/www.fxserver.com/ A "No" that sounds like a "Yes" is still a "No" . That's what the UK Treasury ruled today when it issued a not yet verdict on the pound's membership in the European Monetary Union. Basing its decision on 5 economic criteria-economic convergence, flexibility, investment, financial services and employment-The Treasury kept the door open for a subsequent evaluation of the economic tests in next year's budget in March. But let us not be fooled. Regardless of Mr. Brown's intention to launch a new euro campaign with his PM this week, he will continue to hold the 5 economic cards firmly in his hands and closer to his chest well into the end of the current parliament.
Critical Criteria
Out of the 5 economic tests used to evaluate whether the UK will benefit from adopting the euro, only the City test passed, which assesses the impact on the financial services industry. Amid the 4 failing tests, convergence was the high profile element that highlighted the economic and financial contrasts between the UK and Eurozone. Divergence in growth and interest rates as well as an inherently large level of mortgage debt as part of GDP, renders British housing highly sensitive to interest rate changes. Such sensitivity would prove destabilizing when monetary policy is set in Frankfurt in function of at least 11 other economies.
The lack of economic convergence inevitably leads to the failure of the flexibility test, which dictates the ability of the economy to respond to exogenous or endogenous changes in macroeconomic variables such as GDP growth, monetary policy, fiscal policy and jobs.
Although the investment test was ruled to have failed, it is more likely to get a passing grade once the UK adopts the euro. The criterion is founded on whether Britain will retain its ability to draw foreign direct investment. But the strange thing is how can the Treasury declare this test to have failed after having admitted that it has taken particular account of the qualitative evidence from Japanese, other Asian, American and European investors many of whom have said that EMU membership would be beneficial and is important to them." Since foreign investors would surely welcome the disappearance of currency risk upon UK's EMU entry, they would most likely add to their investments in the UK. If that were the case, then why would the Treasury give the investment test a failing grade?
The employment criterion also failed to get a passing grade, with lack of sufficient convergence once again blamed as the primary culprit. The Treasury said that regardless of the level of convergence, any risks to the UK of EMU entry could be compounded by the European Central Bank's inflation objective and by a rigid and overly mechanistic interpretation of the Stability and Growth Pact . These constraints, the Treasury says, will likely destabilize growth and employment in case of EMU entry. Not exactly a dazzling endorsement of the Eurozone's current monetary and fiscal framework.
So what's the cheapest admission price to Eurozone?
A strong sterling had been amid the recurring arguments cited by euro skeptics, standing in the way of euro entry as it risked locking Britain's trade with that of the Eurozone at a noncompetitive exchange rate. Indeed, the argument remains a cogent one ever since the pound's 1992 spectacular collapse from the Exchange Rate Mechanism resulting from failure to sustain an overvalued exchange rate. But the pound has fallen nearly 10% in trade-weighted terms since PM Blair's Labor party retained leadership in June 2001, sending the currency down 22% against the euro to 71.3 pence-and exceeding the 70-pence figure described by most manufacturers as desirably competitive. But since sterling's appreciation against the dollar has neutralized some of the competitive effects of the currency's weakness against the euro, most economists have revised up their EUR/GBP entry rate to the newly desirable range of 75-80 pence.
Due to Britain's higher export dependence on the EU relative to the US (55% from EU versus 13% from US), it could be argued that British industry will come out victorious in the event that sterling weakness against the euro remains matched by an almost even strengthening versus the dollar. But even if say the sterling became appropriately competitive by weakening against both euro and the dollar, it may not necessarily guarantee immediate EMU entry mainly because such a currency-driven stimulus would risk provoke Britain's inflation prone economy, which would only maintain interest rates above those of the stagnant-prone Eurozone.
Thus, the Treasury's ultimate challenge remains tied to reconciling the benefits of competitively viable currency level, with the virtues of an interest rate consistent with price stability. The Bank of England already confronts these challenges on a monthly basis as it ponders the needs of exporters and mortgage payers on one end, and the government-imposed 2.5% inflation target on the other.
Brown's unrelenting veto power
Despite Mr. Brown's sugar-coating of the potentials of EMU membership and his willingness to inaugurate a fresh euro campaign with his PM as early as Tuesday, the Chancellor prefers not to (at least not yet) be associated with the unpopular euro topic, especially as he gears up for a PM candidacy in the 2005 elections. PM Blair may also choose not to pursue the increasingly unpopular euro cause with the same zeal as a year ago. Not only Mr. Blair's popularity has already been tarnished prior to the war with Iraq, but also it is further stained in the aftermath of the war on reports involving Britain's possible reliance on inconclusive evidence of weapons mass destruction in Iraq.
Over a dozen of private sector studies served in backing up Monday's EMU decision. But the veto power over the final verdict clearly remains with the Chancellor. And despite the objectivity of non-convergence as a valid reason to not join EMU today, the timing of membership remains largely subjective. Unless the UK revises its 2.5% inflation target governing a stubbornly 2-tiered economy, we might never see the day when British interest rates approach their Eurozone counterparts. Below is a chart showing how both UK and Eurozone rate have stayed apart. Even though I could have contrasted and compared other macro variables across the two economies, interest rates simply remain the single fundamental element on which the key convergence test is founded.
Blair's intangible political tests
Meanwhile, PM Blair could continue trumpeting the virtues of joining Europe until the 2005 elections, but his strategic or political arguments can never be quantified via a series of political tests . In contrast, Mr. Brown holds the decisive power over both the viability and timing of the euro question through his 5 economic tests. Despite their apparent subjectivity, these tests stand far more tangible than Blair's vision-based arguments.
Within one week after the September 11 attacks, PM Tony Blair made one of the most emotional speeches of his career pleading to nation that it was such events that justified closer integration with the rest of Europe, extending far beyond trade and economics and reaching into security cooperation. Nearly 2 years later, the PM finds himself more closely aligned with the US and farther away from Europe (and his own electorate) than he ever hoped.
When Mr. Blair became PM in 1997, he exchanged his residence at 10 Downing Street for the Chancellor's larger residence at number 11 to accommodate for Mr. Blair and his family, as Mr. Brown was still a bachelor. While the swap appeared to reflect differences in family sizes at the time, it foretold the size of Brown's growing political ambitions. Meanwhile, the euro issue shall remain hostage to Mr. Brown's politial needs, covered under the guise of economic objectivity.