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Thursday, 16 May, 2002, 10:50 GMT 11:50 UK
Q&A: Is the UK ready for the euro?
The UK government says that if Britain is to join the euro it must meet five economic tests before a referendum would be called. BBC News Online looks at how each test might be judged, and what other factors might be relevant.

What are the five economic tests, and why do they matter?

The debate around the UK's membership of the eurozone has sharpened now that the euro has become a "real currency", with euro notes and coins in use in 12 EU countries.

However, the UK government's broad position on euro membership was set in November 1997, when Gordon Brown outlined five economic tests by which the government would judge whether the UK economy would benefit from joining the euro.

They include whether joining a single currency would be good for jobs, for foreign investment, and for the City, and whether the UK economy was marching in step with other European countries, and whether it had enough flexibility to adjust if it wasn't.

The government has said it will announce whether or not the UK meets the five economic tests by June 2003 - and if it does, it would ask the country's voters to decide in a referendum whether to join the euro.

Are business cycles and economic structures compatible so that we and others could live comfortably with European interest rates on a permanent basis?

This is the key question as far as most economists are concerned.

That is because if the UK joins the euro, it loses control over interest rates, which are set for the whole eurozone by the European Central Bank (ECB) in Frankfurt.

On the ECB's council, the Bank of England would have just one vote - like the central banks of all other member states.

In the past few years, the UK's economic cycle appeared to be more closely aligned with that of Continental Europe - but more recently it appears that the UK is weathering the economic storm better than countries like Germany and Italy.

UK growth is expected to be around 2% this year and 3% next year, compared to negative growth in Germany and around 1% growth in Italy.

The difficulty is deciding whether this is a temporary or permanent difference, because many observers believe that the UK's economy will eventually be affected by the slowdown in the global economy.

Some economists also worry that the UK has a different economic structure than the rest of Europe - for example, the UK is a big exporter of North Sea oil and trades more with Asia and North America - and most people have mortgages with variable interest rates (as opposed to the fixed interest rates more common in Europe).

That means that the UK economy might react more strongly to changes in interest rates than the rest of Europe.

If problems emerge, is there sufficient flexibility to deal with them?

The UK has the most flexible labour markets in Europe, since the governments of Margaret Thatcher reformed the country's labour laws.

That means that lower interest rates produce more jobs in Britain than elsewhere.

The lack of flexibility in the other eurozone countries may be one reason economic activity is slowing more sharply there.

A shock to the world economy (such as the 11 September terrorist attacks) which affects different countries in different ways, makes it more difficult for the European Central Bank to find the right interest rate.

The UK has been pressing hard for economic reforms in the rest of Europe, but has made slow progress despite a special summit in Barcelona this spring.

The introduction of the euro as a cash currency has made it easier to compare prices and wages across Europe, and could increase convergence - but there are still big price differences.

What impact would entry into the euro have on the UK's financial services industry?

The UK has Europe's largest financial services industry, with more jobs in this area than in manufacturing.

The City would broadly welcome euro entry, which would strengthen its position against European rivals like Frankfurt.

But the City of London can still make money by trading in euro-denominated government bonds even if the UK is out of the euro.

However, joining the euro could make the UK financial sector more vulnerable to takeover, for example in the abandoned plan for the London Stock Exchange to merge with the smaller Deutsche Börse of Germany.

And there are also those who worry that joining the eurozone might redirect investment streams, with investors finding it more attractive to put their money with firms on the continent than the UK.

Would joining the euro create better conditions for firms making long-term decisions to invest in Britain?

Almost certainly yes.

Britain has attracted the most inward investment in the EU, but recently many of the big multinationals like Toyota, Ford, and Nissan have begun to warn that they only invested in the UK because they assumed it would eventually join the euro.

The disadvantage for a firm that has invested in Britain is that fluctuating exchange rates, and especially the strength of sterling, has made their exports to the Continent uncompetitive.

Nissan, for example, whose most productive car plant in Europe is based in Sunderland, still cannot make a profit selling its cars to Europe at the current exchange rate.

Of course, if the UK joined the euro at the current exchange rate, then euro membership would not be so advantageous for these multinationals.

Would joining the euro promote higher growth, stability and a lasting increase in jobs?

This the broadest question, and the one that is most difficult to answer.

If there was convergence in economic cycles (the first condition) and flexibility in labour markets, then the gains of euro membership would probably outweigh the costs.

Recent economic research suggests that in the long run, monetary unions could increase trade and growth by up to 20% - a big boost.

But the initial costs of converting to the euro could be expensive, especially for small shops, perhaps reducing UK GDP by 1-2%.

However, whether joining the euro would boost jobs and growth would partly depend on the exchange rate Britain joined at.

What about the exchange rate?

Although it is not one of the government's five economic tests, before the UK joins the euro the government would have to be very sure we join at a competitive exchange rate.

Joining at too high an exchange rate could cost jobs, as UK exports would not be competitive, and possibly lower GDP.

Most businesses, and many economists, believe that the pound is currently over-valued by between 10% and 30%.

But lowering the value of the pound on international currency markets could be a difficult operation.

However, the government is hoping that if the dollar continues to weaken, strengthening the euro, that could indirectly help weaken the pound.

See also:

11 Jun 01 | Business
Pound must fall 10% for euro entry
08 Jun 01 | Vote2001
Labour faces euro decision
08 Jun 01 | Business
Pound under political pressure
25 May 01 | Vote2001
Q&A: Britain and the ECB
30 May 01 | Vote2001
Bosses prepare for euro battle
24 May 01 | Vote2001
Is the UK ready for the euro?
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