On the exchange rate front, the overriding concern of the authorities is the rate at which the pound will be irrevocably fixed against the deutschmark when EMU begins on January 1st, 1999 - assuming that EMU starts on schedule and that Ireland is a founder member. Another, albeit secondary concern, is the prospective inflationary effect of the currency's recent decline. It has dropped 6 per cent in trade-weighted terms since the start of the year, and 15 per cent vis-a-vis sterling since last August. While sterling continues to ride high against the deutschmark these two concerns cannot be resolved simultaneously. The Government is plainly reluctant to strengthen the pound by adjusting its ERM central parity upwards - a move that would be entirely appropriate on standard macro-economic grounds - for fear that this would mean an uncomfortably high EMU entry rate in the event of the deutschmark or sterling falling steeply before the end of next year.
No doubt the authorities' most earnest prayer is that a steep fall in either currency will take place before they have to commit themselves on the entry rate issue, but the gods may not be on their side. There is a distinct possibility that the formula for setting EMU entry rates will be announced after next month's Ecofin meeting. A proposal for addressing the dilemma was put forward in these pages last week by Dr Patrick Honohan of the ESRI. He suggested that the pre-announced entry rate for the pound should be the current deutschmark/pound (DM/IEP) central parity of DM2.41, or the DM/IEP rate corresponding to a sterling/pound rate of 0.87 pence sterling at the time of entry, whichever is the higher.
He described the merits of his idea as follows: by imposing this sterling floor, we prevent a further sharp depreciation of the pound against sterling, without exposing ourselves to the risk that we might have to enter at too high a rate against sterling. (Question: What are the three most important factors in Irish exchange rate policy for so long as such a policy continues to exist? Answer: Sterling, sterling and . . . sterling.)
The Honohan proposal has a certain superficial appeal but there are also several obvious difficulties attaching to it. One is the fact that, while the proposal offers protection from the risk of a sharp fall in sterling over the next 17 months, it offers no such protection thereafter. For example, following the Honohan rule would imply an EMU entry rate for the pound of DM2.61 if sterling were trading at its current level against the deutschmark at end-1998, and a rise in the pound from 0.87 pence sterling to £1.20, if the deutschmark/sterling rate subsequently fell back to DM2.20 where it was trading early last year.
In fairness, this problem cannot be overcome by any formula for determining the pound's entry rate and the example above simply illustrates one of the risks to which the economy will be exposed if we join the single currency without Britain. However, it is when one explores some of the less obvious properties of the Honohan proposal that the fun and games really start.
How would the pound behave if the government announced its intention to adopt his formula? For one thing, at all values of the deutschmark/sterling forward rate for January 1st, 1999, above DM2.77, the pound would move in almost perfect tandem with sterling for the next 17 months. In these circumstances, the Honohan formula would create a situation whereby Ireland would prepare for membership of a currency union with the deutschmark by effectively adopting a fixed exchange rate regime vis-a-vis sterling! This might be regarded as little more than an embarrassing irony were it not for some other unfortunate implications. Consider, for example, what would happen if sterling moved up above DM3.18. Under these conditions, if an announcement a-la Honohan had been made, the pound would breach its current ERM fluctuation limits. The only way the authorities could avert this would be by cutting interest rates, but this would result in the sterling/pound rate falling below the 0.87 pence sterling floor proposed by Dr Honohan. Alternatively, the pound's ERM parity could be re-valued upwards, but this is precisely what the Honohan proposal is designed to avoid. The implications of a fall in sterling against the D-mark are different, but not much prettier. If the deutschmark/sterling rate was to depreciate, the sterling/pound exchange rate would remain broadly unchanged, at least until the DM/sterling forward rate fell below DM2.77. Up to that point the pound would decline pfennig for pfennig with sterling against the D-mark, and would fall further on a trade-weighted basis than it has already this year. If the DM/sterling rate fell to DM2.90, for example, the pound would fall to about DM2.55 (5 per cent below its current value) and by about 3 per cent trade-weighted. In these circumstances the Central Bank might well feel compelled to raise interest rates.
The root cause of the revaluation debate is a recognition of how critical to our economic health the exchange rate against sterling is. There is an obvious conclusion to be drawn here. There is an equally obvious unwillingness to draw it.
