Sterling must fall - but how?

News Analysis: High pound hurts exporters and complicates Britain's switch to the euro
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The Independent Online
IN MOST countries a strong currency is a badge of pride, but not in Britain. Exporters hate it, of course. It has eaten up their profit margins and is nibbling away at their market share. The ever-wider balance of payments deficit is a symptom of the strength of sterling since mid- 1996.

But there is another reason for concern, at least for anybody who hopes Britain will join the single currency not too long after a post-election referendum. That is how to get the pound from its current level of about 66p to the euro to a parity acceptable to British exporters - say 75p to 80p to the euro - and also to our European partners.

In some continental circles there is great hostility to the idea of making any concessions to the pesky British, wanting to join late and on terms that would give UK competitors an unfair advantage in European markets. The negotiations between UK and continental ministers could prove delicate.

One reading of the Maastricht Treaty governing the single currency is that the UK will have to rejoin the Exchange Rate Mechanism formally in order to keep the pound stable for two years before entry. However, most experts agree a more flexible interpretation is correct.

Ireland, for example, saw its currency declining towards its ultimate central rate in the euro for about a year before the 1 January launch. As this was not a crisis-driven devaluation, it was accepted by the Council of Ministers. The same is likely to be true for Greece, rumoured to be seeking early entry in the very near future.

In the end, the level and trajectory of sterling in the currency markets at the time the British government seeks entry to the euro will be decisive. According to Graham Bishop, an expert on European matters at Salomon Smith Barney: "There is a pragmatic view among policy makers that this is for keeps, and you need a rate that will keep everyone relaxed. That includes it being a rate which will pose no challenge in the markets for a year or so."

Sterling is certainly not there at the moment, however. The forward rates in the currency markets imply that the pound will drop to about 68p to the euro within two years - scarcely any help as far as beleaguered UK exporters are concerned.

Complicating the picture is the difficulty in putting a number to the long-term sustainable exchange rate. By the standards of the decade before Britain's disastrous earlier Exchange Rate Mechanism experience, up to September 1992, 75p to the euro looks about right.

But some economists argue that the UK economy is fundamentally stronger than it was in the 1980s and before. There is evidence for this view in the fact that the trade deficit is no worse than it is. If the economy were behaving as it did in the bad old days of regular balance of payments crises, the current account would have gone into the red far faster and more cataclysmically than it has.

Even if this optimism about the economy is right, however, the "equilibrium" exchange rate for the pound is probably well below the current market rate. Economists at Goldman Sachs estimate the pound is currently 15 per cent or so overvalued, and predict a correction to take it into the 75p to 80p range. The trigger would be weaker UK growth and a widening trade deficit this year, compared with faster growth on the Continent.

The Government's task will be much easier if this decline just goes ahead. The mere fact of announcing a firm decision to join the single currency could have an announcement effect, lowering the exchange rate - although, as Mr Bishop says: "Life is not always so convenient."

In its Inflation Report last week the Bank of England spelt out the likelihood of a decline in sterling, generating some inflationary pressure. Mervyn King, one of the Bank's deputy governors, would not be drawn on where he thought the pound ought to be in the long term. "It would give the impression that we had an exchange-rate target," he said. "The only target the MPC has is an inflation target." Mr King elaborated on this in an interview at the weekend. The Monetary Policy Committee could not cut interest rates in order to target a particular level for sterling. Interest rates had to target inflation, and only inflation, because otherwise the MPC could end up inflating the economy excessively and in this way harm the UK's chances of membership of the single currency.

It is certainly true that the Bank cannot hit two targets - inflation and the exchange rate - with one weapon, interest rates. If it aims for one, it has to take what it gets on the other.

But, again, this points to the conclusion that the Government will have to seek UK entry to the single currency on the basis of whatever level the pound happens to have reached in the markets at that stage.

Mr King emphasised: "It would make no sense to have a covert shift of targets and strategy, and that is certainly not the Government's policy."

And Michael Saunders, UK economist at Salomons, said: "There are no easy solutions to this problem if it emerges. There is no clear Plan B to achieve a desirable Emu entry level."

Whitehall officials have started to plan for Emu entry under different scenarios for the pound, including a discussion of whether and when the Bank of England's remit would have to change.

Clearly, after a "yes" vote in a referendum and a successful negotiation on the entry level for sterling, the Bank will have to switch targets. It will then have to give priority to keeping the exchange rate stable for a transition period of one or two years.