Irish Companies engaged in the many operational and technical preparations for EMU still face a few "macroeconomic" issues in the final approach to the introduction of the single currency. The most obvious one is the expected fall in Irish interest rates.
The timing of such falls is still in doubt but most of the reduction should occur before the end of November. This projected, fall depending on whether the Bundesbank raises German rates in the autumn, could amount to as much as two percentage points.
It will further stimulate an already booming economy in Ireland. The strength of the economy has produced difficulties on a number of fronts. The growing labour market shortages, allied to the upward trend in inflation and the larger than expected Exchequer surplus, have raised the heat on public and private sector pay demands.
The risk of overheating in the economy has attracted a fair amount of attention from Ireland's partners in Europe. In essence, our European partners would like to see a tighter fiscal stance in 1999 on the critical assumption that we will have no independent control over monetary policy next year.
The most strident calls have come from the president of the European Central Bank, Mr Wim Duisenberg, but a number of Bundesbank officials have also added their voice to the need for budgetary restraint in Ireland. Although Ireland constitutes less that 1 per cent of the euro bloc, the ECB would be anxious that Ireland should not be seen as the "weak link" in the euro chain.
Comments by the Taoiseach and other ministers have made it clear that fiscal policy in 1999 will be dictated by domestic considerations rather than by demands from Frankfurt. The provision of an appropriate level of tax reliefs in the forthcoming Budget, in the interest of continued pay restraint, is a very legitimate objective.
The Government's strategy must be to persuade our euro partners that we are in command of the situation. One fear is that, by not towing the line on fiscal policy in 1999, we could be penalised in the next round of structural funds.
Furthermore, with the recent agreement on the introduction of the new standard rate of corporation tax in 2003, there is a clear implication that the authorities might be expected to "play ball" with Europe on some other aspect of Irish economic policy.
It has been generally assumed that after the 3 per cent revaluation of the pound in March and the announcement of the planned bilateral exchange rates at the European summit in May, the question of the pound's entry rate into EMU had been put to bed. However, it has not entirely gone away. The pound's forward rate continues to trade at a small premium to its pre-announced fixed rate against the deutschmark of DM2.48338, which is due to operate with effect from January 4th, 1999. This will be the first trading day of the new year.
As the Irish rate of inflation has accelerated towards 3 per cent in recent months, there has been speculation that the pound could be revalued at the end of the year in order to restore the economy's low inflation credentials. A 5 per cent revaluation of the pound's central rate against the deutschmark, for instance, from its current central rate of DM2.48338 to a new central rate of DM2.6075 would bring the sterling/ pound rate back to over 90p. Is it possible that the ECB could propose such a last minute realignment of the pound as an alternative to a tighter fiscal policy? I believe that this is a very doubtful proposition.
However, with the annual rate of inflation set to head higher towards 3.5 per cent in coming months, there will be much more debate about what can be done to control inflation.
The exchange rate option is expected to be raised as a possible solution. This will cause concern to exporters facing an increasingly difficult international environment.
It is unlikely that the Minister for Finance, Mr McCreevy, would accept a second bite at the revaluation cherry. In his recent statements on the inflation rate, he has referred several times to the "temporary pick-up in inflation due to exchange rate movements". There is no denying that much of the deterioration in core inflation has been due to the fall in the sterling/pound rate to below 82p in the first quarter. It would appear from the Minister's comments that he, at least, expects this rate has stabilised and could improve further in the months ahead. Sterling has been slow to fall significantly against the deutschmark as the markets continue to speculate that the Bank of England's Monetary Policy Committee will raise UK base rates at least one more time. Indeed, another rise could come this week. This has prevented sterling from falling to lower levels and thus bringing the pound back closer to 90p. However, in time, this will surely occur, and with the impact of falling mortgage rates on our headline rate of inflation, Ireland's inflation problem should appear less severe within the next 12 months.
The official advice to the Minister is almost certain to be that sterling is overvalued and the slowdown in the UK economy will undermine sterling's value. The revaluation option will be seen as unnecessary from a short term perspective and also potentially damaging to Irish competitiveness in the longer term when the UK decides to join the euro. For exporters, however, the risk, albeit small, of a meaningful revaluation before the start of EMU points to the desirability of having forward cover in place against other euro participating currencies. Forward cover booked now for anytime in 1999 would guarantee an exchange rate very close to the proposed fixed rates announced at the summit last May.
John Beggs is chief economist at AIB Group Treasury
