UK takes a step forward in sterling debate

The British government's ruminations on the euro may have left everyone none the wiser on a likely entry date for sterling, but it did throw some light on the likely entry level.

The good news, from an Irish perspective, is that the proposed level for sterling is not one that should cause undue alarm for Irish exporters. Moreover, that exchange rate will now act as a ceiling on the euro/sterling rate and, if anything, the euro may well fall against the British currency in the short term.

The entry level chosen to join a monetary union is important because the nominal exchange rate is, of course, fixed irrevocably.

If one joins at too high a level, as arguably Germany did, it undermines competitiveness, and this can only be corrected by Germany having lower inflation than the other member-states, perhaps for a long period of time.

Similarly, joining at too low a rate (Ireland, for example?) boosts competitiveness but increases the probability of relatively high inflation in that country, which serves to ultimately erode the initial competitive gain.

In economic terms, the nominal exchange rate may be fixed but the real exchange rate (adjusted for inflation) can still change, although this may be a painful process.

For that reason, the British government decided to commission an expert analysis of the appropriate sterling exchange rate for entry to the euro and nominated Prof Simon Wren-Lewis, a well-known economist specialising in the theory of equilibrium exchange rates, to come up with an answer.

Prof Wren-Lewis noted that a number of other studies had put the equilibrium euro/sterling rate at between 75p and 85p, which immediately grabbed the headlines and led to an initial sell-off in sterling.

However, Prof Wren-Lewis rejects these studies in favour of his own model, which is primarily based on the idea of what is a sustainable balance of payments position for a country.

In Britain, he assumes that the economy should not run a balance of payments surplus or a deficit in the long run - the earnings from British exports should be matched by payments for British imports.

From this he derives an equilibrium euro/sterling exchange rate of 73p, and one suspects that this would be acceptable to the British authorities as an entry rate, particularly as it is weaker than the 66-68p range that had become the market consensus for entry.

In fact, there are some problems with the approach.

For example, Prof Wren-Lewis arrives at an exchange rate of 73p by making more positive assumptions about Britain's ability to attract foreign investment, which would allow Britain to run a balance of payments deficit, and sterling has not traded at 73p or its equivalent since 1996, but the Prof Wren-Lewis rate will probably serve as a proxy entry level in any debate on British membership of Economic and Monetary Union for the next few years at least.

If so, certain implications follow and are of significance for the euro/sterling exchange rate and hence for Irish inflation and Irish export growth.

The first is that 73p is now likely to act as a ceiling in the euro/sterling rate, as long as British membership of the single currency is seen as likely over the next few years. This means that for Irish exporters, the implied punt/sterling exchange rate will be capped at 92.7 pence, which is a long way up from the 83p seen in 2001 but should be far enough away from parity to reassure.

Sterling is also likely to trade higher against the euro in the near term for a related reason, connected with the fact that British interest rates are 1.75 percentage points above that of the euro zone.

The argument here is straightforward. If everyone thinks that sterling will join the euro in four years time at 73p, and it traded there today, then short-term cash would flow into Britain to avail of the 1.75 percentage point pick-up in interest rates.

Consequently sterling would rise and, in theory, would settle at a point that just offsets the annual interest rate differential over the four-year period.

This would imply a current spot euro/sterling rate of under 70p, which equates to 73p in four years time.

So traders will now keep one eye on sterling's forward rate against the euro when trading it from day to day.

I would not be surprised to see sterling trade higher anyway, based on the respective growth outlooks for the British and euro-zone economies, but the market may well keep the entry level argument in the background, thereby providing support for sterling at 72p-73p.

Sentiment on sterling entry will no doubt ebb and flow, of course, but as long as euro membership is given a reasonable probability then the 73p level will retain its significance and importance.