ECONOMICS: Despite the attention given to the dollar, sterling is pivotal both in determining Irish inflation and as a key influence on exporters' profits and employment intentions.

The UK remains Ireland's main trading partner, taking one quarter of Irish exports and accounting for over 35 per cent of imports. For Irish indigenous firms the dependency is even greater than these aggregate figures imply, highlighting the importance of the euro/sterling foreign exchange rate. Despite the media attention given to the dollar, sterling is pivotal both in determining Irish inflation and as a key influence on exporters' profits and employment intentions.

It is not surprising then that Irish exporters have recently taken to the airwaves to complain about the euro's appreciation against sterling (around 7 per cent over the last 12 months) although few went public when the euro was falling against sterling in the first two years of its existence as a single currency.

Indeed, despite the recent rally the euro still buys around 66 pence sterling, against 70 pence in January 1999.

For nostalgic readers, the current euro foreign exchange rate is equivalent to a pound/sterling rate of 83 pence, which one doubts would have caused undue alarm had Ireland kept its own currency.

Yet the euro's upward movement has raised concerns about further sterling weakness, with more serious implications for Irish exporters, although it would be good news for Irish consumers.

Forecasting currency movements is tricky but in sterling's case there is a specific factor at work which has had a significant influence on its value against the euro, and one which may be about to change over the next few months. The event is euro membership, or at least the possibility that sterling will join the single currency.

The Blair government's position is that the UK will indeed join but only when the time is right, and following a referendum.

British public opinion has never warmed to the single currency, it has to be said, and europhile optimism that the introduction of euro notes and coins would change attitudes has now been tempered by the realisation that there has been little or no shift in the percentage intending to vote against membership, judging by the most recent polls.

Nothing new here, and public opinion can change, but a watershed of sorts is fast approaching, with the scheduled publication of the British Treasury's verdict on sterling and the euro, which is due by June at the latest.

The Treasury will judge the merits of early membership using five criteria, including whether the single currency would boost employment and investment and whether it would damage the City of London's financial pre-eminence.

The key tests, however, relate to convergence and flexibility - whether the British economy is flexible enough to adjust to shocks following the loss of monetary independence, and the extent to which the British economy has converged to the euro zone, as it would have to live with a common interest rate.

Market sentiment on British entry tends to ebb and flow and the probability of British membership was certainly seen as much higher in the summer and autumn of 2002. The evidence was there in the foreign exchange markets at the time, with sterling becoming less attached to the US dollar, and drawn towards the euro, specifically the likely entry level of 66 to 67 pence.

This explains why the euro's appreciation was much less pronounced against sterling than the dollar - the market was unwilling to push sterling down to what might have been too low an entry level.

The situation has now changed. The UK economy has diverged from the euro zone in the past year in terms of economic performance, recording growth of 1.7 per cent in 2002 against a meagre 0.7 per cent in the euro zone. The contrast between Britain and Germany is even starker, as the latter grew by only 0.2 per cent.

This divergent performance has already led to a widening of the interest rate spread between the two economies (4 per cent in the UK and 2.75 per cent in the euro zone) because the Bank of England is reluctant to ease monetary policy for fear of adding more fuel to the housing boom in Britain. The result is that the market is now giving a very low probability to a Yes verdict from the Treasury, and the prime minister has indicated that a referendum this year is highly unlikely.

The irony is that the strength of the German economy was once seen as a reason for Britain to join the single currency and the weakness of that economy is now a significant impediment to UK membership of EMU.

Sterling is therefore drifting away from its euro anchor, and may well trade more closely with the dollar in 2003, particularly after June. So if the dollar continues to depreciate we could well see the euro rallying further against sterling as well.

I suspect, however, that the dollar will recover from the spring onwards, which will push the euro lower against sterling, given the latter's likely rebirth as a dollar clone.

Dr Dan McLaughlin is chief economist at Bank of Ireland