Why does the UK stay out of the Euro-zone? Benefits vs.

costs of adopting the Euro for the UK

Blagovesta Chonkova Ruslan Shopov Yana Naneva

HM Treasury Tests

Are business cycles and economic structures compatible with Eurozone interest rates on a permanent basis? If problems emerge, is there sufficient flexibility to deal with them? Would joining the euro create better conditions for firms making long-term decisions to invest in Britain? What impact would entry into the euro have on the UKs financial services industry? Would joining the euro promote higher growth, stability and a lasting increase in jobs?

Common Currency Benefits

Elimination of transaction costs Elimination of exchange rate volatility Price transparency Capital market integration

Since the Euro adoption, trade among the Euro-zone member has increased by 20% without being at the expense of trade with the rest of the world. In contrast, the UKs trade with the EU has diminished relative to its GDP. As we all know, greater trade leads to higher productivity.

The evidence shows that the UK misses a huge opportunity.

Optimal Currency Area

The importance of asymmetric shocks The three economic criteria:

Factor mobility Product differentiation and similar economic structures Openness to trade

The Evidence

Britain is no more different in economic structure from the rest of Europe than the typical US region is different from the whole of the US The UK is very unlikely to experience significant asymmetric shocks

People not only do not move across borders due to cultural factors but they also do not move within their own countries either Labor mobility is limited anyway

50% of the UKs trade is with the EU The independent exchange rate will not help Britain to adjust real prices

The Myths

The UK is Europes only oil economy The UK should not join the Europes failing economy Continental Europes social model will be exported to the UK

Conclusion for the convergence and flexibility test

To sum up, the convergence test set by the HM Treasury measures the likelihood and size of asymmetric shocks. The flexibility test measures the ability of the UK to cope with asymmetric shocks. The limitation of these tests is that they measure the current state of the UK economy and ignore the future accelerated convergence after accession in the EMU. They asses, for instance, how the British economy will react to a single currency given the present level of convergence. But the history of the European Union suggests that after joining EMU the present level will quickly be altered, thus becoming an irrelevant benchmark for assessment.

Impact of EMU Membership on the investment level in UK

Two channels of impact

1) Macroeconomic: Keeping low and stable the inflation rate macroeconomic stability and secure environment for long-term investments 2) Microeconomic: Removing exchange rate volatility vs. the rest of the Euro-zone incentives for investors willing to export in the Euro-zone

1) Macroeconomic channel

Overall decrease in the volatility of the European economy brought by reduced exchange rate, inflation, interest rates, and personal consumption and GDP volatility Increased confidence of the investors in the future prospects of the economy and, therefore, in the inflow of long-term investments.

2) Microeconomic channel

Removing the exchange rate volatility Toyota example Hedging with forward markets?
Drawbacks, related to manufacturing production difficult to predict correctly the revenues and the costs of production Small-scale producers - not accustomed to use this option or cannot bear the costs of financing it Multinational corporation also avoid relying on forward market options because of the high costs associated with exchange rate volatility - uncertainty of the profits and increased risk-premium, generating higher nominal interest rates

The Statistics

1990-1998:
UK: 20% of the total FDI inflows to the EU Euro-zone: 60-75% of the total FDI inflows to the EU

2001:
UK: 16% of the total FDI inflows to the EU Euro-zone: 78% of the total FDI inflows to the EU

Impact of EMU Membership on the financial services industry in UK

Advantages for the functioning of the financial services in EU, brought by EMU:
Relieved comparison of the costs and quality of financial services across national borders; Increased cross-border competition in wholesale banking, retail banking, security markets and financial centers; Promotion of greater securitization of borrowing. Easier functioning of the non-EU investors through introduction of one currency balance sheet to support operation across many countries

Taking into account the comparative advantage of the City of London among the other European financial centers, the British entry into the EMU would further consolidate the leading position of the City

The City
Comparative advantage of the City of London pool of financial expertise in the region, limited regulation of security trading, relatively benign tax system, accumulation of financial market activity and support services, and access to a large English-speaking workforce with relatively flexible labor market regulation self-reinforcing cycle of success, which ensures Citys leading position among the European and worldwide financial centers. It is generally agreed among the scholars that in the short run the dominant position of the City would not be threatened by the decision of British authority to stay out of the Euro-zone In the short run the dominant position of the City would not be threatened by the decision of British authority to stay out of the Euro-zone

Long Run Implications for the City

The financial centers in Frankfurt and Paris increasing shares of financial operations performed worldwide Warnings for shifting the balance of competitive advantage in financial services from London to Frankfurt

Political Criteria

Fiscal transfers Homogeneous preferences Commonality of destiny

Fiscal transfers

Rationale risk sharing Possibility of becoming a contributor or beneficiary depending on the current economic status Fiscal transfers directed to reduce structural inequalities UK is concerned that it could not be able to afford this in a large scale The need to create a system to increase the EU budget and distribute the fiscal transfers automatically

Homogeneous Preferences

Supposes that in case of shocks the countries will react in the same way Hard to achieve due to the fundamental differences in economic philosophy between the UK and Continental Europe

Commonality of Destiny vs. Nationalism

In case of a conflict of national interest a country should accept the costs in the name of the common destiny The UK is very reluctant to sacrifice its national interest Strong emotional attachment to the national currency with a symbolic meaning

Public Opinion

Politicians love making speeches about how we can't be "half-in, half-out". Yet that is something like what we, the British, now are, and we seem to prefer it. Since we fell out of the ERM and later declined to join the single currency, we have proved for the first time that it is positively advantageous to us not to do what Brussels wants, and yet we do not have to destroy "Europe" in the process. It is a precedent of huge importance.

Conclusion:

Although the UK will benefit from joining the Euro-zone, the British public opinion is strongly against it, which makes it politically impossible in the foreseeable future.

Thank you for your attention!