EMU - Euro place or mine?

The second half of our series on preparations for Europe's monetary union considers the likelihood of the UK's entry and the potential benefits and dangers it would bring.

You might as well expect the denizens of a saloon bar to agree onry union considers the likelihood of the UK's entry and the potential benefits and dangers it would bring. which football team is best as persuade the British to agree on whether we should join Europe's economic and monetary union (EMU) and adopt the single currency. The Confederation of British Industry (CBI) says yes, the Institute of Directors (IoD) says no. Marks & Spencer says yes, Dixons Group says no. Labour says yes, the Tories say no. And the recently resurrected Referendum Party says 'over our dead bodies'.

Let's begin with the easy bit. Membership of EMU has three important consequences for each member state.

Its national currency is gradually abolished and replaced by the euro, and the rate of exchange between its national currency and the euro is fixed forever on the date of entry.

Interest rates are no longer set by each country's national bank (such as the Bank of England), but by the European Central Bank (ECB).

EMU membership imposes various economic conditions, which include keeping the annual government deficit to below three per cent of gross domestic product (GDP), and handing over control of foreign currency reserves to the ECB.

With such a huge economic bloc on our doorstep, there is great pressure for the UK to join. 'If the UK does not join, it's outside a major trading club,' says Eunice Lau, a senior economist at the CBI. 'Asia and the US have their own clubs. The UK will be marginalised if we stay outside.'

Businesses would be affected by UK entry in all kinds of ways. Debt would be cheaper, because it is quite likely that interest rates would be lower and fluctuate less than they do now, and that the cost of raising finance would be lower.

Competition would increase, thanks to price transparency with Europe.

'This is all about creating a better single European market, whether the UK goes in or not,' says Adrian Payne, head of the EMU unit at Price Waterhouse Coopers. 'British companies can expect a more competitive environment to work in.'

Company structures are likely to be changed by partnerships, foreign ventures and even mergers. 'To a lot of businesses, EMU is a strategic issue rather than an operational issue,' says Lau.

Staff would also have to be trained to handle dual currencies and conversions.

'Training is one of the key issues that businesses, especially small businesses, have to face up to,' says Stephen Dexter, a partner at Grant Thornton.

Converting IT systems, tills and vending machines, as well as training staff, will cost UK firms a great deal of money and management time. But joining EMU will also bring savings, in the shape of reduced transaction costs, freedom from exchange rate risk and cheaper access to Continental markets. 'One of the few certainties is that if we joined there would be savings in transaction costs,' says Payne.

There have been myriad attempts to put a figure on the costs of entry, ranging from the plausible - #2,000 per small or medium-sized business according to Lloyds Bank - to the improbable - #44 for every person in Europe just to convert the continent's vending machines according to the European Vending Association.

A reasonable average figure for conversion costs in the UK is 1.5 per cent of GDP, spread over several years. Estimates of the annual benefits also vary from 0.5 per cent of GDP according to the European Commission to between 0.1 and 0.2 per cent according to the IoD.

If the annual benefits were worth, say, 0.2 per cent of GDP, and it cost 1.5 per cent of GDP to enter, the UK would recoup its investment in seven or eight years, and then be in profit for ever. Unfortunately, this is far from the end of the story, since the quantifiable costs and benefits of joining EMU are overshadowed by the unknown effect on our economy.

'The big advantage to the UK of staying out of EMU is that nobody knows whether this thing is going to work,' says Payne. 'It could be a fantastic success or it could be a disaster, and it's very difficult at the outset to tell which.'

Success would bring inward investment and economic growth; failure could see amplified cycles of boom and slump and instability through inappropriate interest rates. Even supposing that EMU succeeds - and there is no precedent for a single currency shared by so many independent nation states with such well-developed economies - an equally big question is whether the UK will thrive within it.

The main aims of EMU, including low inflation, steady economic growth and fiscal discipline, coincide with those of the UK government. But the UK's economy is different from that of most EMU members. The UK does more trade outside Europe, for example - the US accounts for 13 per cent of our trade but only eight per cent of Germany's. And the economy is more debt-driven as there are more house owners with mortgages and businesses which pay higher dividends to shareholders.

Our economic cycles may not coincide with the other EMU nations and the blanket measures taken by the ECB - especially control of interest rates - might not suit whatever phase the UK economy is in.

'If structural differences between the UK economy and the other main EU economies are not addressed, it's likely that the UK economy would slip out of synch and need different interest rates,' says Ruth Lea, head of the policy unit at the IoD.

Without being able to increase interest rates to control inflation, for example, the UK government would have only two weapons in its armoury.

Dexter explains: 'One is to put up taxes, and the other is to increase unemployment, and that's where the pain would be.'

But others believe more stable interest rates would more than compensate for the risk. Leslie Gunde, head of the EMU unit at KPMG, argues that interest rates are not a very good lever for controlling the economy.

'There's a danger in trying to second-guess the economic cycle because the effects of interest rate changes aren't felt until 12 to 18 months later,' he warns.

The sterling/euro exchange rate would be fixed for good if the UK joins EMU. Gunde believes this would encourage inward investment and trade outside the EU. 'Arguably, the euro will supplant the dollar as the world's leading currency in the next five to 10 years,' he says. 'Russia and Asia have already shown that in a crisis there's a rush to stability.'

Of Russia's western neighbours, Sweden, which is not joining EMU, has seen its currency fall, whereas that of Finland, which is joining, has remained stable.

But others think losing the flexibility of the exchange rate with Europe would be a mistake, especially since the pound is likely to remain strong against the euro during the early years of EMU.

'Some supporters favour EMU because they feel it would get the pound down against the European currencies,' says Lea. 'Nothing could be further from the truth. If the pound were to enter, the rate chosen would probably be the market rate and we would be locked into this rate permanently.'

Nor is there agreement on whether the UK would take the hit for the kind of fiscal mismanagement which has left Germany and France with public sector pension liabilities greater than their GDP.

'Financing these liabilities could well prove an intractable problem for many countries and there is a real risk that the British taxpayer will end up financing the improvidence of other European governments,' says Lea.

Gunde disagrees. 'I don't understand this fear,' she says. 'There's no suggestion of any cross-border support for national budgets. I can't envisage any situation where the UK taxpayer would be asked to fund German pensions.'

Such examples of what we might call fiscal overlap raise the biggest question of all: is EMU the thin end of the wedge that will open the way to political union? Lau doesn't think so, pointing out that various combinations of economic and political union are possible. The component states of the US, Canada and Germany all have different levels of autonomy, for example.

But others argue that mobility of labour - which is expected to be one of the main methods of levelling out the economic cycles of the different member states once interest and exchange rates are fixed - must be underpinned by portability of pension and social security rights and that will necessitate a greater degree of fiscal co-ordination. 'The economics of EMU will force the political issue and we will have political union by the back door,' says Dexter. 'It's inevitable. The next step is to equalise taxes. I think we're about half way down the road.'

So the only conclusions that can be drawn about the most momentous step facing Britain since the Act of Union of 1603 are these:

Entry into EMU would provide business benefits which would enable us to recoup the cost of entry within a few years.

On the other hand, nobody really knows whether the effects on the economy of becoming part of a larger economic bloc would be good or bad.

Nor does anybody really know whether EMU will work at all, because it was cooked up by a bunch of politicians.

It could take 10 years before the UK finds out. And if we wait until then, it may have missed the boat.

So the most likely outcome is that the UK will join within a few years and keep its fingers crossed.

IMPLICATIONS FOR THE IT INDUSTRY

The cost of converting IT systems for the euro will be huge. IDC estimates that the EU member states will spend a total of $27.8 billion by 2002 on euro conversion, and that 40 per cent of this will go on updating or replacing IT systems. While many companies will update software, IDC believes most firms with fewer than 1,000 staff will replace their old applications.

The applications affected most will be those relating to accountancy, sales transactions, asset management, human resources, payroll, internet commerce and banking.

The vertical markets most likely to be affected are banking, manufacturing, retail, and government departments such as social security. Banks, insurance firms and retailers are already preparing their systems for possible British entry into EMU, while most others are waiting until a decision is made, according to IDC.

Consultancy skills

Much of the cash being spent could find its way into resellers' pockets.

'There's going to be a lot of work, and therefore money, for somebody,' says Stephen Dexter, a partner at Grant Thornton. 'The PC industry will be one of the main industries to benefit.'

Spending on consultancy and other services is expected to outweigh spending on pure products (see chart, p 27), so resellers with value to add are likely to benefit most. 'The higher service providers are in the value chain, the more benefit they will get,' says Mirko Lukacs, a senior analyst at IDC's european consulting and management services. 'They will need not only IT capabilities but business consulting skills.'

So far, only a few businesses in mainland Europe - mostly banks - have completed their conversions. Most are still at the planning and evaluation stage, and will not be ready by the start of next year when trade in euros begins. They have until 2002 to start coping with euro cash and the withdrawal of their own national currencies, but IDC's analysts believe some financial institutions will not make it by 2002 and will suffer badly, or even go bust.

Some conversion or replacement work will have to be done, whether or not Britain enters EMU, by businesses which trade with the euro zone, or whose UK customers or suppliers demand to trade in euros (see PC Dealer, 30 September).

But if Britain enters, even more systems will be affected. Some changes will be trivial, such as converting printouts to say euros instead of pounds. Other systems will require adequate migration provision for current transactions, or the ability to deal with historical data, such as balance sheets.

The doomsters claim that the most serious issue is conversion between the old national currencies. EMU rules stipulate that, for countries in the euro zone, this must be done via the euro, a process known as triangulation.

For example, to convert from French francs to Deutschmarks, systems will have to convert from francs to euros, then from euros to marks.

Significant figures

To ensure accuracy, the exchange rate must be held to six significant figures (for example 123,456 or 1.23456 or 0.123456). The triangulated calculations have to be recorded in the software to three decimal places, although the final result need only be expressed to two decimal places (because currency units, such as the centime or the pfennig, don't come any smaller).

Most accounting software stores results to only two decimal places, and can't handle exchange rates to six significant figures (this theoretically requires a variable field which can record any value from 999,999 to 0.000001).

The programming changes required are not unlike expanding six-figure dates to handle eight figures - minor in themselves, but with significant implications if they are overlooked. And not many applications on the market can do triangulation.

Other experts argue that most businesses will not need to bother with triangulation, since it only affects transactions involving two of the old national currencies. As long as one side of the transaction is already in euros, triangulation is not necessary, and if the UK became fully integrated into the euro zone, all transactions would be in euros anyway.

HOVERING ON THE THRESHOLD OF EMU

The prerequisite for the UK to adopt the single currency is that the government of the day must believe it would be in the national economic interest. The present government has ruled out joining within the lifetime of this parliament (which could run until June 2002), except in exceptional circumstances.

The Conservative party (or most of it) is opposed to British entry into EMU for the foreseeable future. Labour is generally well-disposed towards entry, possibly during the next parliament.

Chancellor Gordon Brown has set out five economic tests which would have to be met before a Labour government would recommend UK entry into EMU:

Are business cycles and economic structures compatible, ensuring that the UK and its partners could live comfortably with euro interest rates on a permanent basis?

If problems emerge, will there be sufficient flexibility to deal with them?

Would joining EMU create better conditions for firms considering investing in the UK?

What impact would entry into EMU have on the competitive position of the UK's financial services industry, particularly the City's wholesale markets?

In general, will joining EMU promote higher growth, stability and a lasting increase in jobs?

People's choice

Once these conditions are met (some commentators argue that they are virtually met already, while others believe they never will be), Labour would call a referendum. Today, UK public opinion is mostly opposed to entry.

But the level of public awareness is low and many of the objections to EMU are largely sentimental, so a government-backed 'yes' campaign early in the next century would have a chance of succeeding.

Assuming the UK wanted to join, the third and final question is whether EMU would want it. That would depend on the UK meeting the terms of the Stability and Growth Pact, an extension of the convergence criteria laid down in the Maastricht Treaty. The criteria are:

an annual government deficit of no more than three per cent of GDP in 'normal circumstances' (in other words, unless there is a recession)

a government debt of no more than 60 per cent of GDP, unless the ratio is 'sufficiently falling'

an inflation rate no more than one per cent above the average of the three best-performing countries in the union

long-term interest rates no more than two per cent above those of the three best-performing countries

membership of the ERM (exchange rate mechanism) without 'severe tensions' for two years

The UK already meets the first three criteria - better, in fact, than most of the 11 countries joining EMU next year - and the ERM, which we left on Black Wednesday in 1992, is virtually moribund.

The only stumbling block is therefore likely to be interest rates, which are more volatile in the UK and could be well above (or even below) those of the euro zone. Rates could either be yanked into line by the Bank of England before the UK joined, or else adjusted at the time of joining.

This is what will happen for Ireland, which is joining in the first wave despite a current rate which is well above the Maastricht convergence level.

So it is perfectly possible that the UK could enter EMU during the early years of the next century.

COUNTDOWN TO EURO CONVERSION

The euro will be introduced on 1 January 1999, in Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain - the euro zone - although only as an option for cheque and electronic funds transfer. The old currencies of the member countries will remain in use, but the exchange rates between them and the euro will be fixed permanently.

On 1 January 2002, euro coins and bank notes will become legal tender within the euro zone. The old currencies will remain in circulation for a further six months, after which the euro will become the only legal currency.

The UK will treat the euro as a foreign currency from 1 January 1999, until it enters EMU.

The most likely scenario for our entry into EMU looks like this:

- As long as the UK's economic position remains stable and as long as EMU has not shown signs of failing, Prime Minister Tony Blair calls a general election in 2001 or early 2002.

Labour wins the election and holds a referendum about six months later, after a government-sponsored 'yes' campaign similar to Ted Heath's campaign to keep Britain in the EEC in the early 70s.

Without a concerted 'no' campaign, the British electorate, somewhat reluctantly, votes 'yes' and Britain enters EMU on 1 January 2003.

The transition period is shorter than for the first wave of entrants, so sterling ceases to exist within two years - possibly by 1 July 2004.

VIEWS OF EMU

'If, in the end, a single currency is successful and the economic case is clear and unambiguous, then the Government believes Britain should be part of it.' Gordon Brown, Chancellor of the Exchequer

'The UK government should only consider joining EMU when there is no doubt that the British economy could be as well run by EU institutions as by British ones. There is absolutely no sign that this condition can be fulfilled for the foreseeable future.' Ruth Lea, Institute of Directors

'If it doesn't become clear fairly soon that we are - or are not - going to join, there will be a lot of uncertainty. Business and capital don't like uncertainty and the UK will be the loser.' Leslie Gunde, KPMG

'There's no point having one foot in the boat and one foot on the quayside, because you get ripped apart or you get wet. The sooner the decision is made to go in, the better.' Stephen Dexter, Grant Thornton

'If the UK remains outside EMU and the EMU countries don't see any commitment from us, they may start to discriminate against us and the UK will be marginalised.' Eunice Lau, CBI