Convergence: Background paper

BACKGROUND PAPER: PRICES

The Treasury believes the effect of euro entry on UK prices would be "limited" at changeover; some would not change but total convergence would take "many years".

Its paper, Prices and EMU, examines the history of single currencies, the euro and its impact since it was introduced.

Short-term costs associated with entry would be transitional and less significant than the longer-term effects, the paper believes. In theory, reduced barriers to trade should cause prices to converge until eventually they are identical across the region, adjusted for the cost of transport and other trade. The elimination of currency costs and exchange-rate risk ought to boost trade and competition, putting further pressure on prices across the region.

But, in practice, EMU would not remove other barriers that limit price convergence. "Significant variations in prices could be expected to remain within the euro area, particularly in sectors which are less exposed to trade," the paper says.

Prices in Britain are significantly more expensive than the EU average, peaking at some 19 per cent higher in 2000. Since, the price differential has fallen to 8 per cent in January 2003, reflecting the sharp depreciation of sterling against the euro. Over the same period, France and Germany have become cheaper, and Italy has remained relatively cheap.

The Treasury says regional price differentials are strongly supported by local labour costs and taxes, which would not be affected by joining the euro. Supermarket goods can be found at half their maximum EU prices in some member states.

No European country is uniformly cheap or uniformly expensive, although British prices tend to be at the high end for several products.

The paper suggests that political boundaries will continue to be an important barrier to trade, and may be the most important factor in determining continued price differentials across Europe.

By Jeremy Warner

BACKGROUND PAPER: HOUSING

The UK is more sensitive to changes in interest rates than the eurozone economy because of differences in the housing and mortgage markets, a Treasury paper showed yesterday.

The report said: "If households' spending is significantly more sensitive to interest rate changes in the UK than in the euro area as a whole, a common monetary policy could induce some instability in the UK housing market and households' spending."

The study, which was made by an in-house Treasury team, was seen yesterday as one of the main arguments for the decision to delay joining the single currency.

The 107-page paper also found there was little hope that joining the euro would eliminate the differences, saying there had been "little" convergence between the member states since joining. The paper found house price growth had been stronger in the UK than in the larger eurozone countries, partly in response to the low level of house building in the UK.

Almost three quarters of Britons own their homes while the two largest euro economies - Germany and France - have owner-occupation rates below 60 per cent. It said the high levels of mortgage debt in the UK and the dominance of variable rate mortgages implied that British households were more sensitive to interest rate changes than their continental counterparts.

UK mortgage debt totals 60 per cent of GDP, well above the EU average.

Six out of 10 mortgages in the UK are on a variable rate, a stark contrast to Germany where 80 per cent of homeowners are on fixed mortgages with a duration of at least five years. The Chancellor acknowledged this issue in the Budget in April when he commissioned Professor David Miles of Imperial College London to look at the feasibility of establishing a market for longer-term mortgages.

Yesterday's study also focused on the issue of mortgage equity withdrawal, when homeowners take out a second mortgage to cash in on the rising value of their home. The report found that homeowners extracted a total of 3 per cent of household income a year between 1979 and 1999. In Germany, France and Italy there was a net injection of funds into the housing market amounting to 6 per cent of income. "The competitive, liberalised mortgage market in the UK makes it easier for households to access housing wealth," it said.

The paper concluded that the differences meant that sharp moves in interest rates would trigger wider shifts in wealth and economic growth in the UK rather than in the eurozone as a whole.

By Philip Thornton