the bottom of that range. Goldman Sachs calculates a fair value of sterling at DM2.55. But in parts of the service sector, the UK is competitive at higher levels than DM3.20. The financial services industry is one: companies base their financial operations here rather than on the Continent because even at a high exchange rate we are more competitive.

It follows that the "right" exchange rate for one industry is going to be the wrong one for many others. Wage rates in the City are so high because the exchange rate is ­ for that particular industry ­ too low. Jobs are being lost in such industries as textiles because the exchange rate has long been too high.

Eventually, the economy will adjust to "wrong" exchange rates. If Britain were to join the euro at too low a rate, we would experience faster inflation than the rest of Europe, particularly in asset prices, as Ireland is doing now. If the rate were too high, we would experience a period of slower growth and falling asset prices. The best example of that is Japan, which for a range of reasons has had to live with an uncompetitive yen ­ or rather a yen that is appropriate for its export industries but not for the economy as a whole.

On a long view, sterling has been both volatile and stable, as the graph shows. The real weighted index, as calculated by the OECD over the past 20 years, is pretty much where it was in the early 1980s. In between, however, there have been enormous swings. I suppose if one were trying to take an appropriate average, one would look around the 115 level ­ perhaps 12 per cent below the present value. But an average is not necessarily right.

Entry into the euro would have to be preceded by renewed membership of the ERM, because that is required under the Maastricht Treaty. This could in theory yield a test period: if the rate were clearly wrong the strains would start to show. But the period might not be long enough, and the idea in any case would be for the ERM rate to be the entry one.

Were there to be a repeat of 1992, the whole idea of entering the euro might have to be abandoned. So choosing a rate inevitably involves an element of guesswork ­ and the acceptance that any rate is going to be wrong for some parts of the economy.

It will also be wrong against the dollar. While more than half of our physical exports go to the eurozone, many UK costs are driven by the dollar. Energy is basically a dollar commodity: the oil price is denominated in dollars, and other energy prices tend to follow it.

UK companies are currently under great pressure from rising energy prices. A strong dollar makes it more profitable to export to the US, but it also jacks up import costs, many of which cannot be passed on.

The best hope for currency convergence would be for the euro to strengthen. It has lost more than one-quarter of its value since its launch and at some stage must be expected to recoup some of this. But trying to talk the pound down to present euro levels carries considerable risks.

What about interest rate convergence? At the moment, the UK has higher short-term rates than the eurozone but lower long-term ones. They cross over at about 10 years. The effect of moving to eurozone rates would therefore suggest cheaper mortgages and overdrafts but higher costs for long-term corporate and government borrowing.

But that is just a snapshot of current rates. There are a range of reasons to suspect that in coming months eurozone rates will fall faster than UK ones. Growth on the Continent, particularly in Germany, seems to be falling faster than here, and the UK economy will be bolstered next year by increases in public spending.

So a snapshot of current rates is not really very helpful. Rates are just as likely to move apart as they are to come together. The best hope would be for Continental Europe to stage a strong economic recovery, forcing the European Central Bank to increase short-term interest rates. Sadly, there is little sign of that.

The danger for the UK would be apparent were it to be forced to cut rates at a time of strong growth in order to bring them down towards European levels. We could have a nice boom for four or five years but there would be a price to pay afterwards.

The key issue ­ which we have had a taste of this week ­ is whether the very fact that the Government is trying to nudge the UK towards euro entry will of itself start to create economic pressures. We might get the bad aspects of euro membership (such as the wrong short-term interest rates), without the benefits of membership (such as the economies of scale from the larger market).

Expect a turbulent few months (or maybe years) in the run-up to a referendum.