The Government has promised to re-examine Britain's stance towards the euro within the next two years. Simon Rubinsohn looks at what signing up to the single currency will mean to the country
As it became clear during the course of the General Election campaign that the opposition would make few inroads on Labour's majority in the House of Commons, speculation in the financial markets turned to the Government's likely approach to the single currency during the next parliament. Comments attributed to the Prime Minister helped fuel the suspicion that a rapid move into monetary union could be on the cards.
Nevertheless, for all the talk, little news of any real substance emerged in the weeks both prior to and following the Election.
That is until Gordon Brown's Mansion House speech. The Chancellor made it quite clear that the official position is still that, at some point over the next two years, there will be a re-examination of the 'five tests' established back in 1997 and, significantly, that the assessment process has yet to begin.
The tone of the comments was, as the Chancellor described, decidedly 'euro realistic' with a further warning that the Government would not take risks with Britain's hard won economic stability.
Labour clearly still wants to be seen to be playing a constructive role in Europe but the implication of this speech, which had the backing of Tony Blair, is that it sees little mileage to be gained from early entry into the single currency.
Ultimately, the success of its second term in power is likely to be determined by its ability to reinvigorate the public services: this much was evident from the tone of the election campaign.
The problem is that, until the euro issue is formally resolved for this parliament, markets are likely to continue to weigh up the consequences of membership and begin, at least in part, to discount such an outcome whether it is likely or not. This will inevitably have some implications for policy whatever the Government may wish.
With this in mind, a key issue for investors will be the exchange rate at which sterling could potentially be locked into the single currency.
The received wisdom is that it would be some way below the prevailing level of £0.61 against the euro (DM 3.20). Sir Edward George, the Governor of the Bank of England, has gone on record as suggesting that the high pound was a 'real obstacle' to joining the euro and indicated that a more suitable level would be 'significantly lower than the DM 3.15-DM 3.20 (area)'.
The sort of range viewed by most commentators as fair value is rather nearer to £0.67-£0.70 against the euro, which would imply a depreciation of sterling of somewhere between 10 and 15%. Whether the other members of the monetary union would be willing to allow the pound to come back quite so far as a precursor to the UK participating in the project is open to doubt, however.
One reason why Germany and France, among others, may be reluctant to accede to such a significant decline is the relatively healthy state of the UK's trade balance with the eurozone at the present time. In the first quarter of this year, the bilateral deficit was just £464m compared with a non-EU trade shortfall of £7.2bn.
This does not, on the face of it, provide a strong case for arguing that the pound is significantly over-valued.
Meanwhile, the British Government may be equally unwilling to countenance too much of a slide in the currency given the likely knock-on effects on inflation and the possible damage to its reputation for economic competence.
A fall in the value of sterling would, of course, provide a timely boost for the competitiveness of British exporters who (like manufacturers elsewhere around the world) have begun to struggle in the face of the sharp downturn in the global economy in recent months.
It would also help to lift the value of overseas earnings when translated back into sterling.
As a result, a weaker currency should still be a real source of benefit to the equity market.
The FTSE 250 index, with its greater exposure to economically sensitive sectors, has the most to gain from such a development although this advantage could, at least in part, be eroded if fears of the inflation implications were to encourage the Monetary Policy Committee (MPC) to tighten its monetary stance.
Herein, however, lies the nub of the problem regarding convergence. If the Government were to be successful in securing a majority vote for monetary union in a referendum, the key issue facing the authorities would not be whether to raise interest rates whatever the inflation environment, but (as things stand) how quickly to bring them down to the levels prevailing in the eurozone.
This is because in a single currency area, there can be only one benchmark interest rate and that is determined with regard to economic conditions across the whole of the region. At present, that would involve lowering the base rate from its current level of 5.25% to the European Central Bank's (ECB) refinancing rate of 4.5%.
Given the sensitivity of the UK economy to short-term interest rates, the likelihood is that this process will provide a significant boost for demand.
Indeed, it could well lead to a not dissimilar set of conditions to those prevailing in Ireland over the past couple of years. It may also bring to mind the experience of the late 1980s when the domestic economy overheated. Unless the Government was prepared to take remedial action on the fiscal front, either raising taxes or (more unlikely still) lowering public spending, the risk is that growth would accelerate, putting further stress on the existing imbalances in the economy.
The prospect of greater economic instability may not necessarily be bad news for the stock market in the near term. Strong growth should provide a further lift for corporate profits, with the interest rate sensitive and consumer related areas being the biggest beneficiaries.
Meanwhile, the other likely winner in this environment will be residential property with the attraction of even lower mortgage rates providing a further stimulus for the housing market.
Participation in the single currency could be something of a double-edged sword for equities, however. Most notably, there is a real risk of a significant outflow of funds to the continent as the big institutional investors change their benchmarks away from a domestic orientation to reflect the broader European market. This has the potential to trigger a migration of around £200bn of funds which, when set against a UK market capitalisation of £1.6 trillion, could lead to a period of underperformance.
That said, our suspicion is that investors will not bail out too quickly even with shifting benchmarks.
The appeal of lower UK interest rates as a precursor to signing up for Economic Monetary Union (EMU) is likely to prove rather more intoxicating at least for a while.
Exchange rate at which sterling could be locked into currency will be key issue for investors.
According to Gordon Brown, the euro assessment process has yet to begin.
Brown has also stated the Government will not take risks with Britain's economic stability.
HL and Liberty SIPP slowest
'IFAs bore the brunt'
'Recovery or boom'
Staying invested could prove lucrative