Memorandum by Mr James Barty, Chief European
Equities Economist, Deutsche Bank
Table 1
MAASTRICHT CONVERGENCE CRITERIA
| | Time Period
| Criterion | UK
|
1. Inflation
Inflation to be within 1.5% of average of three members with the lowest inflation rates Based on lowest three EMU members (on inflation)
| 12m to March 2000 | 2.47
| 1.15 |
| Based on lowest three EU members (on inflation)
| | 2.38
| |
2. Fiscal balance
General government net borrowing (% GDP)
| 1999 | 3% or less
| -1.2 |
3. General government gross debt
General government debt % of GDP
| End 1999 | 60% or less
| 46 |
4. Average nominal long term interest rates
UK yields to be within 200bp of average of the three members with the lowest inflation rates
Based on lowest three EMU members (on inflation)
| 12m to May 2000 | 7.26
| 5.36 |
| Based on lowest three EU members (on inflation)
| | 7.39
| |
| Source: Deutsche Bank estimates
|
The real problem is the exchange rate criterion. The Maastricht
Treaty states that to qualify a currency must fulfil the following:
"The observance of the normal fluctuation margins provided
for by the exchange rate mechanism of the EMS, for at least two
years, without devaluing against the currency of any Member State".
Even if it is accepted that a currency can qualify without entering
ERM2 (which is debatable since every country that has entered
EMU has been a member of the ERM before entry), it is not clear
that sterling would qualify as being stable enough. In theory
over the last two years one could make a case that sterling had
fluctuated within a plus or minus 15 per cent band (which is the
official band range for ERM2) around its average rate over that
period. Indeed, the average rate for sterling against the Deutsche
Mark over the last two years is very close to DEM3.0, and peak
of DEM3.41 and trough of DEM2.74 would represent a fluctuation
band of plus or minus 10 per cent. I believe that would be stretching
the point particularly as the normal fluctuation bands at the
time the Maastricht Treaty was drawn up were either plus or minus
2.25 per cent or more generously plus or minus 6 per cent. Sterling
would fail on either of those criteria.
It is also far from clear that DEM3.0 would be a reasonable
entry rate for the UK into EMU. Most economists would argue that
the equilibrium rate is a good deal lower than that, with a range
of DEM 2.6-2.8 often quoted (a range with which I broadly agree).
Interestingly, if the time horizon over which sterling's stability
is expanded—to four years—the average rate over the
period drops to DEM2.87, but the fluctuation range becomes plus
or minus 23 per cent.
Accordingly, in my opinion, the UK convincingly fails the
exchange rate criterion at the moment. If the government wants
to prepare the economy for EMU entry at some point, some alteration
to the Bank of England's mandate to focus more on currency stability
is likely to be necessary. However politically unpalatable, membership
of ERM2 may even need to be considered—indeed it would seem
odd for a government to be prepared to fix a currency in perpetuity
but unwilling to join an exchange rate mechanism with 15 per cent
bands. In my view, the government's hope that macroeconomic stability
alone will lead to currency stability is not particularly realistic.
The US would score very well on macroeconomic stability through
the 1990s and yet the dollar has oscillated substantially against
the European currencies.
(ii) The Chancellor's Five Economic Tests
These are as follows:
(a) Are business cycles and economic structures compatible
so that we and others could live comfortably with Euro interest
rates on a permanent basis?
(b) If problems emerge is there sufficient flexibility
to deal with them?
(c) Would joining EMU create better conditions for firms
making long term decisions to invest in Britain?
(d) What impact would entry into EMU have on the competitive
position of the UK's financial services industry, particularly
the City's wholesale markets?
(e) In summary, will joining EMU promote higher growth,
stability and a lasting increase in jobs?
To a certain extent these tests overlap. Indeed, I would
argue that if the first four tests are met the fifth will almost
certainly be met. It is the first two questions, however, that
cut to the core of the issue of whether the UK could successfully
enter and remain in monetary union.
(a) Are business cycles and economic structures compatible
so that we and others could live comfortably with Euro interest
rates on a permanent basis?
In its assessment in October 1997 the Treasury concluded
that "the UK is not convergent enough to commit to joining
in the first wave". It argued that the economic cycle was
not in line with others in the EU, that it was not clear enough
that the shocks that had caused the UK to diverge in the past
would cease to be a problem. Indeed, it argued that if the UK
joined EMU too soon that there was a risk that rates would be
too low for price stability in the UK. It went on to state that
the UK needed a period of economic stability to demonstrate that
convergence was sustainable.
In my opinion little has changed over the last 2½ years
to alter that judgement. There is little evidence that the correlation
between the UK and Euro-area cycles has improved. In work carried
out by my colleague George Buckley at Deutsche Bank, and shown
in the table below, the addition of the years since 1987 makes
little difference to the correlation co-efficients calculated
by the Treasury in its 1997 assessment. If we look at 1980-2000
and compare it to 1979-1996 (which the Treasury used), there is
little difference in the correlations reported. The only slight
change is a small improvement in the correlation with the German
economy, although it is still little better than zero. If we shorten
the time horizon and look at 1992-2000, again there is a further
improvement in the correlation with the German economy, although
the correlation with France drops. However, it is worth illustrating
just how sensitive these calculations are to the time periods
used. If we move the calculations forward just one year to 1993-2000
the correlation with the US drops sharply from 40 per cent to
27 per cent, while that with Gemany jumps to 47 per cent. While
it is possible that the UK cycle is more correlated with that
in Europe in recent years, the evidence is far from conclusive.
What we do know is that the correlation between the UK and Germany
and France in all of these calculations is way lower than that
between France and Germany, which hit 74 per cent between 1993
and 2000.
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