EMU sans Sterling

Implications for Irish Policy and the Economy

By
Irish Pounds
EMU sans Sterling : Implications for Irish Policy and the Economy - Christopher L. Burdett

Introduction

Ireland, once regarded as a third-tier economic power in the European Union, is now poised to join the European Economic and Monetary Union (EMU) - testimony to notable economic achievements as well as Dublin's strong fiscal and monetary policies. In Brussels, there seems to be little doubt that Ireland will be included in the first round. Irish Prime Minister Bertie Ahearn is determined as ever to bring his "Celtic Tiger" into EMU.

In early May, the exchange rate of the Irish pound (punt) will be irrevocably fixed relative to the currencies of all other qualifying nations, less the opt-outs and those Member States exceeding the Maastricht criteria. Irish monetary authorities will then be responsible for maintaining this rate on the market until the start of Stage Three (1 January 1999), after which the European Central Bank (ECB) will take over all monetary functions for the euro area. Subsequently, Ireland will no longer control the exchange rate of the punt nor its interaction with the currencies of the EMU outs.

Short of a radical policy change by London, the euro area is not likely to include the British pound sterling, prompting interesting and crucial questions for Irish businessmen and policymakers. The crux of their concerns rests upon Ireland's close market relationship with Britain. Previously, high levels of Anglo-Irish trade have been bolstered by a near de facto exchange rate parity between the punt and the sterling. EMU will permanently break this parity by fixing the punt, but it will not sever the close market ties. Both economies will remain subject to the effects of exchange rate movements/realignments. However, while Britain retains its monetary policy flexibility, Ireland will surrender its ability to adjust the punt and thereby divert negative spillovers brought about by exchange rate movements.

This article will attempt to assess the likely short-term dangers to the Irish economy once the punt enters EMU without the sterling. Special attention will be paid to potential changes of the Irish government's policy that may be necessary to offset negative effects of sterling fluctuations. However, I will first refer to a brief historical analysis of the modern Irish economy and its links with Great Britain in order to establish the context of this discussion.

Evolution of the "Celtic Tiger"

Ireland's economy has experienced relatively high annual growth rates since the 1960s, when the Irish government structured its tax laws to encourage foreign direct investment. This industrial development strategy, built on tax incentives, made Ireland a cheap location for production, spurring general Irish GDP growth as well as the rapid expansion of the export sector. 1 Dublin's accession to the European Community (EC) in 1973, moreover, provided access to the Community's markets, increasing the country's attractiveness to investors and export firms. Ireland has since emerged as Europe's tiger economy.

During the 1970s, the Irish government promoted fiscal expansion to spur growth and following the oil shocks, was subsequently confronted by high inflation, high debt, and current account deficits. The government's first attempt at fiscal reform was structurally unsound, aiming at revenue enhancement rather than spending cuts. In tum, the annual government deficits remained high, between 7 and 7.9 percent of GNP from 1981 to 1986. 2 Though inflation fell, the overall debt soared to as high as 117. 1 percent of GDP in 1987; growth slowed to as low as -0.4 percent in 1986; and unemployment increased dramatically from single digits during the 1970s to a level of 17. 6 percent in 1987.

In 1987 anew government set its economic policy on three pillars: social consensus, fiscal correction, and exchange rate stability.3 The budgetary authorities began to initiate true spending cuts to lower the annual deficit. In conjunction with Irish social partners, Dublin introduced the Programme for National Recovery (PNR) which called for wage-stability and tax increases to eliminate the deficit. This would free the government from domestic wage pressures. Additionally, the European Community Support framework (1989) helped to compensate for the fall-off in public expenditure and thereby in part relieved the stress of fiscal cuts against the growth rate. Lastly, but equally important, the new approach committed the punt to the European Exchange Rate Mechanism's (ERM) central band relative to the Deutsche mark (DM).

The 1987 program was remarkably successful and supported high annual increases in growth. Restored confidence in Ireland contributed to lower interest rates, while tight monetary policy capped inflation.4 Ireland was better poised to exploit its export position, which had been growing throughout this period of instability - exports of goods and services had increased as a percentage of GDP from 30.6 percent in 1960 to 58 percent in 1985.5

Today, the basic pillars of Irish conservative fiscal policy and social consensus are still in place and have been key to the rapid expansion of the Irish economy throughout the 1990s.6 Moreover, the Irish export sector has continued to develop, fueling high growth rates and maintaining a positive trade balance over this same period.7 Foreign direct investment has encouraged the increase of Ireland's high-tech industrial base and increased the country's supply capabilities. For these reasons, even during the continental recession of the early 1990s, Ireland managed sound increases of 3.1 percent of GDP in 1993 followed by an upward trend peaking at 10.1 percent in 1995.8

The Punt/Sterling Relationship

Upon entering the ERM in 1979, the Irish government broke the official punt/sterling parity that had existed since the founding of the Irish Free State in 1921. Even as the punt was nominally stable relative to the DM during the 1980s, pressure from the sterling remained.9 In fact, after 1986, the movements of the punt in the exchange market shadowed those of the sterling though the Irish government had abandoned its official parity policy (See Graph 1). Noting the close Anglo-Irish relationship, market speculators, in essence, artificially pegged the punt to the sterling assuming Irish authorities would ultimately allow the currency to float and maintain nominal terms of trade.

Such speculation has undoubtedly complicated Irish monetary policy. Consider the 1992 ERM crisis. Britain's entry in 1990 at an overvalued rate relative to the DM (coupled with high domestic interest rates and a policy-credibility gap) immediately subjected the sterling to downward speculation.10 By 1992 German interest rate policy and this speculation made the sterling rate within the ERM untenable and Britain opted to float. The sterling's depreciation helped British cost-competitiveness, leading speculators to hedge against a punt devaluation.11 Eventually, in the wake of market pressures, the Irish central bank decided to devalue the punt by 10 percent and stay within the ERM.

In the years since, the sterling has again appreciated in the world markets, pressuring the punt near the limits of the upper 15 percent band relative to the DM. The sterling appreciation has limited the ability of the Irish monetary authorities to fight inflationary pressures, giving rise to speculation that in May the Irish government may seek to revalue the punt (relative to the euro) in order to stave off importing inflation from the UK. Il The Irish government, however, seems committed to holding out until the start of Stage Three.

The 'Embedded' Anglo-Irish Market and EMU

An embedded market structure between two countries, as defined in the context of this discussion, consists of strong, historical market ties supported by micro- and macro-economic similarities. In the case of Britain and Ireland, the embedded market rests on three key levels.

First, there is a pronounced Irish trading relationship with the Great Britain. In 1996, British trade accounted for 34.8 percent of the total Irish imports and 24.8 percent of all Irish exports - worth approximately 10.2 billion ecu and 8.9 billion ecu, respectively.13 These export/import levels with the UK have been consistently high, though declining (See Graph 2). Compared to all other Irish trading partners, Britain represents the single highest importer and exporter, exercising a relative dominance in virtually all sectors, and is notably the only country with whom Ireland runs a trade deficit.

Second, Ireland and Britain share a common employment market, at least in a de facto sense.14 The fluctuations of Irish employment levels are related to British changes due to a distinct pattern of emigration and the general ease of movement between the two countries. During periods of economic growth in Britain and an expansion of labor demand, Irish unemployment levels drop as the excess supply for labor has an alternate location to enter (See Graph 3).

Third, as discussed, the Irish punt and the British sterling have been linked by a shadow exchange rate parity.

Bearing in mind these general characteristics of the Anglo-Irish embedded market, one is able to determine possible consequences of EMU for the Irish economy and income/ output levels. Theory explains that fluctuations in the exchange rate between two countries leads to changes in the relative prices of import/export goods. All else being equal, a country's income level will rise or fall according to the direction of the exchange rate movement: appreciation of the domestic currency will raise the price of export goods and constrict output; depreciation will lower export good prices and boost output.

Recalling that a high percentage of Irish trade is dependent on Britain, the exchange rate movements of the respective currencies are important to Irish output levels. In the past, the shadow punt/sterling parity helped alleviate pressures on output by maintaining a steady rate (nearly 1:1). Once Ireland enters the euro-zone, the exchange rate market might not service this shadow parity. If the sterling, either by government design or by market forces, remains on par with the euro-rates (the exchange rates set as of May), then there is no real cause for concern. If the sterling continues to float, however, Irish output could be duly effected.15

Policy Options

In light of the possible ramifications of EMU without the sterling, there are three key approaches to maintaining output stability and growth that the Irish government has at its disposal. Given the limitations on Dublin's policies once within the euro area and the historical predilections of Irish economic policy in general, the following discussion attempts to discern what, if anything, the Irish government might do if the sterling-euro rate entered a period of volatility.

I. COUNTERACTIVE MEASURES OF FISCAL EXPENDITURE16

As stated above, changes in output brought on by fluctuations in the exchange rate may be counteracted by government fiscal policy. For example, in the event that the pound sterling depreciates, Irish output will fall in step with declining aggregate demand for Irish exports. A rise in fiscal spending could increase output and domestic aggregate demand until the effects of the sterling depreciation are neutralized.

This policy option is handicapped, however, by the Stability and Growth Pact, which commits the Irish government to maintaining fiscal austerity. More specifically, deficits on average at or below 3 percent of annual GNP must be maintained, or suffer penalization for a continued or excessive infraction. Therefore, if the Irish government were running deficits near to or at 3 percent of annual GNP at the time of the depreciation, the freedom to raise fiscal spending or cut taxes would be inhibited. Dublin should thus do its best to maintain its fiscal policies and deficit levels at or around an even balance in the event that an adjustment in fiscal spending is needed.17 (Luckily the Irish government has shrunk its deficit steadily over the past decade, even obtaining a surplus in 1994.)

But is this in fact wise? Though the arguments for this policy are tempting, especially in the event of a decline in output, fiscal expansion would not likely yield any substantial short-term or long-term benefits. If Dublin increased expenditure, the money would first enter the domestic market. However, Ireland's economy is export-driven, and short-term growth is thereby not dependent on domestic demand. Therefore, unless the Irish government could raise expenditure in such a way as to simultaneously spur external demand and purchases of Irish goods, output would still decrease and the government would instead face domestic inflationary pressures (stagflation).

Regarding unemployment shocks due to decreases in output, fiscal policy may likewise be ineffective. The Irish economy has proven itself incapable of creating jobs to match its population growth even during periods of economic expansion.18 The high-tech nature of its export industry creates a great deal of structural, long-term unemployment as more labor intensive, low-skilled sectors - namely agriculture and industry - shrink.19 Therefore, fiscal expansion would in the short-term bloat the public sector with unskilled, temporary workers who are still excluded from the growth engines of the economy: the service sector and high-tech industry.

Additionally, one must consider the relevance of a change in fiscal policy for the Irish economy's credibility as a whole. Throughout the 1980s, Ireland struggled with the fiscal disregard of the 1970s, which affected Ireland's debt-carrying capacity and levels of outside investment. The government's 1987 macroeconomic package was therefore primarily designed to restore faith in the Irish economy both domestically and internationally by reforming fiscal expenditure. A break from this pattern even after several years of consistent success and growth would contradict the principles upon which Ireland's new economy rests.

II. THE "DO NOTHING" APPROACH

Recalling that the main causal variable is the fluctuation of the sterling-euro exchange rate and that these fluctuations are considered to occur in the short term, one cannot be certain that the sterling exchange rate volatility will in fact affect trade volumes.20 In an embedded market, where there is a strong and long-standing trading relationship between two countries, short-term changes in the exchange rate will not substantially influence trade flows as long as the changes remain short-term. Firms may adjust prices temporarily, but the level of purchases ought to be relatively constant as seeking new markets may incur greater costs than simply waiting out the fluctuation.21 As a result, aggregate demand would not shift and output would not rise or fall.

A model designed by Andre Sapir and Khalid Sekkat indicates that, theoretically, exchange rate fluctuations are translated into the market not via changes in trade volume but through changes in prices - which depend on the market structure and a firm's perceptions of exchange rate stability.22 Moreover, the depth of market integration has a tendency to neutralize the effects of exchange rate volatility.

Under this model, trade as related to exchange rate movements essentially becomes a function of risk, market perceptions, and market structure. In the short-term, firms are more likely to hedge against volatility and insure against adverse effects on trade.23 Risk is lower as firms, expecting volatility, counter the effect beforehand. Additionally, if trade volumes are sticky in the short-run, these firms ought not encounter substantial drop-offs or expansions of demand as a result of the change in the exchange rate. The embedded market structure multiplies the stability of trade volume where volatility exists.

On the other hand, in the longer-term where misalignment is perceived, firms are prone to rethink their presence in the market, levels of production, etc. The risk of losses becomes greater and more pronounced. If the exchange rate fluctuates and is perceived by the firms to have long-term implications, firms may adjust their trade volumes or, more drastically, their trade flows.

Thus, in the short term, the Irish export/import trade stands to lose little, especially if the UK is seriously considering membership in the euro-zone by 2002. If perceptions continue to focus on the short term, intra-UK/Irish trade volumes will remain relatively stable in light of the integrated market. Fim1s should be inclined to wait out a period of sterling volatility (if one even arises) with the medium-term understanding that the UK will soon adopt the common currency and eliminate altogether the dangers of currency fluctuations.

Nonetheless, sterling-euro exchange rate volatility may encourage firms to adjust prices to account for revenue shortfalls rather than re-forge market connections. An appropriate means of clarifying this relationship is to look at the Direct Approach to the balance of trade as affected by changes in the exchange rate.24 In the event that the trade volumes are stable in the short term, as the Sakkir (et. al.) model indicates, exchange rate fluctuations will only significantly influence prices, if at all.

The adjustment of prices is not always an automatic response to exchange rate fluctuations, though; instead, the impact on prices relies heavily on the degree of pass-through, or the translation of the cost of the exchange rate into market prices. For instance, if a firm occupies a precarious market position, where changes in price could lead to significant losses in market share (elastic demand), the firm may opt to keep prices constant and absorb any costs in trade profits (zero pass-through). Therefore, pass-through is primarily a distortionary effect and centers on firms' perceptions of risk and of how changes in price will effect demand.

The degree of pass-through is quite important in analyzing the market effect of sterling-euro fluctuations. As volumes are likely to be stable, fluctuations could result in price changes within the Anglo-Irish market. Nonetheless, there may arise certain circumstances where both British and Irish firms would be less willing to pass-through changes in the sterling-euro exchange rate. The latter possibility is deceptive, though, as this aggregate perspective glosses over negative effects on particular sectors.

Reviewing sectoral relationships could shed light on possible 'danger' areas where pass-through may not occur and thereby place downward pressure on a portion of the economy. For example, the agricultural sector - producing primary goods - tends to encounter higher demand elasticities to changes in prices without an extensive profit margin. In terms of Anglo-Irish trade, 55 percent of total Irish food and live animal imports (FLA) are from Great Britain, while 32 percent of Irish FLA exports are to Great Britain.25

(It should be noted that FLA exports constitute 22 percent of total exports to Britain.) In light of such a market dependency, exchange rate fluctuations could create a crowding-out effect as the aforementioned high elasticities would dissuade price adjustment and firms would exit the market due to lower profits. The true extent of this crowding out, however, is uncertain.

The Sakkir (et. al.) model does not address this contingency. It presents a viable argument that Anglo-Irish trade volumes should remain stable as long as any sterling-euro fluctuations are short-term. The analysis, however, fails to take into account the ramifications of pass-through (or zero pass-through) on smaller, specific sectors.

Therefore in an aggregate sense, the Irish economy - bolstered by the embedded Anglo-Irish market - is in a strong position if the sterling-euro exchange rate enters a period of volatility. Thus in the short-term, Dublin may choose to do nothing in response to fluctuations, allowing the consistency of trade volumes to buffer the change in relative prices. Nonetheless, this overall stability should not overshadow sectors that may be more sensitive to pass-through pressures brought on by the movement of the exchange rate.

III. GENERAL RESTRUCTURING OF THE IRISH MARKET

Concerns over the medium and long-term prompt alternative strategies for Dublin and firms operating in Ireland. If Britain does not accede to EMU, the possibility of misalignments becomes more realistic and more dangerous. The stability of trade volume I have described would be called into question. This would then influence, for better or worse, Irish output.

Irish firms should consider equalizing the trade market shares with other countries in the Community (or world), lessening the dependence on British goods and domestic markets. Recent trade statistics indicate that this market diversification is already underway. The shares of British trade for both imports and exports, though still substantial, have gradually decreased (See Graph 2). Meanwhile, both the US and German trade shares have increased. If present trends continue, Anglo-Irish trade levels will reach a more even distribution relative to other trading partners. This normalized distribution would help dissipate the dangers of EMU without Britain. A drop-off in export volume, for example, would have a greater effect on aggregate output if the particular market constitutes 30 percent of total exports. With a decreased share of Irish trade, a sterling-euro misalignment will be less severe.

Additionally, if Irish firms shifted trade toward euro-zone countries, the issue of exchange rate fluctuations would become moot. Cost/price distortions caused by misalignments would not arise as the single currency would ensure stability. Furthermore, this increased and diverse trade would help synchronize the Irish economy with the euro-zone, bringing Ireland's needs further in line with Frankfurt's policies.

The Irish government is best poised to confront negative spillovers from changes in output within the employment sector. (Community legislation prevents too strong a hand in trade affairs.) Fluctuations of the sterling-euro are more likely to affect the labor-intensive industries.26 Retraining programs might actually provide some flexibility in the work force if employment shocks are incurred. Moreover, these programs - some of which are already underway - would address the larger, more consistent problem of structural unemployment.

Concluding Remarks

General prospects for the near future are bright. Irish growth is projected to decline, but remain above 5 percent per year through the tum of the century.27 Unemployment, the bane of Irish economic success, is also expected to decline with job creation stemming from the service and high-tech industry sectors. 28 Likewise, Irish exports should grow due to increasing demand on the continent.29 Dublin must note the expected loss of structural fund support after the year 2000, which is likely to increase strain on the budgetary authorities. (The Dublin Economic and Social Research Institute estimates that Structural Fund assistance accounted for 2.5 percent of GDP in 1993.)30 However, the Irish budget figures indicate that the balance should reach a surplus possibly as early as 1999, and any loss of revenue could be absorbed by an increase in government spending without damaging Ireland's fiscal reputation.31

Ireland's continuing positive economic performance, though, does not remedy the problems of EMU without Great Britain. If anything, these problems arguably call into question the feasibility of the forecasts. But in light of the arguments this article has presented, a euro-zone without the sterling should be a concern and not a preoccupation. Granted, Dublin will have limited resources to combat changes in output in the short term-fiscal policy is likely to be ineffective; monetary policy will be set in Frankfurt; and direct interference in trade flows raises legal questions. Nevertheless, changes in output do not bear definite consequences as exchange rate volatility may not influence trade volume or prices. Certain sectors may be more vulnerable; but the Irish government is aware of this and is nonetheless confident.32

Misalignments between the euro and the sterling pose a greater problem, as the cost and price pressures from exchange rates may impact upon more than just the sensitive sectors. Firms, as I have argued, will be more inclined to rethink their market position, and stable trade volumes may suffer. Whereas trade stability excuses Dublin's inability to extensively control output levels under the EMU regime, misalignments would highlight it. If the Irish market is able to diversify, the severity is lessened. If not, Irish output will be caught between two differing monetary policies.

Ultimately, the exact ramifications of Irish entry into EMU are not clear. Mostly, the degree of concern hinges on the time period of analysis: how long until Britain joins the euro-area? Though UK Prime Minister Tony Blair has expressed his open-mindedness to EMU, it is highly unlikely that the sterling will enter before the close of his first Parliament (or, prior to 2002).33

Regardless, in the face of possible dangers, the Irish government is intent on membership. Dublin has embraced the Union and through it created an Irish economic identity - some might say at the expense of British dominance. Thus, monetary union crowns the country's remarkable economic achievements and marks an important break from Britain, though trade may linger. EMU is in many ways a fait accompli of Irish politics, overriding the economic uncertainty.

Notes