Light at the end of the euro-tunnel
Between 1999 and 2002, when the euro was still in its infancy, sterling's relationship with its continental neighbour was not terribly close. Since then, however, sterling and the euro seem to be moving in tandem.Despite the apparent reluctance of the...
Between 1999 and 2002, when the euro was still in its infancy, sterling's relationship with its continental neighbour was not terribly close. Since then, however, sterling and the euro seem to be moving in tandem.
Despite the apparent reluctance of the British people to join the single currency and the desire to ensure that sterling retains its independence, Europe's two major currencies appear to be shadowing each other.
One obvious advantage of this is the simplicity of conversion. For four consecutive years, the British tourist has known that a euro will cost around 70pence. For four consecutive years, businesses have been able to plan their pan-European activities without having to worry about currency upsets. Economic links between Britain and the continent have strengthened as a result.
For many years, investors took the view that sterling was a halfway house, neither a member of the euro scene nor the closest of friends with the dollar. If the thinking was that the dollar was likely to fall against the euro, the chances were that sterling would also fall - but not by as much.
However, over the past four years the dollar may have been weak against the euro (four years ago you needed about $1.05 to buy a euro; now you need $1.31) but sterling has hardly budged. This limpet-like link with the euro has left sterling stronger against the dollar. Four years ago, a pound sterling would buy $1.60; today, you will get almost $2.
What has been happening? One explanation might be that the Bank of England has given up on monetary independence and has chosen to copy the European Central Bank. This really would be only one step away from a fully-fledged monetary union.
The facts, though, suggest otherwise. Looking at key policy rates in recent years there is no evidence of monetary convergence. The Bank of England was raising interest rates in the second half of 2003 when the European Central Bank appeared to be in monetary hibernation. It was not until the end of 2005 that the European Central Bank decided to push interest rates up. By then, the Bank of England had cut interest rates, even if it was subsequently reversed.
Markets do not really expect any longer-term convergence of interest rates. Ten-year bond yields are a little under 4.9 per cent in the UK but only just over four per cent in Germany. There may have been exchange rate convergence but there is no real evidence of domestic monetary convergence. If sterling is really shadowing the euro, interest rates in the UK and Germany would be more or less the same.
Higher interest rates in one country compared with another often suggests exchange rate weakness. Higher interest rates can be seen as the compensation required to persuade investors to take on the additional currency risk. That is the reason why, back in the 1980s and 1990s at the time of the European exchange rate mechanism, interest rates in Italy and Spain were much higher than those in Germany. It was always more likely that the lira and peseta would fall against the mark than the other way round. The dollar's performance against the euro in recent years fits the same pattern. Interest rates in the US are a lot higher than those in Europe but the dollar has fallen against the euro.
However, sterling does not fit this pattern. Investors may believe at the beginning of each year that sterling is set to take a tumble but it never does. HSBC Research has identified five reasons why sterling has seemingly defied gravity.
First, the Bank of England's job is to control inflation. It does this through setting the level of interest rates. If the level of interest rates required to ensure price stability in the UK is higher than that elsewhere (either because inflation expectations are more deeply embedded or, more likely, because short rates play a much bigger role in the UK housing market than in other housing markets) sterling becomes a rather attractive currency in which to hold excess savings.
Second, the UK has been more willing than others to "sell the family silver" And has attracted more than its fair share of acquisitions from abroad. The government does not protect the so-called "national champions" from foreign take-over bids. Other governments are not so relaxed. Foreign money pours into the UK for other reasons too. Russians regard London property as a safe haven. Middle Eastern states prefer London to New York for political reasons. And the Sarbanes-Oxley legislation has dented New York's ambitions to be the world's premier financial centre.
Third, emerging market central banks who seek to diversify their reserves out of dollars happily regard sterling as an alternative vehicle to the euro, particularly given the now infinitesimally small chance of the UK joining the euro. Dollar weakness therefore becomes associated with both euro and sterling strength, ironically making sterling more euro-like.
Fourth, those investors engaged in the so-called carry trade - borrowing at remarkably cheap rates in Japan, notwithstanding last week's Bank of Japan rate increase, to invest in higher-returning currencies elsewhere - want to make sure they are putting their money into currencies where interest rates may still rise further. There is currently a better chance of that happening in the UK and in the eurozone than in the US.
Fifth, in the late 1990s, people used to buy the dollar because America's productivity growth persistently outstripped the paltry gains seen in the UK and in the rest of Europe. Many investors are rethinking this strategy. US productivity growth has slowed in recent years whereas, in both the UK and the eurozone, there has been something of a resurgence.
None of this implies that sterling will forever be linked to the euro. Nor does any of this imply that the UK should join the euro. Nevertheless, there are increasing economic links between the UK and the euro zone.
• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.
Despite the apparent reluctance of the British people to join the single currency and the desire to ensure that sterling retains its independence, Europe's two major currencies appear to be shadowing each other.
One obvious advantage of this is the simplicity of conversion. For four consecutive years, the British tourist has known that a euro will cost around 70pence. For four consecutive years, businesses have been able to plan their pan-European activities without having to worry about currency upsets. Economic links between Britain and the continent have strengthened as a result.
For many years, investors took the view that sterling was a halfway house, neither a member of the euro scene nor the closest of friends with the dollar. If the thinking was that the dollar was likely to fall against the euro, the chances were that sterling would also fall - but not by as much.
However, over the past four years the dollar may have been weak against the euro (four years ago you needed about $1.05 to buy a euro; now you need $1.31) but sterling has hardly budged. This limpet-like link with the euro has left sterling stronger against the dollar. Four years ago, a pound sterling would buy $1.60; today, you will get almost $2.
What has been happening? One explanation might be that the Bank of England has given up on monetary independence and has chosen to copy the European Central Bank. This really would be only one step away from a fully-fledged monetary union.
The facts, though, suggest otherwise. Looking at key policy rates in recent years there is no evidence of monetary convergence. The Bank of England was raising interest rates in the second half of 2003 when the European Central Bank appeared to be in monetary hibernation. It was not until the end of 2005 that the European Central Bank decided to push interest rates up. By then, the Bank of England had cut interest rates, even if it was subsequently reversed.
Markets do not really expect any longer-term convergence of interest rates. Ten-year bond yields are a little under 4.9 per cent in the UK but only just over four per cent in Germany. There may have been exchange rate convergence but there is no real evidence of domestic monetary convergence. If sterling is really shadowing the euro, interest rates in the UK and Germany would be more or less the same.
Higher interest rates in one country compared with another often suggests exchange rate weakness. Higher interest rates can be seen as the compensation required to persuade investors to take on the additional currency risk. That is the reason why, back in the 1980s and 1990s at the time of the European exchange rate mechanism, interest rates in Italy and Spain were much higher than those in Germany. It was always more likely that the lira and peseta would fall against the mark than the other way round. The dollar's performance against the euro in recent years fits the same pattern. Interest rates in the US are a lot higher than those in Europe but the dollar has fallen against the euro.
However, sterling does not fit this pattern. Investors may believe at the beginning of each year that sterling is set to take a tumble but it never does. HSBC Research has identified five reasons why sterling has seemingly defied gravity.
First, the Bank of England's job is to control inflation. It does this through setting the level of interest rates. If the level of interest rates required to ensure price stability in the UK is higher than that elsewhere (either because inflation expectations are more deeply embedded or, more likely, because short rates play a much bigger role in the UK housing market than in other housing markets) sterling becomes a rather attractive currency in which to hold excess savings.
Second, the UK has been more willing than others to "sell the family silver" And has attracted more than its fair share of acquisitions from abroad. The government does not protect the so-called "national champions" from foreign take-over bids. Other governments are not so relaxed. Foreign money pours into the UK for other reasons too. Russians regard London property as a safe haven. Middle Eastern states prefer London to New York for political reasons. And the Sarbanes-Oxley legislation has dented New York's ambitions to be the world's premier financial centre.
Third, emerging market central banks who seek to diversify their reserves out of dollars happily regard sterling as an alternative vehicle to the euro, particularly given the now infinitesimally small chance of the UK joining the euro. Dollar weakness therefore becomes associated with both euro and sterling strength, ironically making sterling more euro-like.
Fourth, those investors engaged in the so-called carry trade - borrowing at remarkably cheap rates in Japan, notwithstanding last week's Bank of Japan rate increase, to invest in higher-returning currencies elsewhere - want to make sure they are putting their money into currencies where interest rates may still rise further. There is currently a better chance of that happening in the UK and in the eurozone than in the US.
Fifth, in the late 1990s, people used to buy the dollar because America's productivity growth persistently outstripped the paltry gains seen in the UK and in the rest of Europe. Many investors are rethinking this strategy. US productivity growth has slowed in recent years whereas, in both the UK and the eurozone, there has been something of a resurgence.
None of this implies that sterling will forever be linked to the euro. Nor does any of this imply that the UK should join the euro. Nevertheless, there are increasing economic links between the UK and the euro zone.
• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.