Euro launch: A bumpy ride looks likely for sterling

THE LABOUR Government has rightly emphasised the importance of financial stability. An operationally independent Bank of England and explicit fiscal stability rules are proof of good intent.

The main anomaly is a fluctuating exchange rate whose appreciation has already damaged manufacturing industry. The formation of economic and monetary union without British participation leaves sterling exposed to a period of uncertainty and instability.

The Chancellor Gordon Brown wants sterling to be stable and competitive. In practice it has been neither. Even after a decline in the DM rate from the March peak of DM3.10 to DM2.80, the effective rate -taking into account relative inflation and exchange rates of competitors - is still around 10 per cent higher than when the Government took office, according to the OECD. The price competitiveness of exports and import substitutes has declined across the board.

Because the consequent loss in orders takes time to feed through into output, investment and jobs, last year's strong pound will continue to be felt in manufacturing recession. On the Government's own figures, export volume growth will fall from 8.5 per cent in 1997 to 3.25 per cent in 1998 and 3 per cent in 1999. Most of this decline is attributable to sterling appreciation.

What of the future? The Government expects an orderly devaluation sufficient to counter recession in manufacturing but not so large as to jeopardise the inflation target. Interest rate differentials between the UK and Euro zone should close and this should pull sterling down to equalise the return on assets.

These are, however, not normal times. The launch of the euro is a seismic event in economic terms. One of the few areas of consensus among forecasters is that there will be increased volatility for currencies such as sterling, which are outside Euroland but heavily influenced by it. Volatility matters increasingly because, as the euro is more widely used in the UK for business purposes, exposure to foreign exchange risk will grow.

Continued uncertainty over British intentions is inherently destabilising. Another reason for expecting volatility is that the rest of the world is only peripherally important for Euroland economic managers. Most trade is internal.

The exchange rate will become, as it already is for the US, a residual factor. The Federal Reserve takes little account of the dollar-yen and dollar-DM rate in setting policy and the European Central Bank (ECB) will behave in the same way. The world economy will resemble a tropical mud bath in which two large hippos wallow around, crushing smaller animals, like the British, caught in the middle.

In addition to general volatility there is the risk that the euro will cause a major exchange rate shock to sterling. One possibility is that sterling could become a refuge for nervous Euroland investors if there is any loss of confidence in the early years of the euro. This seems unlikely, at present, but, if it happened, the cost of a `safe haven' premium for sterling would be further damage from appreciation to exchange rate sensitive UK firms.

It is more likely that the shock would be a large uncontrolled devaluation. Two factors may make the euro exceptionally strong, relative to sterling. In one plausible scenario, there is a combination of strict monetary policy administered by the ECB and looser fiscal policy administered by left-wing governments in France, Germany and Italy.

Comparable circumstances in the US in the 1980s produced record highs for the dollar. Another influence in the same direction is the potentially huge portfolio shift in reserve holdings. Major foreign reserve holders, such as China, Japan, Singapore and Taiwan, and private funds, will demand euros as a reserve currency pushing up the euro against other currencies including sterling.

Devaluation against the euro would have competitive advantages. But it would present two problems. Imported inflation could undermine price stability. Deep devaluation could also create a confrontation with Euroland over "unfair competition" and the risk of trade sanctions.

Sterling is due for a bumpy ride. Even if the Government tries to minimise uncertainty by signalling a clear intention to join EMU soon after the next general election, there is a potentially awkward transition. The Government has studiously avoided spelling out how it will manage the transition from a freely floating to an irrevocably fixed exchange rate regime. One suspects it doesn't really know.

It would help if the Treasury and the Bank of England set explicit monetary and fiscal convergence targets. Smaller interest and inflation differentials would, in themselves, reduce speculative arbitrage.

The bigger issues concern the timing and rate of entry into EMU. The logic of the Government's position, at present, is that the entry rate will be determined by the timing. The rate prevailing in the markets after a successful referendum will be a likely reference point for negotiations with Euroland on an entry rate and date.

This assumes that the Government controls its present bout of suicidal infighting, gets comfortably re-elected, then, in the Nirvana of rapid and smooth decision-making promised for after the next election, sorts out the technical entry problems; and also wins a referendum.

An awful lot is being left to chance, not least the fact that the prevailing exchange rate, then, could be inappropriate, as it was when we joined the ERM.

It would surely be more sensible to address now the issue of what could be a sustainable long-term exchange rate. There is no objectively "correct" rate. There are different views and methodologies. But some informed estimates are emerging.

Goldman Sachs in October argued for a rate of DM2.50 to 2.60. Williamson's work on a long-term equilibrium suggested a lower rate of DM 2.35 to 2.40. The Government should initiate a debate on a plausible consensus range. It could follow the model of the minimum wage where it skillfully used a political device - the Low Pay Commission - to achieve an economically sensible answer.

Whatever recommendation emerged would influence market expectations and also help to persuade Euroland governments that the proposed British entry rate has a basis in economic fundamentals, not opportunism or pure chance.

If the logic of entry starts with an appropriate exchange rate, a window of opportunity may well open before the next general election. The euro- sterling rate will at some point approach the desired level. If overall convergence was close, this would be the time to lock sterling into a stable exchange rate regime. There would be the additional merit of pre- empting the Maastricht Treaty requirement that Britain should demonstrate a period of exchange rate stability before EMU entry.

The main awkwardness is political. The Prime Minister has ruled out EMU entry before the next election. The Chancellor has ruled out joining a reconstituted ERM as an intermediate step. One of them, almost certainly the Chancellor, will have to eat his words. But that is a small price to pay for a stable and competitive exchange rate and a smoother trajectory to EMU entry.

Vincent Cable is the Liberal Democrat finance spokesman and a member of the Treasury Select Committee