The pound and the euro: Signs of weakness

Date: 15/04/06

Why sterling may lose ground against the single currency

TWICE during Labour's first six years in office, Gordon Brown thwarted Tony Blair's ambition to join the euro. First in October 1997 and then in June 2003, the chancellor of the exchequer in effect vetoed the prime minister's plan.

One compelling reason for staying outside the euro was the unusual strength of sterling, as it is unwise to fix a currency at an overvalued rate. Since the euro started in January 1999 at euro1.42 to the pound, sterling has generally traded high against it, breaching euro1.75 in 2000 and, at its lowest in 2003, falling only just below euro1.40 (see chart). This contrasted with sterling's weakness against an equivalent basket of European currencies after it tumbled out of the exchange-rate mechanism on "Black Wednesday" in September 1992.

The pound's dominance may, however, be drawing to an end. Some City economists are now forecasting a sharp fall against the euro in the months ahead. John Butler of HSBC thinks that the pound will fall to euro1.33 by the end of 2006--the lowest in ten years.

Currency forecasts are notoriously fallible, but there are some good reasons to expect such a weakening. The pound's strength against the euro has largely reflected Britain's economic performance compared with that of the euro area--an achievement that Mr Brown has seldom missed a chance to crow about. For over a decade, Britain has consistently grown faster than the single-currency bloc. Even though GDP growth slackened to 1.8% last year, the slowest since 1992, this still outstripped the euro area's sluggish 1.3%.

However, this margin looks set to narrow this year despite the latest setback to reforms in France. The Economist's panel of forecasters expects Britain to grow by 2.3%, only just ahead of the euro area's 2.1%. Some City economists think that the tables will be turned this year. For example, Robert Barrie of Credit Suisse has just raised his forecast for euro-area growth in 2006 from 2.1% to 2.5%, outpacing Britain.

As important as the rate of growth is its source. For the past decade, consumers have propelled the British economy forward. But now they are burdened by high debt and rising taxes. With business investment weak and the impulse from public spending losing momentum, the impetus for growth must now come from exports. Official figures released on April 11th, however, showed a deterioration in Britain's trading performance, which has been disappointing for several years. The deficit in goods and services in the three months to February widened to pounds 13.2 billion ($23 billion) from a shortfall of pounds 11.9 billion in the previous quarter.

What this suggests is that exporters need a helping hand through a decline in sterling. With half of Britain's exports going to the euro area, the pound thus needs to fall against the single currency.

If the pound does weaken against the euro, this could re-open the politics of joining the single currency. Euro membership will be an easier sell when the pound is weak than when it was strong.

Article suggests that sterling may lose ground against the euro in 2006: will that make euro membership an easier sell in the UK?

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