Euro's stability against sterling is good news

Economics/Dan McLaughlin: Trade with Britain probably accounts for over half of exports and imports in some sectors of economy.

The euro's appreciation trend against the US dollar has received much attention of late, but a more significant development from an Irish perspective has been the relative stability of the euro against sterling. In effect, sterling appears to have "joined" the euro, which is good news for the Irish economy.

The UK remains Ireland's largest trading partner and the scale of this dependency can be gauged by the weights assigned to the currencies that make up the Republic's average trade-weighted exchange rate, which the Central Bank calls the Trade Weighted Competitiveness Indicator (TWCI). This comprises 10 countries, with the UK assigned a weight of 28 per cent with the US coming in at number two, with a weight of 18 per cent.

These figures may understate the UK's importance for indigenous firms, moreover, as trade with Britain probably accounts for more than half of exports and imports in some sectors of the economy.

The euro has certainly appreciated against sterling over the past year (it is currently trading some 6 per cent above its level in mid-January 2003), but what is noteworthy is sterling's relative stability against the euro over the past six months, which is all the more striking given the scale of the euro's move against the dollar. Since June, the euro/sterling rate has traded in a 68-71 pence range, moving in a 2 per cent band around 69.5 pence. One might think the Bank of England was at work here, intervening in the market to keep sterling stable, but the relative stability is purely market-driven, raising the issue as to why this should be the case.

We now know, following the UK Treasury's deliberations last year, that the Blair government feels that euro entry for sterling is not appropriate for now, on economic grounds, so membership of the single currency is clearly not on the agenda for the next few years. However, one study commissioned by the Treasury on the appropriate entry level if sterling did decide to join has perhaps had a more lasting effect.

The study put forward 73 pence as a reasonable rate for EMU entry, and this may now be acting as an effective floor for sterling against the euro. Interest rates are almost 2 per cent higher in Britain than in the euro area, so an expectation of 73 pence in a few years time translates into a rate around 71 pence now. This interest differential in favour of the UK may also move higher in the near term, which is a further support for sterling, and may propel it to the 68 pence level, to test the recent trading range.

Whatever the reasons, the euro's stability against Ireland's main trading partner has resulted in only a limited appreciation of the TWCI in the last six months. The average value in January to date, for example, is only some 1 per cent above its value last June.

There is also debate as to the impact of any given change in the exchange rate. The text book answer is straightforward enough: a currency appreciation will damage export growth, and hence economic growth, but will also put downward pressure on consumer inflation via the import price channel. Yet the evidence from the Irish economy over the past year does imply that the euro's appreciation, even against the dollar, has not had the impact one might have expected.

Take export prices. The euro has risen from 85 cents against the US dollar to around $1.25 over the past two years and from around parity in the past 12 months alone. So a firm making computer chips in Ireland, say, costing 1 (including profit) would have sold them for $1 12 months ago, but the dollar price would now be $1.25 in order to continue to earn €1. Ireland's export prices in euros have been falling, however, and sharply at that (down 6.5 per cent in the year to Q3), which implies export firms are cutting euro prices to maintain the dollar price. The result is lower profits, of course, and against that backdrop it is less surprising to see multinational profits in Ireland fall in 2003.

The broader conclusion is that foreign exchange (FX) movements may have less impact on output and prices than once thought, and that globalisation and enhanced competition mean firms have to absorb such moves into profits, at least for a time. If the FX move is seen to be long-lasting, however, firms are then likely to make a greater attempt to adjust to the new environment, via cuts in costs, including employment. For Irish firms trading with the UK the relative stability of sterling against the euro has minimised the need for this adjustment but it is clearly more relevant for those firms with large exposure to the dollar, particularly if the US currency continues to fall.

Dr Dan McLaughlin is chief economist at Bank of Ireland