Blair maintains pragmatic approach to euro entry

With the Labour victory a foregone conclusion, the financial markets up to early June anticipated a quick entrance to the euro and speculators went short against sterling, feeling that the pound was overvalued. The pound shed some 5 per cent against the euro in the past three months and reached a 16-year low against the US dollar.

But, while the markets were keen on a further downward glide of the pound, sterling managed to recoup part of the losses.

It seems the market spoke before its turn. The British government has made it clear that it will take a pragmatic approach towards the issue of euro entry.

In his cabinet reshuffle of ministers, Prime Minister Tony Blair has demoted two strong euro supporters. He replaced pro-euro foreign affairs minister Robin Cook with the euro-pragmatic Jack Straw, and the proeuro Stephen Byers, outgoing industry minister, with Patricia Hewitt, who is not a euro-enthusiast. More importantly, Mr Blair will first have to convince his Chancellor, Gordon Brown, before a referendum can be prepared.

Then there is the lack of public enthusiasm for the euro. About two-thirds of British voters do not want to give up the pound, although a majority thinks that the euro will be a fact in Britain within a decade. By contriving a smart publicity campaign, Mr Blair hopes to sway the public vote towards adoption of the euro.

In fact, Labour has linked acceptance of the euro to five economic tests. Is the European interest rate appropriate for Britain? Will there be sufficient flexibility to absorb economic shocks? Will the euro entice more overseas investment? Would the euro not harm the interests of the City? And would entry lead to more growth and jobs for the British?

If Labour can convince the voters that the outcome of these five tests will be positive, Mr Blair has a chance of winning the referendum. Given the hurdles that still have to be cleared, a referendum cannot be expected before 2002.

A "Yes" vote is by no means the end of the process. The European Commission and the European Central Bank will have to write a report on the convergence of the British economy with the euro zone. The European Council will have to negotiate Britain's membership and the date of entry.

And the statutes of the Bank of England will need to change to meet the requirements of the EU treaty. British business will have to get ready for the introduction of the euro, and more banknotes and coins will have to made. All in all, British euro membership is unlikely to become fact before 2004.

Negotiating the sterling entrance rate against the euro will be a tricky business, since the government will have to set a clear level that is likely to stir opposition from one group or another and to have a negative effect on winning the referendum. On the other hand, the euro-zone partners will only be prepared to come to the bargaining table once they have heard a definitive British "Yes".

Britain would qualify easily for the convergence criteria (stable prices and interest rates, state debt and fiscal deficit, and a stable exchange rate), but not if the pound is overvalued. Currently, British export products are expensive in Europe and Mr Blair will not want to join at an overvalued rate.

Germany and Italy, who entered the euro zone with overvalued exchange rates, are now being confronted with low growth rates and may be unwilling to welcome a cheap competitor. They will try to force as high an entry rate for Britain as possible. This will meet with resistance from the British, who have fresh in their minds the debacle of 1992 when sterling, which entered at an overvalued rate in the exchange rate mechanism, was speculated right out of it.

But supposing the British manage to negotiate a lower euro-sterling rate - how low should it go? The consensus is that the pound is about 10 per cent to 15 per cent overvalued. A devaluation of that magnitude would have severe consequences for inflation, which at 1.7 per cent is far below the European growth average. A devaluation of the pound would force the Bank of England to hike interest rates. But such a change in monetary policy combined with higher inflation might put the convergence criteria at stake, never mind the pound qualifying as a stable currency against the euro. Fast entrance, therefore, seems to be a non-starter.

Sterling was set at about DM2.95 between 1989 and 1992, whereas it traded DM3.25 against the German currency recently. The British economy has gone through a process of good growth. Unemployment has plummeted to record lows (3.2 per cent), labour productivity has increased and inflation, the scourge of the British economy, seems to be under control. A stronger economy could afford a higher exchange rate.

Whether the pound is overvalued against the euro is, therefore, open to debate.

In the short-term, a euro referendum has been shelved until next year at the earliest and entrance to the euro should not be expected before 2004. Now that sterling is no longer driven by long-term factors (interest rates and inflation), cyclical factors and portfolio shifts will gain the upper hand. Expected growth and long-term interest rate differentials point towards an appreciation of the pound against the euro.

Dr John Ryan is a managing consultant with Davis Langdon Consultancy in Britain. He has extensive experience of euro changeover projects with large firms and governments. He contributed to the Joint Oireachtas Committee on European Affairs second report on European monetary union (April 2000) while a director of PA Consulting euro centre of excellence, which also advised Irish companies on their euro changeover strategies.