Single currency will wipe out varying EU rates

Ireland will have the same interest rates as Holland, Germany, Spain and all the other euro members at the end of this year, because we will all have the one currency. And as an interest rate is effectively the "price" of money, one money across Europe will mean that all shorter-term interest rates on financial markets will be at the same level.

The reason is that simple, but as a reader's letter pointed out earlier this week, probably not adequately explained.

At the moment, for example, the same interest rate prevails in Dublin as in Leitrim, even though it could probably be argued that Leitrim could do with lower rates and Dublin with higher.

The only reason that short-term interest rates should be different across Europe is if there is a risk of one currency changing in value against another. Rates are the same in Cork and Letterkenny because the currency is the same in both places and thus there is no such risk.

If interest rates were lower in Frankfurt than Dublin when we both have the same currency, then everyone would borrow in Frankfurt and lend here. The arbitrage, or trade off, between the two would quickly eliminate the difference.

What is important to remember is that from next January we will be living with "euro" interest rates as the euro will be our official currency. Although the pound will theoretically continue to exist in notes and coins in our pockets, it will in reality only be a denomination of a new currency the euro. And it will be converted into the euro at an irrevocably fixed exchange rate, removing any risk of moving money from one euro currency to another.

As Dr Dan McLaughlin, chief economist at ABN Amro says, the European example is very different to the dollarzone countries, where currencies are simply pegged to one another - rather than their actually being a single currency. The varying interest rates in Latin America reflect investors' concerns that these pegs may break, leading to swinging currency values.

In the euro-zone, the one area where there may be slight differences is in very long-term interest rates, or Government bond yields. Investors may still believe that the risk of lending money to the Irish Government over, say, 10 years may be fractionally higher than lending to the German government over the same time. For example, no-one knows how the euro zone will work and there may be small doubts about whether smaller countries like Ireland can stick the pace in the long term. As a result, Dr McLaughlin is expecting Irish 10-year rates to be about one tenth of a percentage point higher than German rates.

The way our interest rates are set will also change inside the euro-zone. What happens here now is that financial institutions set retail interest rates at a fixed premium over the amount they have to pay for funds themselves.

The benchmark used is the interbank market, where banks borrow and lend to each other. Retail rates are usually about 1.5 percentage points to 2 percentage points higher than interbank rates.

The Central Bank cannot completely control the interbank market, as it is determined by how much banks will pay to borrow and repay to each other. At the moment one-month money on the interbank market is around 6.64 per cent.

But the Central Bank does usually set the ceiling on the interbank interest rates, by guaranteeing to supply funds at a certain rates. At the moment the ceiling is the short-term facility or STF, which is set at 6.75 per cent. However, the banks usually borrow and lend to each other at below this ceiling. And the Irish Central Bank provides them with a certain amount of cash each week at a lower rate - currently 6.19 per cent. This is known as the repurchase or "repo" rate. at its weekly repo. At the same time the discount rate sets the floor as this is the lowest level a central bank will pay to borrow money off from other banks. There is usually quite a wide range between these two figures and so what the Bundesbank and other European central banks do is a weekly "repo" which determines the rate any central bank will lend to the commercial banks for two weeks. In Dublin at the moment that rate is 6.19 per cent.

If the Central Bank wants to influence interest rates, it can alter the amount of money it supplies to the market. If there is a big shortage of money as is the case here at present it will supply more money but if there is plenty of liquidity it may rein back on its lending.

After we move to the euro in January, the European Central Bank will have responsibility for setting the weekly or fortnightly repo - the rate at which funds are supplied regularly to the markets. So if it sets the rate at 4 per cent it will have to ensure that 4 per cent prevails in every centre from Rome to Dublin. So in each centre, the individual central bank will either have to supply more cash if it is above 4 per cent, or less if it is below.

Mindful that Irish interest rates will have to converge down to German levels by next January, the Central Bank is currently supplying a lot of funds - about £1.8 billion - to the money market, to keep rates from going higher. This shortage of funds is due to a number of reasons. One key influence is a substantial demand for cash from consumers, as the economy is booming, while other factors related to currency dealings have also left the Dublin market short of pounds. Turnover in the market, or the amount commercial banks lend among themselves, is about £4.5 billion a week. By setting the "repo" rate the Bank does have some control of interest rate levels, particularly for very short-term lending and borrowing for a month or less. It is these shorter-term market rates which determine mortgage and most savings and deposit rates.

Come next January, of course, full control over these interest rates levels will move to the European Central Bank in Frankfurt and the Central Bank of Ireland will implement its policy, but will not be calling the shots.