Uncertainty over EMU sends pound into freefall


Why is the pound dropping in value when the economy is booming?

The fact that the Irish economy is the strongest in Europe has little to do with the pound's current misfortunes on the foreign exchange markets. The sharp decline in the value of the Irish currency, particularly against sterling and the deutschmark, is primarily being fuelled by uncertainties ahead of European Monetary Union, scheduled for January 1st, 1999.

The Republic is in an unprecedented situation. Next January, the value of all the currencies joining monetary union are to be fixed together irrevocably. For example, the value of the pound will be fixed against the deutschmark, the French franc, the lira and all the other currencies joining monetary union. The pound is being driven down because investors believe we will lock into monetary union at a rate well below that at which the pound has been trading on the markets.

While EU governments have still to decide finally, it appears that the so-called central rates in the ERM band will be used to decide the levels at which the currencies will be locked together. At the moment, currencies are allowed to diverge by a certain amount in value from these central rates under the ERM rules. The pound's central rate against the deutschmark is DM2.41 and it has been trading well above this level, leading to speculation that it must fall in the final run up to the locking of currencies.

The other European currencies remain relatively unscathed because most are already trading at or close to their central rates.

Because of the wide differential between Ireland's central rate and its prevailing rate of exchange against the deutschmark, there has been much speculation that the Irish authorities might seek to revalue the central rate to bring the pound into EMU at a higher rate. This is now thought unlikely to happen by investors, leading to the selling pressure on the pound, although the Government has yet to outline its attitude.

What about sterling?

The pound's weakness has been compounded by the phenomenal strength of sterling on the currency markets. The British currency's new-found strength has been gained mainly on the back of a surge in the dollar, prompted by the turmoil in south-east Asia. The dollar is being seen as a safe haven currency, with investors switching enormous funds out of those regions into the US currency, sending its value soaring ahead. This has had a profound affect on sterling, which is also attracting funds out of the Far East and which traditionally moves in line with the dollar.

In normal circumstances, the pound would rise in tandem with sterling. But the wave of selling pressure related to Ireland's entry to the single currency means this has not happened, the pound dropping to eight-year lows against the British currency.

How long will the uncertainty continue?

Over the next three months, it is now expected that the pound could weaken even further against sterling, although its decline may be offset should the British currency lose ground. Sterling's current rise may turn out to be short term in nature, stemming from the troubles in the Far East. In the longer term, it is unlikely to be able to maintain its strong position, particularly with economic forecasts now signalling a significant slow-down in the British economy this year.

At the start of May, EU leaders are to sit down and decide which currencies will join monetary union and how the joining rates will be set, which should remove any remaining uncertainty. In the meantime it is unclear how much further the pound will fall.

Will interest rates fall and when?

At the moment, short-term Irish interest rates - the rates on which mortgage and bank interest rates are based - are around two percentage points above German interest rates. As Irish and German interest rates are set to converge in the run up to EMU, it is just a matter of time before Irish rates begin to fall.

If the pound stabilises at a level close to where it is likely to join monetary union - and at the moment the markets are betting on the central rate of DM2.41 - then Irish interest rates should drop quickly. And while the Central Bank would be reluctant to allow rates to fall at the moment, events in the markets are dictating the pace.

What will be the effect on the economy?

The drop in the pound could throw up some anxiety over inflation as it will almost certainty raise the cost of living. It will make the cost of imports more expensive, with the price of items such as clothing, footwear and magazines all likely to rise, particularly if the pound remains weak against sterling.

But the drop in the value of the pound is broadly good news for Irish exporters and should enhance profits and support jobs in the indigenous sector. It will also assist earnings at the large companies with international subsidiaries, particularly in the US and British markets. The main beneficiaries will be companies such as Bank of Ireland and AIB, which have significant operations in those markets. The weaker pound will also boost the tourism industry, encouraging more visitors.