The euro paradox is choking our economy


A small paradox: the UK economy avoided the formal recession feared earlier this year and is now picking up speed rapidly - heading to 3 per cent GDP growth next year. So the Bank of England raised short-term rates to 5.5 per cent.

However, euroland's economy also slowed down during the first half - to only 1.6 per cent GDP growth. But it is now accelerating vigorously towards a 3.5 per cent growth rate in mid-2000. So the European Central Bank raised its rates - but only to 3 per cent.

This discrepancy may be particularly galling to UK home-owners. It is widely argued that the UK economy is far more sensitive to short- term interest rates because the vast majority of consumer debt is held in the form of floating-rate mortgages. The Bank of England remains fearful that rising houses prices will feed through into inflation because the precedent of the 1980s is still fresh in the mind.

But would this sensitivity persist if the UK were to join EMU? Even the Bank's own researchers have concluded that such a change would make past relationships invalid. So a big discrepancy in interest rates might be unnecessary in the future if the structure of the British economy moved towards that of euroland.

A lengthy period of interest rates that seem low to UK home-owners could impact on the form of housing finance, encouraging a move towards Continental- style, fixed-rate mortgages. But this requires long-term British interest rates to be low enough to stimulate a demand for mortgages fixed for, say, 15 years or even longer.

That would swing attention to the big paradox: the rate for 30-year bonds, not for short-term deposits. Little attention is given to this arcane subject but those who play in this market are not taking a bet for the next three months, they are playing for the remainder of a lifetime.

Many people approaching retirement are forced by government regulations to buy an annuity with the proceeds of their personal or money-purchase pension schemes. The rate offered for this annuity hinges on the interest rates that the government of the day pays on its long- term bonds.

During 1999, these rates have fallen to amazingly low levels - 4.2 per cent today. The current pattern of interest rates implies that, in a decade, 10-year rates will be around 3 per cent. Recently, these "forward" rates even fell to about 2.5 per cent - the lowest level this century. Annuity rates could ratchet down even further in the years ahead. Moreover, the returns on endowment insurance policies could also decline again, to the even greater discomfort of those relying on such policies to repay their mortgages.

Would-be annuitants are engaged in a battle with their friends in "final salary" pension schemes. Both are required to invest in safe assets, and the bonds issued by the Government itself are ideal in a world of low inflation. But the Government's finances are increasingly healthy so it needs to issue very few long-term bonds: good news for "sound money" but bad news for these savers.

The combination of an ageing population and government regulation is swelling the cash available to pension and life funds. As these two groups have already bought up nearly all the Government's long bonds, they are competing with each other to snap up any new ones, so sending prices spiralling. Correspondingly, this shrinks the returns available to new annuitants and boosts the costs of final-salary schemes to employers.

These distortions in Britain's financial system seem extraordinary when viewed from across the Channel in euroland. Corresponding German government bonds yield 5.6 per cent - nearly a third more than in Britain.

Continental yields may be enticingly higher but they are in a different currency. Sterling has appreciated dramatically against the European currencies over the last three years and the consequences are now showing up in a bulging current account deficit, leading many commentators to believe sterling to be substantially overvalued.

If Britain's attitude to joining the euro was clear - thereby removing that currency risk - then those high yields could flow to British pensioners. Interestingly, the corresponding currency outflow could force sterling down to a more realistic level. If extra competition in the UK market obliges companies to absorb the resulting surge in import prices, rather than passing them on to consumers via inflation, then investors could get a double benefit.

n Graham Bishop is adviser, European financial affairs, for Salomon Smith Barney/Citigroup.

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