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Seeing cents over the euro

Tony Blair said last week that if he had to vote on entry to the euro right now he would vote no. The statement sent a chill down the spines of most europhiles. First, Blair has been reticent up until now about saying anything publicly in support of the euro and now he is openly muttering against it.

Of course, the PM would point out that he said he would not vote to join the single currency now which means his position might change this position tomorrow, next week or, as is most likely, some time next year after he hopes he wins another term in office. His statement reflects the level of politicisation of entry into the euro in this country.

Sure, the Government pays lip service to the economic tests set out by the Chancellor but those tests are vague enough that any person would be able to bend them to say we meet/do not meet the criteria at any given point in time. The important questionis, therefore, if the decisionto enter the euro is political and not economic, how isthat going to affect the pound in relation to the euro over the longer term and what will IFAs have to know to be able advise their clients on currency fluctuations?

On Tuesday, October 24, the Government announced some good news – the UK had registered a trade surplus in goods with the European Union of £39m over the past month, giving proof to euro-phobes who would have you believe that Britain does not need to be in the euro. But the surplus is a blip on the screen for the most part, as it was the first such surplus in five years.

The truth is that if you are producing goods and trading with Europe right now, your business is either suffering from reduced margins (to offset the value of sterling which hit a high of nearly 1.74 eurosto the pound in the last week) or reduced sales as a res-ult of losing business toEuropean competitors whose goods are cheaper becauseof the weaker euro.

Over the next few years, the situation will remain much as it is today. The pound will continue to be strong against the euro. There is no single cause for this but a few reasons include lack of investor confidence in the extent of reforms taking place in European labour markets.

Add to this the relative weakness (despite robust growth across the Continent this year) versus the US economy and the lingering effects of the appreciation all European currencies experienced in the run-up to the launch of the euro, creating an artificially high initial exchange rate against the dollar.

The comments of European central bankers such as Wim Duisenberg and Continental politicians (at the EU and national level) do not reinforce investor confidence and do not help. Instead, they remind investors of their traditionally meddlesome rolein the economy.

So, if the pound remains strong against the euro in the next two to three years what does that mean for British entry? The answer is that there will not be any formal accession during this period. Even if Tony Blair wins his second term in office and callsa referendum and wins (a highly unlikely eventuality, it would seem), it is unlikely that any decision will be taken to fix irrevocably the exchange rate and trade in sterl-ing for euros

Why? Because it would bepolitical suicide to join at too high an exchange rate, permanently handicapping British business. No politician would embark on such a suicidal course, not after Britain&#39s ejection from the ERM which occurred primarily for the same reason – Britain joining at an unsustainably high rate.

However, if one extrapolates a little further and imagines a slowdown in the UK economy beyond the next two years and continued vitality in Continental economies partly as a result of the weak currency, there will likely be a slow decline in sterling versus the euro, bringing up the possibility of a sustainable entry rate.

What does that mean then overall for the value of sterling in the next decade? Well, within a decade or so, chances are we will not be using pounds and pence in Britain but euros and cents.

The next two to three years will see continued weakness in the euro against sterling. But it will likely pick up in value as investors realise it is a currency that is here to stay and as European nations continue to reform labour markets and pension systems making long-term prospects more positive.

Only when you have the combination of a weakening pound, strengthening euro and reforming Continental economies will UK accession occur. The economic tests set forth will therefore be decided by political decisions made here and in the EU.

What does this mean for IFAs? In the longer term, they are going to have to pay more attention to the political decisions of leaders in France, Germany and the other EU countries to be able to provide advice on currency fluctuations between the pound and the euro.

The tough political choices being faced on the Continent – particularly in terms of tax structures, pensions and labour market regulations – have economic consequences and these will drive Britain&#39s entry date into the euro.

If European politicians are successful in reforming their economies, they will improve the prospects of the UK&#39s entry into the euro-zone sooner rather than later. But if European governments choose to hold off reforms, the euro will likely remain weak and Britain will remain outside.

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