The German Bundesbank wants to go further than the harmonization of central bank operating procedures, and harmonize what it calls "financial cultures":
"An effort should be made to achieve the maximum harmonization of the underlying conditions in the financial sector - with the aim of promoting a convergence of the "financial culture" in Europe. From the point of view of monetary policy, it would be useful to gradually eliminate existing differences in the financial structures of EMS members in the wake of the progressive integration of the European financial markets. One outstanding example of such persisting differences is the prevalence in the UK of floating-rate loans as opposed to the preference in Germany for longer-term locked-in interest rates. For this reason changes in short-term interest rates that are subject to central bank influence have a comparatively large impact on disposable incomes in the UK where households moreover have a relatively high level of indebtedness; this may well have implications for the deployment of the central bank's set of instruments, as was demonstrated by the events of the EMS crisis in 1992. Clearly, this could give rise to problems for monetary policy cooperation in the EMS and for the later single monetary policy." (1)
The point has been acknowledged by the Bank of England and private sector UK commentators. A former Bank of England analyst, writing in a broker's circular, put it as follows:
"The way in which a given change in European interest rates will affect various countries is likely to differ greatly. So even if inflationary pressures were the same throughout the currency area before a change in monetary policy they could not be after" (2).
The Bank of England's evidence is that the UK differs from other countries less in its corporate financial culture than in its household financial habits, notably mortgages (3). Although most bank loans to British companies are at variable rates of interest, 35 per cent of their outstanding debt is in fixed-rate bonds, so perhaps a total of 40 per cent is at fixed rates, including some bank loans. The comparable figure for France is also about 40 per cent, and for Germany about 50 per cent. Small and medium enterprises, which cannot issue bonds but have to rely banks, suffer from having most of their debt in variable rate form. This is a problem common to all EU countries.
By contrast, about 80 per cent of UK mortgages, and most consumer credit, is at variable rates of interest. In 1990, British households were paying out 10.9 per cent of their income in interest, about three times the European average. By 1994, this had fallen to 6.5 per cent, with the fall in interest rates and the slowdown in the mortgage market (4). It was the prospect of sky-high mortgage rates following 15 per cent bank base rates which tipped the political balance towards the UK's departure from the ERM in 1992.
The UK's variable mortgage rates, and their tendency to rise in times of crisis, are sometimes given as a reason for not joining the single currency, on the grounds that monetary tightening by the European Central Bank would have a severer effect than in other countries, where more mortgages are on fixed rates (5). The move to fixed mortgage rates in the UK has not refuted this argument, because most fixed rates are for a limited period, and apply only to new loan contracts.
Fixed rates became popular when they fell below variable rates, and borrowers decided that variable rates were more likely to rise than fixed. Their popularity peaked in the second quarter of 1994, when 65 per cent of all new first mortgages were granted at fixed rates, but this fell rapidly to 28 per cent in the first quarter of l995, as fixed rates rose. In mid-1994, no more than 21 per cent of all mortgages outstanding by value were at fixed rates. This could fall as new fixed rate mortgages tail off, and existing short-term contracts switch to variable rate.
Differences in financial culture are deep-rooted, and bound to persist after the single currency has been set up. The Bank of England might be justified in pointing out to the Bundesbank that Britain's cult of the equity - the use of share issues as an important source of company finance - might have some advantages for the German corporate sector, which is financed to a relatively great extent by bank loans and bonds rather than shares. The high proportion of equity finance gives the UK one of the lowest interest to corporate income ratios in the EU, in contrast to the position of the UK household sector with its relatively high interest burden.
The principle of subsidiarity must leave a good deal of independence to national financial systems, after the requirements of the single monetary policy at European level have been met. The operation of the single market in financial services will bring about some convergence, but it should not be for the ECB to dictate its pace and nature.
While Continental corporations may find advantages in the diverse and flexible financial culture offered by the City of London, British mortgage borrowers will be attracted by the Continental fixed rate system, provided that the level of rates is fixed at a low enough level. The differences in financial culture, far from being a reason for the UK not to enter the single currency, offer opportunities for improvement in financial packages for both corporations and households thanks to cross-border competition on product and price.
The Bundesbank's point, that the transmission mechanism of monetary policy differs between countries, remains valid, if something of a truism. The implication is that national central banks will need to use some of the discretion allowed to them by the Treaty in the application of the single monetary policy to local conditions. If the ECB is to use monetary policy to damp down the growth of demand so as to avoid inflation, then the high British proportion of variable rate finance could be an advantage, because a fairly small rise in interest rates would have a big real effect, and it would not be necessary to raise rates to punitive levels.
The different impact of monetary policy in different countries will make it necessary to use fiscal policy as well to get the right balance between growth and inflation. The tighter fiscal policy can be, the lower interest rates can be set by the ECB. A bias towards tight fiscal and loose monetary policy will keep a rein on public expenditure and favour private investment and economic growth. If fiscal policies are not tight enough, the ECB will have to raise interest rates to keep inflation under control, thus jeopardizing the boost to economic growth expected from the single currency through lower interest rates. If the ECB can use short-term variable interest rates to achieve its targets, and companies and households can shift more to long-term fixed rates, damage to the real economy could be kept to a minimum.
The European Single Market in financial services will also bring down interest rates by promoting greater cross-border competition between banks on lending rates. The single currency is even more necessary to the single market in financial services than to that in goods. It is intuitively obvious that the existence of separate currencies must divide the market in money even more than those in other goods and services.
Financial and business services are the UK's largest industry, accounting for a quarter of the national income. They had faster than average growth during the 1980s because of financial deregulation, but that has now run its course. If the UK is to continue exploiting its comparative advantage in this field, it must enter the single European market in a full-blooded way that has up to now not been possible. The obstacles consist partly of regulations in other countries which are gradually being dismantled, and partly of the multiplicity of national currencies and payment systems.
The more efficient banks are likely to profit at the expense of their sleepier rivals. To quote Professor John Kay of the London Business School, it will be a case of "more competition, more consolidation". The banks that win the competition will not necessarily be the existing market leaders. The shake-up in banking will be good news for borrowers. Small firms and personal mortgage and consumer borrowers will do particularly well, because they will have an alternative to the domestic banking/building society networks. Both the general level of interest rates and the spread above it reflecting the riskiness of the type of loan should come down.
The single currency is of vital importance to financial services and to investment income, where the City of London has a comparative advantage. The City would have a better chance of playing a leading role in the new Euro markets if the pound was part of the Euro. Business lost in the foreign exchange market could be regained in the Euro money market covering the whole single currency area, which would replace the intra-European foreign exchange markets as the conduit for the flow of funds around Europe. The City will be missing a great opportunity if the UK does not join the single currency, because much financial and investment business using the single currency may migrate to its home territory on the Continent. The City can hope for only a limited share of this market if it remains offshore.
The City is the leading international financial centre in Europe, but has never so far managed to oust Frankfurt, Paris and other European centres from their well-protected domestic patches. City bankers differ on whether to give priority to pushing the City in Europe's new and barely yet open single financial services market, or to exploiting their traditional advantages in the fast-expanding rest of the world.
The City, like island Britain, has in the past benefited from being offshore. Self-regulation, the English language, the time-zone straddling New York and Tokyo, and the clusters of interacting financial specialists, have attracted banks from the US, Japan and Continental Europe to come and set up international operations that would fall foul of domestic regulation back home.
Most of the City's market now belongs to foreign banks, and British customers for its services are in a minority. It creates 800,000 jobs. The financial and business services sector of which it is the hub accounts for 22 per cent of Britain's gross domestic product. Ever since the City got going again after the second world war, its prosperity has been independent of the fluctuating pound sterling and the arthritic British industrial sector. By the same argument, many in the City maintain that it can continue to do well whether or not Britain and the pound opt in to the single European currency. As Stanislas Yassukovich, Chairman of the City Research Project, says: "What is the relevance of the currency of the realm to the success of an international financial centre? In my opinion, there is virtually none." He is contradicted by Sir Nicholas Goodison, a former Chairman of the Stock Exchange and now Chairman of the TSB bank: "It will do us no commercial or financial good to be left out. " The Bank of England, as can be expected, sits on the fence. Alastair Clark, a Deputy Director, says: "The Single Market programme has brought real and important gains, which will continue and grow irrespective of whether or when the UK joins a monetary union".
The City is in any case having a hard time coming to terms with Brussels regulations designed to create a level playing field for financial services, on top of the already costly new structure of self-regulation set up in 1986 by the Financial Services Act as a result of the Big Bang on the London Stock Exchange. The securities firms in the City are particullarly restive at capital adequacy regulations designed to suit German universal banks which do banking and securities off a single capital base.
The single market in financial services requires some harmonization of financial cultures for reasons of fair competition, quite apart from the monetary policy reasons for harmonization. The single monetary policy that goes inescapably with the single currency will require harmonization in money markets, including a uniform system for bank reserves, and the end of many features peculiar to the City, such as the discount houses monopoly of money market operations with the Bank of England. However, the Bundesbank tends to exaggerate the extent to which markets other than the Euro money market will need to be harmonized to make monetary policy effective; other central banks are likely to take different views.
The importance of the single currency to the City will vary by market sector. The City is number one in the world in foreign exchange, with a market share of 30 per cent in April 1995, compared with 27 per cent in April 1992. New York has 16 per cent, Tokyo 10 per cent, Singapore 7 per cent, and Hong-Kong and Zurich 6 per cent each. Of the continental markets, Frankfurt has only 5 per cent, and Paris 4 per cent.
Equity markets will still remain nationally-based for a time, because of differences in corporate accounting, even when all shares are quoted in the single currency. A Europe-wide stock exchange will need some harmonization of accounting standards.
London already has 64 per cent of all cross-border stock exchange dealings; this will increase if the UK joins the single currency, and fall if it does not. In the longer run, London should be able to build on its lead in international equity dealing to dominate the European single currency-based stock market once the accountants and the regulators can agree on common standards.
Bond markets are already dominated by London in the corporate eurobond sector, and City banks arrange 75 per cent of all eurobond issues. The big change will come in European domestic government bond markets. Once they all switch to the single currency, spreads will be based only on credit and not on currency risk, and will narrow dramatically, so that British and German bonds, for example, become closer substitutes. The single currency will account for 32 per cent of all domestic bonds and 37 per cent of all international bonds, and many of these will be issued and traded in the City. It is hard to see the City getting a big share of the pan-European bond market if Britain opts out of the single currency, in spite of the hopes of LIFFE, the main City derivatives market now leading in German bund contracts.
Success in the European financial market has been elusive for the UK; Continental banks from Germany and Switzerland have done better in London than their British counterparts have in Frankfurt and Zurich. Deutsche Bank has taken over Morgan Grenfell, and Swiss Bank Corporation S.G. Warburg. If the City increases its market share in Europe, albeit through Continental-owned banks operating out of London, this need not prevent it continuing to exploit its comparative advantage in other parts of the world.
More of the 50 per cent of all international bank lending done by banks of EU national ownership may become concentrated in the City, which is now the leading international banking centre in the world, with 16 per cent of total bank loans. City banks also lead the world in mergers and acquisitions (50 per cent of the total), and institutional fund management (81 per cent) (6).
The City's a la carte approach looks doomed to failure. Either Britain will have to come in to the single currency, and try to get the kind of monetary policy operation that suits the UK banks, or the City will find itself effectively shut out of the single market in financial services, to the benefit of Frankfurt and Paris, which are trying to win market share from London.
Optimists argue against this that the City will continue to provide offshore markets for financial instruments in the single currency with greater efficiency and less regulation than the onshore centres. The City would like to play the part that New York plays in the US system, with the Bank of England as the Federal Reserve Bank of New York acting in the financial markets as the operating arm of the central bank headquarters in Frankfurt or Washington. To make the analogy exact, the City would have to be within the single currency area, however.
The City of London does more business with the rest of the world than with Europe, and less business with Europe than the industrial sector of the economy. That shows what unrealised potential there will be once the City is allowed to compete on equal terms in the single European market for finance - to which the single currency is essential. It is a myth that the City has better prospects outside than inside Europe. On the contrary, it has some catching up to do on the Continent, and can be the main financial centre in Euro markets - as opposed to euromarkets - only if it is in the Euro area. The UK is already committed to European regulation in financial services, and no longer has the option of being an unregulated offshore haven. Neither Hong-Kong, not Norway, nor Switzerland, are appropriate models for the UK, which is a major European power.
(1) Deutsche Bundesbank Annual Report 1993 p. 92.
(2) A Single European Currency: Options for the UK David Miles (London: Merrill Lynch lobal Fixed Income Research 1 March 1995).
(3) "Fixed and floating-rate finance in the UK and abroad" David Miles Bank of England Quarterly Bulletin vol 34 no 1 February 1994.
(4) Blue Book 1995 (London: HMSO 1995) table 4.9.
(5) Convergence criteria and Maastricht Penelope Rowlatt Seminar paper November 1993. "Fixed and floating-rate finance in the United Kingdom" David Miles Bank of England Quarterly Bulletin vol 34 no 1 February 1994 table G p. 41. "The development of fixed rates mortgages and annual review schemes" Fionnuala Earley Housing Finance no 24 November 1994 ppl7-24, and various other issues.
(6) The View from No.ll Nigel Lawson p. 275