Memorandum by Mr James Barty, Chief European
Equities Economist, Deutsche Bank
The Treasury Committee has asked the author
of this report for his personal opinions on the issue of the UK
and Economic and Monetary Union. The report that follows outlines
those views.
The Committee asked for comments on a number
of issues including an assessment of the ECB's and euro area's
economic performance since its inception. The general conclusion
is that the euro area economy has performed well, with growth
improving and inflation remaining under control. In my opinion,
the ECB has conducted an appropriate monetary policy, albeit that
there were some teething problems. The euro has struggled, but
this is probably a cyclical rather than a structural phenomenon.
In terms of convergence between members of the euro area, on whole
I believe it is too early to draw definite conclusions although
there are some worrying signs in the likes of Ireland.
On the question of the UK's suitability for
entry into EMU there are still significant problems in my opinion.
The UK continues to meet the quantitative Maastricht criteria
on debt, deficits, interest rates and inflation. However, there
would need to be amendments to the Bank of England's statute to
meet the independence criteria of the Treaty. More importantly,
in my view, the UK continues to fail the exchange rate criteria.
Much more stability is needed in the currency if this is to be
met and that would require either a change to the Bank of England's
mandate or entry into ERM 2, or both.
In terms of the Chancellor's five tests, the
key problem is the failure of the UK economy to converge with
that of the euro area. What signs there are of convergence are
largely the product of different monetary policy settings in the
euro area and the UK. In my opinion it is still the case that
euro area interest rates would be inappropriate for the UK economy.
If the Government wants to ensure macro economic
convergence with the euro area it needs to be more proactive and
cannot rely merely on the attainment of economic stability to
generate convergence. Two areas in particular need to be addressed,
the lack of currency stability and the UK's greater sensitivity
to short term interest rates.
The views contained in this report are those
of the author and not those of Deutsche Bank AG.
INTRODUCTION
The Treasury Committee asked for written evidence
on Economic and Monetary Union addressing the following issues:
— monetary conditions to date (in
the Euro area), including the value of the Euro and its position
as an international reserve currency, and the actions and structure
of the European Central Bank;
— the performance and the future prospects
of the Euro area economy and the progression of economic convergence
between member states since the Euro's launch;
— whether developments in the Euro
area economy and the UK economy have made any substantive difference
to an assessment of whether the UK satisfies (i) the Maastricht
convergence criteria(ii) the Government's "five economic
tests";
— the implications for the Euro of
enlargement of the EU;
— the National Changeover Plan and
the level of preparation undertaken by (i) UK firms and (ii) the
public sector for possible entry into Stage III of EMU.
I intend to address the first three points,
the latter two are outside my areas of expertise. This note is
not intended to be all-encompassing and will not attempt to go
over ground already covered by the considerable literature on
the issue of UK entry into Economic and Monetary Union. It will
instead directly address the issues identified above, outline
developments since the Euro's launch and, finally, assess areas
that need to be addressed if the UK wishes to enter EMU. The views
expressed in this note are those of the author and not of the
Deutsche Bank Group.
1. MONETARY CONDITIONS,
THE EURO
AND THE
ECB
(i) Monetary Conditions
Monetary conditions in the Euro area in the
run up to EMU were broadly stable with the appreciating Euro (or
more correctly the Euro-area currencies) being offset by falling
interest rates, particularly outside the core (ie Germany, France
and Benelux). The combined effect of exchange rate and interest
rate moves can be captured by a monetary conditions index[4]
(see Figure 1). This initially rose in early 1998 as the Euro
appreciated, but then fell back as interest rates were cut in
the second half of the year. This was in response to the need
for short rates to converge ahead of EMU and to offset the negative
effects of the Emerging Market crises.
However, after the start of EMU monetary conditions
were relaxed markedly as the Euro fell and then the ECB cut short
rates to just 2.5 per cent in April 1999. As can be seen from
the chart below this produced a sharp easing of monetary conditions.
I would argue that such a marked easing of policy was justified
as growth slowed markedly into 1999 (annual growth dropped below
2 per cent in the H1 99) and inflation on a core basis fell below
1 per cent. Indeed, while much was made of the sharp decline of
the Euro, given the limited external exposure of the Euro area
(around 15 per cent of GDP), a sizeable decline in the currency
was needed to generate a stimulus to the economy. Indeed while
the pace of decline of the Euro may have been worrying from a
credibility perspective, it was not a major concern from a policy
perspective.
This phase of easier monetary policy conditions
came to an end in November 1999 as the ECB decided to reverse
its 50bp rate cut of the spring, as growth recovered and headline
inflation headed higher. It has subsequently followed this with
a further 125bp of tightening, the latest move taking place on
8 June. This interest rate tightening was initially offset by
still further declines in the Euro. Indeed, when the Euro dropped
below 90c against the US dollar in early May, the Deutsche Bank
MCI was actually lower than when the ECB began tightening back
in November. It is only with the latest interest rate tightening
and rebound in the Euro that the MCI has started to rise again.
It still indicates however that monetary conditions are loose
in the Euro area.
It is also useful to consider current versus
neutral or equilibrium levels of interest rates and exchange rates,
to get a feel for the stance of monetary policy. First interest
rates. There are a number of methods that can be used to calculate
the neutral level of the interest rate, and there are no hard
and fast rules to decide on which to use but one that is often
favoured is that derived from the so called Taylor rule. This
states that central banks set interest rates above or below a
neutral level depending on the deviation of inflation from its
target level and the amount of spare capacity in the economy (usually
measured by the gap between actual and potential GDP). In work
carried out by my colleague Carlo Monticelli he calculates that
the neutral level of interest rates in the Euro area is around
4.5 per cent. At 2.5 per cent rates last year were clearly below
neutral, but with the recent move up to 4.25 per cent it could
be argued that interest rates are now only moderately expansionary.
The same would be difficult to say about the exchange rate. Over
time Deutsche Bank has calculated a number of different measures
for the equilibrium exchange rate, which point to a fair value
against the US dollar of at least 1.15 and some in excess of 1.20.
That would suggest that the Euro is still 15 per cent or more
undervalued at current levels. The combined effect of interest
and exchange rate levels would again suggest that monetary policy
is expansionary.
Money supply and credit growth in the Euro area
would also lead to a similar conclusion. M3 money supply growth
consistently ran above the ECB's 4.5 per cent reference value
for the whole of last year. Over the last six months it has been
running at above 6 per cent on average with a further acceleration
to around 6.5 per cent in the latest months. Credit growth has
been even more buoyant with annual growth rates consistently in
double digits.
Accordingly, the evidence would seem to suggest
that the ECB has been running an expansionary policy through the
course of its first 18 months in existence. With unemployment
high, significant spare capacity in the Euro area and inflation
(on the core measure) comfortably inside the ECB's target such
a policy has, I believe, been justified. Going forward with the
Euro area economy likely to extend its recovery and inflation
to pick up (see Section 2), such a policy is likely to become
increasingly less appropriate. I would therefore expect the ECB
to continue to tighten monetary policy. The primary route for
this is likely to be through interest rates, with the money markets
currently discounting rates rising to a little over 5 per cent
by the end of next year, a level that I think is broadly appropriate.
Some recovery in the Euro is also likely towards its equilibrium
level, particularly if the US economy slows as is generally expected.
(ii) The Euro
As I have discussed above the Euro has struggled
in its first 18 months of its existence. It fell from a peak of
1.18 in January 1999 against the US dollar, to a low of around
0.89 in May of this year, before recovering to around 0.96 at
the time of writing. Despite the recent recovery that still represents
a drop of some 20 per cent. On a trade-weighted basis the decline
has been more modest, but at 14 per cent it still represents a
significant fall. At this stage there is little to say whether
this drop in the Euro represents a lack of confidence in the fledgling
currency or merely a cyclical swing in the currency. As can be
seen from Figure 5, swings away from equilibrium for the Euro
against the dollar are not unusual. Back in 1995 the Euro (or
its synthetic equivalent) rose well above its equilibrium rate
in a period when the dollar was weak and European currencies strong.
Moreover, with the Euro area now a more closed area because of
the single currency, it can be argued that the ECB can take a
more relaxed attitude to the currency than the Bundesbank did
in the past. Accordingly currency swings could become more exaggerated.
In terms of the Euro's status as a reserve currency,
the evidence suggests that the dollar remains the predominant
reserve currency and as yet there has been little switching of
central bank reserves into the Euro. Again it may be too early
to draw conclusions from this and the fact that the Euro has been
weak has probably acted as a deterrent to central banks altering
their portfolios. In financial market terms though there has been
more evidence of success for the Euro, with bond and equity issuance
rising markedly in the aftermath of monetary union. Indeed, in
terms of corporate bonds, Euro denominated issuance is comfortably
outpacing dollar denominated issuance. Figures supplied to me
by my colleagues at Deutsche Bank show total issuance since the
start of 1999 to be Euro 484 billion for Euro issues agains US$
396 billion for Dollar issues. While the currency may not have
achieved an international reserve status its arrival has undoubtedly
allowed the creation of a much deeper and larger financial market
in Europe.
(iii) Actions and Structure of the ECB
The ECB's monetary policy stance has, I believe,
been broadly appropriate, with policy eased in response to weak
growth and falling inflation and then more recently re-tightened
as the economy has recovered and inflation has picked up again.
If the ECB is to be criticised it should be in the way it has
conducted itself, often sending confusing messages both on likely
changes in monetary policy and on the currency. This may reflect
teething problems as the ECB was still finding its feet last year.
However, it may also reflect its structure as with 17 members
it has a large decision making body. In the long run, with further
members to join, starting with Greece and continuing through to
some of the EU aspirants, the current structure of the Governing
Council will almost certainly have to be changed. The six-member
Executive Board of the ECB will have to take on a much more dominating
role.
2. PERFORMANCE
OF THE
EURO AREA
ECONOMY AND
PROGRESSION OF
ECONOMIC CONVERGENCE
BETWEEN MEMBER
STATES
(i) Performance and Prospects for the Euro
Area Economy
As discussed briefly above, conditions in the
Euro area economy at the start of monetary union were difficult.
Growth was slowing in response to the impact of the emerging markets
crises, with the German and Italian economies, in particular finding
life difficult. Indeed growth in Germany virtually stalled over
the winter of 1998-99 with annual growth dropping below 1 per
cent for the whole of the first half of 1999. Growth for 1999
as a whole was a disappointing 1.5 per cent in Germany (down from
2.2 per cent in 1998) and just 1.4 per cent in Italy. The peripheral
countries, Spain, Ireland, and Finland weathered the storm better
as did France, where growth came in at almost double that of Germany
in 1999. The differences between growth performance came from
two factors. First, Germany and Italy were more exposed to the
emerging market countries than the others and accordingly their
export sectors suffered more. Second and probably more importantly
both lacked strong domestic demand as low real wage increases
and continuing fiscal tightening constrained consumer spending.
The easing of monetary conditions detailed above,
particularly in the first half of the year, and a turnaround in
the global economy, triggered a recovery in the Euro area economy.
Growth having averaged little more than a 2 per cent annual rate
through Q4 1998 to Q2 1999, accelerated to 3.6 per cent annualised
in the second half of 1999. This recovery was led by the industrial
sector where growth, having slowed to a halt for most of the first
half, had accelerated to 5 per cent year on year by the early
months of this year. With most surveys continuing to show buoyant
conditions, the latest EU Commission survey saw consumer confidence
hit a new record high and business confidence match its previous
record; the recovery seems set to continue through the course
of this year. Indeed, the Deutsche Bank official forecast is for
growth in the Euro area as a whole to accelerate from 2.4 per
cent last year to 3.5 per cent this year. Indeed, as can be seen
from Figure 11 only Italy is expected to see growth below 3 per
cent this year.
Inflation has remained subdued since the start
of EMU with the core measure oscillating around the 1 per cent
level. Headline inflation has been more volatile dropping below
1 per cent in late 1998 and early 1999 as falling oil prices impacted.
From the middle of the year onwards, however, headline inflation
started to rise as oil prices began to recover, rising to 1.7
per cent by the end of 1999. In early 2000 it continued to rise,
breaching the ECB's 2 per cent ceiling in March. Although it has
fallen back below 2 per cent since, Deutsche Bank forecasts that
it is likely to remain at or close to 2 per cent for some months
to come.
While such a rise in headline inflation might
at first sight appear troubling for the ECB, the bulk of the upward
move has come from higher oil prices. Indeed, as the chart shows,
core inflation has been more stable, with the year-on-year rate
currently 1.3 per cent. There are some signs though that core
inflation is starting to pick up, with the three-month annualised
measure of DBCI (Deutsche Bank core inflation) rising to 1.44
per cent in the latest month, largely reflecting the impact of
the feed-through from higher oil prices and the weak Euro. This
measure has a good track record of predicting future movements
of the year-on-year core rate and Deutsche Bank expects core inflation
to rise above 1.5 per cent by the year end.
There may well be more cyclical pressure on
inflation going forward as the Euro area economy continues to
recover. Indeed, on Deutsche Bank estimates, which show growth
of 3.5 per cent this year and next, the output gap (a measure
of spare capacity in the economy) will be closed and even move
into positive territory. There will therefore be an incentive
for the ECB to push rates up to slow growth next year. That, in
turn, will mean that the decline in unemployment which has dropped
from 10.5 per cent at the end of 1998 to 9.2 per cent in the latest
month (April) is likely to slow too. Indeed, most projections
suggest that Euro-area unemployment will level out at or above
8 per cent. This reflects the higher natural rates of unemployment
in the Euro area, which most economists, myself included, attribute
to the still inflexible labour markets in most Euro area economies.
On the whole I would conclude that the Euro
area economy has performed reasonably well in its first 18 months
of life. The more difficult challenges for the ECB lie ahead,
as spare capacity is absorbed and it has to head off any cyclical
inflationary pressures. In particular it is likely to find that
some economies are running into bottlenecks much faster than others.
(ii) Progression of Economic Convergence
The evidence of economic convergence since the
start of EMU is mixed. If we look at the charts on GDP growth
(Figures 10 and 11) there certainly does appear to be some convergence
on this front, particularly if the forecasts for 2000 prove correct.
Whereas in 1998 the lowest growth rate was 1.2 per cent below
the rate for the Euro area as a whole, that had narrowed to 1
per cent last year and this year is projected by Deutsche Bank
to fall to just 0.8 per cent. The picture is more stable on the
high side. Ignoring Ireland, which is just way ahead of everybody
else the strongest growing country outpaced the Euro area by 1.2
per cent in 1998, 1.3 per cent in 1999 but narrowing to a projected
1 per cent in 2000. Even in Ireland, the gap between its growth
rate and the Euro area is expected to narrow (on DB estimates)
from 6.6 per cent last year to 5 per cent this year. Whether anything
can be read into this convergence is unclear as it may just be
cyclical and even three years is only a very short time period
over which to judge this.
The inflation picture is less clear. The gap
between Euro area HICP and the lowest HICP is steady at 0.5 per
cent in 1998, 1999 and 2000, although the highest, which is Ireland,
in all three years shows a widening gap from 1.1 per cent in 1998
to 1.4 per cent in 1999 and a projected 2.7 per cent in 2000.
While there are some special factors distorting the Irish inflation
rate particularly in the current year (eg higher tobacco duty),
inflationary conditions in Ireland do appear to have deteriorated
relative to the Euro area. Outside Ireland however the picture
is more encouraging with the highest inflation rate being 1.1
per cent above the Euro area rate in 1998 and 1999, but projected
to narrow by DB to 0.9 per cent this year.
More evidence should be forthcoming in the next
few years as the stronger growing economies eliminate their spare
capacity faster than the slower growing economies. This is already
becoming evident in countries like Ireland and to a lesser extent
Finland, Spain and Portugal. These countries have seen rapid credit
growth, strong domestic demand, and in Ireland signs of labour
shortages and wage and price pressures. If these trends continue
then their inflation performance may start to deteriorate relative
to other Euro area countries. Even this may not be undesirable
in the medium term as price and wage levels in the less well off
Euro area countries (eg Portugal, Spain, Ireland to a lesser extent)
should converge with those in the better off countries. This is
desirable, providing productivity rates converge too. Equally,
those countries experiencing rapid credit growth now could find
that they are more susceptible to rising interest rates going
forward and therefore will slow more sharply as the ECB moves
to a tighter policy stance.
It is difficult to draw an overall conclusion
on whether there has been convergence or not. To be sure there
are some worrying developments in Ireland, which if they spread
to other countries would signal potential problems. However, again
it is far too early to draw definite conclusions.
3. CHANGES IN
THE ASSESSMENT
OF WHETHER
THE UK SATISFIES
THE MAASTRICHT
CONVERGENCE CRITERIA
AND THE
GOVERNMENT'S
FIVE ECONOMIC
TESTS
(i) The Maastricht Convergence Criteria
There are six criteria to be met to satisfy
the Maastricht Treaty for entry into EMU. The UK has consistently
met the ones on debt, deficits, interest rates and inflation and
in the last couple of years this is even more the case now than
a couple of years ago. Inflation has fallen further with the Harmonised
CPI currently just 0.6 per cent; accordingly the UK is not just
within 1.5 per cent of the average of the lowest three inflation
rates but has the lowest inflation rate in the EU. Equally, the
budget surplus and consequent declining government debt more than
comfortably meet the 3 per cent of GDP deficit and 60 per cent
of GDP debt limits. The combination of lower inflation and falling
debt levels has allowed 10 year government bond yields to within
a few basis points of those in Germany. So again the 200bp limit
is more than comfortably achieved.
Where the UK does struggle is on the central
bank independence criteria and, most importantly of all, the exchange
rate stability criteria. Although the Bank of England is independent
in making its decisions there are a number of areas where the
current statute fails to meet the Maastricht Criteria. The Chancellor
retains the right to intervene in exceptional circumstances; he
sets the inflation target while the Monetary Policy Committee
rather than the Governor alone sets interest rates. All of these
would have to change if the Bank of England is to be independent
as defined by the Maastricht Criteria. That, however, would be
relatively simple to achieve should the government so wish, given
the size of its majority in Parliament.
4 The monetary conditions index is a weighted average
of exchange rate and interest rate indices. Deutsche Bank uses
a 15 per cent weight for the exchange rate and 85 per cent for
interest rates. Back
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