Wednesday, February 18, 2009

Pro & Cons For UK When Adopting Euro

Benefits for UK if adopting euro:

(1) No transaction costs. This is the most obvious advantage. UK people will no longer need to incur transaction costs in exchanging currency when they go for a holiday in Euro-land. For businesses the advantage is considered bigger, as they no longer need to incur higher transaction costs which include the costs of hedging against huge currency swings

(2) Price transparency. Since everything will be quoted in euro, UK consumers will find it easier when comparing prices of goods & services. Also this ensures that local firms will always price their goods competitively. This results in increase in consumers’ welfare. For firms, they can also take this opportunity to source their raw materials from the cheapest suppliers thus minimising their production costs

(3) Eliminate exchange rate volatility. Manufacturers in UK will have greater incentive to invest e.g. expanding operation into Euro-land, import capital goods from German etc when exchange rate is certain. Also they can plan their production of output systematically, as the trend of demand for UK goods will be more apparent. This is very important considering UK has more than 50% of trading share with Euro-zone. Ability to explore the wider market also means greater EOS (economies of scale)

(4) Attract investors from outside. It is said that UK could have attracted more investors if it adopts euro earlier. According to critics, no doubt UK has its own advantage such as pool of productive workforce, flexibility in labour market, independence of the monetary committee etc which largely explains for the influx of foreign investment all this while. However with single currency, the attraction is larger as it helps investors to further minimise their costs of production as accrued to the first 3 reasons as above

(5) Improvement in inflation performance. Compared to UK’s Bank of England, the ECB (European Central Bank) is said to have ‘zero-tolerance’ policy against rising inflationary pressure. In UK, CPI is allowed to increase up to 3% but in Euro, its targeted inflation is close, but not more than 2%. Countries that have high inflation could benefit from these

(6) Rising importance of Euro. Euro currency is increasingly becoming more influential in international trade. Some economists argued that it may replace dollar one day as the most sought after currency in period of globalisation. This is because, the size of Euro’s economy is much larger than US alone & this is not considering other potential members which may be joining at later date. The market is large & it is politically stable too. On the other hand, instability of dollar & rising national debt in US has sort of spark fears that the dollar will collapse one day. China is also accused of slowly diverting its dollar holding to euro holding

Costs of adopting euro:

(1) Sensitivity of changes in interest rates. This is the MAIN reasons as to why UK chose to stay out of Euro. House ownership in UK is the highest in any parts of Euro-land & also traditionally Britons store their wealth in property market. As such any changes in interest rates even by 25 basis points or 0.25%, will have a severe effect on UK economy.

For instance, Euro’s interest rates are lower than in UK (much earlier before the mortgage crisis). Upon joining, UK interest rates will be lowered in accordance with ECB rate. This will surefire raise the inflationary pressure in UK as everybody will be taking up loans to buy property. Another classic case, Ireland. Before joining it had 6% of interest rates. After adopting euro, its interest rate was 3%. This largely explains why inflation rate in Ireland is reasonably higher than others

(2) Constraint in government spending. Stability pact signed by member countries makes things worse. It states that members’ annual budget deficit (how much spending exceed tax revenue) cannot exceed 3% of GDP. This will be the biggest stumbling block when it comes to recession. In downturn the figure is easily in excess of 3%. Look at it mathematically. When economy slows down, it makes sense for government to continuously increase public spending. So budget deficit widens (numerator). At same time, GDP is falling (denominator). Of course this will lead to a huge number!

(3) Surrendering of monetary decisions to ECB. Since gaining independence from Labour government in May 1997, UK’s MPC (Monetary Policy Committee) has gained credibility & international recognition. Due to this, it sounds more like an embarrassment if MPC loses control in the monetary decisions by bowing to the ECB. Also the council members in ECB are representative from different countries with varied vested interests. Consensus & interest rate decisions will therefore be less frequent than MPC who will only consider what is best for UK

There are other problems like loss of devaluation as an economic management policy. UK is no longer be able to influence the exchange rate by manipulating interest rates. This could be detrimental to exports

(4) Inflexibility in labour market. Labour market in UK is much more flexible than most of those in Euro. UK has finally reaped all the benefits under the reforms during the era of Margaret Thatcher (1979-1990) after some effect lags. Trade union has been under control thus wage-push inflation is of limited influence. Meanwhile, UK firms are given more autonomy when it comes to employment. As a result, more part time works have been created & this result in lower unemployment. By joining Euro, UK will have to strictly adhere to many new labour rules, many which are created with employees in mind e.g. hiring & firing will be more difficult, more benefits etc. These will ultimately increase production costs & give unions more sense of power which could be harmful in many aspects.

After losing control in monetary tools & fiscal spending, surrendering the flexibility in labour market is the last thing UK should do.

(5) Costs of adjusting currency. Machines & other tools will have to be adjusted. In between firms will be in darkness regarding the proper exchange rate to use. Nevertheless all these are once-off costs

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