Basket case, safe haven, volatile shuttlecock or effective euro shadow - David Smith considers four possible ways for sterling to behave outside the euro.
Early in May this year, European Union leaders will gather to rubber-stamp a deal decided in advance by their finance ministers. That deal, fixing the rates at which participating countries will convert their currencies to euros at the beginning of 1999, will effectively mark the beginning of European monetary union (EMU).
There is, of course, many a slip 'twixt cup and lip. Between the setting of the euro conversion rates in May and the start of the final stage of EMU on 1 January 1999, speculators will have an opportunity for a final assault on European currencies while they still exist as separate entities.
Equally, between the start of that final stage and the issue of euro notes and coins in 2002, the process is more reversible than it will be subsequently.
As we enter the endgame, 11 countries - Germany, France, Italy, Belgium, the Netherlands, Luxembourg, Austria, Finland, Ireland, Spain and Portugal - are lining up to be members of the euro zone from the outset. Only four EU countries - Sweden, Denmark, Greece and, of course, Britain - will remain outside it. Of these, only Britain has a large internationally traded currency, which can and has varied widely in value in recent years.
How will it behave?
The sterling currency has a somewhat schizophrenic character. After plunging out of the European exchange rate mechanism (ERM) in September 1992, under Norman Lamont as chancellor, it was one of Europe's weakest currencies for about three years. Its initial precipitous drop was followed by a second fall in 1994. From an ERM central rate of DM2.95, it fell to below DM2.20, with a sub-DM2 pound apparently a certainty.
But sterling found its floor, stabilised and, last year, became the dealers' darling. Strong economic growth and a newly independent Bank of England ready to raise rates pushed it back to its old ERM central rate and, occasionally, beyond. This rollercoaster ride is revealing. If, as the Government plans, entry is reserved for early in the next parliament, the pound will be outside EMU until at least 2003 and four broad possibilities emerge.
First, sterling as a basket case. If EMU is seen to be working, and the euro zone becomes an area of strong economic growth and low inflation, the traditional prejudice of the foreign exchange community will re-emerge.
Much depends on two things: the length and severity of the current slowdown and the extent to which the backwash of recent strong growth is higher than acceptable inflation. It is easy, in the wrong circumstances, to see Britain caught in a vicious circle in which a weak pound is seen by the Bank as adding to the inflationary danger in Britain, to which the response is higher base rates, which in turn further slows the economy and so on.
The safe haven scenario
Second, sterling as safe haven. The mirror image of the basket case pound is the one in which the markets see the euro as a dodgy construction, badly conceived and ineptly executed. The euro zone is beset with the problems of integrating a collection of disparate economies, with intractable budget deficits and chronically high unemployment. Britain, however, is seen as having minimum fiscal problems, a dynamic labour market and a central bank which, unlike the European Central Bank, controls inflation in just one country. As such, the pound's 1997 strength may be just a foretaste of what is to come.
Third, an aimlessly volatile pound like a weekend sailor trying to maintain a steady course in the swell created by passing ocean liners. A small country living next to a bigger and much more important neighbour could easily be the subject of whim and destabilising short-term capital flows.
Fourth, an effective euro shadow. The pound would shadow the euro just as Nigel Lawson attempted prior to ERM entry in the late 1980s, but this time with considerably more success. After all, Lawson was shadowing the D-mark without any explicit agreement that sterling would enter the ERM at a specific date. Given that countries in the euro zone have no interest in a very weak pound - it would increase the competitive pressure on them - and since they do have an interest in Britain's EMU entry, a policy of co-operation to keep sterling from collapsing could work.
A mix of the best and worst
So which will it be - basket case, strong safe haven, volatile shuttlecock or effective shadow? My guess would be elements of all four. Initially, I suspect, the euro will be quite a strong currency. Some of the likely 11 participants will make significant short-term growth because the interest set by the European Central Bank will be lower than their own pre-EMU rates. Other EMU benefits - such as savings in transaction costs and the fact that continental Europe is in the up phase of the business cycle, perhaps for the next two or three years - should help.
Things could change, however, as tensions begin to emerge and sterling could easily become a safe haven. If the tensions are serious enough, a sensible UK government might postpone entry. If not, the problem would be one of a rising pound in the run-up to joining the single currency and the danger of entering at an uncompetitively high rate. Either way, it could be an uncomfortable ride.