Stephen King: Why the pound and the euro are as entwined as lovers

It's time to reveal a remarkable secret. Back in 2003, Britain joined the euro.

Neither Tony Blair nor Gordon Brown will admit that Britain made this momentous step. Given the opportunity, Mr Brown is still likely to argue that membership is ruled out given Britain's failure to meet his "five tests". But the facts speak for themselves. Against the dollar, sterling has been all over the place. Against the euro, sterling has offered remarkable stability.

The first chart tells the story. Between 1999 and 2002, when the euro was a mere babe in swaddling clothes, sterling's relationship with its continental neighbour was not terribly close. Since then, though, sterling and the euro have been engaged in something of a passionate embrace. And while not all love affairs last, this one seems as solid as a rock. It's as if these two lovers were chiselled and shaped by Auguste Rodin.

My claim, of course, is nonsense, as nonsensical as the suggestion that, in 2003, the euro became part of an extended sterling zone (an idea equally consistent with the facts). Nevertheless, despite the apparent desire of the British people to ensure that sterling retains its independence, there hasn't been a great deal of autonomy of late. "Me and my shadow" might be a good way of summarising the symbiosis between Europe's two major currencies.

One obvious advantage of these links is the simplicity of conversion. For four consecutive years, the British tourist has known that a euro will cost around 70p. For four consecutive years, businesses have been able to plan their pan-European activities without having to worry about currency upsets. Economic links between Britain and the Continent have strengthened as a result.

For many years, investors took the view that sterling was a halfway house, neither a member of the euro scene nor the closest of friends with the dollar. If you thought the dollar was likely to fall against the euro, the chances were that sterling would also fall, but not by as much. However over the past four years the dollar may have been weak against the euro (four years ago you needed about $1.05 to buy a euro; now you need $1.31) but sterling has hardly budged. Our limpet-like link with the euro has left sterling stronger against the dollar. Four years ago, a pound would buy $1.60; today, you'll get almost $2.

What's going on? One explanation might simply be that the Bank of England has given up on monetary independence and has chosen to copy the activities of the European Central Bank. This really would be only one step away from a fully fledged monetary union.

The facts, though, suggest otherwise. The second chart shows movements in key policy rates in recent years. There is no evidence of monetary convergence. The Bank of England was raising interest rates in the second half of 2003 when the European Central Bank appeared to be in monetary hibernation. It wasn't until the end of 2005 that the European Central Bank decided to push rates up. By that stage, the Bank of England had delivered an interest rate cut, even if it was subsequently reversed.

Nor do markets really expect any longer-term convergence of interest rates. Ten-year bond yields are a little under 4.9 per cent in the UK but only a smidgeon over 4.0 per cent in Germany. There may have been exchange rate convergence, but there's no real evidence of domestic monetary convergence. If sterling really had joined the euro, interest rates in the UK and Germany would be more or less the same.

Higher interest rates in one country compared with another often suggests the likelihood of exchange rate weakness: higher interest rates are, if you like, the compensation required to persuade investors to take on the additional currency risk. It's why, back in the 1980s and 1990s at the time of the European exchange rate mechanism, interest rates in Italy and Spain were much higher than those in Germany. It was always more likely that the lira and peseta would fall against the Deutsche Mark than the other way round. The dollar's performance against the euro in recent years fits the same pattern. Interest rates in the US are a lot higher than those in Europe, but the dollar has fallen against the euro.

Sterling, though, doesn't fit this pattern. Investors may believe at the beginning of each year that sterling is set to take a tumble, but it never does. I offer five reasons why sterling has seemingly defied gravity.

First, the Bank of England's job is to control inflation. It does this through setting the level of interest rates. If the level of interest rates required to ensure price stability in the UK is higher than that elsewhere (either because inflation expectations are more deeply embedded or, more likely, because short rates play a much bigger role in the UK housing market than in other housing markets) sterling becomes a rather attractive currency in which to hold excess savings.

Second, the UK has been more willing than others to "sell the family silver". The UK has attracted more than its fair share of acquisitions from abroad. The Government doesn't make a song and dance about so-called "national champions". Other governments aren't so relaxed. Foreign money pours into the UK for other reasons too. Russians regard London property as a safe haven. Middle Eastern states prefer London to New York for political reasons. And Sarbanes-Oxley has dented New York's ambitions to be the world's premier financial centre.

Third, those emerging market central banks who seek to diversify their reserves out of dollars happily regard sterling as an alternative vehicle to the euro, particularly so given the now infinitesimally small chance of the UK joining the euro. Dollar weakness therefore becomes associated with both euro and sterling strength, ironically making sterling more euro-like.

Fourth, those investors engaged in the so-called carry trade - borrowing at remarkably cheap rates in Japan, notwithstanding last week's Bank of Japan rate increase, to invest in higher-returning currencies elsewhere - want to make sure they're putting their money into currencies where interest rates may still rise further. There's currently a better chance of that happening in the UK and in the eurozone than in the US.

Fifth, in the late 1990s, people used to buy the dollar because America's productivity growth persistently outstripped the paltry gains seen in the UK and in the rest of Europe. Many investors are rethinking this strategy. US productivity growth has slowed in recent years whereas, in both the UK and the eurozone, there's been something of a resurgence.

None of this implies that sterling will forever be linked to the euro. Auguste Rodin's The Kiss will still be lingering when Europe's major currencies have eventually gone their separate ways. Nor does any of this imply that we should join the euro. Nevertheless, as Humphrey Bogart might have said, "Frankfurt, I think this is the beginning of a beautiful friendship. "

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com