Home > Publications > Speeches > 1997 > Speech by John Townend, Deputy Director, Bank of England

Speech by John Townend, Deputy Director, Bank of England
UK Preparations for the Single Currency and London's Position if the UK Opts Out

IIR Conference on Preparing for the Impact of European Monetary Union on the Financial Markets, 29 September 1997

1. I have been asked today to talk on three topics relating to the developing preparations for the single currency: first the Bank of England's role; second the state of preparations in the UK; and third the implications for London's role as an international financial centre if the UK exercises its opt-out.

The Bank's roles

• Let me take these in turn and begin with the Bank of England's role. I am going to focus on our role in contributing to the practical preparations, since that is the focus of this conference; but I should begin by noting the Bank's role in contributing to the on-going economic debate about the pros and cons of Monetary Union.
• The Bank has consistently argued that sustainable convergence, not just getting under the wire by hitting the Maastricht criteria at one point in time, is critical for a successful Monetary Union. If there really is genuine sustainable convergence, the prize is worth even more than a double rollover Jackpot in the lottery - you get exchange rate certainty, lower transactions costs and greater price transparency, with the prospect of better resource allocation, greater competition and a more dynamic European economy. But if there is not genuine sustainable convergence, the problem is that the single monetary policy for the whole euro area - the "one-size-fits-all" interest rate, as the Governor put it last week in Hong Kong - would not suit all. It could result in economic weakness and unemployment in some areas if the European Central Bank pursued a firm monetary policy or unwanted inflation in others if it were more accommodating.
• Divergent national monetary policy needs within the euro area could arise first from differences in cyclical positions between different countries, as plainly between the UK and much of Continental Europe now; secondly from differences between fiscal positions even though these will be constrained to some extent by the Stability and Growth Pact; and thirdly from external shocks which affect different countries differently. The classic case is obviously German reunification: even though this is unlikely to happen again, other shocks might be waiting to happen. They may be more likely because of the considerably different levels of unemployment with which European countries start - from under 7% in the UK to over 20% in Spain.
• With no flexibility to adjust interest rates or exchange rates, with limited room for fiscal manoeuvre under the Stability Pact and with very little labour mobility or room within the EU budget for fiscal transfers from one country to another, the potential problems and tensions in a euro area without genuine real economic convergence could be very considerable indeed.
• That is why meeting the Maastricht criteria, in substance and not just in a formal, or informal, accounting sense, is crucially important. The task of assessing which Member States qualify will fall to the European Heads of State when they meet next May, and they will have to weigh in the balance the huge potential economic benefits in the right circumstances with the real economic risks in the wrong circumstances.
• But, having said all that, it is hard to resist the conclusion that the time for rational economic debate, certainly on the Continent, may simply have passed. The absolute determination on the part of Europe's political leaders to press ahead, and their absolute political commitment to the single currency project, could not be clearer. And markets have concluded that it is hard to see what could now derail the timetable, particularly given the developing recovery in many Continental economies, which makes it more likely that the convergence criteria will be met on the basis of calendar 1997 data.
• It has in any event been clear for a long time that the only prudent planning assumption for every financial institution and business to make, given the long lead times for the necessary practical and strategic preparations, is that the single currency will begin on time at the beginning of 1999.
• As for the UK's position, formally the Government has said that it retains the option to join at any time whilst acknowledging that it is "highly unlikely", because of the "formidable obstacles", to be a first wave participant. Nevertheless there has been speculation recently that the "mood-music" has changed. I cannot possibly comment. All I can tell you is that the Government is required, under the UK Protocol to the Maastricht Treaty, to convey its intentions in relation to first wave membership before 1 January 1998.
• On the assumption that EMU goes ahead, it is clear that - whether or not the UK opts-out - the euro will have a significant impact on wholesale financial markets in London. It will also significantly affect many UK businesses, particularly multinationals with operations throughout Europe. But its impact on the UK retail sector will be much less if the UK stays out. So I shall be concentrating on the preparations in wholesale financial markets since this is the Bank's natural focus and locus.
• Let me turn then briefly to the Bank's role before giving an overview of the current state of UK financial sector preparations for the euro. The Bank is best known externally for its work helping the City to prepare, where we have a rather prominent profile; but it is often forgotten that there are two other aspects to our contribution to the practical preparations.
• First we are devoting a great deal of resources to contributing to the ongoing preparations in Frankfurt to turn the European Monetary Institute into a fully functioning European Central Bank. Indeed many of our very best staff are involved, representing the Bank on each of the myriad sub-committees, working groups and task forces which all report to the Alternates' Committee, on which I sit, and to the EMI Council on which the Governor sits. No-one should be in any doubt as to our absolute commitment to help prepare an operational framework for the ECB which will technically work. We can bring to the table a unique perspective, from one of the three global international financial centres in the world; and a pragmatic, market-friendly approach which may not be the obvious starting-point of the other countries.
• It has been an enormously constructive debate, for the most part, with central banks prepared to compromise to reach workable solutions. And you can see that the entire conduct of monetary operations is to be based on a market approach; and you can see the influence of pragmatism in the whole approach to the transition scenario - the so-called 'no compulsion, no prohibition' approach to the changeover from national currencies to the single currency. I do not believe the UK's influence has been reduced by the opt-out; we are fortunate in having a Governor who commands widespread respect amongst his peers because his technical knowledge of central banking is second to none.
• Second we are of course preparing the Bank itself to be ready to participate as a full member of the European System of Central Banks, from the start of 1999, against the - admittedly highly unlikely - possibility that the Government decides to opt-in. We described in the last (August) edition of our Practical Issues series of broadly quarterly papers how we were approaching the task in the Bank, with an indication of the complexities of the project and the scale of resources involved. Altogether some 90 separate technical projects are underway; and these are quite distinct from the policy-related work in which the Bank is also engaged. All but 12 of the 90 projects need to be completed by no later than the end of 1998. We are therefore practising what we preach - planning against a start date of 4 January 1999 and preparing for both UK 'in' and UK 'out' scenarios, because prudence demands that we should.
• As for the Bank's more prominent role in helping prepare the City for the euro, we are continuing in the way that we have been for some 21 months now. We are co-ordinating the preparations where we judge this is necessary; we are convening groups of, and chairing meetings for, experts on particular subjects, and serving generally as a catalyst to stimulate the preparations of the necessary infrastructure; we are plugging gaps where we identify them; we are promoting consensus in those areas where we believe that a harmonised approach makes sense, and promoting discussion on the relevant issues between the EMI and national central banks with market participants across Europe; and finally and most importantly communicating, as widely as possible, the state of the developing preparations, both in London and in Frankfurt, so that all individual financial institutions and other firms can plan and implement their own in-house preparations on a fully-informed basis. That is the significance of our Practical Issues series; it has a circulation of some 32,000, of which about 4,000 go directly overseas.
• The Bank's role in helping to prepare the financial sector for the euro was recognised and reconfirmed by the Chancellor earlier this summer when he launched his complementary initiative to begin preparing the UK business community. We will continue to provide whatever help we think we can, recognising that much of the work has to be done in the private sector since that is where the expertise lies.

• The UK preparations: an overview

• There is increasing evidence that financial institutions in the UK are now taking the steps necessary to ensure that they are ready for the introduction of the euro, whether or not the UK is a participant. In the early summer we invited a representative sample of firms to confirm that their preparations were on track to be ready for January 1999.
• I am happy to say that the response was broadly reassuring, although a number made clear that they could be held up unless decisions in a number of areas were made soon. We fully understand this and are doing all that we can to expedite the process. The urgency of the need to prepare is widely recognised, and has been confirmed in the banking sector by a recent BBA survey. Our impression however is that some other parts of the financial sector, including the fund management and insurance industries, are perhaps not quite so advanced in their planning; and we will be trying in the near future to confirm whether or not this is so and give whatever assistance we can.
• We have also taken stock of the preparations at the infrastructure level, by inviting all those market associations with whom we are in touch and through whom we are working - the BBA, LIBA, ISDA, IPMA, ISMA and so on - and those responsible for payment and settlement systems - including APACS and Euroclear/Cedel - to confirm that work is in hand on all the issues of concern to them. It is reassuring that no completely new subjects were raised although, inevitably, the greater the detailed preparation the more technical questions are thrown up.
• The main messages from our recent consultations seem clear, including the immediate priorities for the practical work in the next few months. Let me pick out just a few.
• First market participants agree on the need to be able to trade in London the full range of euro-denominated instruments even if the UK opts 'out'.
• Second they also agree on the need for appropriate payments mechanisms to carry out transactions in euro both between parties within the UK and cross-border from and to the UK.
• Third efficient, cost-effective, mechanisms for settling transactions in euro-denominated securities also need to be made available.
• Fourth there is agreement on the desirability of harmonised market conventions for the issuing and trading of euro-denominated instruments.
• Fifth there is agreement on the need for as sound a legal basis as possible for euro transactions, to provide legal certainty and to ensure continuity of contract.
• Sixth there is need for guidance from Inland Revenue on a number of tax and accounting issues related to the introduction of the euro, preferably to ensure that this is not a 'taxable event'.
• And seventh there is a desire that the UK supervisory authorities should clarify the treatment, for capital adequacy and other supervisory purposes, of the co-existence of national currencies and the euro as different denominations of the same currency during the transition period.
• There is work going on in each of these areas as reported in the August edition of Practical Issues ; and good progress on many of them. For example on market conventions, with the Bank's assistance, the main international market associations together with the two International Central Securities Depositories (Euroclear and Cedel) have agreed on the harmonised approach they would like to see adopted for the issuing and trading of financial instruments in the euro money, bond and foreign exchange markets. That is, essentially:

• in the euro money markets, a day count for interest calculation of 'actual over 360'; spot (ie 2 day) settlement; and business days to be based on when TARGET is open (ie every working day in the year except Christmas Day and New Year's Day);
• in the euro bond markets, a day count of 'actual over actual'; quotations in decimals rather than fractions; TARGET business days; 3 day cross-border settlement for internationally-traded bonds; but no standardisation for annual or semi-annual coupon frequency;
• and in the foreign exchange market, spot settlement, quotations in the form of 1 euro for x units of foreign exchange; and central bank publication of daily closing reference rates.

• With the Bank's encouragement, the EMI has recently very helpfully said that it "welcomes and supports" the market associations' initiative. But there is still no guarantee that these market conventions will be applied in the market-place without further efforts by all those involved, market associations and the authorities, to promulgate as widely as possible the desired approach in order to ensure that harmonisation becomes a reality. We will certainly be playing our part in this process.
• Another area of good progress relates to the law. After much discussion, at official and Ministerial level and on the basis of considerable consultation with, and input from, the private sector (including particularly the City of London Joint Working Group of practitioner lawyers), agreement has been reached on two European Regulations to introduce the euro under the law. The first, introduced under the general provisions of Article 235 of the Treaty, is already in force throughout the EU, including in the UK. This Regulation secures the 1 for 1 substitutability of the euro for the ECU, unless parties can show good reason otherwise; the general continuity of contracts denominated either in ECU or present national currencies; and establishes conversion and rounding rules. These rules are mandatory, not optional, and so it is important to understand what they require (to help we provided some worked examples in the December edition of Practical Issues ).
• The other Regulation, to be introduced under Article 109l(4) of the Treaty, has been substantially agreed but it cannot be formally adopted until the first wave countries are determined, since only they are entitled to vote on it. This Regulation ensures that the euro becomes the single lawful currency of the participating countries from the beginning of 1999, with national currencies continuing during the transition simply as non-decimal expressions of the euro, like pence on the pound except not in a relationship of 100 to 1. Those who have recently argued that you may be better off holding Deutschemark assets rather than other denominations during the transition, as protection against a possible break-up have, I think, failed to appreciate the significance of the legal position under the 109l(4) Regulation.
• This Regulation also places a general obligation on banks to convert payments received in national currency for the account of a creditor where the account is in euro, and vice versa. And the Regulation provides for issuers to redenominate into euro any of their outstanding national currency denominated debt securities which they have issued, so long as the relevant government has taken action to redenominate its own national currency debt liabilities into euro.
• There are one or two points in the 109l(4) Regulations that still need to be settled; in particular, the date for the issue of euro banknotes and coin has yet to be decided. The Commission held a hearing on the subject a week ago, and the familiar mixed views were expressed. The UK preference is for an issue date in February 2002, as this avoids the peak Christmas period and minimises the risk that an inadequate supply of euro cash will be available on the day of issue.
• I should note that, if the UK opts 'out', it will be important to clarify the extent to which this particular Regulation will apply in the UK, to provide legal certainty and to give as sound a base as possible for transactions carried out in London.
• Turning to the future, in addition to continuing to progress the work in the areas I have already identified, I think there needs to be a particular focus on three related areas.
• First price sponsors need to clarify urgently how they propose to replace disappearing price sources. In the case of LIBOR the BBA has already helpfully done so: a euro LIBOR will be calculated whether or not the UK is 'in' and the BBA will continue to publish participating national currency LIBORs - for the DM and so on - although they expect they will be the same as the euro LIBOR. Other sponsors however have yet to indicate how they will respond to the euro. Moreover the detail of the proposed EURIBOR euro-area wide rate is not yet available. It is important that it is a rate in which the market can have confidence, reflecting deep and liquid market price quotations for euro deposits, and avoid so far as possible becoming an administrative construct. In any event it is clear that, at least for a time, national reference rates will continue in many countries.
• Second it is not yet clear how, precisely, the redenomination of securities from national denomination into euro will take place. It is clear that such redenomination is not necessary to be able to trade and settle securities in euro from the outset of EMU. But, where redenomination does take place, it would help to avoid confusion and error if a limited number of methods could be used. This would require agreement particularly amongst sovereign issuers in Europe; but frankly this looks a rather remote prospect. The French government has decided to redenominate to the nearest euro, whereas the German government favours the euro cent, in line with the UK's probable preference were we to opt-in. But if agreement on method is unlikely, what matters above all is giving market participants certainty, so that they can begin the necessary systems development. At the Bank, we are considering providing an information-service to help the London market keep up-to-date with the relevant decisions and announcements by overseas governments or central banks.
• Third there is the whole area of securities settlement where the potential for confusion and error appears considerable. In the UK, we have recent experience of the kind of teething problems that can arise with the introduction of major changes to a securities settlement system. And that was just one market and one country. Yet in relation to the euro, it is envisaged that systems in many countries and across many markets will more or less simultaneously switch to the euro from 4 January 1999. At the very least an extensive education programme will be needed across Europe so that everyone from front-office through the middle-office to the back-office understands in detail what is required. But we are also considering whether in particular areas some kind of market standardisation might be helpful to minimise the risk of confusion; and if so how this might best be achieved. We will report in forthcoming editions of Practical Issues .
• I am conscious that I have not so far said much about the development of the payments system which lies at the heart of the UK's preparations for the euro. That is because it is by now, I hope, widely understood that the UK's sterling RTGS system is being developed to accommodate the euro, so that from the beginning of 1999 euro wholesale payments may be made in as safe, efficient and cost-effective a way as sterling payments can now, whether or not the UK opts 'out'. That development remains on schedule and it is encouraging that CHAPS have had expressions of interest recently from a number of overseas banks wishing to join.
• The UK euro system - CHAPS euro- will allow payments to be made both between parties within the UK and cross-border from and to the UK through its link to TARGET. Using the knowledge and expertise we have acquired through developing and operating by far the largest RTGS system in Europe - with average daily volumes of some 70,000 payments, worth some £150 bn - we are contributing a great deal to the technical development of TARGET. Because it extends the benefits of RTGS systems, in reducing the risk in payments, for the first time cross-border, it is a project which we wholeheartedly support.
• But we also want to see TARGET as efficient and cost-effective as possible, so that it becomes the payments system of first choice for banks, in order to maximise its benefits in reducing systemic risk. We have to recognise that TARGET will be competing with alternative euro payments mechanisms, including correspondent banking and the EBA net end-of-day settlement system. Consistent with this view, we believe that it is essential not to place within the system artificial restrictions or limits on access to intraday liquidity so that payments can flow freely throughout the system. We do not believe that any monetary policy implications would arise, including where intraday liquidity is granted to an 'out' central bank, so long as adequate mechanisms are in place to prevent such intraday liquidity becoming extended - spilling over - into overnight credit.
• This remains one of the few areas where agreement at the EMI has so far proved elusive; and we may need to wait until next summer for the ECB's decisions on the terms and conditions for access to intraday liquidity, including to 'outs'.

• London as an international financial centre if the UK is 'out'

• Let me turn finally to London's position as an international financial centre if the Government opts 'out'. I think there is every reason to be optimistic about London's future on two main conditions. First the UK must continue to pursue, in parallel with the euro area, the sound consensus policies of monetary and fiscal discipline, directed towards price stability and medium-term fiscal sustainability. So long as the euro area does not believe the UK would be taking a 'soft' option in opting-out, there would be no reason for the euro area to seek to act in any discriminatory way against it. Second London must be ready, in practice, for the euro, since it does not have any pre-eminent right to its position as one of the three truly global financial centres but must continue to earn it. That is the significance of the practical preparations underway.
• Accepting these conditions, London's considerable advantages which have contributed to its development will all remain:

• it is a global international financial centre rather than just a European centre, with much of its business generated around the world outside Europe;
• London has always thrived on financial innovation; and it is not a zero sum game - even if greater financial activity develops, as we hope, in Frankfurt and Paris, this is likely to lead to more, not less, activity in London as the major interface with the rest of the world in the European time zone;
• the economics points to concentration, to gain economies of scale and enable better management control. That is why many firms have been moving their operations, and even headquarters, to London as the preferred financial centre - and this despite at least a scintilla of doubt over UK participation in the single currency and indeed its ambivalent attitude towards Europe for a number of decades;
• London has a huge range of markets and ancillary services, and an associated deep skill base; we have the English language; an unbureaucratic, rather flexible, approach to financial regulation which has been developed working with the grain of markets; and, as a cultural centre, partners like living here.
• All these advantages and more help to explain why there are more people working in financial services in the City of London - over 600,000 - than there are in the entire population of Frankfurt and its surrounding region!

• We cannot afford to be complacent but, so long as London prepares adequately, I think its future remains secure.
• Let me conclude by addressing a single question. Can it be construed in some way as 'anti-European' for the City to capture as much euro business as possible, if the UK is initially outside the euro zone? My answer is simple: quite the contrary. As I have said the City is not just a UK financial centre. It is an international centre, with more foreign-owned financial institutions than British. Second the UK will continue to be part of the Single Market; and competition will not just be between the City and euro area but within the euro area itself, for example between Frankfurt and Paris. And third, if the City is internationally competitive that will bring more financial business to Europe as a whole, and serve as a model to increase efficiency in other European financial centres. What is good for the City of London is good for Europe as a whole.

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