Sterling's entry to the euro not a critical issue

It came as no surprise when earlier this week the British government announced that it was deferring any decision regarding entry to the European Monetary Union.

From an Irish perspective a decision in favour of sterling joining the euro would be viewed as positive for the Irish economy given the continued importance of trade with the UK. However, the Irish economy has prospered in recent years and quite clearly the continued independence of sterling seems to have had little negative impact.

The British authorities are clearly finding it very difficult to make a decision on whether to become part of the euro or not. The extent of this dilemma is reflected in the enormous effort being put into assessing whether the British economy would gain from joining the European single currency.

The Treasury's assessment of Chancellor of the Exchequer Mr Gordon Brown's five key tests was accompanied by no fewer than 18 independent studies by renowned British and international experts.

In contrast, the debate leading up to Ireland's entry to the euro was far less contentious. This reflected to a significant degree the fact that Ireland's decision was more straightforward given that the option of maintaining an independent Irish currency never really existed. Therefore, the practical choice facing Ireland was to join the euro or re-establish the link with sterling.

In reality Ireland's decision to join the euro was probably driven more by political considerations than by in-depth economic analysis. In almost any scenario, Ireland's monetary policy would effectively be decided elsewhere.

As part of the euro, Ireland has benefited from low and declining interest rates as the "one-size-fits-all" European monetary policy was determined by the large sluggish economies of Germany, Italy and France. With the Irish economy booming, such low interest rates were clearly inappropriate.

If Ireland's monetary fortunes had been tied to sterling over the past three to five years, Irish interest rates would have declined at a more modest pace and would now be based on the British base rate of 3.75 per cent as opposed the ECB repo rate of 2 per cent.

However, with interest rates and inflation rates declining across all industrialised economies in recent years, it is clear that the Irish economy would have enjoyed lower interest rates in most conceivable circumstances.

If monetary policy had been linked to that of Britain, arguably the somewhat higher level of interest rates would have dampened the Irish economic boom. Also, the substantial boost to Irish international competitiveness from the very weak euro in 2000 and 2001 would not have occurred in the event that Ireland had linked to sterling.

With the euro now very strong the key challenge facing the Irish economy is whether it is flexible enough to adapt to the resultant loss of international competitiveness. If the economy can successfully adapt to a prolonged phase of a strong euro, the decision to join the euro will have been vindicated.

In contrast, for the UK the economic arguments for and against joining the euro are much more finely balanced and ultimately it will be a political decision that may well not occur for several years.

The implication for Irish investors in equity markets is that currency factors will continue to require careful attention in the investment decision-making process.

The currency factor is important even for those investors who confine themselves to Irish equities, given that most quoted Irish companies have substantial overseas subsidiaries.

Many of the larger Irish quoted stocks, such as AIB, Bank of Ireland and CRH, have significant British operations whose profitability is affected by movements in the euro/sterling exchange rate.

Most of these companies also have significant US operations, where reported profits are affected by changes in the euro/dollar exchange rate. For many Irish companies, their US subsidiaries are far larger than their UK subsidiaries. Examples include CRH with approximately 60 per cent of profits generated in the US, and Waterford Wedgwood, which is heavily reliant on dollar-based sales.

Therefore, if sterling did join the euro, it would only partially reduce the impact of currency movements on the reported profits of Irish-quoted companies.

For active investors in equities, the main benefit of sterling membership of the euro zone would be the elimination of exchange rate risk and related transactions costs when investing in quoted British companies.

Compared with other European bourses the UK market offers investors a much better range of liquid shares to invest in, with the further attraction that many quoted UK companies are household names in Ireland. However, it does now seem that it could be several years before Britain enters the euro and it is conceivable that sterling will remain an independent currency indefinitely.

At the margin, it would clearly be better for the Irish economy and Irish investors if sterling were to join the euro. However, the success of the Irish economy since joining the euro strongly indicates that the status of sterling is a relatively minor issue.

Of far more importance to investors in the Irish equity market is whether the economy can adapt to the current tougher economic environment thus enabling Irish companies to continue to grow their profits.