Soaring punt creates headache for Dublin

Date: 20/02/1997

By Tim Jones

THE EU's monetary system is facing its most difficult test in nearly four years as the Irish punt surges towards its Exchange Rate Mechanism ceiling.

Dragged higher by sterling, the punt's rise is giving the Irish monetary authorities and their Union partners a serious policy headache, as it could jeopardise the chances of one of the few countries which currently qualifies for membership of the single currency zone making the grade.

Inflation is starting to creep into the economy and the logical response from the Central Bank of Ireland would be an increase in interest rates. But it cannot, because of the ERM.

Under the system, which was reformed in August 1993, each member currency is allowed to fluctuate 15&percent; either side of a central rate against every other currency. This week, the punt was trading around 12&percent; above its central rate against the French franc.

If a currency falls to its floor against any other currency, both relevant central banks will guarantee to buy the weak unit and sell the strong one to any market participant. If this fails, the weak currency authorities could raise interest rates to defend their parity, while the strong currency central bank could cut rates.

In the case of Ireland, this is purely theoretical. Whatever Irish Finance Minister Ruairi Quinn may like to think, the country's economy is still closely linked to that of the UK. Last year, 25&percent; of Ireland's exports went to the UK and 47&percent; to the rest of the Union while 36&percent; of its imports came from the UK and 21&percent; from other members of the EU.

When sterling starts to rise against other European currencies, the punt tends to go with it. This has left Dublin in the worst of all worlds.

On the one hand, the strengthening punt has put some of Ireland's most labour-intensive industries - clothing, footwear, agricultural products and foodstuffs - under intense pressure. On the other, the punt has not risen as quickly as sterling, leading to a 7&percent; depreciation against its biggest trading partner's currency since September.

Combined with a give-away budget in January which is expected to provide the economy with a fiscal stimulus worth as much as 0.5&percent; of gross domestic product this year, the punt's fall against sterling is putting upward pressure on prices.

“We are starting to see some signs of inflation,” said Jim Power, chief economist at the Bank of Ireland. “If this position is sustained, this should deliver inflation of 2.4&percent; this year, up from 1.6&percent; last year, and that takes us dangerously close to the Maastricht Treaty ceiling.”

This is a major risk for the Irish, given that they have been so virtuous in reducing their budget deficit and public debt from 115&percent; of GDP in the late Eighties to 80&percent; - and falling - today.

But this is only part of the story. The biggest problem of all is not in Dublin or London but in Paris and Bonn. The most sensible thing the Irish authorities could do is revalue the punt within the ERM and use all the policy levers at their disposal to stave off inflation. But one capital's revaluation is another's devaluation.

A revaluation of the punt would mean that the deutschemark, guilder and French franc had devalued against a European currency for the first time in a decade.

Apart from this being an unthinkable humiliation, it could even threaten to unpick their candidacy for monetary union. All EMU applicants must have avoided devaluation for two years before March 1998, when their membership will be considered.