Select Committee on Treasury Sixth Report

Exchange rate

99. The exchange rate is of critical importance to the assessment of the five tests. This has been recognised by the Treasury, which has commissioned a study to analyse "different approaches to the sustainable real exchange rate". As the Chief Economic Adviser acknowledged, entering at an inappropriate rate imposes short term costs on the economy as prices and wages adjust to regain competitiveness.[187] The entry rate is important for all the tests­for example entering at an exchange rate that is too far away from the current value could cause divergence between the UK and eurozone economies (although this will depend on economic conditions at the time of entry). Entering at an overvalued rate would cause a loss of competitiveness for UK industry and could jeopardise investment and lead to a period of slower growth and fewer jobs. We asked our witnesses what methods were available to estimate the sustainable real exchange rate. Various methods were put forward including purchasing power parity (PPP), which provides an estimate of the exchange rate that equalises the prices of a similar basket of goods. Other witnesses advocated an exchange rate that would lead to equilibrium on the balance of payments. The Governor told us that estimating the rate would be "a real art" and that you have "to get the views of people who are actually exposed to the euro exchange rate" and "do an awful lot of academic work".[188] Several employers' organisations, including the Engineering Employers' Federation and the British Chambers of Commerce, also submitted survey evidence.[189]

100. We asked a number of our witnesses how far they thought the current exchange rate was from a sustainable rate. As shown in the graph above, since we started our inquiry in August and during our evidence sessions in January and February sterling has fallen against the euro by around 10%. Mr Weale thought that a feasible entry rate was "1.48 to now we are pretty close".[190] Mr Bootle believed that "we are pretty close to a feasible rate, but ... some way away from a desirable rate", referring to the imbalances in the economy. "We are going to need the external part of our economy to be pretty competitive".[191] The Governor told us that "a year or so ago the sterling/euro exchange rate was an immediate obstacle to entry"[192] but following the recent fall in the exchange rate that obstacle is certainly reduced. Mr Stephens drew attention to the fact that "the glide path towards what the Treasury regards as a sustainable rate is probably the most awkward thing in all this".[193] The Chancellor told us that as part of the assessment the Treasury were undertaking "two very detailed studies, one on the approaches to the sustainable real exchange rate, and one looking at the exchange rate in its macroeconomic context" but would not speculate on what kind of conclusions they would reach and if they would indicate the Government's view of what was a sustainable rate.[194] It is of fundamental importance that entry to the euro, should this take place, is at a viable and appropriate exchange rate. Although there is no unanimity on what the precise appropriate rate would be, we note that a number of expert witnesses are now of the view that the exchange rate is close to such a rate.

101. The process by which the UK would fix the entry rate against the euro provoked some discussions amongst witnesses, both on when the rate should be determined and the process for doing so. Mr Regling, referring to the Maastricht criteria, told us that "the treaty is very clear in this respect. One of the five criteria relates to the exchange rate and it says very clearly¼that a country that wants to join the euro area has to be a member for two years in the Exchange Rate Mechanism".[195] The Chancellor disagreed with this, telling us that "the ERM...described in the Maastricht treaty no longer exists" and stating that "we would not rejoin the ERM and have no intention of doing so". He also drew attention to the fact that if the UK were to apply to join the euro it would "be a matter for the Council to decide".[196] Professor Giavazzi told us that "asking a country to be in a system for two years that has proved very unstable would be very dangerous¼not only thinking about the UK¼but also the countries of central and Eastern Europe that are thinking of joining".[197] The Governor drew attention to the wider 15% bands of ERM2 compared to the earlier years of the ERM, noting "That is a pretty wide margin for error".[198] We recognise the potential drawbacks of a process of entry involving a two year membership of ERM2. There is potential for the UK to provide leadership on this issue and to set out its preferred method of joining. Whatever the exact process were to be, it is important that the electorate knows, at least in approximate terms, the Government's view of an appropriate exchange rate range before they are asked to vote in a referendum.

Influence of UK on reform

102. The influence that the UK would have on the process of reform of the Stability and Growth Pact and the announced review of the European Central Bank's monetary policy framework and the voting procedures was discussed by a number of witnesses. Professor Giavazzi believed that "an important window for reform—in monetary policy, financial regulation and fiscal design—is now opening" and "it will be of finite duration".[199]

103. Opinion was divided on this point. Some witnesses suggested that the UK would in a sense gain by waiting to see if the reforms change in an optimal manner. On the other hand, Dr Coyle cautioned that if the UK says that it is "going to wait to join" until reforms have been resolved satisfactorily then the UK may be less likely to secure a satisfactory outcome.[200] The example of the Common Agricultural Policy was put forward by both sides: as a demonstration of doubts about the grounds for assuming the UK would be able to secure reform from the inside, and as a demonstration of the fact that a country outside when something was originally negotiated would find it being structured in a disadvantageous and inferior way. John Monks of the TUC believed that there was the opportunity for the UK to "provide the catalyst...for some necessary changes in the Stability and Growth Pact".[201] The Chancellor told us, regarding the Pact, that "there is a growing recognition that you cannot simply look at fiscal policy on an annual basis, but you have to look at it over the economic cycle" and that "people are coming to accept...the view that we have consistently put forward about the importance of debt being taken into account and the importance of investment being distinct from consumption".[202] The Governor told us that the Bank had a technical relationship with the ECB which he thought likely to continue regardless of the near­term decision, although he confirmed to us that there had been no Bank of England input into the review of the ECB's monetary policy strategy.[203]

104. In this period, when the eurozone's monetary policy and institutions are bedding in, there is clearly a greater 'window of opportunity' for British influence in negotiating reforms within the system, than would be the case later if there is a decision not to join the euro in the foreseeable future. The Government should continue to play an active role in the debate over reform of monetary and fiscal policy and structural reform. The analysis of the five tests and the accompanying studies will be of value to the eurozone states in this respect. Encouraging reform which improves the performance of the eurozone economy will also help to improve the performance of the UK's main export markets, whether or not the UK joins the euro.

The present options

105. This section of the Report has shown that the issue of timing—like so much in the debate over the euro—is not just an economic issue about whether or not there has been sufficient convergence. There are also politico­economic issues relating to whether the current moment is particularly opportune in relation to possible reform of the supporting institutions and structures of the single currency, not to mention the political impact that seeking to join might have on Britain's influence in the discussions inside and outside the Convention on the future structure and treaty base for the EU.

106. Government (and then Parliament) now face a range of options. These might be summarised as follows:

­ To conclude that the time is right to apply now to join the euro

­ To conclude that the economic case is made for joining, not immediately but at some fixed date in the near future

107. The implication of these options is that the economy would have been judged to be ready to move into the euro in the near future. For those convinced by the economic case for joining, the envisaged economic benefits of membership of the eurozone would then flow, but if the judgement proved premature there would be adverse economic consequences. The focus would move to the referendum campaign. The benefits of joining in terms of taking advantage of the 'window of opportunity' discussed above would be maximised by the first option rather than the second, but any wider political benefits could result from either option. A 'delayed' entry option would presumably involve a delayed referendum (leading in practice to a longer campaign), rather than the holding of an early referendum on the principle but delaying the actual projected time for entry; in such a case there would be an onus on the Government to explain why the delay was appropriate.

­ To conclude that the economic case has been made for joining provided certain conditions are met

­ To conclude that the economic case for joining has not yet been established but that it would be right to re­examine the issue within a certain timeframe

108. These two options would both involve a judgement that there were circumstances in which the economic case had been made. Future freedom of action would be maximised, but whether any hoped­for political benefits in terms of British influence within the Union would be realised could depend on the way in which the decision was presented—i.e. whether the Government gave positive or negative signals about the likelihood of a later decision to seek to join, and whether any 'conditions' set down or the timescale for future re­consideration appeared reasonable. On the basis that there is indeed a 'window of opportunity' for maximising the benefits of joining in the near future, this might be lost. There is also the possibility that the Government might want to preserve for itself maximum flexibility and announce, in the event of a negative assessment by this June, that it reserves the right to re-run the assessment of the five tests at some indeterminate time or times in the future. For understandable reasons the Chancellor declined to speculate on this point when asked, but such a rolling re-run of the five tests could lead to uncertainty in the British economy.

- To conclude that there is no prospect of it being appropriate for the UK to join the euro, and to make no plans for revisiting the decision at a later date.

109. This option would promote certainty in policy making by ruling out one option and, in the opinion of those who are not convinced by the economic case for joining, would bring with it long term economic benefits. However, it would represent a dramatic change in declared government policy and could thus create considerable uncertainty. It might also carry some of the most immediate risks, in respect of a loss of confidence (more specifically a possible loss of enthusiasm for investment) in the British economy amongst those who consider Britain's economic future to lie within the euro. It would of course also have significant political implications in respect of Britain's influence both within economic policy making in Europe and more generally over the future direction of the EU.

110. We do not judge between these options, but we have sought in this Report to provide additional analysis and information on the implications of each option. The point we would emphasise is that while there are indeed political implications to each option (to which we have referred throughout this Report) it is of fundamental importance that the economic case for entry is met first of all if the UK is to enter the euro.

187   Cairncross Lecture 4 December 2002 Back

188   Qq 1201-1203 Back

189   Manufacturing and the euro-any change? EEF Europe Survey 2002; Single Currency Survey, BCC January 2003. Back

190   Q 328 Back

191   ibid Back

192   Q 1203 Back

193   Q 80 Back

194   Q 1082 Back

195   Q 478 Back

196   Qq 1075-1077; TEC Article 122 Back

197   Q 503 Back

198   Q 1219 Back

199   Ev 196 Back

200   Q 70 Back

201   Q 171 Back

202   Q 1086 Back

203   Qq 1158-1161 Back

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