Investor/An insider's guide to the market: As a founding member of the euro, the Republic has enjoyed several years of membership of the euro zone. The euro is now well established as an international trading currency, second only to the dollar.
The amazing success of the Irish economy over the period must be at least in part due to the stability provided by the euro umbrella. The days prior to the euro, when the Irish pound was regularly buffeted by developments in the British economy and particularly by the volatile sterling exchange rate, are now a distant and fading memory.
As our largest trading partner, movements in the old pound/sterling exchange rate had a very large bearing on Ireland's international competitiveness. Therefore, those periods of persistent weakness in sterling often created pressure for an adjustment in the pound exchange rate within the old European monetary system of quasi-fixed exchange rates.
Not surprisingly, prior to the advent of the euro, developments in the British economy and the sterling exchange rate were very carefully monitored by Irish-based analysts and investors.
Now developments in the Britsh financial markets receive only moderate attention. As well as euro membership, the Irish economy has become more diversified and broadly based over the past decade. Therefore, the relative importance of the British market has diminished. Nevertheless, the British economy remains a major trading partner and developments in that economy still have the potential to have far-reaching consequences for Ireland's trade-weighted international competitiveness.
Last week the Bank of England surprised the markets by raising its official short-term interest rate by a quarter point to 4.75 per cent. Investors have become used to central banks delicately managing expectations so that when interest rate rises do come, they have only a marginal impact on the prices of financial securities. This time the Old Lady of Threadneedle Street surprised an unwary market, causing a 1.5 per cent drop in the FTSE 100 index on the day of the interest rate announcement. Gild yields rose and sterling hit a one-year high on a trade-weighted basis.
For investors in Britain, the question is whether this rise merely marks the start of a new monetary tightening cycle, or whether it is a one-off fine-tuning exercise. Most analysts seem to favour the latter explanation. Although inflation in Britain, currently at 2.5 per cent, may remain above the targeted 2 per cent for some time, there are few signs of excess in the British economy. Previous interest rate rises have calmed the housing market and economic growth is well balanced.
From the perspective of the Irish economy, the impact of the interest rate change on the sterling exchange rate is significant. Movements in the sterling/euro exchange rate have a large bearing on the Republic's international competitiveness.
A very weak sterling could undermine the competitiveness of companies that sell into the British market. Fortunately, the interest rate hike led to an improvement in an already strong sterling. On the day of the announcement, sterling jumped to a seven-month high of £0.6752 against the euro and a 15-month high against the dollar. The rate versus the euro would translate into approximately 86p to the old Irish pound. This is a rate which ensures the competitiveness of Irish industry vis-a-vis Britain.
The recent rise in sterling interest rates, even if it is not followed by further rises, protects the already favourable sterling yield premium versus the euro, and thus should act to support the sterling exchange rate. For Irish investors, the hike in British rates makes investing in sterling deposits relatively more attractive, with British interest rates at a premium of 1.75 per cent to euro deposits.
Over the past year this premium has narrowed as the European Central Bank raised euro interest rates. While the yield pick-up is attractive, the relative attractions of sterling deposits depend critically on the future direction of the sterling/euro exchange rate.
Similar considerations apply to Irish investors in the British equity market. In the long term, the total return prospects for the Irish and British equity markets are probably similar, but Irish investors in Britain securities must also take into account the currency risk. However, in Investor's view, British securities offer an attractive option for those Irish investors who wish to diversify their portfolios. The British economic cycle is different to the European one; the medium-term prospects for the sterling exchange rate are positive; and the British equity market offers a broad range of quoted companies that currently trade on relatively attractive valuations.
