ECONOMICS: Concerns about potential effect of the euro's recent appreciation against sterling on competitiveness of Irish exports to UK may be overdone
For the euro, the year 2002 may be remembered for more than the introduction of notes and coins - it may be the first in which the single currency appreciates on the foreign exchange markets.
The euro traded as high as $1.19 in its first few days of existence at the beginning of 1999, but then fell steadily in value against the major currencies, including the dollar, trading under 83 cents at one stage in the autumn of 2000. Since then it has traded in a broad range between 85 and 95 cents against the dollar, so the recent breach of 95 cents is significant and supports the view that a new range of 90 cents to parity may well be established over the coming year.
The euro has also appreciated against sterling, which has heightened concerns about the potential impact on Irish competitiveness, as the UK is still the Republic's largest export market, accounting for almost 25 per cent of total exports, or over half of the foreign sales of indigenous companies. Fortunately, such concerns may be overdone, as recent trends in the foreign exchange markets imply that any sterling weakness against the euro will be limited, with the prospect of UK membership of the single currency acting as an important determinant of the euro/sterling rate, and hence the exchange rate between the UK and the Republic.
The British government is committed to joining the euro but only when the time is right. Judgment on the latter is ultimately a political one, but the UK Treasury has outlined five tests on the timing of entry, using such criteria as the impact of membership on employment, the future of London as a financial centre and whether the economy is flexible enough to withstand economic shocks following the loss of monetary sovereignty.
A verdict from the Treasury is expected within 12 months, although an announcement is now expected earlier rather than later, and so the conventional wisdom is that the Blair government will call a referendum on euro membership by the autumn of 2003, on the assumption that the Treasury verdict is not an unconditional rejection of EMU entry. A "Yes" vote in the plebiscite, it is argued, will mean euro entry for sterling some two to three years later, most probably in early 2006.
The entry level for sterling, should it join, has been much debated, with the consensus now moving away from earlier views centred on about 2.75 deutschemarks (equivalent to a euro sterling rate of 0.71) to a higher level of DM2.90 or DM2.95. The latter was sterling's old central rate when it was in the ERM in the early 1990s, so it has a particular resonance.
Interestingly, the euro's recent rally has pushed the spot sterling/ DM rate below DM3.05, which in turn generates a rate of DM2.95 three-and-a-half years forward, i.e. if one wanted to trade now for delivery in early 2006. In that sense, the market may well be effectively pricing sterling entry in now, and if so a number of consequences follow. In the first place, sterling will be far less volatile against the euro, because it will not deviate too much from its potential entry level. Second, sterling will gradually decline towards the entry level as UK interest rates converge to those of the euro zone.
Third, a strong sterling rally is unlikely in the absence of a political shock to euro entry (e.g. Brown replacing Blair). Finally, and crucially, sterling is capped on the downside, as a big fall now would imply entry at too low a level. For example, a euro sterling rate now of 0.69 cents would imply entry in 2006 at 0.71 cents, which is DM2.75.
As long as entry in 2006 is seen at DM2.90 or above, then the euro will not appreciate above 0.65 pence against sterling. If sterling is indeed capped on the downside, then so is any punt appreciation against the UK currency. Moreover, if the entry level is indeed DM2.95, it would lock sterling in at the equivalent of 84 pence against the punt, and hence conserve the huge competitive gains made by the the Irish economy relative to the UK over the past decade, at least for a good few years, which would be positive for Irish growth and employment.
The flip side is that a sustained euro rally would help to drive Irish inflation down as some 80 per cent of imports come from outside the euro area, and a limit on the appreciation against sterling would similarly limit the disinflationary impulse from the foreign exchange markets.
• Dr Dan McLaughlin is chief economist at Bank of Ireland
