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Economic and Monetary Union
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BCC Brief - October 2002
Background
On 1 January 1999 the euro became the official currency of eleven of the fifteen member states of the
EU (Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal and
Spain - referred to hereafter collectively as the Euro-zone). This created an Economic and Monetary
Union (EMU). On 1 January 2001 Greece became the twelfth member to join.
The new euro notes and coins were introduced on 1 January 2002 and the old notes and coins were withdrawn within a few weeks
(they ceased to be legal tender in March 2002 and can now only be exchanged for euros at specified banks). The euro
is divided into 100 cents. There are seven notes (500, 200, 100, 50, 20,10 and 5) and eight coins
(2 euro, 1 euro, 50 cents, 20 cents, 10 cents, 5 cents, 2 cents and 1 cents).
The European Central Bank (ECB) sets the interest rates for the eurozone and its primary objective is to
keep inflation at a level of 2% or less. The bank is independent although its' Executive Board' is
appointed by the European Council. The ECB President appears frequently in front of the European
Parliament.
Denmark, Sweden and the United Kingdom, the three remaining members of the European Union, have not joined
EMU for political and economic reasons. Denmark negotiated an opt-out at Maastricht in 1992 that it
chose to exercise, following a negative referendum result in September 2000. The United Kingdom
negotiated an opt-in subject to a referendum, which many pundits expect to be held in 2003. Sweden also
opted for a referendum to decide upon participation and it is expected some time in 2003.
The question of whether the UK should join the euro is one of the most significant economic and political
decisions of the decade. The purpose of this brief is to provide BCC members with an overview of the
economic aspects of the issue and to offer them with some objective information on the business
benefits and disadvantages of joining and the challenges facing the euro over the next few years.
| The business case for EMU |
Comments
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The key benefit of EMU is the removal of the 'exchange rate' risk thus making it easier
for companies to sell their products elsewhere in the EU, which
in turn will stimulate trade and investment flows; |
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EMU creates a more complete, effective and competitive single market. Price transparency across the eurozone will intensify
competitive pressures thereby eventually bringing down prices and making firms fitter
and better able to compete internationally;
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A larger and more liquid EU capital market
should allocate funds more efficiently and at lower cost, making it easier for business
to invest.
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The euro also offers a wider range of financing instruments, as well as greater opportunities to diversify. |
Cross border trade will be cheaper and tourism should be boosted with no
currency transaction costs between participating countries. |
Estimates suggest that the euro will reduce transaction costs by 0.4% to 0.5% of GDP. This is a significant and ongoing benefit, but is equivalent to only two months of average European growth). |
Joining at a competitive rate could benefit those British businesses that are exposed to international trade.
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The UK would have to negotiate sterling's entry rate with the existing eurozone members. While it is unlikely that they would allow the UK a highly competitive rate, the market rate prevailing at the time of the entry decision will play a key role in determining the agreed rate. |
Staying out could damage UK foreign direct investment. Sterling instability versus the
euro, coupled with perceptions that by not joining we distance ourselves from Europe
could diminish the UK's attraction to foreign investment. While staying out has not
so far damaged inward investment, the UK's position may worsen if it becomes clear
that our absence from the euro is permanent.
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Britain's share of new foreign investment projects into the EU has fallen from 28% in 1998 to 21% in the first half of 2001. France has now overtaken the UK as the principal recipient of foreign investment in manufacturing. |
Not joining could damage the UK financial
sector. Although the City of London's dominance will not be challenged in the near
term, there are long-term concerns if we remain outside. Outside the euro, London's
position may be threatened if Frankfurt or Paris can get cheaper or preferential
access to euros, or if regulations are introduced favouring banks and other
institutions operating within the euro-zone.
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With the exception of the foreign exchange market, London is currently growing at a slower rate than Frankfurt and Paris.
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Not joining will weaken the political
influence of the UK within the EU. The UK's absence from important decision-making
bodies will make it more difficult for the government to protect our interests, and
to prevent the introduction of rules and regulations that may damage UK business. |
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| The business case against EMU |
Comments
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The European Central Bank sets a single interest rate for the whole euro-zone and this may
not be appropriate for individual countries or regions. |
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Because of the fixed exchange and single exchange rate, national governments are limited in
their ability to counter the adverse affects of internal or external shocks.
And if interest rate and exchange rate flexibility is surrendered, labour market flexibility
is vital. For EMU to work, wages need to be flexible and/or labour needs to be mobile.
It is clear, however, that the labour market across the eurozone is generally rigid, and
is leading to higher unemployment in some countries.
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Both the French and German governments have put off vital but politically sensitive
labour market reforms due to recent and forthcoming elections. As for the UK, the
Government will have to demonstrate that we are sufficiently flexible to cope with the
absence of interest and exchange rate flexibility. |
Higher unemployment, if it persists, would lead to pressures for fiscal expansion and fiscal
transfers. However the Growth and Stability Pact (GSP) limits the scope for extra
government spending and the central EU budget is less than 1.3% of GDP.
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To increase the central budget significantly would require greater economic & fiscal
co-ordination and, political integration. |
The conversion costs to the euro will be considerable, particularly for retailers and banks.
Indeed the cost to retailers alone has been estimated at 11bn (£6bn), around 1% of their turnover.
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These will be spread over several years and are 'one-off', having no impact on ongoing costs.
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Joining at too high an exchange rate will put the British economy at a competitive disadvantage.
Most commentators agree that sterling is currently overvalued. However, attempts to "manage" the
exchange rate towards a more competitive level could lead to inflation, abrupt devaluation, and
economic instability.
The European Central Bank is more opaque than the MPC and its overriding
objective of price stability can introduce a deflationary bias during times of economic slowdown,
particularly in view of the constraints imposed by the GSP.
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| The Euro's result so far |
Comments
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Despite a smooth launch and a successful changeover to notes and coins, the first three
and a half years of the euro's life have been mixed. Much has been made of the fall in
its external value (overall it has lost a quarter of its value although it has gained 9%
against the dollar this year and temporarily broke parity in July 2002 for the first time
since February 2000).
The euro's weakness was a response by the financial markets to low eurozone growth vs. the
US, worrying euro-zone structural rigidities, ECB mistakes, and fears of long-term
political pressures. However the weakness of the euro was also an important impetus
behind the eurozone's (admittedly weak) economic growth, with rising exports offsetting
the effects of low domestic consumption.
However, the recent strengthening of the euro could increase the pressures on the eurozone
economy. Domestic demand, which will need to rise to compensate for the impact of lower
export growth, remains very weak. Indeed, the slow pace of reforms to free up labour and
product markets, combined with the restrictions on government borrowing imposed by GSP,
may will delay the necessary rise in domestic demand.
There is some evidence that EMU is starting to have a beneficial impact on trade, is
encouraging price convergence and is consolidating the euro zone market. Cross border
trade in the eurozone has expanded significantly. Germany's trade with the EU has
increased from 27.2% in 1998 to 32.2% in 2001. Likewise France' s trade with the EU has
risen from 28.0% to 32.2%, and Italy's from 23% to 24.2%.
A survey by 3i of companies in major European countries showed that two thirds of them
now charge identical prices across the euro-zone, a rise of 50% since 1998.
Finally the gradual increase in "shareholder power" within the euro-zone should put pressure on
governments to improve their domestic business environment, not least with regards to the
flexibility of product, capital and labour markets.
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In the first few years of its existence the ECB failed to establish a level of
credibility commensurate with the US Fed or the Bank of England. The ECB's President often
made comments that worsened speculative attacks against the euro either by confusing and
misleading the markets, or by hinting to an attitude of "benign neglect". The problem was
made worse by the habit of Central Bank Governors (who are also ECB non-executive Directors)
and of Finance Ministers to make conflicting and potentially critical comments. Happily,
these problems have diminished considerably this year.
Fears of long-term political pressures reflected concerns that, in the event of
a major recession, the "one-size-fits-all monetary policy" may create huge political
tensions that could (in extreme circumstances) endanger the euro's existence. These
concerns diminished after the introduction of euro notes and coins, but did not entirely
disappear.
The trend towards price convergence however has been interrupted, following the rounding up
of some prices after the introduction of notes and coins. The trend towards convergence is
expected to resume in the coming years.
Inflation has not risen in line with the perceived
rise in prices as the rounding up has not occurred across the range of products and services
available to the consumer. Nevertheless the rounding up has caused political embarrassment
in some eurozone countries.
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Conditions for EMU's future success
Looking ahead there are some key tests to be overcome. There need to be urgent reforms to
make labour markets more flexible and to liberalise protected markets, but progress so
far remains too slow. There will be pressure from some members to relax the rules of
the stability pact, but this raises many problems and radical changes will be difficult
to introduce. There will be mounting pressure for the ECB to become more accountable
and to make its decisions more transparent. And the eurozone countries will need to
find ways of making economic co-ordination more efficient.
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The UK Government position
The UK Government is in principle in favour of UK membership of EMU but in practice the
economic conditions must be right. Hence the Chancellor's famous five economic tests
that will help the Government determine whether the economic case for joining is 'clear
and unambiguous'. If it is, there is no constitutional bar to joining.
The five tests are:
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Sustainable convergence between Britain and the economies of a single currency;
- Whether there is sufficient flexibility to cope with economic change
- The effect on investment
- The impact on our financial services industry;
- and Whether it is good for growth & employment
The Government has said that the Treasury will complete an assessment of the five tests
within two years of the start of this current Parliament i.e. by June 2003. The Treasury
has begun the preliminary analysis that will allow the assessment to be made.
If the five tests are deemed to have been met, the Government will recommend UK entry.
Such a recommendation will be put to a vote in Parliament and then to a referendum of
the British people.
If a referendum does deliver a positive result, the UK could have
euro notes and coins within 24 to 30 months of that decision. |
The Prime Minister is unlikely to call a referendum unless he is confident of it
delivering a 'yes' result. |
Preparations for possible UK entry
The Chancellor's Standing Committee on Euro Preparations (on which the BCC sits) leads
planning across the whole economy and the Financial Secretary's group of Euro Ministers
leads in the public sector. These are underpinned by a series of consultative sectoral
and issue based working groups (on which BCC is also represented) led by the Treasury's
Euro Preparations Unit.
Together these groups have produced two outline National Changeover
plans in 1999 and 2000 respectively. The first sets out the critical path to a successful
changeover, and suggests a period of 24 to 30 months from referendum to the introduction
of euro cash. The second suggests a phased approach to a changeover under which most
businesses would have to convert towards the end of the transition period.
Most recently the Treasury published the private sector's conclusions on the lessons to
be learnt from the Changeover in the euro area (to which the BCC contributed). These
will be fed into the national planning process.
In June 2002, the BCC published its Euro
Fitness Guide, setting out practical steps that businesses can take now, at minimal cost,
to ensure that they are ready for all eventualities.
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The outline National Changeover Plans as well as the Lessons for the Changeover in the
Euro Area can be found on the Treasury's dedicated website at www.euro.gov.uk.
Copies of the Fitness Guide can be obtained from the BCC on (020) 7565 2000.
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Business Preparations
Even though the UK has not joined, many British businesses are
affected by the introduction of the euro in the eurozone. The Government, the BCC and
the local and regional Chambers have been working to increase the awareness of the UK
SMEs of the possible issues facing them such as increased competition and relationships
with customers and suppliers. This has included producing literature, setting up a
dedicated euro website (www.euro.gov.uk) and providing support through a network of
Regional Euro Forums (now disbanding). |
Demand for information and advice from Chamber members rose to a peak shortly before
the introduction of the euro on 1 January 1999 and again before the introduction of notes
and coins on 1 January 2000. It has largely tailed off now and businesses, particularly
SMEs, are unlikely to make the euro a top priority until the Government makes the decision
to join or a referendum delivers a yes result.
Those businesses that do require advice and
support can access all the related literature from the Treasury's website (www.euro.gov.uk)
or may contact their local Chamber/Business link.
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BCC Line
The BCC believes that UK should only consider joining the euro if and when the economic
conditions are right for business. The Government must make a persuasive case that there
are 'clear and unambiguous' advantages in joining, and the impact on British business,
notably SMEs, must be given appropriate weight in the Government's examination of the 5
tests (and the 14 supporting studies). Business is also concerned by the slow pace of
reform, in particular of labour market and fiscal policy, in some of the key euro-zone
economies.
Adopting the euro, or not, are both major decisions that will impact on the
future competitiveness of UK businesses. The BCC's main priority is to ensure that its
members are well placed to prosper whatever the final decision on whether the UK adopts
the euro.
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This position is subject to change as the BCC will be polling its members on their
attitudes towards UK membership of the euro later this year.
The subjects covered in the
14 supporting tests announced by H. M. Treasury cover most of the areas that need to be
addressed according to the BCC. The most important of these are: The effect on business,
including location & investment; The exchange rate; The labour market; Interest rates;
Fiscal policy & the GSP; Economic shocks; The cost of capital. |
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