Pound's relative overvalution against the euro may be corrected by London's fixed interest markets
The UK corporate bond market may help remove a key obstacle to British membership of the euro by helping to drive the pound lower in coming years.
Labour favours joining the euro provided membership is good for the British economy. It will assess in the next two years if that's true before deciding whether to hold a referendum. The pound, however, trades at about DM3.21 ' stronger than UK exporters are likely to put up with.
That's a problem the bond market might help solve. UK institutional investors who've stuck to their domestic market will move more of their holdings into euro-denominated assets, as they vie to win business managing European pension fund money and seek euro experience in anticipation the UK may join.
European companies, meantime, are finding that there's still little continental appetite for bonds repayable in more than 10 years. So when they need long-term funding, they borrow in the sterling market, and swap the pounds they don't have any need for into the common currency.
The result is a double whammy for the pound, as UK fund managers sell the currency to add euro-denominated securities to their portfolios, and European borrowers use the sterling bond market as a route to long-term funding while jettisoning unwanted sterling in favour of euros along the way.
Barclays Capital calculates that the value of bonds eligible for its euro corporate index is growing about six times faster than that of its sterling index. UK institutional investors need to show European clients such as pension funds that they have a track record in that growing market or else miss out on chances to manage European funds.
'It's obviously something we need to be more aware of, both for returns and our asset allocation, and winning corporate bond money,'' said Sajiv Vaid, a fund manager at Royal London Asset Management. 'The European corporate bond market is a growing market, and to grow with the business you have to show some sort of capability.''
Royal London only has 2% or 3% of its £5bn of fixed-income funds invested in overseas bonds, Vaid said. Boosting that is 'definitely up for discussion.''
As European investors became convinced that the single currency would be introduced in January 1999, they began to move money out of their domestic markets in preparation for the creation of a single bond market, Vaid said. Provided UK polls begin to indicate the electorate is warming to joining the common currency, the same is likely to happen with British investors.
'If you eventually are going to join, it makes sense to see euros and sterling as homogenous assets,'' Vaid said. 'Obviously there'll be some hesitancy initially but eventually market momentum will go for it.''
For borrowers, however, the euro corporate bond market can't satisfy their need for funding much beyond 10 years. Although RWE of Germany, Europe's fourth-biggest power company, found buyers for e500m of 15-year bonds in April, the Brussels-based municipal financing bank Dexia chose the UK market for 25-year funds, borrowing £125m.
Governments still carry most of the European pension burden; while that's changing as the onus for pension provisions is shifted more onto the individual, there are currently few buyers of long-dated European non-government bonds. That creates a chicken-and-egg situation; companies won't sell long-dated euro debt until there are buyers, and there's no supply to stimulate that demand.
About 45% of euro-denominated debt with a tenor of more than 10 years is from banks and other financial institutions, according to research compiled by Deutsche Bank. A further 32% is either sovereign or government agency debt, with just 6% from companies.
(That would change if the UK joined the euro. Not only would all the existing long-dated sterling debt be redenominated into the European currency, UK pension funds would be keen buyers of new debt from European companies.)
Bank of England Governor Sir Edward George wants to prevent speculation about the UK quickly joining European economic and monetary union from prompting a collapse in the pound, which would stoke inflation. By damping such talk, he's managed to revive the pound to about $1.41, from as low as $1.37 two weeks ago.
Still, he said earlier this month that one of the conditions for adopting the euro 'would be an exchange rate which people thought would be sustainable into the medium term,'' and that the pound's current value 'is a real obstacle.''
By creating two natural sellers of the pound ' UK investors expanding into euro securities, and European companies borrowing pounds they don't need ' the bond market might help to deflate the British currency to levels at which its value isn't an issue for the common currency debate.
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Short-term noise or something sinister?