Euro conversion and interest convergence key unknowns

This year will be a defining period for the economy. With monetary union set to start on January 1st, 1999, and Ireland's participation virtually assured, 1998 is the last year in which Ireland will have its own currency - and control of interest rates.

Although the notes and coins in your pocket will remain the same until 2002, their value and the cost of borrowing will be determined by the policies of the European Central Bank (ECB) in Frankfurt.

Before EMU commences there remain two key uncertainties for Ireland: first, at what rate will the pound convert to the euro and, second, when can interest rates be expected to fall to continental European levels.

The EU Council will announce the conversion rates to the euro in May and there is a broad consensus within the market that the ERM central parities will be chosen.

For Ireland this would present difficulties. The pound has been dragged away from its ERM central rate by the strength of sterling. The sharp depreciation required to reach that level again might destabilise the economy.

The danger of converting at the existing central ERM rate is that the exchange rate boost to exporters would coincide with the stimuli of falling interest rates and the tax cuts announced in the December Budget. Such a potent concoction is liable to overheat an economy which is already close to boiling point. This possibility has led to suggestions that the pound's central ERM parity should be revalued ahead of the conversion to the euro.

Minister for Finance, Mr McCreevy has until May to decide what to do. The stronger sterling is in the meantime, the more likely a revaluation will occur. Mr McCreevy will also be aware that sterling is well above its longterm "fair value" and that it is expected to fall over the coming 12 months.

Political considerations - mainly relating to the official farming and export lobby groups - point to a conversion at the central parity. And it is unlikely that Mr McCreevy will opt for a large revaluation of the pound's central rate, meaning the pound is likely to fall further against the core European currencies in the coming months.

Looking at interest rates, short-term Irish borrowing costs are more than two percentage points above Germany's and this difference will have to disappear by the start of EMU. The only issue is timing.

It is likely that the Central Bank will delay cutting interest rates until the conversion rate uncertainty is resolved. The foreign exchange market might interpret an early interest rate cut as a signal to sell the pound. With the conversion rate question out of the way, however, the market will not require the bidding of the Central Bank to push rates lower.

Once convergence is complete, interest rates will be set with regard to European rather than domestic conditions. Already, the focus of forecasters is broadening to the European stage in an attempt to gauge future interest rate prospects. Although conditions are beginning to improve in the continental countries, it is unlikely that rates will increase sharply during 1998.

Kevin Daly is Treasury Economist at Ulster Bank Markets. The views expressed here are personal.