House of Commons - Treasury

Select Committee on Treasury Eighth Report

IV. THE EURO AND THE UK

33. The Maastricht Treaty established criteria by which the European Commission and the ECB could report to ECOFIN on whether EU Member States had achieved the "high degree of sustainable convergence" necessary to join Stage Three of EMU.[180] These criteria are:[181]

— the sustainability of the Government financial position, measured as the ratio of the planned or actual Government deficit to GDP being less than 3 per cent, unless that figure is exceeded for temporary and exceptional reasons or the ratio has declined continuously and substantially and comes close to the 3 per cent reference value; and the ratio of Government debt to GDP being less than 60 per cent, unless the ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace

— the observance of the normal fluctuation margins provided for by the Exchange Rate Mechanism (ERM) for at least two years, without any devaluations

— the durability of convergence with other participants in the ERM, measured by an average nominal long-term interest rate not more than 2 per cent above that of the three best performing Member States in terms of price stability.

There is broad agreement that the UK meets all of the Maastricht criteria, bar that of exchange rate stability,[182] although some witnesses pointed out what they perceived to be weaknesses in the formulation of the criteria.[183]

34. A key issue if the UK were to decide to join Stage Three of EMU would be how the exchange rate criterion could be met. It is not clear whether the UK would be required to join the semi-fixed exchange rate mechanism (ERM2) similar to the system which the eleven existing members of Stage Three were part of before the launch of the euro, or whether a period of exchange rate stability outside of ERM2 would do.[184] In our 1998 report we invited the Treasury to spell out in more detail its thinking on how the UK could achieve exchange rate stability before joining Stage Three, an opportunity which was not taken up.[185] In oral evidence, the Economic Secretary told us that "we have no intention of being either in an ERM2 or shadowing the euro or whatever arrangement there might be" and Mr O'Donnell observed that the Maastricht Treaty "does not specify anything with respect to exchange rate stability for a period post-euro".[186] The Treasury has accepted that "exchange rate stability is an important part of preparation for EMU" but argued that "what matters for exchange rate stability are sound economic fundamentals. For Britain, the best way to achieve this is through the monetary and fiscal framework which we have set in place".[187] As many witnesses pointed out, however, the sterling/euro exchange rate has been anything but stable since the launch of the single currency.[188] Witnesses offered a range of views on the sterling/euro exchange rate at which it might be appropriate for the UK to join Stage Three;[189] the length of time and the mechanisms required to establish that such a rate was the right one;[190] and the changes which might be required to the UK's monetary policy regime in order for the exchange rate, rather than inflation, to be the target variable.[191] Some argue that if a decision were taken for the UK to join Stage Three, exchange rate stability might need to replace price stability as the primary goal of monetary policy during the transition period before full membership. As Professor Buiter explained, "if the Chancellor and the Government decide that joining is going to be a serious objective, then the exchange rate has to become the overriding nominal target. You cannot be a little bit pregnant in these things. You have to do it seriously and have a formal change in the [Bank of England's] mandate".[192]

THE CHANCELLOR'S FIVE TESTS

35. In his October 1997 statement on UK participation in Stage Three of EMU, the Chancellor of the Exchequer set out five tests which "will have to be met before any decision to join can be taken." These are "whether the UK has achieved sustainable convergence with the economies of the single currency; whether there is sufficient flexibility in the UK economy to adapt to change and other unexpected economic events; whether joining the single currency would create better conditions for business to make long-term decisions to invest in the UK; the impact membership would have on the UK financial services industry; and, ultimately, whether joining the single currency would be good for employment".[193]

36. In our 1998 Report we questioned the precision of the tests and called for more information from the Treasury on the way in which they would be assessed.[194] The Government promised that, if it was to recommend that the UK should join Stage Three in the next Parliament, "we would of course set out the various factors behind that decision".[195] It does not intend to revisit its 1997 assessment of the tests before the next general election,[196] however, and nor is Government policy specifically tailored to meeting the tests.[197] Some witnesses were critical of the tests, questioning why they were necessary and the extent to which they could be considered objective measures of the economic case for UK entry.[198] Irrespective of these criticisms, the five tests are likely to play an important part in the debate about UK entry to Stage Three. We asked witnesses for their views on whether their assessments of the five tests had changed since the launch of the euro, and consider each of the tests in turn below.

Sustainable Convergence

37. Convergence is the most crucial of the five tests and the one most difficult to assess objectively. If the business cycles of the euro-area and the UK were not sufficiently converged at the time the UK joined Stage Three, the monetary policy applied across the euro-zone might be inappropriate for the UK economy. Several witnesses speculated on what might have happened to the UK economy had the UK joined Stage Three in 1999, drawing on comparisons with the rising inflation rate in Ireland.[199] The OECD's recent conclusion that "on several scores, even as an 'out', the UK is projected to be as close, or even closer, to the economic centre of gravity [of the euro-11 area] than some of the current 'ins'" generated a lively debate amongst witnesses.[200] Britain in Europe thought that a recent analysis by the House of Commons Library "gives some evidence of convergence".[201] Ms Lea said that there had been "a bit of superficial convergence on things like growth rates, output gaps, unemployment and short-term interest rates ... but, nevertheless, there are still some very large gaps there, even on short-term interest rates".[202] Ms Barker argued that "cyclical convergence is really a timing problem. While I do not think we are cyclically converged today, I think it is possible that in a couple of years we may well find we are cyclically converged ... [But] I cannot really be sure either way".[203]

38. A point repeatedly made was that sustainable convergence required more than the coming together of key UK and euro-11 economic indicators for a short period of time.[204] The Treasury has already stated, in October 1997, that it might take "some years" for it to be demonstrably concluded that any convergence that was to occur was sustainable.[205] Structural obstacles to sustainable convergence, including the different trade patterns and debt structures of the UK and euro-11 area economies, have been identified,[206] although some witnesses disputed the importance of these factors.[207] Ms Barker, for example, considered that the UK's trade patterns and debt structure could change significantly if the UK joined Stage Three.[208] Professor Begg advanced this argument on a broader front, stating that "convergence is something that happens not just before you join a monetary union but also afterwards and as a direct result of joining", citing as examples changes to the behaviour of labour market institutions in Ireland and Spain as a result of membership of the single currency.[209] Mr Barty and Mr Bootle both played down the importance of post-entry convergence by arguing that close convergence was required before a decision to join Stage Three was taken.[210] Our witnesses agreed that sustainable convergence is the most critical of the five tests and that it should be more than a short-term cyclical coincidence, though, as some witnesses argued, entry itself might bring the economies of the UK and the euro-area closer together.

Flexibility

39. If the UK were to join Stage Three, then, as the Treasury has argued, "with the loss of domestic control over monetary policy and the exchange rate as a means of adjusting to shocks, a greater burden of adjustment will fall to factor and product markets".[211] The Treasury's conclusion in 1997 was that "persistent long-term unemployment, lack of skills and in some areas insufficient competition indicates insufficient flexibility to adapt to change and to meet the new challenges of adjustment that a single currency would bring".[212] The Institute of Directors argued that UK labour markets "have got less flexible" since 1992 due to the introduction of new employment regulations, such as the minimum wage and those arising from the Parental Leave and the Working Time Directives.[213] This was disputed by Mr Brinkley, of the TUC, who said "in the OECD lists, this is the least regulated, most flexible labour market in the western world", and by Ms Barker, who acknowledged "a question-mark about skills flexibility" but said she did "not think that it is something that would mean we should not join the euro-zone".[214]

Investment

40. The Chancellor's investment test referred to "the quantity and quality of long-term investment in industry, infrastructure and new technologies" which,[215] as we observed in 1998, "appear to us to be consequences of the first two tests having been satisfied".[216] The test has come to be interpreted in terms of the impact staying out of Stage Three of EMU might have on inward investment into the UK, an issue which has generated much debate in Parliament and in the press in recent weeks.[217] Mr Cushnaghan, of Nissan UK, forcefully argued that "it is getting increasingly difficult to make the cost case for mobile projects to attract them to the United Kingdom" because of the high value of sterling against the euro, a situation which might be improved if the UK were to join Stage Three.[218] Corus, the steel group which has recently announced significant UK redundancies,[219] told us that "the volatility of the pound against the euro greatly increases the risk of investment in the UK in any industry competing with Euroland companies. As long as this volatility persists, firms are likely to minimise risk by investing in euro member states".[220] Other witnesses questioned whether the UK's decision not to join Stage Three was a major influence on the decisions of inward investors. Business for Sterling wrote "for sophisticated global investors, exchange rate movements are largely irrelevant and can be easily and cheaply hedged. Far more important are differences between regulatory systems, tax regimes, workforce skills, telecommunications and other infrastructure. In so far as these would be affected by joining the euro, we believe it would make us less attractive to global investors, not more".[221]

41. Both sides of the debate have used recent inward investment statistics to back up their arguments. The Invest in Britain Bureau announced on 5 July that inward investment for the year ending 31 March 2000 had totalled £252.4 billion, an increase of 23 per cent on the previous year. Mr Anthony Nelson, of Schroder Salmon Smith Barney, writing in a personal capacity, drew attention to the declining proportion of foreign direct investment into Europe flowing into the UK, however, stating that "recent studies suggest that France, Spain and Germany are catching up rapidly with Britain as a favoured location for internationally mobile inward investment projects".[222] Mr Cushnaghan expressed the view that, for a major manufacturing inward investment project, at least two years typically elapses between the decision to undertake an investment project and the major expenditure on it taking place. He concluded that the effects of the UK's decision not to participate in the launch of Stage Three of EMU would not be felt on expenditure on inward investment projects until "at the earliest ... 2002-03-04".[223] It is therefore too early to be certain whether foreign firms are being deterred from undertaking new investment projects in the UK as a result of the UK's decision not to participate in the launch of Stage Three of EMU, although it would be wrong to be complacent.

The City

42. The Treasury has stated that "given the importance of the financial sector to the UK, it is vital that the decision on whether to join the single currency does not damage its competitiveness. The dynamic nature of the sector means that there is no room for complacency".[224] Witnesses from the financial services sector were united in the opinion that they, and, in particular, the City of London as a global financial centre, have not yet been adversely affected by the UK's decision not to participate in Stage Three of EMU from the outset. British Invisibles supplied us with a breakdown of trading volumes and recent developments in a broad range of City markets, drawing on a poll of seven major investment banks, and concluded that "the launch of the euro has not had any significant impact on London's status as an international centre".[225] Credit Lyonnais UK wrote that "the introduction of the euro has had much less overall impact than either the bank restructuring and rationalisation that is currently taking place, or the shift to electronic trading. We are of the view that the success of the City will not be much affected if the UK joins the EMU or chooses to stay outside. Rather the City's performance depends on a range of other factors such as the infrastructure, the skills base of the labour force, and the regulatory and fiscal environment".[226] Mr Christopher Johnson, however, thought that "some elements in the City have been complacent about the euro", and cited as evidence the recent agreement to merge the London Stock Exchange and Deutsche Börse.[227] Mr Sweeney, of the British Bankers' Association, said in oral evidence that "it was our view before that [UK membership of Stage Three of EMU] was largely irrelevant to the health of the City whether we were in or out, and that is largely borne out in practice. There are no areas of business which have manifestly suffered, and there are some which have manifestly grown since the euro was launched".[228] He went on to argue, however, that market rules and conventions could develop in such a way as to encourage cross-border business within the euro-zone, but not with countries outside the zone, and that such developments, or even merely an apprehension that they might happen, might disadvantage the UK financial services sector if the UK remained out of Stage Three.[229]

Employment

43. We commented in 1998 that the employment test, like the investment test, is likely to be satisfied if the first two tests are met.[230] Mr Christopher Johnson has written that "it has become increasingly difficult to argue that the UK needs EMU to promote employment, since unemployment, at under four per cent, is at its lowest level for twenty years ... However, it can hardly be claimed that joining EMU would increase British unemployment. Employment levels are not much influenced by whether a country is inside or outside EMU". Business for Sterling, on the other hand, argued to us that "joining the euro in the foreseeable future would ... increase unemployment in Britain substantially" because "the Eurozone is chronically over-regulated and over-taxed".[231]

180 Maastricht Treaty, Article 109j Back

181 Maastricht Treaty, Articles 104c and 109j and associated Protocols Back

182 Qq116-8; Ev,pp4, 18, 72, 77, p79 paragraph 4.1; App 1, App 6 section 3, App 7 paragraph 2.19, App 15 paragraph 3.3.i, App 16 paragraph 39, App 18 Back

183 App 16 paragraph 39; App 23 paragraphs 12-13 Back

184 Ev, p20; App 5 paragraphs 20-1 Back

185 EMU98 paragraph 89; Treasury Committee, Sixth Special Report, 1997-98, The UK and Preparations for Stage Three of Economic and Monetary Union: The Government's Response to the Committee's Fifth Report of Session 1997-98, HC905, (hereafter EMU98 Reply), piv Back

186 Qq509, 518 Back

187 EMU98 Reply, piv Back

188 For example see Qq154, 191, 218, 248 Back

189 Qq74-7, 191-2; Ev, p20 Back

190 Qq69-70, 73 Back

191 Qq70-3; Ev, p20 Back