Is there gain in the City's euro pain?

It is unrealistic to think London would not be discriminated against as an abstainer from the euro
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The Independent Online
THE CITY is fully prepared, or so it believes. Over the next week we'll find out just how far this is true. What is certainly the case is that though many British businesses may still be refusing to acknowledge the seismic shift about to occur within the European economy, in the high octane driven world of the City's financial markets, hundreds of millions have already been spent on adapting IT and trading systems for the advent of the euro.

Investment and commercial banking, the two parts of the financial services industry most immediately affected by the launch of the new currency, have planned for "conversion weekend" in meticulous detail. From securities custody, through currency trading, how to deal with fractions and unmarketable units, to the most complicated of customised derivative instruments, the City is ready.

Thousands will see in the New Year in anxious sobriety - at their desks attempting to grapple with the closing exchange rates at which currencies will from tomorrow lock into the euro. Many IT and trading specialists will continue working through the weekend, testing and adapting their systems for last- minute glitches. Getting it right will give competitive edge over those who don't and could make the difference between big profits and losses.

Given the City's position as the world's biggest and most successful international financial centre, it would perhaps be surprising if the City were in anything other than a state of high preparedness. Over the past 15 years, the Square Mile has changed out of all recognition. The closed shop of largely domestic firms and partnerships it once was has been transformed into an open market place for international capital; it has become the location of choice for international bankers and securities traders everywhere.

Virtually every complicated European banking transaction of importance now takes place through London, and its markets - from foreign exchange to debt and futures - dominate the European time zone.

So being prepared comes with the territory. The bigger question is not so much whether London is practically capable of meeting the challenge of the euro - that scarcely seems in doubt; initially, at least, the City looks destined to dominate the euro markets. Rather it is whether the Square Mile can hope to maintain this pre-eminent position if Britain stays out of the single currency.

For Peter Levene, Lord Mayor of London, and to the extent that there is one, titular head of the City, there is no doubt that it can. Financial and business services such as IT, accountancy, consultancy and legal work now account for in excess of a quarter of the UK economy, and the City is a large part of that.

Quite apart from this vital position in the national economy, the wealth generated in the City has become core to the vitality and economic health of the capital, helping to sustain its vibrant arts scene, its property markets, its restaurants and a whole panoply of other service industries and jobs.

The consequences of losing out because of the launch of the euro would therefore be disastrous. In this sense, the single currency might be regarded as a serious threat to the City. If your business is commission driven, it is obviously more lucrative to deal in 11 currencies than just one. The opportunity to pursue profitable trading strategies is also that much greater.

More importantly, rival European financial centres have always looked jealously over the Channel at their bigger London counterpart, and in recent years, Frankfurt in particular has been chasing London hard in certain markets, particularly German bond based derivatives. Are Frankfurt, Paris and Milan really going to allow what would in effect become an offshore centre to dominate markets in their own single currency?

Lord Levene is adamant that Europe needs the City as much as the City needs Europe. If the euro is to survive and prosper as a powerful reserve currency capable of looking the dollar in the face and attracting cheap foreign capital in the same way as the US does, it needs to develop deep and liquid capital markets. The City is uniquely placed to offer these markets, more so than any other centre, and to act as a conduit for foreign capital into Europe.

Key to the single currency's success as a reserve currency will be the development of an integrated debt, or bond, market, both national and corporate. All the indications are that the City will dominate this eurobond market in the early years, but will it remain that way?

Already there are warning signs. The very location in Frankfurt of the European Central Bank will in itself act as a powerful magnet for markets. Physical proximity to policy makers still seems to matter in markets, even though advanced IT systems render it unnecessary.

More worrying, Brussels seems intent on removing some of the City's present competitive tax advantages. The most serious immediate threat is posed by the planned imposition of a 20 per cent withholding tax on income from bonds.

On the face of it, this would seem a quite innocuous piece of anti-evasion tax harmonisation. All countries have withholding taxes, the deduction of tax at source, in some shape or form. In this country, employers pay salary net of income tax. Interest on building society accounts is also paid net of basic rate tax.

Non taxpayers then reclaim the tax from the Revenue at a later stage. However, to impose it on bonds might cause these markets to shift offshore to rival international centres where bonds could be traded gross, as well as acting as a general deterrent to foreign capital.

Certainly, when such a tax was imposed in the US it caused a large part of the bond market to shift offshore. The euro dollar market was born. A large part of the City's present success is based on this single act of tax lunacy, since it persuaded many US investment banks to set up operations here in London and helped generate the critical mass of foreign interest and trading to push the City into the super league of financial centres.

At present, the planned scope of the tax is limited to individuals - or only about 10 per cent of the total Euroland bond market - but there are proposals from a group of MEPs to extend it to companies as well. Tony Blair, the Prime Minister, has vowed to use Britain's veto to block the move and there is good reason to believe that Brussels might eventually accept the Corporation of London's case. If the effect was to cause a general flight of capital from Europe, that would plainly be bad for everyone, not just the City.

All the same, many see in these proposals a harbinger of things to come. Brussels and its Continental masters might seek to punish the City for being outside the euro. If Britain joins the single currency within a relatively short period of time, then the City can realistically hope to retain its position as Europe's leading international centre. If it does not, then its chances would seem remote, notwithstanding Lord Levene's protestations to the contrary.

It is not realistic to think that Britain and the City would not in some way be discriminated against as long-term abstainers from the single currency, or that the integrated debt market so vital to the new currency's sustained health could tolerably be based outside Euroland. That would not be dissimilar to allowing the gilts market to be run out of the Bahamas.

If, on the other hand, the euro is a failure, then all bets are off. London would be left as the default centre of choice and in prime position to pick up the pieces. Already there are signs of capital flight from Euroland, albeit quite limited in scope. The extent to which that process gathers pace depends crucially on what type of single currency the euro becomes.

Will it be a liberalising, free market force across Europe, or will it mark the onset of ever greater centralised regulation, including centrally imposed tax harmonisation. That debate is only just beginning. The City has a powerful vested interest in making it the former, but it cannot do so if Britain remains outside.