UK will join EMU but only when time is right

Gavyn Davies on the likely timetable for a single currency
Robert Peston, the Financial Times journalist whose work nowadays has more impact on the markets than the Budget speech itself, set the cat among the pigeons on Friday by suggesting that the British government has recently decided in principle to join the European single currency, if not in 1999, then very shortly thereafter. This was dismissed as "mere speculation" by the Government press machine, but it is significant that there were no outright denials of the substance of the story. Even Robin Cook, until recently thought to be an EMU-sceptic, has said Britain could not remain indefinitely outside a successful European single currency.

It will be interesting to see whether the Prime Minister or Chancellor decides to come off the fence in public at Brighton this week. The odds seem to be against it. After all, there is still a chance, albeit extremely slim, that the single currency will not be launched on time in 1999. So far, the Government has quite rightly taken the view that the option value of the UK opt-out, negotiated at Maastricht, should be jealously guarded until the last possible moment - which means near the end of this year, by which time we must inform the EU whether we intend to be in the first round. It is doubtful whether we will hear anything definitive on this until Parliament returns in a few weeks.

Still, the broad outlines of the Government's likely position are becoming clearer. Entry in the first round still seems most improbable. But so too does a bald rejection of the single currency. Instead, we are likely to hear some warm noises about a desire to join EMU in principle, along with a set of criteria that will be used to make the eventual decision on precise timing. This could be accompanied by a programme of policy measures to speed the process of integration. The Government would then try to engineer a situation in which sterling could join the system before 2002, the date when the euro notes and coins come into existence.

Whether they can accomplish this depends on politics and economics. Obviously, the political element concerns the referendum pledge. There is no sign that Tony Blair would like to wriggle out of this pledge, and nor should he - it will be impossible ever to settle this, the most contentious issue in British politics, until the people have decisively spoken. But the timing is very tricky. Some commentators have suggested that the Government should pre-commit itself to a referendum in mid-1999, to coincide with the European elections. But is would seem foolhardy to throw away the weapon of opportunistic timing, and nobody can predict in advance what the state of public opinion will be in two years.

Even bolder would be a decision to hold the referendum next year, perhaps at the end of Britain's EU presidency in the summer. The case in favour of doing this is that Labour's honeymoon, and William Hague's anti-honeymoon, seem to be lasting longer than anyone expected, so why not take advantage of the public mood? In addition, a positive referendum result, even if not accompanied by a precise entry date, would allow the UK to wield at least some political influence in the EU in the crucial early days of monetary union.

But the case for caution is that it might be easier to win a referendum after the single currency has been successfully launched by the rest of Europe. Furthermore, the one sure way of rejuvenating the Tory party would be for Mr Blair to lose a referendum campaign to them next year. Government advisers believe that they would probably win a referendum in 1998, notwithstanding the negative sentiment still being shown in opinion polls, but a favourable result would not be certain. So the stakes are very high, and it would be perfectly understandable if a risk-averse Prime Minister decided against rolling the dice so early in his tenure.

Turning to the economy, the main obstacle to early membership of the single currency is that the UK requires much higher interest rates than the rest of Europe. Under the single currency, however, short-term interest rates will essentially be the same throughout the Union, except possibly for a very small risk premium to reflect the possibility that the scheme might blow apart before 2002. This means that the European Central Bank (ECB) will set rates at the level deemed appropriate for the whole Union, and not just for any single country within it.

Next year, in the run-up to the 1 January 1999 start date, interest rates in the various member countries will have to start converging towards each other, so that there is no sudden shock on the day that the ECB comes into existence. In fact, in May 1998, the member states will announce the exact exchange rates which will be used in the single currency eight months later. From that moment on, the national central banks will need to act in close concert, with the setting of interest rates likely to be the subject of greatly increased international discussion.

At present, German and French short-term interest rates are around 3.3 per cent, while Spanish rates stand at 5.1 per cent, and Italian rates at 6.1 per cent. This leaves considerable scope for argument about where EU interest rates should converge next year; indeed, this argument has already begun. The graph attempts to shed light on the debate by showing what the market expects to happen.

Essentially, forward interest contacts imply that all EU interest rates next year will converge towards the present weighted average rate for the region as a whole, which is around 4.5 per cent.

This also happens to be the path for rates implied by the Goldman Sachs forecast. Furthermore, for much of next year this level is quite close to the "optimal" level of rates implied by the Taylor Rule, an "objective" rule for setting monetary policy according to the behaviour of inflation rates and output gaps.

What does all this imply for the UK? In order to join the single currency in the first round, we would need to embark fairly soon on a programme to cut base rates to around 4.5 per cent in a year - 2.5 per cent below present levels. Furthermore, we would need to push the sterling exchange rate down to about 2.50-2.60 against the German mark so that we could enter the single currency at a sensible rate. The combined effect of this huge monetary stimulus would undoubtedly be to blow the lid off the economy, unless it were combined with a fiscal tightening of previously undreamed proportions.

This is why first-round membership is not a serious option. It is also why the Government cannot now pre-commit itself firmly to a specific date for future membership, since nobody can be sure exactly when it will be safe to bring UK interest rates into line with those set by the ECB. Agreement to join "when the time is right" is a notorious formula, with unpleasant shades of the Thatcher government's disaster on the ERM, but it is the most likely.