U.K. Euro Decision: Assessment and Analysis Guide

A report published on Monday 9 June by Bloomberg News provides a concise guide to the UK decision on the euro. It lists the five tests and the 18 separate studies used in the decision process as to whether to call a referendum on adopting the euro in the UK.
A report published on Monday 9 June by Bloomberg News provides a concise guide to the UK decision on the euro. It lists the five tests and the 18 separate studies used in the decision process as to whether to call a referendum on adopting the euro in the UK.

First published by Bloomberg News, 9 June, before the formal announcement was made at 3.30 p.m. UK time.

U.K. Chancellor of the Exchequer Gordon Brown will tell parliament today whether the U.K. government plans to call a referendum on adopting the euro. He speaks at 3.30 p.m.

Brown's statement will include the Treasury's assessment of five economic tests on whether euro membership would be in the nation's economic interest. Earlier today, the Treasury published 18 separate studies that helped shape the government's decision.

Here's a list of items to expect from his speech in London:

The Recommendation:

The government is unlikely to say now is the right time to push ahead with adopting the euro, economists, investors, political observers and pollsters say. With surveys showing almost two-thirds of voters opposed, the government may put off the issue until after the next election, which must be called by mid-2006.

The Assessment:

Brown based his recommendation to the cabinet on five economic tests. Treasury economists evaluated those tests during the past two years. Brown will release that assessment along with his speech to parliament at 3:30 p.m. Those tests are:

1. Convergence -- whether the economic performance of the U.K. and the euro economies match.

2. Flexibility -- whether the euro economy can cope with economic shocks.

3. Investment -- whether using the euro will spur industry to expand and consumers to spend.

4. Financial services -- whether a common currency is good for City of London banks and brokerages.

5. Jobs -- whether the euro will spur employment.

Will the Tests Pass?:

The test on financial services passed in 1997 and probably will pass again, analysts say. The government has declined to discuss the outcome of the tests before today's statement.

On June 3, the Financial Times, quoting unidentified pro-euro cabinet ministers, said four of the five tests have failed.

Brown has said he wants the merits of joining to be ``clear and unambiguous'' before he recommends pushing ahead. Many of the 18 studies released this morning detail problems with adopting the euro now, suggesting the pound must weaken and the European economy become more ``flexible'' before entry would be comfortable for Britain.

The Government's Current Policy:

Prime Minister Tony Blair's government favours adopting the euro once the economic conditions are right. In 1997, Brown ruled out scrapping the pound in time for the euro's debut in 1999.

Before leading Labour to a second election victory in 2001, Blair promised that Brown would reassess the case for joining in the first two years of his next term in office. It's that assessment Brown is delivering today.

Blair and Brown's Comments:

Blair and Brown said on May 16 they were ``totally united'' on forming a euro policy. Nevertheless, each has given a different emphasis to the importance of adopting the European common currency, fuelling speculation they disagree on the matter.

Blair has said it's Britain's ``destiny'' to adopt the euro, that it would be ``a shame'' not to push ahead and that the nation will lose influence in the European Union unless it uses the euro.

What Happens Next?:

If Brown says ``yes,'' that the economic tests have passed, then the matter would be put to a vote in parliament. A positive vote in parliament, which is controlled by Blair's Labour Party, would trigger a referendum.

A ``no'' from Brown would rule out a referendum for now. Brown would have to sketch out when -- or if -- the government will assess the case for adopting the euro again.

Who Should Care?:

Money managers, analysts and politicians from across Europe will comb through the Treasury's assessment and Brown's comments for a steer on a handful of issues. Those include:

1. Currencies. The Treasury assessed the ``equilibrium'' exchange rate at which it would be comfortable to swap the pound for the euro. The pound has fallen 10 percent against the euro so far this year. Brown's comments and the Treasury documents will give clues on the government's thinking on sterling's appropriate entry rate.

2. Housing. In April, Brown identified the housing market as an obstacle to adopting the euro, since British house prices are much more sensitive to interest rate changes than those in the rest of Europe. Brown may sketch out a way to make the U.K. housing and mortgage market more European.

3. Economic Reform. Brown has criticized euro nations for a lack of economic ``flexibility.'' He wants to see changes to the way the European Central Bank is run and a loosening of restrictions on government budget deficits. His statement today may detail what changes must be made before the U.K. would considerer using euros.

4. Banking. The Treasury studied whether investment banks would be less likely to work in the City of London so long as Britain remained outside the euro nations. Brown's comments on the matter may give clues how concerned the government is about banks fleeing the U.K.

5. Exporters. Manufacturers including Ford Motor Co. and Unilever NV have said Britain will lose out on investment and trade so long as it avoids using the euro. The Treasury will discuss whether those claims have merit.

6. Interest rates. The government may order the Bank of England to target the European measure of inflation, known as HICP, instead of the U.K. standard, called RPIX. That may allow the U.K. central bank to cut interest rates further from their lowest in almost 50 years, since HICP has shown lower inflation than RPIX in recent months.

The 18 Studies:

In addition to the five economic test, the Treasury drew up 18 separate studies, some relying on outside consultants and academics, detailing the costs and benefits of adopting the euro in the U.K. The studies total 1,738 pages and weigh almost 7 kilograms. They were released at 9 a.m.

Those studies are:

1. The five tests' framework -- details the measures in place to assess the economics of using the euro.

2. Analysis of European and U.K. business cycles and shocks - - concludes that the ``U.K.'s cycle is strongly correlated with that in the U.S., somewhat more than with those in Europe.''

3. Estimates of equilibrium exchange rates for sterling against the euro -- says the pound should weaken at least 5 percent against the euro to make entry more comfortable.

4. Housing, consumption and EMU -- says that using Europe's lower interest rates could extend a house price surge in the U.K.

5. EMU and the monetary transmission mechanism -- concludes the U.K. economy is more sensitive to interest rate changes than the euro nations.

6. Modelling the transition to EMU -- details the ways Britain can minimize the costs of swapping the pound for the euro.

7. Modelling shocks and adjustment mechanisms in EMU -- says it is ``not possible to say whether macroeconomic volatility in the U.K. will increase or decrease inside the EMU compared to outside.''

8. EMU and labour market flexibility -- found ``evidence that the U.K. labour market has become more flexible'' since 1997, though ``major challenges remain'' and other EU nations have only ``mixed'' successes.

9. The exchange rate and macroeconomic adjustment --concludes that a flexible exchange rate more often than not will ``help to stabilize the economy than destabilize it.''

10. EMU and the cost of capital -- found ``little scope'' for interest rates on risk-free U.K. debt to fall if the nation adopted the euro.

11. EMU and business sectors -- the euro's creation places a ``premium on flexibility'' of U.K. companies, who may face tougher competition and increased trade opportunities regardless of whether Britain uses the euro.

12. The location of financial activity and the euro -- concludes that London's position at the centre of European financial markets hasn't been hurt by the U.K.'s decision not to adopt the euro.

13. EMU and trade -- foresees an increase in trade of between up to 50 percent with euro nations if the U.K. adopts the euro.

14. Prices and EMU -- concludes there may be ``small'' rises in retail prices from the costs of swapping the pound to the euro.

15. The United States as a monetary union -- concludes that single currency areas require ``a high degree of confidence'' in the capacity to fix problems and respond quickly to shocks.

16. Policy frameworks in the UK and EMU -- says that the U.K. economic framework is ``up-to-date'' while comparable structures in the rest of the EU are still in the middle of an ``evolution.''

17. Submissions on EMU from leading academics -- includes papers from 23 university professors arguing both for and against the euro.

18. Fiscal stabilization and EMU -- says fiscal policy ``may need to be more activist'' to dampen economic shocks within euro- member nations.

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