Speech by John Townend, Director for Europe Institute for International Monetary Affairs Euro Symposium in Tokyo on 16 November 2001

The Completion of the Euro as a Currency: a UK Perspective

I am very grateful indeed for the invitation to join this distinguished panel of speakers to discuss 'The arrival of the euro currency: January 2002 and beyond'. I am particularly grateful, since it is perhaps not immediately obvious why an invitation should be given to a speaker from the UK for an event to discuss this subject. But I hope I can add to the remarks of Christian Noyer, for the European Central Bank, and Klaus Regling, for the European Commission, both my fellow members of the European Economic and Financial Committee, by providing a perspective on the euro from a country which is a full member of the European Union but which is not at this point in time participating in Economic and Monetary Union.

The introduction of the euro in physical form at the beginning of next year - in just 30 working days' time - is undoubtedly an historic event and an enormous challenge. It is an event in which the UK will not take part, but equally an event with potential implications for the UK. This will be the subject of the first part of my remarks. Then I propose to speak about the wider significance of the event, and to put it in context by addressing the impact the euro has already made over the past three years.

The euro as a complete currency

The challenges

The completion of the euro changeover at the end of this year in the first wave of 12 EMU member countries is an enormous challenge, in three main ways. The first challenge is for the banks to complete the bank account changeover, from legacy currencies (like Deutsche marks and French francs) to euro, in time before the New Year. Public sector institutions and businesses also need to be ready in time. Although the vast majority of these have been making the right preparations, and should be ready, it is still a particular challenge for many local authorities and small businesses.

Once euro cash has begun to enter circulation at the beginning of January, the second challenge is to meet the mid-January ambition, which euro-area governments have set themselves, for converting the majority of cash transactions to euro. A crucial precondition for this is the widespread pre-distribution (or 'frontloading') of euro banknotes and coin, to banks and retailers throughout the euro area, during the final months of this year, so that they will be available for immediate public use from the beginning of next year. A further condition is that it will require the full co-operation of shopkeepers, in giving their customers change only in euro from the very start of January, and of the public in accepting this. And the third challenge is to complete both the banking and the cash changeover without a discernible impact on prices across the euro area.

The immediate implications for the UK

Although the UK is not currently participating in EMU, there are some direct implications for the UK arising from the completion of the changeover in the first wave. In the UK, as elsewhere, legacy currency bank accounts will be converted to euro by end-year - indeed many already have been. These are primarily company accounts. If companies hold a number of different such accounts, for Deutsche marks, French francs, and so on, they need to consider whether, and if so at what stage, they should consolidate them into a single account; and to ensure that payment messages are correctly addressed, so that payments are not misdirected. This will not happen automatically, but requires thought and timely action on the part of banks' corporate customers.

And from the New Year, UK travellers will need access to euro cash. We are therefore grateful that the ECB has recently agreed that national central banks and credit institutions within the euro area may, from the beginning of December, 'frontload' euro notes to banks involved in the wholesale banknote market in countries outside the euro area, including the UK, so that these banks can pass the notes on to retail banks, who will then be in a position to meet demand from their customers from the very beginning of January. For us in the UK this is nevertheless clearly a very limited operation, to meet essentially tourist demand for euro notes: it is not a 'life-changing' event as it is for residents of the euro area itself.

Broader implications for the UK

Besides these immediate implications, there are also broader implications for the UK flowing from the completion of the changeover in the first wave. First, we need to learn lessons from the first wave, in case the UK joins EMU at a later stage. And in order to do this effectively, we need to compare and contrast the approaches to the changeover that different countries in the euro area have taken, within the overall framework agreed at European level. Some countries have closely co-ordinated their changeover according to a common plan, while in others the approach has been considerably less prescriptive and more informal, leaving more to the initiative for example of individual banks. Building on the experience of first-wave countries, we would need in a similar way to decide whether, and if so how and when, to encourage banks to begin the changeover of their customer accounts during a UK transition period, in order that they could complete this in time without undue risk.

We also need to learn lessons from the first wave about the cash changeover. For example, is 1 January the best date for the introduction of euro cash? It coincides with the financial year-end for a significant proportion of companies. But it also coincides with the busiest time of year for retailers, and the annual peak in banknote circulation, so there are huge quantities of notes to exchange. Our own analysis shows that, in the UK, note circulation would be over 20% lower just six weeks later so, if we were to join EMU, our banks and retailers would much prefer to have euro notes introduced in the UK around mid-February. Again, how long should the cash exchange period be? In the first wave, the cash exchange period has already been reduced from six months to a maximum of two, and some countries intend to complete the cash changeover in an even shorter period: four weeks in the Netherlands, for example. There are of course many more detailed issues, and lessons to draw, and we will be reporting on these in the Bank of England's next Practical Issues publication in early December.

Second, besides learning lessons in the UK from the completion of the changeover in the first wave, there may also be implications from the changeover for the euro-sterling exchange rate. All sorts of explanations have been offered over the past three years for the comparative weakness of the euro against currencies such as sterling and the dollar. Some market practitioners say that the euro began life at too high a level, though this was not said at the time. Others say that euro-area growth has not matched the market's expectations, even though euro-area growth is not as subdued now as in the US. Others point to capital outflows from the euro area to the US, because of the high rate of productivity growth it has enjoyed over a long period and its more 'business-friendly' environment. Yet others say that it will take time for the European Central Bank to acquire fully the credibility of the Bundesbank. And now the argument is gaining ground, ahead of the introduction of the new notes and coin, that when the euro becomes available in physical, rather than simply virtual, form it will undergo a sustained recovery in the foreign exchange market. We fervently hope that it will.

In the UK, we have a considerable interest in this issue, both because the undervaluation of the euro - or the overvaluation of sterling - is causing difficulties for UK monetary policy now; but also because of the question of the exchange rate for possible EMU entry in future. Insofar as economists ever agree on anything, almost all accept that sterling's exchange rate on entry would need to be substantially lower than the present rate, which is judged unsustainable in the medium and longer term, even though economists may differ on the precise margin of overvaluation. The problem for us is that, if a lowering came about by a substantial depreciation of sterling's effective exchange rate, against other currencies generally, it would be bound to put strong upward pressure on UK inflation and carry potential implications for UK monetary policy. By contrast, if the euro were to strengthen generally, so that sterling fell back bilaterally against the euro but was unchanged or stronger against the dollar and other currencies, this would have considerably less potential impact on UK inflation. Regrettably, however, any such benign outcome seems to be in the lap of the gods rather than policy makers, in the UK or elsewhere.

Third, the introduction of euro notes and coin may also be significant for the UK because of its possible impact on UK public opinion. So far, although the euro has been extensively used in the City of London since it was launched at the beginning of 1999, it is still very much a theoretical construct for the general public in the UK, who have a less than perfect understanding of what the single currency means in practice. They can be forgiven, I think, for that! But our Government believes that once the British public actually start to use the euro banknotes and coin as tourists - and apparently about 40 million visits to the euro area by UK citizens are expected next year - they are likely to become much more sympathetic to UK membership of EMU.

Public opinion in the UK is vital, because the Government is committed to a Referendum of the British people, if it decides to recommend EMU entry. But UK policy depends first on meeting five economic tests. These are: whether there is sustainable economic convergence between the UK and the euro area; whether the UK economy would have sufficient flexibility to adapt; what the impact of UK entry would be on foreign investment; on financial services; and more generally on growth and jobs. The Government has said that it will make an assessment of these tests within two years of the UK general election in June this year - in other words, no later than June 2003. The tests are, of course, quite distinct from the Maastricht convergence criteria, which the UK would also have to meet, and would be confident of meeting as well as any first-wave country did in the spring of 1998.

The wider significance of the euro

Let me turn now to the wider significance of the euro. The introduction of the euro in physical form is clearly a momentous event for over 300 million euro-area citizens. And clearly the completion of the single currency will have some significant economic impact, as for example prices across the entire euro area may for the first time be readily and directly compared by consumers. A more efficient allocation of resources should ultimately result. But much of the broader macro-economic and market significance of the euro began three years ago, when the exchange rates of the legacy currencies were fixed irrevocably against the euro, and when the changeover to the euro in wholesale financial markets largely took place.

Macroeconomic significance

The euro's wider macroeconomic and market significance can, I think, best be illustrated again in three ways, by referring to: the single monetary policy of the ECB; the fiscal policy constraints imposed by the Stability and Growth Pact; and the structural changes that the euro is bringing, particularly in labour and capital markets.

First, the single monetary policy. I believe that there is a widespread consensus that the ECB's actions in implementing the single monetary policy - the interest rate decisions it has made, in both directions, during its relatively short life - have been entirely appropriate, and certainly no-one is in an informed position to second-guess the ECB; but equally the market's view is that the communication of these decisions, and perhaps of the Eurosystem's overall guiding strategy, might only be given a ß+ grade rather than an a+! I am sure the ECB is aware of this.

Second, fiscal policy. In EMU, the budget deficits of participating countries are strictly constrained by the Stability and Growth Pact, with penalties for infringement and strong peer pressure among euro-area countries to conform with the best-performing. There is a consensus that the Pact is essential to make EMU work, to avoid excessive strains being placed on the single monetary policy. It may well be that, in a number of cases, fiscal policies would not have been as prudent without EMU, including in the run-up to 1999 when countries were striving to meet the Maastricht criteria. But adhering to the Pact is not without its challenges, when growth is relatively weak, as at present. And, in a broader sense, the institutional structures underpinning EMU, and the interrelationships involved, are still bedding down, inevitably with EMU still in its relatively early stages.

Third, structural reform, under the Cardiff and Luxembourg processes, which is a matter for the European Union as a whole rather than for euro area alone. Even though the UK is not participating in EMU, it is a full member of the European Union, like other European Member States, both contributing to, and benefiting considerably from, the Single European Market. As the British Prime Minister said on 5 November: "A single currency makes a proper completion of the Single Market essential." So the UK has been encouraging reform, especially of labour markets, in order to make the EU economy more flexible. But change is not just required within the euro area. The UK itself is engaged in reform as well. It is too soon to form a judgment on how well structural reform is working across the EU as a whole. A key test will be at the Barcelona European Summit next March. In the meantime, the jury remains out.

The financial markets

Besides structural reform in labour markets, the euro has acted as a catalyst for structural reform in capital markets. The City of London has of course been in a good position to play a leading role in the structural development of the euro markets, because it is by a long way the biggest international financial centre in the European time zone. Arguably, this is the most positive and constructive contribution that the UK can make on the 'outside'.

Let me briefly illustrate the structural changes in capital markets that have been taking place since the launch of the euro. These are not of course confined to the euro area but are relevant to all EU countries, and indeed beyond. First of all, there has been substantial growth in non-government bond issuance, which has traditionally been much lower in Europe than in the US. Second, trading in the euro has been increasingly integrated across borders, though not yet fully in all market sectors. Overall, the euro market is more liquid and spreads between borrowing and lending rates are generally narrower than before. Third, international fund managers have begun to diversify their bond and equity portfolios away from national markets across the euro area as a whole - and even in some cases across the EU - though there may be further to go. And fourth, from the outset there has been a highly successful integrated wholesale euro payment system, based on TARGET, established by all 15 EU central banks - though the clearing and settlement infrastructure is still highly fragmented and badly needs consolidation. However, as this is mainly controlled by the private sector, the authorities are in a position at present only to encourage consolidation through a market solution.

As a result of the positive and constructive contribution that the City of London has made to the development of the euro markets, the evidence continues to indicate that, since the launch of the euro, London's position as the dominant international financial centre in the European time zone has remained unchallenged. The most recent evidence for this is from the BIS Triennial Survey, published last month and covering the foreign exchange and over-the-counter derivatives markets, where the London markets continue to be much the largest in the world.

One of the reasons that London has continued to thrive as an international financial centre is because of the level playing field and balanced regulation we provide for financial institutions of every nationality and for foreign investors. The most recent demonstration of this was the friendly takeover of LIFFE (the London futures exchange) by Euronext, based in Paris, in preference to the London Stock Exchange. No favouritism there! The City of London will act as Euronext's derivatives centre, and LIFFE will continue to be subject to UK regulation. The partnership between LIFFE and Euronext helps both to cement the relationship between the City of London and the euro area, and to bring about the consolidation in Europe's financial infrastructure that is needed to increase its efficiency.

Conclusion

So in summary, the introduction of the euro in physical form is an historic event and an enormous challenge. We are monitoring it very closely in the UK, and we are keen to learn lessons from the experience of the first wave, in case the UK subsequently joins. But the euro also has a wider significance in macroeconomic and market terms. The City of London has played a leading role in the structural development of the euro markets. Arguably, that is the most positive and constructive contribution that the UK can make at present on the 'outside'.