Speech by John Townend, Director for
Europe
Nicosia, Cyprus on 22 February 2001
The Euro So Far
It is a great pleasure to be here in Cyprus. This is not just for the obvious reason associated with our respective climates at this time of year. There is a more substantive reason. The UK has taken a particular interest in EU enlargement, and in developing its relations with the prospective accession countries. Today's conference is one small symbol of this, and I am therefore honoured and delighted to have been invited to play a part.Let me begin by saying that we in the UK have always been in favour of enlargement as soon as possible, and we welcome the outcome of the Nice summit, paving the way for enlargement and your own potential accession to the EU. We hope to see new Member States participating in the elections to the European Parliament in 2004. And we congratulate you on being designated by the European Commission as a "functioning market economy", which "should be able to cope with competitive pressure and market forces within the Union". This is, of course, one of the key conditions in the Copenhagen criteria for accession to the EU.
Even so, you might reasonably ask: 'Why is someone from the UK speaking today on the subject of "The euro so far"?' After all, neither the UK nor Cyprus is participating yet in Economic and Monetary Union, so is it not a bit like the blind leading the blind? I hope you will agree that it is in fact not quite like that. Both our respective countries have a special interest in the euro, as prospective future participants; and it is perfectly natural that we are both therefore taking a particularly close interest in its development. The euro certainly matters a great deal to the UK: both from a technical point of view and a policy point of view. And I would like to explain why.
Technical euro preparations
From a technical point of view, the euro matters to us in the UK because London, as the Lord Mayor has already said, is a major international financial centre - and much the largest financial centre in the European time-zone. That means that London needed to be well prepared for such a significant event as the launch of the euro at the beginning of 1999. And it was well prepared.
The conversion weekend at the beginning of 1999 for the changeover of the wholesale markets to euro was one of the biggest logistical operations that the London market has ever undertaken. This is not surprising given the scale of financial activity in the London markets previously denominated in Deutschemarks, French francs and so on. Despite the scale of the exercise, the conversion weekend in London was a great technical success. Key market firms in London all completed their changeover operations in good time. And there were no material problems in London, nor within the euro area.
In the Bank of England we played our part by co-ordinating closely the preparations and by producing, every three months, a series of guides for financial institutions to the practical preparations necessary. Practical Issues, as we called it, was described by EU Commissioner Monti in Brussels as the 'Bible' for euro preparations - and the definitive text not just in London but across the euro area - which was very satisfying for us but, as central bankers in the euro area were not slow to point out, it was ironic that it was an 'out' central bank providing this service. The key point I continually stress is that the Bank had a unique advantage in producing such an authoritative and well-informed guide about the practical issues which market firms were facing because we could draw on the great depth of market expertise in London - all of the major names in the world have operations there - and because of the Bank's long history of working closely together with market practitioners.
We have continued to publish Practical Issues bi-annually since the launch of the euro. We have used it to explain developments in the euro markets, which are of course of great interest to our constituency of market firms in London. And we have used it to report on preparations for possible future UK entry into EMU, including any lessons that we can learn from the changeover in the first wave - a changeover that will be completed with the introduction of euro banknotes and coin in place of national banknotes and coin at the beginning of next year. There is also material relevant to accession countries and I will be very happy to add to our circulation anyone who contacts me afterwards.
The UK's EMU policy
I shall say more about the euro markets in a minute. But let me first explain why the euro matters to us in the UK from a policy point of view. At one level, it matters because the euro area is our largest trading partner. But even more fundamentally, it matters because the UK has to decide whether, and if so when, to join EMU.
Leaving aside the politics, as central bankers should, we in the Bank of England can see that EMU has both economic advantages and disadvantages. The main advantages are, first, the nominal exchange rate certainty which membership of the single currency brings, with all the attendant benefits like improved price transparency, more efficient allocation of resources and ultimately, as a result, potentially a more dynamic economy; and, second, the development of deep and liquid euro markets, tending to increase competition and reduce spreads between borrowing and lending rates, to the benefit of issuers and investors alike. On the other side, however, the main disadvantage is the 'one size fits all' monetary policy. You cannot have a single currency without a single monetary policy. A single monetary policy means a single official short-term interest rate. And the problem is that the chosen rate may not necessarily suit all of the participants all of the time, indeed at any particular time it may not suit any of the participants.
Now, as a general proposition, we in the UK share the same broad macroeconomic objectives as the euro area. Like the euro area, in fiscal policy the UK is pursuing a course which is designed to be sustainable in the medium-term (indeed the UK's Golden Rule, of only borrowing over the economic cycle to finance public investment, not public consumption, is arguably even tighter than the Stability and Growth Pact requirements). And as in the euro area, where an independent European Central Bank is required by European Treaty to secure price stability through its monetary policy setting, so in the UK the Government has given the Bank of England operational independence to achieve price stability in a similar way. There are some points of difference and detail, but this should not take away from the big picture that the UK is working in close parallel with the euro area.
Nevertheless while our broad economic objectives are the same, it would still have made no sense for the UK to join EMU at the outset, either for the UK or for the euro area. UK participation at the outset would have enormously complicated the euro project. It is difficult enough anyway. It would have been even more so, with the UK as a participant.
One of the reasons for this is that the UK economic cycle has not been synchronised with the economic cycle in the core of the euro area, though these cycles appear to have become increasingly similar recently (as my chart shows). But there is another reason. This is that, for much of the past decade, the UK economy has been operating much closer to capacity than the euro area. The labour market has been much tighter, with unemployment much lower in the UK than the euro area average. In this situation, not surprisingly, inflationary risks are higher and, to offset the greater inflationary potential, nominal interest rates have to be set rather higher - as they have indeed been in the UK than in continental Europe through much of the 1990s.
So it is not surprising that the UK decided not to join EMU at the outset. This decision was a disappointment to some of our continental partners, but it was also a relief. If the UK had been 'in' at the start, this would have given the ECB a considerable headache, and led either to inflation in the UK or depressed growth elsewhere in the euro area, or conceivably a bit of both.
However, although the UK is 'out', the British Government has articulated a positive and constructive approach to Europe since its election in May 1997. The Government has made clear that it does not see any constitutional barrier to UK entry. Instead, UK entry will depend on the national economic interest. And the Government has set its five famous economic tests to measure this. They will be used to assess: sustainable convergence between the UK economy and the euro area; the flexibility of the UK economy to adapt to shocks; the impact on long-term investment decisions in the UK; the impact on our financial services industry, primarily - but not, just - in the City of London; and finally the long-term impact on jobs.
The British Government intends to be in a position to assess the economic tests early in the lifetime of the next Parliament, after a General Election. That is what it said back in October 1997, when the UK opted out of initial entry; and the Government's position has not changed in any way subsequently, including as a result of the Danish Referendum.
The General Election must take place by May 2002, but could take place earlier, if the Prime Minister chooses. As you may have seen, there has been intense media and market speculation in Britain about the prospect of a General Election in the spring of this year, which has been refined to a single date of 3 May - although central bankers prefer to work with probability distributions!
And the Prime Minister has now defined rather clearly the window within which the Government will assess its five tests, namely within two years of the Election, although not within a matter of months. If the Government reaches a positive assessment, UK entry would then be subject to the so-called 'triple lock', involving a recommendation by Government to join Monetary Union, a vote in Parliament and finally a Referendum of the British people. The Government has indicated that there would be around four months between a Government decision to recommend entry and the date of a Referendum.
The euro area economy
In the meantime, you will not be surprised to learn that we have been following economic developments in the euro area very closely indeed. And the economy of the euro area has performed much better so far than many of its detractors had expected. Economic activity picked up from just over 2% in 1999 to some 3½% last year, and a reasonable outcome is still projected for the current year, despite the recent downturn in the US. Unemployment in the euro area has begun to fall, to 8.7% on average last December, although it remains high. Public finances have become more prudent, encouraged by the constraints of the Stability and Growth Pact. The general government budget deficit fell to an estimated 0.8% last year, although some further progress remains to reach the desired position of balance (that is, no government deficit at all) in the medium term. Seven of the governments in the euro area have triple A credit ratings. Government debt has fallen to 72% of GDP on average. The euro area has been running a small current account deficit on its balance of payments. And last, but by no means least, inflation averaged 2.6% per annum across the euro area in the latest (December 2000) data, despite the impact of higher oil prices and the depreciation of the euro in the currency markets, though naturally there are some regional variations.
The euro exchange rate
So why, for much of the period after its launch, did the euro weaken against the dollar and other major currencies in the foreign exchange market, contrary to most initial expectations? At its low point around the end of last October, the euro had fallen by around 30% against the dollar (as my second chart shows). It is not easy to explain a fall of this magnitude, even with the benefit of hindsight.
The most convincing explanation seems to be found in the acceleration in productivity growth in the US - raising there, at least temporarily, prospective corporate earnings growth and attracting long-term capital inflows, much of which represented net long-term capital outflows from the euro area. This development in the US also focused attention in financial markets on perceived supply-side weaknesses in the euro area, though such weaknesses can be overstated. The implication was that, at some point, the benign supply-side shock in the US was likely to moderate, and at that point, the conventional 'fundamentals' were likely to reassert themselves.
This explanation seems to have been given greater credence by the euro's limited recovery since the end of October, on the back of data revealing a sharper slowdown in the US than markets had been expecting. But it is unlikely to be a complete explanation. Market psychology has also no doubt played a role. Last year, the European Central Bank could do nothing right in the market's eyes, and the euro overshot in the foreign exchange market on the downside as a result.
In the UK, we have of course taken a close interest in these developments, not least on account of the local difficulties created for our own monetary policy. The strength in the sterling exchange rate against the euro, only partially reversed in recent months, has created something of an imbalance between the domestic and external sectors of our economy. The sectors which are most internationally exposed, particularly to the euro area, have suffered, while monetary policy has had to continue targeting domestic inflation across the UK as a whole. This experience has demonstrated well the advantages which would be obtained from exchange rate fixity, but equally the disadvantages that would have resulted from fixing sterling against the euro at the wrong exchange rate. Of course I readily accept that judging what the right exchange rate would be is no easy matter, given the wide range of rates between sterling and the euro (or its predecessor component currencies) that we have experienced in the last few years.
This question is not just relevant to us in the UK. It is also relevant to you and to all the other accession countries. As a collective group, you are in something of the same position as we are. It is true that we in the UK have an 'opt out' from EMU, while you are committed to join EMU in principle, once you join the EU. But you do have some latitude over the timing of joining EMU. And, as I have implied, there may well be reasons not to rush into EMU prematurely - both for the UK and for those countries aspiring to join the EU.
In particular, in the accession countries, there is a risk that productivity growth, spurred by structural reforms and foreign capital inflows, will lead to real appreciation in the exchange rate (the so-called 'Balassa-Samuelson effect'). This can take the form of either nominal appreciation in the exchange rate against the euro, or a higher inflation rate than in the EU, or some combination of both.
I personally do not underestimate the difficulties in this area for the accession countries, taken as a group. Looking at the issue in terms of exchange rate objectives, it is easy to see three which potentially conflict. First, a stable exchange rate is desirable, given the degree of openness of the accession countries, and the importance to them of external trade. Second, to the extent that real appreciation is inevitable in the catching-up process, it is important that any resulting nominal exchange rate appreciation is in practice smooth and orderly, so as to avoid losing competitiveness. And third, to meet the Maastricht inflation criterion, it is important not to allow too much of the real appreciation to come through faster domestic price inflation, which puts more of the upward pressure back on the exchange rate. Although it is straightforward to identify the potential for conflict in this way, there are no easy answers and each accession country will have to decide how best to balance the conflicts, in its own circumstances.
All this suggests that it would be prudent for the accession countries not to join EMU before they have achieved sustainable convergence in the broadest sense. Sustainable convergence is certainly something which our own Government will need to weigh up carefully before reaching a decision about whether to recommend UK entry.
The euro markets
In the meantime, let me turn to one of the immediate benefits and early success stories of EMU, namely the development of the euro markets, which we are also following closely. While public attention on the euro has tended to concentrate on the level of the euro exchange rate and short-term interest rates, the real challenges for the big financial institutions are the structural changes that are taking place in wholesale financial markets in Europe. The euro has been the catalyst for these changes, though not of course the only cause.
We are not simply monitoring the developments of the euro markets from the outside, as a bystander, but London market firms are playing an active role and making a positive and constructive contribution. Helping to develop deep and liquid euro markets is arguably the main contribution which we in the UK can make to the success of the euro from the 'outside'. Deep and liquid euro markets have become well established in the City of London, as they have in continental Europe, replacing the previous, more segmented, national markets, and thereby beginning to achieve one of the objectives of the single currency.
It is disappointing that this message has been largely obscured by the temporary weakness in the euro exchange rate. Comparatively little attention has been paid to the structural changes taking place in the euro markets, yet these changes are of much greater long-term significance. Let me briefly mention five structural changes, in particular.
First, the growth of euro issuance - particularly in the private sector. While the financing needs of euro-area governments have been limited by fiscal discipline and special influences, the flow of corporate euro bond and equity issuance has grown significantly, though the stock of issuance outstanding in both cases is still - by some margin - lower than the US. At the same time as corporate issuance has been growing, the focus of risk assessment in the corporate debt market has shifted from currency risk towards credit and liquidity risk. A growing number of companies in the euro area have been seeking external credit ratings. And an equity culture is beginning to take root, despite the volatility in Technology, Media & Telecommunications (TMT) stocks over the past two years.
Second, the integration of euro trading and settlement. Trading has increased in most euro markets, and dealing spreads have narrowed. In particular, there has been much greater cross-border activity, supported by fully-integrated pan-European systems for making wholesale payments. But systems for the trading, clearing and settlement of securities are still fragmented nationally by sector. Market firms are keen to see consolidation of the arrangements for clearing and settling securities trades, where costs are still considerably greater here in Europe than in the US. Even without mergers, market firms can of course trade remotely from a single location, though this does not address the issue of duplicate investment costs. However, it seems that full rationalisation would take years to implement and, while the broad vision of integrated European systems is widely shared, there are still differences of view about how best to achieve it.
Third, the diversification of investment. The launch of the euro has begun to encourage a shift in funds away from the particular national market in which they have traditionally been invested, and towards investment across the euro area as a whole. This helps explain the increasing use by fund managers of European benchmark indices against which to measure investment performance, rather than national benchmark indices. Although portfolio diversification has so far been rather slow, there is evidence that it is continuing to take place, and it is expected to pick up over time.
Fourth, financial institutions themselves are consolidating, including in some cases across borders, so that they can better provide a service to clients across the Single Market as a whole. Consolidation is already far advanced in investment banking, where critical mass is of particular importance to profitability, and a US link has proved a competitive advantage. It is much less far advanced in retail banking, where national markets are still pronounced.
Fifth, regulation. Although much has been done to remove obstacles to the integration of Europe's capital markets, the launch of the euro has served to highlight the barriers that remain. To remove these barriers, market practitioners do not believe that it is necessary to provide uniform regulation of securities markets. Rather, the changes required can be implemented by relying on the principles of the Single Market, and giving the necessary priority to the European Commission's Financial Services Action Plan. We welcome the final report of the Committee of Wise Men, chaired by Baron Lamfalussy, on this subject, which was published last week.
I have identified five main ways in which the structure of the euro markets is developing. The City of London has been making a positive and constructive contribution to their development. And all the available evidence continues to indicate that, since the launch of the euro, London has fully maintained its market share. The major international market firms believe that London's role as an international financial centre does not primarily depend on whether the UK is inside or outside EMU, but on remaining internationally competitive. In particular, the environment which London provides for financial business must remain attractive and consistent with international 'best practice'. And that is nothing new.
Conclusion
So, in conclusion, I would like to leave you with four main messages about the euro so far.
First of all, the launch of the euro at the beginning of 1999 was a great success, from a technical point of view, both in London and across the euro area.
Second, the euro area economy has performed since the euro's launch much better than many feared. This makes the substantial initial fall in the euro exchange rate, before its recent recovery, quite difficult to explain. The best explanation is probably the US acting as a 'magnet' for capital flows.
Third, what the resulting volatility in the sterling:euro exchange rate has shown are the advantages of exchange rate fixity, but equally the disadvantages of fixing at the wrong rate. This has implications both for the UK and for the accession countries.
And fourth, the euro has acted as a catalyst for a number of important structural changes in the euro markets. Integrated euro markets are one of the main advantages of EMU. Helping these deep and liquid euro markets develop is probably the most positive and constructive contribution that we in the UK can make to the success of the euro on the 'outside'. And that is what we will continue to do.
