After the customary spats between EU countries and the inevitable hype in the media about the seriousness of the various disagreements, the Luxembourg Summit ended in the usual series of compromises. The French and the British went away with most of their pride intact, the Germans achieved the agreement they sought and the way has now been set for a relatively smooth transition to the single currency in 1998.
The German Chancellor described the summit as the most important meeting since the war. This seems a tad exaggerated, because the meeting was never going to end in anything less than success. It is virtually impossible to conceive of a situation at this stage where agreement cannot be reached on issues relating to EMU.
This pattern will continue over the coming year and the Irish economy should now wake up to the fact that, in just 12 months time, the reality of the single currency will have dawned, with this State and 10 other countries on board.
An examination of Irish economic statistics would appear to suggest that this State has a lot less to worry about than the others, but a number of important issues will have to be addressed over the coming year. These include the rate at which we should lock into the single currency, the manner in which interest rates can be taken down to the European norm, and how we should handle British position on EMU.
Of more serious longer-term consequence are the recent shocks on the foreign direct investment (FDI) front, and the issue of EU enlargement, now that the path to a wider EU has been cleared. On the currency question, the speculation about whether the Irish pound's ERM central rate should be adjusted upwards will inevitably persist over the coming weeks and months. At one level it is possible to argue that, when we have to make the decision on the euro entry rate next March or April, the decision should depend on where sterling is at that particular time. In other words, if sterling is as strong then as it is now, we should seek to go in at a rate of around 2.55 against the deutchmark.
Such an approach would be extremely short term and is not to be recommended under any circumstances. A longer-term perspective is required. This approach should consider where sterling is likely to trade over the coming years, at what rate it is eventually likely to join the single currency, assuming it does join, and what rate would be in the best interests of the Irish economy.
Exchange rate forecasting is a very imprecise and dangerous activity, and it is impossible to predict precisely where sterling will be trading a couple of years down the road.
However, it is possible to state with confidence that sterling up at current levels is not sustainable in the longer term and that the British government will eventually seek to take the currency into the euro at a rate of no higher than 2.60 against the German currency and most probably no greater than 2.50.
This prognosis suggests that the Irish would be ill advised to join the single currency at a rate above 2.41 against the deutchmark and risk a possible uncompetitive exchange rate against sterling down the road. Furthermore, the Irish authorities should be loathe to give away a short-term competitive advantage by joining the single currency at a higher rate than is necessary under the likely rules of engagement which will be agreed in May.
The interest rate options are also quite straightforward. Basically, the Central Bank will have to start engineering money market rates down towards core European levels in a more aggressive manner once the festivities are out of the way. This will necessitate cuts in official rates in the early weeks of 1998 and, by April, we will need to have money market rates trading comfortably under 5 per cent, with a target of close to 4 per cent attainable by the time the summer ends.
This rate path may generate some nervousness in Dame Street, particularly following the sharp uptick in November inflation, but the bullish rate prognosis is inevitable in an EMU context. It is clear that the rate decisions will be taken in an EMU context, because, despite the reservations which some of us share about participation without Britain, the Irish will be joining on January 1st, 1999.
The recent cut by the Spanish and comments from Tietmeyer reiterating that rates outside of the core will have to fall, place the onus very squarely on countries like Italy and Ireland to get their rates down quickly.
From a longer-term perspective, recent announcements by a couple of multi-nationals are worrying, particularly if they represent the beginning of a trend. This is hardly the case, but if nothing else, these developments should wake us up to the reality that things can start to go wrong very quickly.
It is quite easy to manage a strongly growing economy, but once it passes its peak, it can get a lot trickier. A couple of years down the road we may be wishing that we had acted in a much more prudent manner during the roaring 1990s, so our policy makers should sit up and take notice before it is too late. This great challenge going forward will be compounded by the enlargement process which gets under way next March. Here's to a challenging 1998.
Jim Power is chief economist at Bank of Ireland Group Treasury. The views expressed are personal.
