Dr Bruce Morley, Lecturer in Economics, Department of Economics
The UK along with Sweden and Denmark opted not to join the Eurozone when it was formed in 1999. Since then a number of other transition economies including Poland, Hungary and the Czech Republic have joined the European Union (EU), but have not joined the European single currency (Euro). There are a number of important implications for countries that are members of the EU but not the Eurozone, which relate to the effectiveness of the single market, financial stability and the need for continued convergence of the Eurozone economies. Despite not being a member of the Eurozone, what happens in the Eurozone has implications for the UK economy and financial system.
When the UK was considering joining the Euro in 2003, the UK government published five criteria to determine if joining would be in the UK’s national interest[1]. In many respects the broader issues addressed by these points are still relevant when considering the UK’s relationship with the Eurozone. For instance the effects of changes in the Eurozone economies on UK economic growth and employment levels. If trade between the UK and the Eurozone were to be affected adversely then both growth and employment could fall. At the moment the UK has a large trade deficit with the Eurozone economies, which it needs to reduce and arguably the lack of demand in the Eurozone has contributed to this. For instance in 2014, 44.6% of UK exports were to the EU and 53.2% of UK imports were from the EU[2], however the UK’s trade deficit with the EU, reached £59 billion (exports minus imports) in 2014, although in the same year it recorded a surplus of £15.4 billion in the service sector. Policies such as the Common Agricultural Policy (CAP) also directly affect relations between the UK and the Eurozone, again this has contributed to the trade imbalances, as many products that are imported could just as easily be produced in higher quantity in the UK, such as wheat.
A further feature of the 2003 criteria, related to the City of London’s relationship with the EU. A particular feature of the UK economy is the reliance on financial services in general and the City of London in particular for output, employment and substantial amounts of tax revenue. For instance in the year to March 2015, UK financial services contributed £66.5 billion in tax revenue, or 11% of total tax receipts in the UK, with the industry employing approximately 1.1 million people[3]. The UK financial services industry is affected by both the UK’s domestic regulatory regime and increasingly the Eurozone’s regulators. This is an area where the UK’s relationship with the Eurozone is particularly important, as it is moving towards some common regulation across the Eurozone and other EU members. Traditionally EU financial regulation was done by various directives, however this left substantial variation in the way that individual countries regulated their financial institutions. There was a change of direction after the 2007/08 sub-prime mortgage based financial crisis, when it was decided more co-ordination was required. It was felt that some countries had coped better than others, for instance Spain had not suffered to the same extent as the UK, as Spanish banks were limited in their ability to hold mortgage backed assets off balance sheet. This has led to the formation of the single rule book, which aims to provide a set of prudential controls over the financial institutions across the whole of the EU, which they are expected to abide by. This has coincided with the Basle III accord, which aims to strengthen the prudential controls of the world’s banking system. Under the single rule book, the European Banking Authority (EBA) will ensure that Basle III is implemented in a consistent manner across the EU. However Basle III is a voluntary code and there are already suggestions that its implementation will impede world economic growth by between -0.05 and -0.15% per annum (OECD, 2011), so there are reservations among some member states about implementing it. Likewise it is not entirely clear the extent of any national autonomy over prudential controls and whether the EBA can impose regulations on member states.
There are fears in the City of London that the EBA will impose excessive controls on its activities, making it uncompetitive and ensuring that it loses business to other financial centres around the world. The introduction of controls on bonuses has been one area of concern, with the City suggesting it inhibits its ability to attract the top bankers. However there have been reassurances regarding the relationship between the UK financial sector and the EBA, such as a double majority vote requirement to change regulations, where both the Eurozone and non-Eurozone members require a majority vote in favour of specific rules. In addition the member states broadly accept the basic tenets of the new financial regulatory system, such as the need to hold more tier 1 capital, although the UK is not in favour of increased transaction taxes. There is however a clear potential for future problems, for instance what would happen in the event of a crisis to a Eurozone headquartered bank, which does much of its business in the City of London.
The UK economy is influenced by the performance of the Eurozone economy and the strength of the Euro, with most of the recent focus on the performance of the Greek economy in particular and the souther European economies in general. Much of the analysis has been on sovereign debt levels and rates of interest, with the International Monetary Fund (IMF) recently publishing a report questioning whether current levels of Greek debt could be sustained in the long-run, although not included in the report, the same concerns apply to other members of the Eurozone. However the level of debt can’t be the only problem for the Greek economy, as Greece’s debt to GDP ratio is substantially below that of Japan, where there is little evidence of a problem. This has directly affected the UK financial system previously, when a previous write down of Greek sovereign debt in 2012 involved private investors in Greek government debts having to accept a 50% write down in the value of the debt, known as a haircut.
However over recent months this problem has been reduced, following the decision of the European Central Bank (ECB) to carry out Quantitative Easing (QE). This mainly involves the ECB buying government bonds from all the Eurozone member states in proportion to the size of their respective economies. So the ECB now holds many billions of Euros of debt, of mixed quality on its balance sheet. Much of it is very safe, especially the German debt, but much of it is more risky, such as the Greek and other southern EU economy debt. At the moment the ECB based demand for this debt is keeping its value high and return low. But what happens when the ECB stops QE? Will it return to the crises of earlier months, will there be more bailouts and write downs of debt? On the positive side the amount of the riskier Eurozone sovereign debt held by the UK financial system has been reduced, but if the Eurozone crisis returns and countries are forced out of the Euro, there will inevitably be adverse implications for the UK economy, economic growth and employment.
None of the bailouts or financial strategies used so far are really confronting the fundamental problems in the Greek economy or the Eurozone as a whole. In particular the structural differences in the economies across the Eurozone, which mean that a common monetary policy is not always appropriate. The fundamental problem is arguably a lack of convergence across the Euozone economies and the moves to encourage greater convergence could affect the non-Eurozone members too. The differences cover many aspects of the economy including labour and goods markets and aggregate consumption levels. For instance a study published by Carruth et al. (1999), just as the Euro was being formed, found substantial differences in consumption patterns across the member states. The findings indicate a common policy response to shocks across the EU may not be appropriate, even when the core states alone are considered.
The final aspect of the Eurozone that has an important effect on the UK economy is the strength or otherwise of the Euro. The recent problems in the Eurozone impacted on the value of the Euro, which has suffered increased volatility and a loss of value against other major currencies during the Eurozone crisis. Although since the beginning of QE, the Euro has stabilised. During the Eurozone crisis, a potential reason for the volatility in the Euro has been the increased likelihood of the Eurozone breaking up. For instance studies by Eichler (2012) among others found strong evidence that the Euro depreciates when the risk of a Eurozone break up increases, in addition it also created increased volatility in the currency. However a devalued Euro is not necessarily all bad news for the Eurozone, as it can encourage their exports and economic growth. Although, countries that rely on exporting to the Eurozone, such as the UK will potentially suffer. This has become increasingly apparent in the UK agricultural sector, as farm payments are based on the value of the Euro and as the pound has appreciated against the Euro, so payments have fallen.
This recent crisis has again highlighted the need for a longer term solution to the problems in the Eurozone, rather than short-term market intervention in the form of QE. This could possibly involve greater fiscal integration within the monetary union and many economists, such as Alan Greenspan (former head of the US Federal Reserve) have gone as far to say that a fiscal union should be formed in order to prevent future crises.[4] Although he didn’t specify the extent of this union, in the USA, which is often used as an example, federal government expenditure is about 20% of GDP. This may require a central fiscal body with increased powers over taxation and some expenditure across the EU, going further than the currently proposed European Fiscal Board. But even this may not be enough as a political union could also be required. When the Euro was formed, it was felt that the retention of fiscal policy was necessary as a mechanism for individual members to stabilise their own economies in the event of asymmetric shocks to the Eurozone, so fiscal union may not be popular across the EU. Further fiscal integration in the Eurozone would again have an impact on the UK. An example of this could be corporation tax levels, which in some EU countries are much lower than the UK. If this was to become more widespread across the EU, more multinationals could be encouraged to move their headquarters to these countries at the UK’s expense. It is also possible that any form of fiscal union could freeze the UK and other non-Eurozone members further out of the core membership, as single taxation levels create a more uniform single EU market for these members.
This blog post is part of a new IPR Series – all related to the BREXIT debate and the EU Referendum. This collection of commissioned blog posts will be published as an IPR Policy Brief in May 2016. Sign up to the IPR blog to get the latest blog posts, or to our mailing list to receive invitations to our events and copies of our Policy Briefs.
References
Carruth, A., Gibson, H. and Tsakalotos, E. (1999), Are aggregate consumption relationships similar across the European Union? Regional Studies, 33, 17-26.
Eichler, S. (2012), The impact of banking and sovereign debt crisis risk in the Eurozone on the Euro/ US dollar exchange rate, Applied Financial Economics, 22, 1215-1232.
Slovik, P. and Cournede, B. (2011), Macroeconomic impact of Basle III, OECD Economics Working Papers. DOI: 10.1787/18151973.
[1] In order to join the single currency, all potential participants had to meet a set of economic criteria, known as the Maastricht criteria. All passed except Greece, but it was allowed to join a couple of year later.
[2] Data from the ONS Statistical Bulletin, Balance of Payments, Quarter 3 (July to September) 2015, 23 December 2015, Tables B and C During 2014 the UK’s total deficit (exports minus imports) was approximately £35 billion, as a result of a surplus with the rest of the worlds. Initial estimates for 2015 suggest this has worsened, although 2015 values are subject to revisions.
[3] Data taken from https://www.cityoflondon.gov.uk/business/economic-research-and-information/research-publications/Pages/Total-Tax-2015.aspx
[4] Taken from an interview with the BBC at http://www.bbc.co.uk/news/business-31249907.
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