London has the ring of confidence

ECONOMICS In or out of Europe's grand scheme, the City may gain from a single currency, writes Peter Rodgers
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The Independent Online
It is easy to forget that much of the City of London's success as a financial centre in the 1980s and 1990s has been a result of obscure banking regulations imposed by the US authorities on their own banks many decades ago. A few minor pieces of ill- thought-out interference were enough to prompt a flight of money to London, which by the 1970s became a gigantic offshore haven for the dollar.

It was a classic demonstration of how a financial centre can be built or destroyed by apparently technical decisions, probably made at quite low levels of government.

The City is therefore regarding the changes in its market, which are inevitable as a result of monetary union in Europe, with trepidation. They will have a huge impact on the banking and securities industry in the European Union, regardless of whether Britain takes the plunge and joins the single currency.

This explains why, as politicians debate the pros and cons of the grand scheme of monetary union for the economy, the City is just as interested, if not more so, in scrutinising the regulatory and banking minutiae of Emu. The devil will be in the detail when it comes to deciding where the banking and securities business takes place in Europe, and the City could suffer badly if Paris or Frankfurt assert too much influence over the rules.

The most famous of the accidental American boosts to the City of London was Regulation Q, which held down the interest rates banks could offer for deposits in the US. Banks in London were able to pay higher rates for dollar funds, which flowed across the Atlantic and created the giant Eurodollar market.

A City of London starved of money because of squeezes on sterling suddenly found itself in possession of a new currency to finance world trading, which happened to be offshore dollars rather than British pounds.

At the same time, controls on capital, particularly an interest equalisation tax, effectively closed New York to foreign borrowers, whose banking markets could not then compete internationally. America's banks, and later its securities firms, found they had to follow the business that had left New York, and invest heavily in building their operations in London.

Could there be something similarly favourable to London lurking in the small print of the agreements being drawn up by the European Monetary Institute and other bodies involved in the transition to monetary union?

Or will there be a clause that works the other way, tipping the balance of advantage away from London towards Paris and Frankfurt? The French and the Germans are already lobbying to ensure the rules work in their favour.

It is early days yet, but a couple of candidates for the honour of being the European equivalent of Regulation Q have already emerged.

The first is the possibility that countries inside the single currency area will discriminate against those that stay out, by hampering their access to clearing systems and other vital cogs in the machinery that makes money go round.

If Britain stays out and its banks cannot get access to liquid funds in Euros, the single currency, on the same terms as those within Emu, banks in London will be fighting for business in a new and very powerful trading currency with one arm tied behind their backs.

There is already serious concern about this prospect in London, while other possible non-joiners such as Denmark are up in arms about threats of discrimination. What sparked it all was an indication from French and German central bankers earlier this month that they want tight restrictions on access that banks in countries outside Emu will have to Target, a new clearing system that will handle Euros.

They are said to argue that access to the clearing system must be restricted to improve the effectiveness of monetary controls within the single currency area. If they get their way, which is far from certain, it could produce a two- tier banking system in the EU, which is not what the single market was meant to create.

A second candidate for the new Regulation Q is a more intriguing one, because it could work the opposite way, in London's favour. The European Central Bank, when it is set up during the transition to monetary union, will have the power to impose reserve requirements on banks, as the Germans and others do now.

The central bank may demand that commercial banks place part of their money on deposit with it. The commercial banks are paid no interest or - more likely - a below market rate. The main purpose is to influence the money supply, as a tool of monetary policy.

The Bank of England has told any central banker who cares to listen that it believes reserve requirements are a waste of time, claiming it is more effective to use a combination of interest rate changes and purchases and sales of paper in the short-term money markets than to use reserves to fine-tune monetary policy.

But it is not the monetary argument that matters to the City. Reserves deposited with the central bank, paying below the market rate of interest, are effectively a tax on banks, driving up the cost of money. There's nothing the City would like to see more, if we do stay out of the single currency, than an aggressive use of reserve requirements by the European Central Bank.

The market in the new Euros would decamp to London, just as a huge amount of deutschmark business has gone from Frankfurt to Luxembourg to avoid German reserve requirements. As a result, Germany has been able to make very little use of bank reserve deposits in monetary policy in recent years.

If we are inside the single currency, then it does not matter so much because everyone will be treated equally, whether or not reserve requirements are used. Perversely, the Bank of England is most likely to win the argument over reserve requirements if Britain stays out, because of the threat from London's banks.

The Germans are still bruised by their experience with Luxembourg and are also mindful of the fact that for different reasons much of the trading in German bond futures has decamped to London. They know the risks, and may be less than enthusiastic about the use of reserve requirements, preferring them to be kept small, or to pay interest at almost the market rate. But it would be a game where the slightest mistake by the Germans and French could be of great benefit to London's 500 banks.

More of these vital technicalities are bound to surface as the transition period to monetary union approaches, and it is impossible to know at this point whether any of them will tip the balance in favour of one side or the other. But there is one lesson from the great Eurodollar flows that gives good reason for the City to be optimistic about profiting from a single currency, whether we are in or out.

The flight of American firms to London in pursuit of dollars turned what could have been an ephemeral flow of money through bank accounts into a secure and continuing business, employing tens of thousands of people. For different reasons over the last couple of years, but with a similarly beneficial effect on the City's critical mass, some of the biggest European banks have been establishing their investment banking headquarters in London.

It is certainly not in the commercial interests of the newcomers to see the City undermined. Perhaps the new European recruits to London have already been placing their own well-informed bets on which financial centre will do best from the single currency, whether its government decides to go in or stay out.