the pound sterling chronicles - a ten year history by william b.z. vukson

THE POUND STERLINGCHRONICLES

G7BOOKS

The Pound Sterling Chronicles. Copyright 2001 by William B. Z. Vukson. All rights reserved. Printed in Canada. No part of this book may be used orreproduced in any manner whatsoever without written permission except in thecase of brief quotations embodied in critical articles and reviews.

Published by G7 Books First published in 2001

Books by Vukson, William B. Z., 1962-Canadian Dollar Chaos 2001Political Structure and Technological Change 2001The Pound Sterling . 2001The Regal Dollar 2001World Money Guide 2001

ISBN: 1-894611-21-7

G7 BooksToronto, Ontario, Canada

[email protected]

CCOONNTTEENNTTSSForeword . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .viiThe G•7 and Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1Sterling Circus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5Soros and the “Big Picture” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10City of London Interview - Andreas E.F. Utermann . . . . . . . . . . . . . .13For Monarchy & Single European Currency . . . . . . . . . . . . . . . . . . . . .16One Market One Money? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23First Quarter 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28Second Quarter 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .30Third Quarter 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .32Fourth Quarter 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35Year End 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .38First Quarter 1993 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .41Second Quarter 1993 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44Third Quarter 1993 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .46Fourth Quarter 1993 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .49First Quarter 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .52Second Quarter 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55Third Quarter 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .58Fourth Quarter 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .60December 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .64First Quarter 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .68Two Crises for the Conservatives: Europe & Northern Ireland . . . .71Second Quarter 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .72Third Quarter 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .76Fourth Quarter 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .81December 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85First Quarter 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .89Second Quarter 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .93

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Third Quarter 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .96Fourth Quarter 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .101December 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .107January 1997. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .111February 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .115First Quarter 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .120Second Quarter 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .122Third Quarter 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .124Fourth Quarter 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .126First Quarter 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .128Second Quarter 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .130Third Quarter 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .132Fourth Quarter 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .134First Quarter 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .136Second Quater 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .138Third Quarter 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .140Fourth Quarter 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .142December 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .144Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .147

The Pound Sterling Chronicles

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Foreword

The G•7 Report Project came about unexpectedly. After having spentmany years in academia, trade and merchant banking, I felt that a new commu-nications forum was needed that would bind together an inter-disciplinaryapproach to the new developments and challenges faced in this emerging newdecade, the 1990s. As things turned out, the past decade proved to be one of themost revolutionary periods in the twentieth century, with an unprecedented com-bination of global markets and technological invention. All of this called for afresh new start in media, research and documentary journalism that yearned fordirection from a unique type of leader; perhaps one that brou--ght to the table arare combination of both academic and theoretical grounding, combined withunequalled practical know-how. To be an effective leader or strategist in the1990s, it was not enough to just be a specialist within a narrow area of expert-ise, nor was it sufficient to rely on just many years of “experience” within a par-ticular sector of the economy.

In this respect, the academic approach to economics and world businesswas deprived of what John Kenneth Galbraith once termed as “practical goodsense” evident in great abundance throughout the revolutionary 1990s. Evenwithin the confines of the “new high tech economy” a great deal is lost in tryingto understand the longer term trends that are in play, let alone in predicting therise and progress of this new high tech world. Very few Economists in the earlyyears of this decade predicted what has transpired via the internet, nor has theprofession been too adept at charting the long term trends that have been emerg-ing in global stock markets, not to mention the currency markets. In fact, on thelatter point, most have dismissed trends in currency markets as belonging with-in the sphere of the random walk. Asked where the dollar-yen parity may betomorrow or one month from now, the quick reply would have been “the same aswhere the relationship has stood at the close of business today.” Asked where itwould stand one or two years from today, the answer would amazingly have beenthe same. Yes, the new orthodoxy in the 1990s was the random walk. Under thismethod of analysing currency markets, there was no way to predict the short termdaily or hourly parities between two currencies, nor was there any strategy topursue long term risk management of fluctuating currencies.

The name, “The G•7 Report,” was derived from an international mon-etary economics course that I attended and which was taught by ProfessorMichele Fratianni, an expert on exchange rates and interest rates and formerChief Economist of the European Commission in Brussels and a member of theCouncil of Economic Advisors in Ronald Reagan’s Administration, not to men-

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tion a good friend of mine. Of interest was how both fiscal and monetary policywas formulated within the industrial grouping of the most powerful economies inthe world, the interaction between them, and the effects a particular directionwould have on the emerging market group of countries that border these power-ful G•7 nations.

In simple English, if all of the members of the G•7 were expanding fis-cal spending or lowering interest rates in concert with one another, the disrup-tion as reflected via fluctuating exchange rates would be kept to a minimum. Thiswould be of particular benefit to all parties transacting international business,since strategy and planning within organisations find it most difficult to hedgethe effects of gyrating exchange rates. On many occasions, the serious financialpress is full of reports of disappointing earnings results due to financial hazardsthat have impacted subsidiaries in various parts of the world.

The initial attempts to co-ordinate official demand-creation activitieswithin the G•7 have been motivated to a large extent on purely trade grounds.Liberalised capital mobility and the burgeoning “herd-mentality” lead by somewell known hedge-funds is a phenomenon that arose in the early 1990s, throughGeorge Soros’glorious victory in ejecting the pound sterling out of the EuropeanExchange Rate Mechanism, which was the prelude to the present day single cur-rency- the Euro. However, in the mid 1980s, the hey-day of G•7 policy co-ordi-nation exercises, it was trade concerns which were at the forefront of the policydebates.

After Francois Mitterrand’s Socialist Party took power in 1981, politi-cians in France broke with their G•7 counter-parts in order to pursue a massivere-inflation which ultimately proved very short-lived. To break from the pack insuch a manner, the French franc nose-dived in global currency markets as infla-tion skyrocketed upwards. The Mitterrand government quickly learned that indi-vidualistic approaches to policy were dead ends, and that the short-lived expan-sion quickly made the exchange rate attractive to foreign buyers, but that theensuing price increases, or inflation, choked off the gains that buyers would havehad from the lower franc. In short, the “Mitterrand experiment” exacted greatinefficiencies on fellow member G•7 nations and had limited real impacts on thedomestic French economy. Mitterrand quickly retreated from this approach andagreed to become a team player thereafter.

Not only were such policy directions between the world’s most powerfuleconomies vital in understanding how business cycles interact between thesecountries, but a collective decision to increase spending or to lower interest ratesexacted a real impact on the global economy, and the emerging market countries

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Pound Sterling Chronicles

in particular. During the transformation of Russia and the former communistcountries of central and eastern Europe, many have argued in favour of a con-certed G•7 expansion in spending and their creation of a more global demandthat would in turn assist in the transformation to a market system. This criticismremains valid as trade and investment flows from the G•7 to the newly emergingmarket economies and vice-versa, has been disappointing, hence prolonging thetransformation process and creating more hardship than what would have beenotherwise necessary.

The G•7 Report project was not just about economics and business, butwas a new vehicle that introduced a number of journalists and commentatorsunfamiliar to the readers of the daily news in major North American cities. Weretained some leading contributors over the years, such as Harvard ProfessorBenjamin Friedman, Belgian Senator and leading international trade EconomistPaul DeGrauwe and compliance and regulatory expert Dr John Pattison, butalso introduced numerous writers that would normally not have had the oppor-tunity in the commercialised or market-driven media to express their views andcommunicate with our readers. We became known as a media that was madeavailable to some leading European based journalists such as Italian basedorganised crime expert, Antonio Nicaso, and to his counterpart in Canada, Mr.Lee Lamothe, the former head of the crime section of the Toronto Sun daily news-paper.

The G•7 Report project attained a small “niche” circulation in majorNorth American cities such as New York, Boston, Miami, San Francisco, LosAngeles, Toronto and Montreal, but was never able to develop a following inplaces such as Vancouver or Atlanta. Moreover, throughout 1995 and 1996 wewere also available over the retail newstrade in the City of London at selectivenewsagents. Furthermore, The G•7 Report project was not something that wasdeveloped by marketers residing in New York, Toronto or Los Angeles. In fact, Iwould be the first to stick my neck out and say that this was among very fewrecent launches which went the other way around. I did not “measure” or “test”the market with this concept before launching the product. In essence, The G•7Report made and shaped its own following and market over the years. It was aleader which was embraced by a very loyal grouping of reader, that felt that wehad important things to say about global trends and the rising “new economy.”

The G•7 Report project was particularly foreign to advertisers, espe-cially among the agencies in Toronto. We counted very limited success in solic-iting advertising support, and agency calls and presentations tended to borderon the absurd. In short, The G•7 Report was simply not a concept that was wel-comed within this realm. Most of the major corporate supporters were much

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Foreword

appreciated, yet very rare. Among this select group, we are very grateful to FordMotor Company, the Montreal Stock Exchange, NatWest Markets and KapitalTrade as our core group of advertisers. The problem that any “niche” publishermust go through is retaining a core group of supporters over the long term. If thiscan not be maintained, then the publication either dies or gets transformed overthe years. We greatly relied on the latter technique to ensure our survival.However, it was interesting to note that we did not deviate much from our coregroup of readers, regardless of the format of The G•7 Report. Since 1992, wewent from an academic-looking journal to an expensive full-glossy magazine, toa newsprint version and ending with the current newsletter look. We found thatthe constant throughout this entire process of transformation in design were ourcore readers over the years, and for this we thank them for their ongoing andunbending support.

William B.Z. Vukson


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The G•7 and Exchange Rates

The G•7 members including the U.S., Canada, Germany, France,Italy, Japan and the U.K., with the latter inclusion of Russia, have alwaysbeen a fiscal and monetary policy information forum. Only for a very briefperiod of time since its creation, did the G•7 actually co-operate to co-ordinatethe direction of economic activity. Central to the whole concept of policy co-ordination is controlling wildly fluctuating exchange rates among the world’smajor industrialised countries. Adverse exchange rate movements distortinternational investments, as well as strategic planning initiatives, whilecreating uncertainty and project delays. Based on the premise that it is goodto control the fluctuation of exchange rates, a good beginning would be toco-ordinate fiscal and monetary expansions among a grouping of countries.If the G•7 moved in tandem to expand money supply by ten percent, meaningthat money supplies in dollars, euros, yen and pounds sterling went up byten percent, inflationary expectations would be the same in all of the G•7countries and there would be no real effect on exchange rates. However, ifthe G•7 decided to expand money supply by ten percent, with the exceptionof Japan; preferring to hold its growth to zero, then the yen could appreciateby ten percent relative to the dollar, pound sterling and the euro. This latterunco-ordinated approach would cause havoc in global currency markets,hence distorting investment and trade. In short, it should be avoided.

The historical development of the G•7, must be traced back towardsthe development of the Bretton Woods System of pegged exchange rates afterthe second world war, and was influenced by one of the most well knowneconomists in modern times, John Maynard Keynes. Where Bretton Woodsended off in 1972, during the peak of the Vietnam crisis, the EuropeanMonetary System tried to take over the function of coordinating monetarypolicies. Both the Bretton Woods system and the European Monetary Systemare fundamentally different from the G•7. Whereas the former two are formalagreements to coordinate monetary policies and inflation rates by fixingexchange rates, no such formal agreement exists within the G•7. In that respect,the G•7 is a forum that idealises the concept of coordinating policies in threedifferent trading blocs throughout the world. However, there is no enforcementmechanism that forces its members to pursue monetary policies based onsome form of pre-arranged fluctuation band for the group of currencies, andthere is no assurance of success, given that no member is obliged to follow thefinal communique’s that are issued at the yearly summits and through themore informal gatherings of Finance Ministers throughout the year.

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In Europe, monetary policy coordination has a long history thatpredates the famous Schmidt-Giscard d’Estaing agreement to formallyestablish fluctuation bands in 1978. It was as early as 1959, that the EuropeanParliament proposed the formation of an institution patterned after the U.S.Federal Reserve system for the purpose of coordinating monetary policiesin Europe. The European Monetary Agreement of 1958 strengthened theprovisions of the Bretton Woods system, which was already in place andfunctioning. However, the Monetary Agreement of 1958, proposed that thebilateral margins of fluctuation among the EC currencies be limited to threepercent.

At the same time that the European Community decided to “harden”its commitment to monetary coordination practices alongside its commitmentto the Bretton Woods system of pegged exchange rates, the Bretton-Woodssystem was under severe strains. The gold standard under which its centralcurrency, the dollar was based on, began to slowly unravel in the 1960s atthe height of the Vietnam war and the spending commitments made for thearms race, together with the strains of Lyndon Johnson’s Great Societyprograms, proved to be too much for the system to bear. By 1968, goldconvertibility at $35 per ounce had virtually ceased, when President RichardM. Nixon moved to formally end it on August 15, 1971.

In 1969, the French franc was devalued and Germany allowed themark to appreciate, while a wholesale unravelling began the process thatwould see the eventual demise of the Bretton Woods system. In 1973, theUnited States itself, the anchor currency in the Bretton Woods system,announced a ten percent devaluation of the dollar, hence formally ending theinternational experiment of currency management which held together sincethe second world war.

The demise of monetary co-ordination in the 1960s, culminatingwith the French devaluation and the German revaluation, put enormousstrains on the European Community, which considered monetarycoordination a vital element in furthering the twin goals of political andeconomic union. After the crisis with the franc, mark and dollar began toappear, German Chancellor Willy Brandt, put forward an idea for monetaryunion at the summit of the European Council in the Hague in 1969. This leadto several attempts to coordinate exchange rate fluctuations, resulting in the“snake” agreement in 1972. However, this was short lived, as the O.P.E.C. oilembargo and the general inflationary environment during the 1970s, causedsevere fluctuations in exchange rates, chaotic policy initiatives and desperatepolitical manoeuvring in Europe, to cope with the rising energy costs.


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In 1978, German Chancellor Helmut Schmidt and French PresidentValéry Giscard d’Estaing, created a new initiative that would establish theenduring European Monetary System and a formal Exchange Rate Mechanism(ERM), which would govern fluctuations among European membercurrencies tied to fluctuation bands of 2.25 percent on either side of thecentral parity for some countries, and six percent trading bands for othercountries that were not considered to have a good inflation record. This wasthe final solution that eventually yielded a single currency and one EuropeanCentral Bank.

The G•7 has at its core this incredible accomplishment among itsEuropean members, that moved a loose framework for policy coordination,into outright monetary union. Certainly, the G•7 never moved to replicatewhat had existed in the Bretton Woods framework of pegged exchange ratesprior to 1969. For whatever reason, the G•7’s agenda was a far more informalmandate to loosely exchange information and to act only when periodicfinancial crises arise in the global financial system. In essence, the G•7 hasadmitted that what has worked among its European members, can notnecessarily be extended to include countries located among three diversetrading blocs around the world.

The glory period for the G•7 culminated in the Plaza Accords,negotiated in New York in 1985, and formalised two years later in the Louvresummit in France in 1987. The growing trade deficit in the U.S. automotiveaccounts with Japan, required a revaluation of the yen and Deutsche markand the devaluation of the U.S. dollar, which lead to a new trade equilibriumin this turbulent period. Never again has such a high level of cooperationbeen noticeable, as the new era of globalisation presented an interesting newset of challenges. With deflationary conditions prevalent in the early 1990s,the “Anglo-saxon” grouping of countries that included the U.S., Canada andthe U.K. were experiencing a sharp adjustment and a severe downturn, whilethe continental European members were experiencing a boom from Germanreunification. Under such a period of “structural” change, it was difficult forthese two groupings of G•7 countries to be on the same point in theirrespective business cycles, hence unwilling to pursue any coherent form ofpolicy coordination that made any sense.

For example, if the “Anglo-saxon” group of countries had arguedfor an expansion in the money supply or in fiscal spending, it would be, andwas countered with a negative response from the inflation-conscious GermanBundesbank. The fact that globalisation brought naturally diverging responsesin the 1990s, made the whole mandate of the G•7 somewhat redundant.

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The G•7 and Exchange Rates

How could policy be effectively coordinated in light of each country beingat opposite ends with respect to its business cycle? Moreover, there did notseem to be any room for any compromise or middle ground either, whichwas probably the most disappointing part of the failure to take an active rolein policy coordination among the members of the G•7 during this period.

The 1990s have become a decade of open capital flows, budgetarysurpluses and less active monetary policies. The role of the G•7 is now moreimportant than it was ever before, during the closed economic era of theCold War. Speculative pressures are now far more prevalent than at any timeafter the second world war, and many respected world leaders have called forsome form of control in global currency markets. Many have even called fora reinstatement of the old Bretton Woods system, that would be much morefar-reaching than the European Union was in establishing the Euro. Thedifficulty with any such moves, however, has to do with the divergence ofinterests of members in terms of where they are in their respective businesscycles. As in the early 1990s, Germany wanted to see a decrease in spending,while most other recession-plagued countries called for an expansion. Thiskind of coordination is redundant in the world of growing global capitalflows, which would create severe speculative pressures on currencies if suchan imbalance were allowed to proceed at the policy end.

The hope that remains in coordinating business cycles, is theexpansion of the information economy, even in countries on continentalEurope which have realised that the rigid labour structures that have cometo define this region, will inevitably need to disappear over time. These arethe kinds of “structural” impediments which make co-ordination of policiesvery difficult, but which have the potential to lay a framework for a successfulG•7 agenda over the next five to ten years.


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Sterling Circus

For a very long period of time, the pound sterling was supported bya unique combination of production in the Midlands and North Yorkshire,and the financial powerhouse offering of the City of London. In the 1970s,Britain was an industrial powerhouse that was gridlocked by a powerfullabour union. In many cases, union demands on industry in the 1970s werevery much anti-technological change and advancement in orientation. Thelong time Assistant Editor of the Financial Times of London newspaper, SirSamuel Brittan, recounted to us in detail the days of publishing under the siegeof powerful labour. In the case of the printing press, British unions still insistedin performing tasks a second time, despite the fact that these activities werealready being absorbed by automation. For example, the process of bundlingor bagging a newspaper or magazine, when it came off the printing pressand into its final product stage, was often repeated over again by a workerstanding at the end of the printing press. The printers union in this case,resisted any modifications in its age-old production practices, but whichwere becoming a real detriment to the advancement of the U.K. out of its oldindustrial age.

The ascent of Margaret Thatcher’s Conservatives in 1978, was almostmanufactured in order to change the balance of power back in the favour ofcapital, and away and out of the control of the increasingly powerful labourunions of the 1970s. In this period, the U.K. economy went through oscillatingboom-bust cycles that were very much prone to inflation. Consequently,sterling fluctuated wildly on global currency markets, reflecting the opennature of this island economy, as well as the price competitiveness of itsexports. Margaret Thatcher’s government came to define the 1980s, as the fiscalposition of the government came closer to balance over time, and themomentum gained on the continent via a system of pegged exchange rates,began to gather political momentum in the U.K as well. Very soon, opendiscussion was engaged by commentators, journalists and opinion formulatorsin the U.K. on the likely benefits of the U.K. joining this currency peg, andultimately one day participating in the crowning achievement; a singlecurrency itself in the whole of Europe.

Within the Thatcher Cabinet, there were several high profile Ministersthat were pro-European, and more importantly, pro-single currency. Theirarguments were justifiably based on the need to even out the constant boom-bust nature of the U.K. economy. These Ministers were Nigel Lawson at theTreasury, and Sir Leon Brittan, who was the Home Secretary at that time, and

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who after his tenure in the government, went on to play a very prominentrole as a high ranking trade official at the European Commission in Brussels.When the single currency lobby spread to the U.K. in the early to middle1980s, the Thatcher government became the focal point of the pro-singlecurrency lobbying efforts. Influential Ministers such as Lawson and Brittan,tried to convince the Prime-Minister and many who were considered to bemarginally sceptical about the entire project, to join the European ExchangeRate Mechanism. The argument for doing so, was that the Bank of Englandand the Treasury would buy credibility from the Deutsche Bundesbank inconducting monetary policy, and would thus be able to count on externalfactors in reducing inflationary spirals, and at the same time curtail union powerin negotiating wage increases. A fixing of the sterling exchange rate wouldeffectively reduce the options on what the non-independent Bank of Englandcould do in terms of its monetary policy choices and inflation rate.

As mentioned, sterling throughout the 1970s and the 1980s followeda boom-bust cycle. When inflation was driven higher by a combination ofprice pressures and union negotiating power, the Treasury, which controlleda non-independent Bank of England, moved to raise rates and puncture theinflationary bubble. Likewise, when property prices went up during boomtimes, mortgage rates were raised, sending them spiralling downwards. Manyadvocates of the single currency during these years, felt that a peg was theonly way in which the Bank of England could achieve an independent policystance, after so many years under the control of the Treasury and politicalinfluence. The fastest and most sound way in doing so, would be to buy theexisting credibility from the highly successful Deutsche Bundesbank; probablythe best managed central bank in the history of the European region. Onlythen, would policy be taken out of the hands of the inept local politicians,and the boom-bust cycle would come to an end.

Treasury Minister Nigel Lawson tried to convince a sceptical PrimeMinister Margaret Thatcher that participation in the Exchange RateMechanism was a good thing for just this fact. A sterling peg would ensurethat labour negotiating power would be kept in check, and that incompetentpoliticians at the Treasury, would not be able to re-inflate out of tight situationsthat required hard choices for the country. This was exactly the kind ofprescription for the U.K. that Margaret Thatcher liked to hear, thereby allowingthe Treasury Minister to manage sterling in such a way so that it was allowedto float at a parity of three Deutsche Marks since 1987. Ultimately, GreatBritain joined the European Exchange Rate Mechanism in October, 1990,under the aggressive promotion of the new Prime Minister, John Major.Sterling entered the Exchange Rate Mechanism with a six percent fluctuation


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limit on each side of the central rate, meaning that it was allowed to fluctuateby twelve percent, without being devalued or revalued in some way. It wasthought that since Sterling was highly successful in the late 1980s in trackingthe Deutsche mark and the Exchange Rate Mechanism, this success wouldcontinue in the 1990s after the peg of six percent was formally announced.

In a way, London was a victim of its own success in the late 1980s.The development of commercial property projects ranked right up withactivity in U.S. cities during the massive boom. Expanding ambitious newprojects such as Canary Wharf in the Docklands district, was a symbol of theaspirations that London held as an expanding global financial centre. Already,it had a large share of international financial transactions, as well as theEurobond markets. Moreover, it was poised to become a leading player infinancing the newly-emerging countries of central and eastern Europe.

However, the success of London in attracting global financialinvestment in the important commercial property sector came under attack,as the new decade began, and both deflation and disinflation were in the airafter the opening of markets that were closed during the Cold War. The GulfWar in 1991, added to the general uncertainties, and soon investment driedup when the Canary Wharf project filed for bankruptcy, and became a symbolof the excesses during this period. The “bust” in the commercial property sectorhit London hard, and was enough to dislodge sterling from its newly-obtainedExchange Rate Mechanism membership.

The G•7 Report, published on July 22, 1992, sent out the followingwarning to subscribers: “... as soon as markets become uncertain as to thepolitical resolve of maintaining the parity, as is the present case with theU.K., faced with a deteriorating economy. Then Sterling will and has comeunder speculative attack. Ever since the election majority was gained by theConservatives, the aspirations were such that the newly won political stabilitysupplemented with a pro-business environment, would immediately provideeconomic benefits through this election “dividend.” This has proved false, asSterling has fallen from the immediate post-election high of 2.95 to theDeutsche Mark down to the bottom of the E.R.M. grid to 2.85 to the mark.In light of the continuous deterioration in the economy, the positive sentimenthas been broken and the commitment to a fixed parity increasinglyquestioned.”

Enter George Soros, and the announcement by Finance MinisterNorman Lamont, that sterling is suspended from the European ExchangeRate Mechanism with immediate effect, on September 17, 1992, and the

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The Sterling Circus

planned base rate increase to fifteen percent in its defense is irrevocablycancelled. One week before this crisis, The G•7 Report published the followingadvisory: “The worsening economic conditions in the U.K. are a testimonyto the real pressures that can build-up when a government pre-commits toan overvalued fixing of the exchange rate level. As inflation falls further, realrates rise having serious repercussions on real economic activity andemployment. ... The situation has so deteriorated that one industry leaderafter another has urged intervention by the government. The latest being SirJohn Quinton- Chairman of Barclays Bank who did not see any end to thedownturn until well into 1994. ... The great pressure of the real economicdownturn in the U.K. has affected their credibility to commit themselves tothe E.R.M. Consequently, the opportunity cost of investment in Sterlingdenominated financial instruments increased over the past month. This canbe seen as yields on 10 year gilts rose from one percent to 1.3 percent vis-à-vis German bunds, leaving a perception that devaluation of Sterling is morelikely.”

The daily currency volume in London doubled from April of 1989,from $187 billion to more than $303 billion by April of 1992. With such anincrease, the Treasury was virtually defenseless in trying to fend off currencyspeculators and George Soros. The casualty in the entire affair was TreasuryMinister Norman Lamont, as the humiliated government of John Major wasforced to reduce base rates to eight percent on October 16, 1992, followedby yet another drop to seven percent, after the tabling of the mini-budget onNovember 12. Base rates were now at their lowest point since 1978, and theU.K. has completely washed its hands from its experiment with a peggedsterling to the Deutsche mark.

After the abandonment of the fixed peg to the Deutsche mark,sterling was left to float, while the Bank of England adopted a system ofinflation targeting. The Bank of England was now formally independentfrom the Treasury, and it chose to target an inflation rate between one andfour percent per annum, as measured by the retail price index, excludingmortgage payments. As The G•7 Report reported on December 9, 1992:“The government has, however, announced that it would like to formulateits interest rate decisions around a basket of financial indicators such asmoney supply figures, asset prices and the exchange rate. ... the inflation ratewill be targeted between one and four percent...”

With London being the most vital global financial centre, and withglobalisation creating record capital flows, a fixed exchange rate is anextremely difficult prospect during periods of erratic volumes. This occurred


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in the early 1990s, and the timing for joining a pegged system of exchangerates could not have been worse. As foreign direct investment and crossborder mergers and acquisitions accelerated in the latter half of the decade,the U.K’s historical record of being a jurisdiction where capital could comeand leave as it wished, created intense direct investment interest from U.S.and Japanese firms. They also were convinced that the early Exchange RateMechanism experiment with Sterling would ultimately lead to participationin the single currency, hence removing all export concerns and uncertaintiesfrom their currency risk models.

As it happened, the prelude to the launch of the single Europeancurrency in January of 1999, drove sterling back up to a level of three Deutschemarks, based on “fright capital” from the continent taking refuge in London.As it happens, those investors who were sceptical at the start have been rightin the short term. The new Euro has underperformed all expectations, andthose that moved assets into sterling have had a net currency gain in excessof thirty percent. Moreover, the higher rate of return on sterling assets aswell as the emergence of direct investment and cross border mergers andacquisitions, have also tendered a net gain to sterling holders. London is alsobecoming the true focal point in the Euro zone, as it moves to consolidateits leading position by merging its capital market operations with institutionsbased in Frankfurt, or even Stockholm? The traditional advantages of Londonin the capital and Euro markets, has combined with its unchallengedadvantage when it comes to the quality of life and interest that the city hasto offer; a very difficult combination for an emerging financial centre suchas Frankfurt to beat on its own.

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The Sterling Circus

Soros and the “Big Picture”

On the rare occasion, the “boring” financial industry tends to producecelebrities of its own. During the 1970s, it was Felix Rohatyn, the former Partnerof Wall Street investment bank, Lazard Brothers, that was credited in savingNew York City from inevitable bankruptcy. The 1980s was synonymous withthe notorious Wall Street corporate raiders, Michael Milken and Ivan Boesky,while the collapse of the pound sterling in 1992, netted hedge fund operatorGeorge Soros a massive fortune. To this day, the patriotic English still grumbleat the mention of Soros’ name. What George Soros has accomplished bybreaking the fixing of Sterling in the Exchange Rate Mechanism, was to signalto the world that the new era of free capital mobility, coupled with the ease incommunication, has the ability to cripple governments and eminent institutionsin a matter of minutes, or even seconds.

The growing global capital pool and the speed in which it can beinvested in various countries, and then re-patriated, has produced a systemthat can be lethal to those that are elected to formulate policy. Any governmentthat desires a higher standard of living, cannot escape foreign portfolioinvestment any longer. Not only are foreign investors calling the shots, but also,investors that are based locally now have the option to send their money abroad,even though their countries are officially closed, or have some vestigesremaining that control foreign exchange. What this means to policy makers,is that a new level of efficiency has been placed on their shoulders. With thishighly efficient system that sends money spinning around the world, comesthe obligations to restructure the local banking system and stock market sothat transparency is never in doubt. The catch-phrase in the 1990s, has beenthat if investors perceive a country to be open and transparent, such that moneycan flow in and out at the click of a mouse, then the country in question willbe the ultimate beneficiary over the longer term. Just look at Hong Kong, theU.K. and the U.S.

George Soros made a fortune in hedging situations that wereinconsistent with the general trend towards open and efficient markets. Anytimewhen evidence existed of a fundamental overshoot in one market, he wouldleverage his bet that it would eventually come back to its fundamental values.For instance, the pound sterling initially joined the E.R.M. at an overly inflatedprice, in relation to the Deutsche mark and the general basket of Europeancurrencies. The hard landing in the U.K. in the early part of the 1990s, was nodifferent from that in most of the Anglo-saxon countries, including the U.S.The collapse of the commercial real-estate market in the U.K., symbolised bythe problems at Canary Wharf, wiped out most private developers in London.

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It sent the local, intensely real estate-oriented economy into a deep recession,meanwhile, rates were based on the over-inflated conditions in Germany shortlyafter re-unification. George Soros made a common-sense bet that sterling couldnot continue at such an inflated level, with inflated interest rates serving tokeep it artificially propped-up in the E.R.M. With the help of the Londonmarket’s liquidity, he was able to effectively sell it short, by selling the sterlingthat he did not hold in the hopes of buying it back at a later date at a far cheaperprice. This scenario materialised, sterling was dropped from the E.R.M., andthe former Minister of the Exchequer, Norman Lamont, was made the scape-goat in British politics and had to tender a reluctant resignation to the PrimeMinister at the time, John Major. Soros’ bet paid off handsomely; created ahistorical event in the process and elevated him to celebrity status, which heuses to great effect even today.

It is interesting to note, however, that this same George Soros, hasgone on record in communicating to his investors that returns of the type madeduring the sterling debacle, are much harder to make as globalisation advancesfurther. In essence, Soros is a “fundamental” investor, or one that arbitragessituations that are not rational or consistent with free market ideology. In thecase of sterling, it was not consistent with its natural free market level, sincethe E.R.M. propped it up artificially, creating great misery and financial distressin the British economy in the early part of the decade.

As the 1990s progressed, and the internet added even moretransparency to financial markets, it overshot its point where financial valuationswere true reflections of real economic activity. In other words, does the stockmarket make sense where it currently rests? What can we make of the wildvaluations in the price/earnings ratios of newly formed internet companies?Does Soros have it right, when he says that he can no longer expect to makereturns in excess of thirty percent for his funds, when the current gyrations inthe markets are very difficult to value on a sensible or fundamental basis? Capitalmarkets and the global flows of money have become overly transparent inmany ways. In fact, the culture of investment has spread so rapidly, that tradersare no longer buying and selling based on fundamental values, but are doingso based on the movement of the stock or currency in itself. In this respect,the movement of financial assets has become a “casino.” Soros knows andunderstands this, as does U.S. investor Warren Buffet, who openly admits hisshortcomings in understanding the new high tech economy.

The click of the mouse has made it possible to shuffle the deckglobally. There are no more barriers in buying stocks anywhere in the world,and as stock markets form “electronic” alliances, the prospect of twenty-four

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Soros and the “Big Picture”

hour trading is at hand. Under such a system, the creation of a huge electronicherd of investors will wreak havoc on governments everywhere, which aredeemed as being untrustworthy or not open to the concept of quick entryand exit of capital. The challenges that will come about under such a fast-paced system of investing, will ensure that more and more regions of theworld that were perceived as once being “closed,” will be connected andmaking a pitch to powerful pension fund managers in hoping to attract theirshare of this growing pool of global money.

George Soros is right in that fundamentals don’t mean too muchany more when it comes to the valuation of currencies or stocks. What is mostimportant now, in order to arbitrage gains in the markets, is the investors’ ormoney managers’ nerve in timing the trend in this new casino economy.The fund managers job has become harder as the decade has progressed. Somuch so that venture capital investing in risky biotechnology ventures hasnow become commonplace, and will only continue to expand as more andmore money will be added to this internationally mobile pool of capital. Inessence, it seems that the time to have benefited from playing thefundamentals game passed when George Soros hammered sterling out ofthe E.R.M. Shortly thereafter, opportunities for hedge funds to score bigbecame less and less apparent as the 1990s progressed. The time to havegotten in and played the “fundamentalist” game in investing seems to havebeen long gone, as more emerging market countries adopt a commonmanagerial standard and move ever more closer to the standard oftransparency evident among the G•7.


12

City of London Interview

Interview with: Andreas E.F. Utermann, European Investment Fund Manager,

Merrill Lynch Asset Management

Directed by: William B.Z. Vukson

From the spectacular collapse of Barings merchant bank tocontinuing challenges posed by Frankfurt and Paris as European capitals ofbanking and finance. London continues to confront the unexpected undera climate of domestic political instability

Has there been any notable financial developments in the City ofLondon over the past while?

The main concerns about the City’s competitive position in Europe asa financial centre, have had to do with terrorist bombings in the early 1990s.However, with recent negotiations over re-unifying Ireland, these have beenreduced. Additional security measures have also helped to allay fears. Moreover,concerns over financial institutions withdrawing from London to re-locate onthe continent have not materialised. Fears over the European Monetary Institute(EMI) usurping London’s financial pre-dominance, by locating in Frankfurt,has not turned out to be a convincing argument. By example, a precedentexists in the US, where the Federal Reserve bank headquarters in WashingtonD.C. has not in any way eroded the hegemony that New York has always had,and will continue to have as the pre-eminent financial centre in the US.

What kind of policy mix would you like to see coming from the presentUK government?

Broadly speaking, the present mix is appropriate concerning theinflation target. However, greater attention should be focused on the externalvalue of sterling, especially in relation to European currencies. A greater pushfor more independence for the Bank of England must develop. Greaterindependence would ultimately produce lower interest rates and lower nominalbond yields. It should also reduce the current risk premium existing on variousUK based financial assets.

When can you foresee an independent Bank of England?

It is not on the agenda of the current government of John Major.

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Having said that could the UK be a participant in a single European currency?

A single currency cannot include the UK under the current statutesof the Bank of England. Also, under the Maastricht Treaty for monetaryunion, currencies must be stable for a two year period before joining a singlecurrency.

In its current form, is the Maastricht Treaty good or bad?

I believe that the Maastricht Treaty is a bad one, because it allows fortoo many compromises. However, under the circumstances, it is the best wecould probably have hoped for. Without initiatives such as Maastricht, theEU is prone to back-pedaling and a re-installation of all types of barriers totrade in the EU, could conceivably re-surface.

Is the Exchange Rate Mechanism (ERM) approach to a singlecurrency good or bad?

I would state it a little differently. I don’t think the ERM was ever anapproach to a single currency, but was created to remove instability inEuropean currencies. At the end of the 1980s, it was widely recognised thatthe ERM itself would not be sufficient to guarantee the long-term stabilityof exchange rates in Europe, leading to sufficient convergence in each of itsmember economies, hence making the single market a success. This is whythe European Union membership decided to take the entire process somewhatfurther and create a plan for a single currency. The ERM itself was neverintended to be the primary and only means for the EU to introduce a singlecurrency anyway.

How can we introduce a single currency if exchange rates are notsufficiently locked in together?

It is more important to have a general trend moving towards macro-economic convergence in each EU country. For example, this condition hasexisted for many years in countries like Germany, Austria, the Benelux andpossibly France and Denmark. Within this group, monetary and fiscal policiesare tightly linked, and deficits are being reduced continually. If we ever seea single currency emerge, it will be by a quick move in this core group ofcountries sometime between 1997 and 1999.If the UK does not participate in a single currency, what may happen?

If sterling is left out of monetary union, there could be a permanentupward shift in rates across the entire yield curve.


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Were you surprised to hear of Barings misfortune?

Yes, it was very surprising and tragic at the same time. What itillustrates is that the increasing size of deals on international capital marketsand the complexity of derivatives, should heighten everyone’s attention tothe increasing risks, and all of us in the City must work extra hard to containthese risks in the future.

What fall-out occurred in the London markets over the Barings affair?

The only fall-out was in the far-eastern markets, where large openfutures positions needed to be squared. The longer term affects are extremelydifficult to judge.

Has the Barings affair weakened sterling?

Although difficult to judge, the psychological fall-out from theepisode certainly could not have helped.

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City of London Interview

For Monarchy & SingleEuropean Currency

British Political Traditions Will Endure Under a New Economic Order

Interview with: Sir Samuel Brittan,Assistant EditorFinancial Times of London

Directed by: Tihomir Mikulic and William B.Z. Vukson

Margaret Thatcher

Reflecting back to the reign of Margaret Thatcher as Prime-Minister,how has the UK mostly benefitted by her methods of governing?

It may be easier to qualitatively appreciate the benefits from this periodthan what the statistics represent to be the case. Prior to Margaret Thatcher, wewere really in the grip of trade union Barons. This meant that we had a lot ofunemployment although most of the unemployed showed up for work. Manyrestrictive practices were implemented by labour unions and managementwas afraid to manage. Worst of all, we had a tiny union (the National Unionof Mineworkers) in a tiny industry, led by an agitator (Arthur Scargill) thatbrought down two successive Conservative governments. That was aboutenough. It also looked as though he would bring down the Thatcher governmentearly on in its tenure, however, hers was the first to stand its ground and rallythe police force to enable miners that wanted to work to safely go to work, andensure that coal was delivered. In retrospect, the action was regarded by allstatesmanlike people as provocative, but in fact had worked quite well.

Something similar had also happened in my own industry withseveral newspaper proprietors exhibiting the courage to face down verystrong print unions. Newspaper print unions at that time were used toobstructing any modern developments in the production process. In particular,they became very well known for something called Spanish practices. Thismeant that unions would insist on being paid for wrapping newspapers whichwere already wrapped by machinery. It also meant that there were constant

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stoppages where one never knew whether next morning’s newspaper wouldat all appear. All of these practices came to an end under the Thatchergovernment.

Contrary to the common view, public spending was not cut verymuch and the tax burden actually rose, since the public sector deficit was keptdown. There was also a small reduction in the dependency culture. It becameless easy to draw benefit while not attempting to obtain work. I think thatall of these were quite great achievements.

In retrospect, how damaging was the speculative bubble that was builtup under Thatcher during the latter part of the 1980s?

It looked very damaging just afterwards in the early 1990s, butcompare the outcome with what has materialised in Japan. One can say thatthe effect was a minnow in the UK.

Did Margaret Thatcher harm the Monarchy?

There was no more of a supporter of the Monarchy than MargaretThatcher. The truth of the matter is that she is not a radical in any true sense,although her actions are often construed as being so. She never liked to hearanyone ridiculing the Royal family. It was more a coincidence that we hadboth a queen and the first woman Prime-Minister. There was a feeling aroundmainly fueled by the media, that the queen did not approve of all of MargaretThatchers attitudes.

The Monarchy has always traditionally stood to unify the country.It tends to stick up for people very different from themselves, who theybelieve may have in some way been left out of the ruling establishment. Forinstance, they had great sympathy for the miners which was very romanticand out of date, but nonetheless very much there at the time.

A Lasting Monarchy

Is Elizabeth II the last ruling monarch in the UK?

My first reaction to that is that there is no such luck. I cannot standthe hypocrisy that circles the Royal family, often disguised as criticism. Theobsession with one family, as if they either were or ought to be miraculousif only they can behave better, is offensive to me as a rational being.

Equally, I can see the disadvantages of having an elected President.For instance, you could never have a situation of having an elected mayor ofa city not being acceptable to a particular President, because in the UK, the

For Monarchy & the Single Currency

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queen does not take part in politics. She is very much advised by her privateSecretary of what the constitutional precedents are. Basically, her guidingprinciple is not to get involved in politics. Very few Presidents can behave thisway, and you can not really expect them to, because even the most respectedPresidents have usually got a career in party politics behind them.

In your view, what is the prime reason for preserving the institution ofthe Monarchy?

There is an advantage in having someone that is above politics andis a point of continuity between governments. There are duties for a Presidentto perform. In Italy, for example, a President is sometimes not regarded as beingentirely above the battle.

What is the big disadvantage of the Royal family to the UK?

It certainly is not a disadvantage to the economy, as it draws insubstantial tourist dollars. However, the disadvantage of it is that it tends todivert attention from the more difficult and perhaps less glamorous issues inthe UK. It is much easier to discuss the affairs of Diana and Charles, than todiscuss the discount rate policy of the Bank of England.

Bankers to the Queen

What has been the link between the Monarchy and the collapse ofBarings bank? Has not the queen been forced to open up castles andvarious monuments to tourists after Barings occurred?

The Monarchy was not much affected by the collapse of Barings,since most of the assets of the Royal family are in shares, trusts or land. Theyreally only keep petty cash in the bank. In any case, the assumption of Baringsby Dutch based ING bank, has preserved all of Barings former deposits.There is no reason to believe that the Royal family had a major proportionof its assets managed by Barings at all.

I may be wrong, but I cannot think of any additional Royal residencesthat were opened to the public as a result of the Barings crisis. The openingof Buckingham Palace to tourists began well before the Barings crisis.

I do not understand how Nick Leeson was able to acquire suchuncontested powers to destroy a bank?

The analogy would be one where you had an individual notacademically talented, but one that had great ability in making money,nonetheless. It would be most tempting to give him a great deal of


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independence. Before the crash, they were reporting profits from this oneindividual in Singapore that were greater than in all other activities in whichBarings was engaged in. In the end, he was not doing anything thatcomplicated; he was simply betting on the Tokyo Stock Exchange.

The Bank of England

In a period of independent central banking, why has the UK notfollowed suit with the overall European trend?

Mainly because of the confrontation between the two main politicalparties. According to the mythology, the government is responsible foreverything that happens. John Major is terrified that somebody will criticisehim over the direction of interest rates and he will have no choice but torespond: “I can’t do anything about it.” I favour central bank independencemyself, but its probably easier for a country with a written constitution afterWorld War II like Germany, to write out formally.

Has the lack of central bank independence affected the value ofsterling on the foreign exchange markets?

It’s difficult to relate the value to events that have not taken place.However, having said that, if an announcement were made that the Bank ofEngland were to be independent, or not subject to a directive of the Chancellorover monetary policy, I think that bonds and sterling would go up and wouldgo up even more if the Labour party were to proclaim full support for sucha move and refrain from any policy reversals.

Contemporary Issues of Concern

How do you view George Soros speculative power that was attributedto plunging sterling out of the European Exchange Rate Mechanism(ERM) in 1992?

It was not at all Soros on his own. He saw the way the wind wasblowing and made some very wise investments accordingly. He did not,however, cause the wind to blow. In retrospect, when the UK joined, it hadno idea that the German interest rate would stay so high for so long. At thetime, there was some support in the UK treasury for a general re-alignmentin the ERM, which also would have involved France, which was not preparedto have a depreciation against the mark, since they were already focusingtheir sights on monetary union.

For Monarchy & Single European Currency

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How do you respond to the constant criticism that the UK has hardlya manufacturing base left?

I do not lose any sleep over it at all. In the 18th century there werea group of economists known as the Physiocrats that thought that agriculturewas the most important activity. The ones that talk about manufacturingcurrently, belong in a similar category. Manufacturing is just one sector in theeconomy and activity has been moving away from manufacturing in manyadvanced economies quite recently. The whole process seems pretty naturalto me.

Is it not the UKs unofficial policy to de-face what is left of itsindustrial base?

It is not a policy, but can be more accurately described as allowingthe natural course to run and just letting things happen. The US has a farsmaller proportion of its population in manufacturing than does the UK. Ifwe look at a trend of Gross National Product (GNP) per head in a givencountry, what we will find is that the higher the GNP per head; the smalleris the proportion of the economy in manufacturing. The UK is exactly on thistrend, but Germany is very much off of trend, which may make it a bitvulnerable as change takes place.

Policy Suggestions

What in particular excites you about the UK economy at thismoment?

If you asked me what could excite me? I would respond by sayingthat I do not think that economies are unique. For the first time, we seem tobe combining reasonable growth, falling unemployment and no visibleinflation pressures. It seems to be the first time in about thirty years that wehave developed such a positive combination of macro-economic aggregates.

Although UK GNP is rising, it is rising very slowly. I think there aretwo reasons for that, one is that markets on continental Europe are verysluggish and that statistics under rate GNP growth rates. For instance, theeffect of information technology has not been fully captured by the numbers.

If you could change one thing in the UK economy in a real sense,what would it be?

I would try to abolish the standard wage that exists across an entireclass of jobs. For example, there is currently a big shortage of science teachers,


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however, a surplus exists in the field of art instruction. It would be very muchagainst popular culture to allow schools to pay more for science instructors.

Also, a great divergence exists between insiders and outsiders. Thosethat have jobs try to keep up their wage at the expense of outsiders, who areprepared to work for a lower pay. One way around this would be for firmsto hire outsiders at a lower wage. In other words, I would like to rid the UKof the fixed wage construct.

Do you favour a Labour government under Tony Blair, or would youlike to see an extension of the tenure of the Conservatives?

One party has been in office for far too long, but I would prefer achange based on economic policy. I find that these Conservative politicians arerather tired people and appeal to all of the worst instincts to hang on to power.

Will sterling become a part of a single European currency soon?

I do not think it will be among the inner group of participants. Ithink that it is very likely that the government will like to join later on, whichhas been our story with relations to Europe since World War II.

Is Germany importing many UK financial practices at this time?

Paradoxically, Germany has a very admirable record with itsmonetary policy, but a very poor record in business. One disadvantage of theGerman corporate model is that there exists only one point of pressure toconform- and that is from the banks, which is not always enough. It may notbe a bad thing if there were to be some fear of a takeover of a German firm.

Do you not think that the German culture of production and exportswould find it hard to adapt to the new changing environment amongall industrial economies?

Yes, the German model is in great trouble. German companies areexporting investment to countries where labour costs are much less.

Would not the UK’s participation in a single European currencysomewhat strain its historical trans-Atlantic commercial relations?

Only to those business people who have always been opposed to asingle European currency for the UK from the very beginning.

For Monarchy & Single European Currency

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Are there more business people against, as opposed to being in favourof a single currency?

Not in the manufacturing sector, which still composes some 20 to25 percent of GNP in the UK and composes more than one-half of all exports,even though I referred to its relative unimportance earlier on. Moreover, thebiggest opposition exists in the City of London, as opposed to the generaloverall business community in the UK. The attitude in the City is based moreon their political orientation than it is on their commercial interests.

What would have to happen for the UK to accept a single currency?

Either something very good or something very bad. If the singlecurrency is working, then a Blair government may opt to join immediately.The other event that may cause Britain to change its mind would be yetanother sterling crisis. After which the prevailing sentiment which mayemerge, would be one that questions our ability to solve our problems throughdevaluation yet again? Faced with a choice of devaluation, yet again, andraising interest rates to punitive levels, and joining a single currency, thelatter option may emerge as the least worst of the three evils. Therefore, wewould need to have a climate where the single currency is shown to beworking, or a sterling disaster is in the works, or some sort of combinationof these two events.


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One Market One Money?

Interview with: Paul DeGrauwe, Member of the Belgian Senate & Advisor on European Monetary Union

Directed by: William B.Z. Vukson

What do you expect from the 1996 Maastricht constitutionalconference?

It is becoming clearer that the present strategy towards monetaryunion simply will not work. There exists just too much turbulence in thecurrency markets at this time, in order to pursue the framework as wasenvisioned in the Maastricht Treaty towards European monetary union (singlecurrency).

Specifically, what is the strategy that must be changed?

The present strategy calls for a long time period in order to reach theultimate goal of monetary union, together with economic “convergenceconditions” on a number of economic variables such as deficits, debts, inflationand long term interest rates among a majority of European countries, whichare basically irrelevant to monetary union. In fact, economic convergence canonly come after a successful introduction of a single currency, which is theopposite to the strategy that is presently being followed by Europeangovernments. In that respect, one of the visions that must be addressed isthe softening of this criteria.

Would this also call for a complete revision in the current role of theEuropean Exchange Rate Mechanism (ERM)?

The ERM must be revised completely, especially within the currentmood of speculative pressures in the currency markets. Moreover, theturbulence witnessed presently should become even more pronounced as thefinal date of 1999, inscribed in the Maastricht Treaty approaches. Why isthat? One fundamental reason is that a guessing game of what country willbe in or out is continually on the minds of investors, and world moneymarkets just cannot cope with this kind of uncertainty. The solution willeither shorten the transition period significantly, or allow maximum flexibilityin our managed system of exchange rates.

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What would you propose to be the correct road to monetary union inEurope?

First, it would not be a good idea to attempt a monetary union withthe entire European Union as it presently stands with 15 members. Thereason being that many member states are still very different structurally andinstitutionally, such that they have to maintain as an option, flexible exchangerates to correct any imbalances that affect their economies. Having said that,how do we then select those that should be in? The criteria should be basedon the individual countries themselves- they are the ones that would knowif monetary union would be in their best interests.

Regardless of their economic fundamentals?

No, but the current criteria that has been imposed touching on suchconcerns as debts and deficits is not the right way to go either. This scientificapproach to European monetary union as per the Maastricht Treaty has gonetoo far. Many of the criteria, such as the one on inflation convergence arecompletely irrelevant. For example, when east and west Germany wereunited, no one referred to inflation differences, yet the monetary union isholding to this day rather successfully.

Why has the Maastricht criteria been introduced?

The Germans imposed this on the entire European Union to restrictaccess for the southern members, such as Portugal, Spain, Italy and Greece,due to their distrust of their economic management skills.

Stated differently, if there is a single currency for the European Union,it can only be the Deutsche mark?

Yes, since the Bundesbank has displayed a successful track record offinancial management since the second World War. Nonetheless, I believemonetary union in Europe will be a very difficult idea to successfullyimplement if the Germans insist on imposing their terms.

In essence, the entire program depends on Germany, which is whyI am relatively pessimistic because my reading is that the opposition withinGermany will only increase to monetary union. The German government willcontinue to insist on the rigid implementation of the strict convergencecriteria as per the Maastricht Treaty. Since monetary union in Europe meansthrowing away the German mark.


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Is the French economy fundamentally different from the German?

All European economies are different, but the question is whetherthese differences will be an obstacle to monetary union? I believe thatstructural differences should not be obstacles to monetary union.

Even at the expense of greater long-term unemployment in France?

I would not attribute the current unemployment problems in Franceon issues concerning monetary policy. They are a direct result from policiesintroduced by the Socialist government elected in the early 1980s, such asminimum wages, large increases in social security costs, and so on. However, Iwould agree with you that restrictive monetary policies practised thus far in the1990s, have added to the overall problem of unemployment needlessly. Muchof the problem was imported by overly restrictive policies in Germany whichthe French slavishly followed and which intensified the recession in France.

Would you agree that the active pursuit of restrictive monetary policyover the past 14 years, together with the movement making centralbanks independent or unaccountable to the political process hascontributed to the current problem of demand deficiency inindustrialised countries?

I’m not so sure that central bank deflation is the major cause of thecurrent deflationary climate, but I would argue that it has been caused inthe way in which the ERM has functioned. For example, in the recession of1991 to 1993, the German Bundesbank pursued an objective of low inflation,countering the price pressures which arose from German re-unification.

However, France did not have this problem, but was forced due toits commitment to a relatively fixed exchange rate within the ERM tomaintain a fixed parity to the Deutsche mark, as the mark began to appreciate.Therefore, it was more an issue centred around the willingness of the Frenchpolitical authorities to maintain a relatively fixed parity with an appreciatingmark, than it is with regards to the independence of the Bank of France. Itwould have been far wiser for French policy-makers to allow the franc tofloat during this period of severe imbalances in the German domesticeconomy.

Do you agree that inflation must exist in a market economy for it tofunction effectively?

Yes, it could be a valid objective to pursue. The recent experiencewith respect to the pursuit of monetary policy from 1991 to 1993 was a repeat

25

One Market One Money

of the errors that the US Federal Reserve made during the years of the 1930sgreat depression. When the depression began, the Federal Reserve restrictedmoney and credit formation, when indeed the opposite should have occurred.This entire episode was repeated in the 1990s in Europe. Germany convincedmost European Union members that inflation was about the only importantpolicy goal to be concerned with.

Can it be viewed as a unique scenario that built up as a direct result ofthe European Union’s pre-occupation with monetary union?

Yes, I believe so.

European Financial Architecture

If it is decided at the 1996 Maastricht constitutional conference that asingle currency ought to be pursued, how must the banking systemprepare for it?

I think that transitional problems will exist, but it really should notchange too much. The inter-bank market will grow dramatically, since allnational wholesale credit markets will become one larger European basedmarket, with lower transactions costs and perhaps with cheaper credit overthe long term.

Which financial centre will prosper under a single currency: London,Frankfurt or Paris?

It will depend much on the regulatory environment. In the recentpast, London was open and Frankfurt very heavily regulated. If a singlecurrency comes about and regulations become standardised, those notparticipating in the single currency project may end up the losers. If the UKexercises its opt-out clause, it will lose ground to both Frankfurt and Paris.

Will London not be the loser anyway, since regulatory standardisationacross all financial centres in the European Union will result in itslosing this advantage that it has always held claim to?

Yes, but London does have a unique access and availability of financialtalent that is very unique to the three financial centres. From this perspective,London may become even more attractive in a monetary union. Even thoughthe European central bank will be located in Frankfurt, there is no guaranteethat Frankfurt will become the major financial centre in Europe. We can onlylook to the US, where New York is the major financial centre, but WashingtonD.C. is where the major financial policy decisions are made.


26

What is the attraction of Paris as the main financial centre?

I see very few attractions to Paris as a financial centre. If the UKparticipates in a single European currency, there is no question of Londonremaining the pre-eminent financial centre. If the UK stays out, the issuebecomes one of who takes over? This is very difficult to predict at this time.

Will a single currency help to develop a unified retail banking systemacross Europe?

It will all depend on the regulatory framework in the individualcountries, more so than through the actual presence of a single currencycirculating in the economy. If we look at the US example once again, a singlecurrency and common monetary policy did not prevent the development ofone of the most segmented banking systems in the world at the state level,regardless of the circulation of a common dollar.

Will Belgium, Sweden & Italy default on their debts?

I don’t believe so.

Will it not be harder for them to participate in a monetary union?

I don’t believe that debt levels have anything to do when making sucha determination. If a single currency comes about, debts will be denominatedin the same currency, but will still be identified with their respectivegovernment borrowers such as Italy, Germany, Belgium and so on. However,now there will not exist a currency risk component priced into the bonds,and each government bond will be rated based on the risk of default. Forexample, an Italian government ECU-denominated bond may be rated (BBB),whereas the German government ECU-denominated bonds will be rated(AAA) and so on. Each government will have only a risk premium pricedaccording to its default potential reflected through its rating and interestrates. Why would this not be workable?

Do you foresee an acceleration in currency crises as we approach theMaastricht constitutional conference in 1996?

I foresee multiple currency crises up to the year 2000. The only wayto avoid these at this point in time is to shorten the transition period to asingle currency, because this transition period itself encourages speculation.The entire reason for speculative attacks in the currency markets centresaround credibility issues at this very moment.

27

One Market One Money

The European Monetary System (E.M.S.) defines a maximumfluctuation band of 2.25 percent for Germany, Italy and France and sixpercent for Great Britain. The two month trend has continued to show aweakening in Sterling relative to the strongest currency- the Spanish Peseta.What is most surprising is the weakness that the German mark hasexperienced due to a mixture of the general domestic downturn in productionand the pressures of the wage-negotiating rounds at the moment.

France and Britain, while both experiencing politically sensitiveunemployment figures edging up towards three million, and deterioratingGross Domestic Product (GDP), must now face upcoming elections. Thepolitical impacts on the economies, with Britain on the verge of a nationalelection campaign and France an important regional election, will workagainst Britain more than France, since the results are expected to be oppositeto one another. As of March 19, 1992, the labour party had a small lead ofapproximately five percentage points. A conceivable labour government,even if in a minority, may require a rate increase and heavy intervention insterling markets to maintain standing within the six percent band of the(E.R.M.)

British political effects on sterling are compounded by deterioratingexports, which is on e area that the Tory government of John Major wascounting on to boost the country out of its worst recession since the secondworld war. Exportsto the EC fell from £794 million in December 1991 to 409in January 1992. In addition, exports to a recessionary US economy fell byeight percent over this period. Adding to the gloom, unemployment doubledin January 1992 to 53,000; twice the number expected by analysts, with anadditional 40,000 redundancies recorded for February 1992.

The pre-election budget presented by Treasury Chancellor NormanLamont delivered an across the board tax break, which is designed to createan illusion that the government is fighting the recession with the election calledfor April 9, 1992. The result of the cutwill produce a large deficit, resultingin the Public Sector Borrowing Requirement (P.S.B.R.) reaching £12 billionthis year, and expected at £25 billion in 1992-93, or 4.5 percent of GDP.

28

First Quarter 1992

This figure will add upward pressure to the discount rate withcorresponding downward pressure to the domestic gilts market and equities.Investors and the City may not be too hostile to the outcome, as the fixed levelof sterling in the (E.R.M.) may compensate for the increase in the P.S.B.R.since an important policy instrument traditionally relied on- exchange ratedevaluation is no longer available.

Currency Outlook

Unless sterling is supported by massive interventions by fellowmembers participating in the (E.R.M.), the political uncertainty at this pointin time along with a serious recession will force a devaluation or re-alignmentin the grid. And with the present inflationary climate gripping the domesticGerman economy, together with evidence of continued buoyancy in theGross Domestic Product (GDP), it can be expected that the current highlevels will remain, if not increase. As the central bank is quite wary concerningthe transmission of further inflationary pressures from a weaker mark vis-a-vis the U.S. dollar. However, the risk of having the Lira fall outside of the gridis negligible compared to the precarious position that Sterling will find itselfin.

29

First Quarter 1992

The trend of voting out the ruling parties or coalitions on thecontinent stood out from the outcome in Great Britain, with the rulingconservatives under John Major winning a majority that should implantvaluable political stability in U.K. markets for the upcoming five years. Theuncertainty associated with daily opinion polls from early March to the finalday when voting took place, was the prime information that moved thefinancial markets on a daily basis. The distressing effects of first a hungparliament, as the early opinion polls predicted, down to a possible scenariowhere the labour government was thought likely to obtain a majority, or atleast a working majority under a coalition with the Liberal Democratic Partywas all too much to bear for investors. Given the precarious circumstancesof having sterling tied to the exchange rate mechanism (E.R.M.) and for thelast two months being consistently on the bottom of the grid with thepossibility of devaluation, coupled with one of the worst domestic economicdownturns for over forty years led the informed observer to conclude that thiswould not be an opportune time to be weighted towards sterling-denominatedfinancial assets in the short term.

A financial overview of the markets prior to the run-up to electionday on April 9, 1992, brought downward pressure on the gilts market. Thiswas accomplished initially by the impact of the Lamont budget with themagnitude of the Public Sector Borrowing Requirement (P.S.B.R.) reaching£28.1 billion, and exceeding the expectations of analysts by £3 to £4 billionfor fiscal year 1992-93 or 4.5 percent of GDP. This compares with a 1991-92P.S.B.R. of £13.8 billion or 2.25 percent of G.D.P., and represents a seriousrise in government indebtedness which will see a flood of new issue activityin the domestic and international capital markets over the year to come. Thedramatic rise can be attributed to the conservative government adoptingmany of the Labour Party’s initiatives on re-distribution to lower incomevoters, while at the same time maintaining the basic tax rate at 25 percent.

The negativity that gripped investors and bond traders at the beginningof March 1992, concerning the doubling of the deficit from the budget was notlong afterwards displaced by negative sentiments that emanated from opinionpolls. Sterling continuously was relegated to the lower band of the E.R.M., whilegilts were under a downward bias throughout, as weakness in sterling raisedfears of a post-election devaluation or increase in the discount rate.

30

Second Quarter 1992

A Reuters opinion poll taken by London City economists indicatedthat expectations were already in place of a hung parliament as the most likely outcome. Furthermore, sterling did not obtain any assistance from thereal side of the economy, as commercial property continued to be in one ofthe worst slumps ever and the unemployment rate for the first quarter stoodat 9.4 percent or 2.65 million, showing a rise for the 22nd consecutive monthand representing the highest level since September 1987.

The miracle of a Tory majority, once again revealed the creativitybehind the art of forecasting or polling, and for the first time in over fivemonths, sterling was displaced by the Danish Kroner from the lower bandof the E.R.M., entirely based on the euphoric sentiments of investors. As talknow of controlling inflation and the timing of bringing sterling into thenarrow E.R.M. bands of 2.25 percent instead of the existing six percent rangewholly replaced the pessimism that persisted prior to the dramatic majorityvictory. Thoughts of either raising rates, realigning the E.R.M. to account forpressures on sterling or outright abandonment in the form of devaluationwere the pervading themes prior to the outcome of the vote.

This powerful sentiment had sustained positive effects in the giltsmarket, and more or less overshadowed the rise of 1.1 percent in industrialproduction and the 0.8 percent increase in the output price index for Februaryand March of 1992. The gains from an investors view point to a steady progressionin sterling from a pre-election parity of 2.89 Deutsche marks to 2.945 as at May8, 1992 (the narrow bands beginning at 2.95 Dm.). In addition, a balancedportfolio of gilts returned 4.8 percent on the month, in contrast to a 0.8 percentreturn that an equally weighted portfolio of German Bunds would have yielded.

Currency Outlook

British sterling should continue to strengthen vis-a-vis the Deutschemark, based purely on continued positive sentiment and resolve of the Majorgovernment to remain within the Exchange Rate Mechanism (E.R.M.). Thefact that there is now a right of centre stable government for the next five yearsshould ensure that sterling will be protected regardless of whether or notthe domestic real economic fundamentals continue to deteriorate. In thisday and age of reputations and sentiments becoming the conventional wisdomof contemporary financial markets, the Tory election “dividend” will persistfor quite some time. With sterling on the edge of the narrow band over thelast week, it may very well be late in the third quarter when ChancellorLamont decides to officially adopt the 2.25 percent range as the future anchorfor the currency. In all, the election has reversed the fortunes of sterling.

31

Second Quarter 1992

Pressure on the European exchange rate grid was once again causedby political events. First with the dramatic victory of the Conservativegovernment in the U.K., followed by the unexpected rejection of theMaastricht blueprint for European economic and monetary union by areferendum in Denmark and the inability of the Italian four party coalitionto agree on a candidate for Prime Minister. All were events which encouragedwild speculative swings that could have severe perercussions on not onlythe stability of the Exchange Rate Mechanism (E.R.M.), but more importantlyon the progress towards eventual economic and monetary union.

However, newer entrants to the ERM- which was designed primarilyfor them to borrow credibility from members with proven reputations, suchas the Bundesbank. Will initially find it difficlt to convince investors of theirresolve towards price-stability over the longer term. Hence, the possibility ofeliminating currency risk by pegging it to the deutsche mark, still will overthe short to mid-term provide investors high yields.

Presently, the situation with France is a perfect example of how amember has used the system of fixed exchange rates to its advantage. As thepresent French inflation rate is lower than the usually lower German rate, ithas managed to convince investors of their solid commitment to price-stabilityover the long term, with a resulting convergence in French-German bondyields. Another case in point is the late formal entry of the U.K. in the sixpercent wider band of the E.R.M. This case also shows benefits in reducingthe base rate in a series of consecutive decreases to its present ten percent.The U.K. Treasury was able to do so, while maintaining sterling in its place,due primarily to the fact that since 1987, the then Chancellor of the Treasury,Nigel Lawson, maintained an unofficial parity more or less at three deutschemarks to one pound sterling. This performance has convinced investors ofthe resolve that the present government has toward domestic price stabilityover the longer term based on the political commitment to indirectly forfeittheir control over monetary policy to the Bundesbank.

However, as soon as markets become uncertain as to the politicalresolve of maintaining the parity, as is the present case with the U.K. facedwith a deteriorating economy. Then sterling will and has come underspeculative attack. Ever since the election majority was gained by the

32

Third Quarter 1992

Conservatives, the aspirations were such that the newly won political stabilitysupplemented with a pro-business environment, would immediately provideeconomic benefits through this election “dividend.” This has proved false, assterling has fallen from the immediate post-election high of 2.95 to oneDeutsche mark down to the bottom of the E.R.M. grid to 2.85 to one mark.In light of the continuous deterioration in the economy, the positive sentimenthas been broken and the commitment to a fixed parity increasinglyquestioned.

Therefore, it is this political commitment to the E.R.M. that bindsthe domestic monetary lever to the Central bank having the best record onprice-stability and creating the highest level of investor confidence, whichis vital to making the entire system function properly. Any deviation from thiscommitment of tying the monetary hands with the resultant abandonmentof stable prices domestically will re-order the expectations of borrowers andinvestors. The outcome of which will most certainly result in higher-yieldingdebt instruments.

The economic fundamentals over the past two months confirmed thatthe European region is in a period of deflation. The U.K. continued to recorddismal economic figures, as the April 1992 unemployment rate rose by 42,600reaching 2.7 million, its highest level since August 1987 or 9.5 percent whilethe May 1992 figures went above the 2.7 million mark. The deterioration indomestic demand was further exacerbated by the savings ratio increasing to11.5 percent of personal disposable income during the first quarter and thehighest in over a decade. As consumers burdened by debt and unwilling tomake major purchases were attributes to the weakness.

In addition, the Central Statistical Office reported a 0.6 percentdecline in manufacturing in May 1992 and a 0.4 percent fall in overallindustrial production from the March 1992 to May 1992 period. Thepersistently high rates of interest were harming in a serious way plannedinvestment in the industrial base which would have long term consequencesfor the U.K. economy. This was confirmed by the six percent fall that wasrecorded over the first quarter. The severity of this economic downturn hasprompted several respected organizations such as the London Business Schoolto call outright for a devaluation in sterling. As mentioned above in theoverview, the sacrifice of monetary policy to the E.R.M. has relinquishedthe stimulative effects that a devaluation may have brought to the domesticeconomy at this point.

33

Third Quarter 1992

Currency Outlook

The resolve of the U.K. government to maintain membership in theE.R.M. will win over in the end, although at great cost to the domestic realeconomy. The Treasury will not tolerate any parity that dips below 2.85deutsche marks to one pound sterling and will be prepared to raise base ratesin order to protect the currency. This will further add political pressure onthe government, as a much needed recovery will not materialise causinggreat economic and social pressures. Therefore, further devaluation in sterlingshould not be expected.


34

Throughout the past month we witnessed a series of negative eventswhich seriously tested the foundations of the European Monetary System. Ofthe most notable were the collapse of the Dollar markets leading to intensespeculation against sterling, coupled by the advance of the Deutsche markto the top of the grid of the Exchange Rate Mechanism (ERM) and thecontinuing problems in Italian dometic fiscal finances. All have yet to facewhat will prove to be the final test to the entire process of European economicand monetary union according to the guidelines set out in the MaastrichtTreaty when the French hold their referendum on September 20, 1992.

Doubts about further European progress are presently so high thatECU- denominated debt markets have occasionally ceased trading due tothe thinness in the volume of bids. Moreover, the doubting sentiments havehit hard domestic gilt markets in the U.K.; and what has over the last severalmonths become a familiar fixture- large capital shifts out of the high-yieldingcurrency areas (Sterling, Paseta, Lira, Escudo) into the Deutsche mark.

In fact, the economic justification for further European economicintegration has become so questionable that Financial Times of Londoncorrespondent Ian Rodger wrote of the resurrection in the Swiss Franc as asafe haven: “For many Swiss analysts, however, the explanation is simple. TheEuropean Community is in such a state of turmoil that Switzerland and theSwiss franc have recovered their safe-haven status.” Emerging out from thepresent impasse in EC relations with even more status and power will bethe German Bundesbank. In fact, with the U.S. Dollar in free-fall over thepast month, any increase in the Federal Funds rate or discount rate will beconstrued as being an act that will portray the Fed as a de facto member ofthe E.R.M., dictated to by the powerful Bundesbank. A situation by itself,which will clearly instill powerful incentives for further easing in domesticU.S. rates.

The worsening economic conditions in the U.K. are a testimony tothe real pressures that can build-up when a government pre-commits to anovervalued fixing of the exchange rate level. As inflation falls further, real ratesrise having serious repercussions on real economic activity and employment.In fct, the only policy lever that is momentarily available to confront thisgrave situation is fiscal policy. The situation has so deteriorated that one

35

Fourth Quarter 1992

industry leader after another has urged intervention by the government. Thelatest being Sir John Quinton- Chairman of Barclays Bank who did not seeany end to the downturn until well into 1994.

With new forecasts showing the yearly GNP down by 0.5 percent,a lack of consumer confidence showed a sharp fall in consumer credit demandin June 1992. With M0 up 2.4 percent in July 1992, and M4 (representing bankand building society deposits) up 5.7 percent in July 1992, it clearly indicatesthat consumers are opting to save more of their incomes and shying away frompurchases of durables. This behavioral effect has had a profound effect on thedeepening of this recession.

Initial estimates of the Public Sector Borrowing Requirement (PSBR)have by now become obsolete, as a large shortfall in expected VAT receits thisyear should add an additional £4 billion to the gilts financing program. Thecumulative (PSBR) for the first four months of 1992-93 will be £11.3 billioncompared with £5.9 billion during the same period last year. This comes asthe unemployment rate rose to a five year high in July 1992, the figurerepresenting the 27th consecutive increase or 2.75 million in total, almost 1million of whom are long-term redundancies. Presently, the officialunemployment rate stands at 9.7 percent.

With this additional increase in the (PSBR) attributed to a largeextent to large shortfalls in expected receipts, the deficit/GDP ratio exceedsthe three percent Maastricht guideline for European economic and monetaryunion. The deteriorating public finances prompted economist David Haleto make the following comment in the Financial Times of London: “Thedeflation occurring in the British economy will ultimately create thepreconditions for improved competitiveness and economic recovery, butprobably not until the second half of the 1990s. As a result, the U.K.government deficit is likely to rise to six or sever percent of GDP this yearand remain there for much longer.”

The great pressure of the real economic downturn in the U.K. hasaffected their credibility to commit themselves to the E.R.M. Consequently,the opportunity cost of investment in sterling-denominated financialinstruments increased over the past month. This can be seen as yields on tenyear gilts rose from one to 1.3 percent vis-à-vis German bunds leaving aperception that devaluation of sterling is more likely. The Treasury repeatedlytried to change the course in sterling by massive intervention. For instance,on August 26, 1992, it conducted the largest intervention in over six years,as £1 billion was bought in the markets. Recently, the Treasury borrowed about


36

£8 billion in deutsche marks in order to fend off any further attacks. This lastact seems to have convinced speculators of the government’s resolve tomaintain sterling within the six percent E.R.M. bands.

Currency Outlook

Without the French vote on Maastricht hanging over the currencymarkets, the Franc relative to the Deutsche mark would not be affected.However, if rejection is the outcome of the referendum, the franc wouldenter a free-fall along with most of the other high-yielding currencies that aretied to the E.R.M. The downward spiral would not be as severe as the sterling,lira, paseta and Portuguese escudo would experience, and the subsequentrise in interest rates to stabilise the franc would be far less than what wouldbe needed in the case of the other three.

Sterling without the Maastricht vote would be able to weatherinvestors’ expectations of impending devaluation and be true to the resolveof messrs. Major and Lamont. While facing a debilitating domestic economywith recovery nowhere in sight, any increase in the base rate would produceirreparable damage. Therefore, as was the case just recently, the governmentborrowed approximately £8 billion in deutsche marks in order to support thecurrency. They will continue to use such creative financing to stave off anypotential to devalue since a number of senior Ministers have staked theirpolitical careers on their commitments to the E.R.M.

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Fourth Quarter 1992

• STERLING IS SUSPENDED FROM THE EUROPEAN EXCHANGE RATE MECHANISM (E.R.M.) ONSEPTEMBER 17,1992. BASE RATE INCREASE TO 15% IS CANCELLED

• ON SEPTEMBER 22,1992, BASE RATES ARE REDUCED TO 9% AND THEN TO 8% ON OCTOBER16,1992

• STERLING REACHES HISTORIC LOW OF 2.38 DEUTSCHE MARKS ON OCTOBER 5, 1992• AUTUMN MINI-BUDGET REDUCES BASE RATE TO 7% ON NOVEMBER 12,1992 - THE LOWEST

SINCE 1978• OFFICIAL BRITISH ECONOMIC POLICY IN STATE OF CONFUSION• REAL DOMESTIC ECONOMY CONTINUES TO BE DEPRESSED

Economic and Financial Overview

Having brought both the Treasury and the Bank of England intosubmission, currency speculators were prevented from doing the same to theBank of France through heavy support from the German Bundesbank. Was itthe case that Sterling was unable to hold its position in the E.R.M. because ofmiscommunication, incompetence or simply a lack of support from othermember banks? To apportion blame to any of these reasons would assumethat under perfect capital mobility, fixed currency parities could be maintained.However, to observe the volume of turnover in the foreign exchange marketswould lead informed observers and participants to conclude otherwise.

The following chart powerfully displays the volume of Dollar turnover in the mainfinancial centres over the past six year period:

CURRENCIES: DAILY TURNOVER IN MAIN FINANCIAL CENTRES (bn. $)

Centre March/86 April/89 April/92New York so 129 192Tokyo 48 115 128London 90 187 303TOTAL 188 431 623

38

Year End 1992

As the table indicates, there has been a tripling of the volumes thatpass through the main foreign exchange centres in the world. Clearly, sucha development easily can overcome any intervention that may be planned bycentral banks. The fact of the matter is that only the scale of currency hedgingis producing investment flows which rival the reserves that Central banks hold.The emerging importance of a global strategy in pension and investmentfunds is primarily attributable to the rising volume of currency transactions.With increasing emphasis on foreign exchange risks in the move to"internationalize" asset holdings, the growth has been driven in directproportion to the movement to remove capital controls. For instance, a typicalU.K. fund now is 20% exposed compared to 6% in 1980.

With this recent development in mind, it becomes virtuallyimpossible for countries such as Britain to get away with an unrealistic fixingof Sterling. If the fiscal and real economic fundamentals continue todeteriorate, as they most certainly have in the case of Britain, any attemptsby the Treasury to reverse this by raising base rates will only have a shortterm effect, if any. The entire currency episode was a culmination to pressuresthat were building up in the foreign exchange markets since the Conservativevictory in April/92, and even beforehand. These pressures reflected thedoubtful voices of market participants, as corporate profits tumbled andredundancies rose.Specifically, the rise in unemployment by an unexpected 47,000 in August/92,not only represented the 28th consecutive monthly rise, but also was doublethe expectations. This pushed the figure to a five year high of 2.8 millionwhich increased even further in October/92 to 2.87 million. In addition,informed sources have revealed that 1 in 5 households in Britain have anegative equity position, with an average deficit of Sterling 6,000. And businessfailures in the third quarter increased by 53% over last year, with a continuationof losses reported across numerous industrial sectors.

Now that the policy of fighting Inflation by pegging Sterling to theMark has unravelled as the central focus of government policy. Thegovernment still to this day has not fully been able to account for having tosubstitute It by a policy that emphasizes growth and employment. This shiftaway from fighting inflation was made clear in the Autumn budget statement,although specific polIcy directions remained unclear. The government has,however, announced that It would like to formulate Its Interest rate decisionsaround a basket of financial Indicators such as money supply figures, assetprices and the exchange rate. Undoubtedly, asset prices seem to be divertingmost of their attention span at this moment, but the Inflation rate will betargeted between 14% as measured by the yearly rate in the retail price index,

39

Year End 1992

excluding mortgage payments. The recent change of emphasis on growthrather than inflation is an outcome that was driven by the widely held perception that British industry has had Irreparabledamage done to its ability to compete. This Is a perfect Illustration on howthe movement of free market capital was able to deliver a signal to thegovernment by causing a run against the Sterling and forcing a devaluation.In this sense, speculators have performed an essential social service byalleviating domestic social pressures on those that are not willinglyunemployed, as well as the catastrophic pressures on profits from industrythat the high exchange rate policy has exacted.

Currency Outlook

With the value of Sterling overcome by domestic economicfundamentals and the recent position of government fiscal finances, theinability of the government to articulate a coherent and credible economicpolicy post-E.R.M. generates negative sentiments about Sterling on thecurrency markets. As the government tries hard to get back on track andovercome its present confusion, fiscal finances continue to deteriorate to thepoint where the gilts markets find it difficult to attract Investors. A F,28 billiondeficit that was projected In the last budget, Is now forecast to be L37 billionIn 1992-1993 and L44 billion in 1993-1994.

Since reaching a historic low at 2.38 Deutsche Marks, Sterling hasrecovered and settled in the 2.4-2.5 range to the Mark over the past twomonths. With the base rate set to decrease further and the continuing crisisof confidence within the ruling Conservatives, the only positive sign is thatthe severe devaluation will allow British industry to once again becomecompetitive in International markets. However, unless the government canregain the confidence of Investors by proposing credible policy options overthe short to medium term, and attending to the growing budget deficit, thenSterling will once again challenge Its historic lows. The gain in competitivenessfrom the devaluation will be felt over the longer term, but will take timeuntil Industry repairs the serious structural damage caused by the E.R.M.link. Over the mid-term, Sterling should stay within the low end of the 2.4-2.5 range to the Mark, with an even chance of falling between 2.3-2.4 to theMark.

40


• producer input prices rise by 2.4%- the largest since 1976• social costs rise as P.S.B.R. approaches sterling 50 billion in 1993194• independent panel of Treasury advisors fear unemployment to attain 3-4 million over the medium-

term• a successful recovery can only occur from increase in exports• consumer borrowing continues to be depressed• base rates expected to fall to 5% after failing to 6% - 15 year low• sterling continues to hit new historic lows• industry experiences increasing orders from devaluation effect• unemployment surpasses 3 million - flrst since 6 years• further policy confusion between Major and Lamont• hopes of policy clarification in march 17, 1993 budget


The only sign of an end to the worst downturn in Britain since thesecond world war has been reflected In the rising export orders due to therecord devaluation in Sterling. The casing in domestic monetary conditionswas recently reported in the Confederation of British Industry's latest monthlyindustrial trends survey. As manufacturers' order books were at their bestlevels for more than two and a half years and for the second consecutivemonth, manufacturers were planning to raise production over the next quarter.

Expectations of further record cuts in the base rates to perhaps the5% level have by now been fully factored into the value of the British currency.The consensus is that the drastic measures taken thus far in order to revivethe economy reflect a complete neglect in appropriate industrial policythroughout the 1980s. These were exactly the sentiments that were expressedby the Chairman of Ford of Britain- Ian McAllister recently. The neglect ofindustrial competitiveness in the U.K. in favour of the mythical idea thatwealth could be generated on purely the support of a service-orientedeconomy was sharply criticized. Moreover, as the service sector attempted to

41

First Quarter 1993

increase its efficiency recently, over-reliance on this sector was beginning toescalate redundancies.

This lack of competitiveness in British industry, and the failure inwhich an indifferent Thatcher government throughout the 1980s held thevirtues of promoting a mixed economy in contempt is a main reason forBritain's present problems, as well as the prime reason for Sterling falling outof the E.R.M. last September. To have still remained tied to the DeutscheMark at about 2.95 would have brought serious repercussions to exportmarkets, which are now back on the road to recovery. In fact, severalindependent advisors to the Treasury are urging that the governmentencourages industry to invest in proven export-enhancing sectors. Thisaccording to one of the advisors- Wynne Godley, suggests that sustainedgrowth in the economy can only be achieved if an expansion in exportsoccurs through investing in sectors that produce internationally tradablegoods and services.

Such long-term considerations as shifting investment resources to thetradable sector, along with adopting a fundamentally realistic economicstrategy by the Treasury over the short to medium term is what is nowrequired. Hopefully, the upcoming budget speech on March 17, 1993 willaddress the concerns that business leaders have been preoccupied with eversince Sterling was suspended from the E.R.M. last September, 1992.

The failure in the early 1980s to target money supply growth,eventually abandoned in favour of buying credibility from the GermanBundesbank by allowing it to set money targets for the Treasury have beentotally inadequate as appropriate policy prescriptions over the recent past.Although the present targeting of inflation between 1-4% will likely notgenerate an acceptable decrease in unemployment, it is, nevertheless, one ofthe remaining untried options. The only question is whether furtherdeteriorations in the social conditions will take precedence when decidingon the appropriate base rates and value of Sterling.

Currency Outlook

At time of writing, Sterling has attained a historic low of 2.3125Marks. This reflects expectations that the base rate will be further reducedto new historic lows of 5%. Although we do not yet know the contents ofthe upcoming budget, encouragement can be taken from the increasinggrowth in the export sector. Since consumer confidence is at a very low level,and asset values of homes are likely to be depressed for a very long time,


42

exports at the moment seem to be the only game in town for economicrevival. The importance of addressing an industrial strategy in the upcomingbudget will be vital to the continuing growth in exportable goods and servicesover the medium to long-term.For the moment, the benefits of a historic low in Sterling will last given thatthe French or similar such industrial competitors do not match the devaluationin the hope of winning back lost markets. As the French economy deterioratesfurther, the risk of some downward realignment in the Franc becomes veryreal. Should the Franc fall, Sterling will need to break new record lows, sincemost of the exports have gone to formerly French markets within France. Therisk of having such competitive devaluations dominate the European industrialscene, and the fact that the export component in the U.K. is what most areplacing their bets on to generate a long awaited recovery, are both factors thatwill maintain Sterling within the 2.30 to 2.40 range vis-A-vis the DeutscheMark.

43

First Quarter 1993

• Finance Minister Lamont replaced by Clarke• conservatives lose credibility over resignations and scandals• Sterling not to return to E.R.M. until next election• concerns over Sterling 50 billion deficit growth- taxes likely• by 1998 debt is expected to double to 50 percent of g.d.p.• early signs of recovery in commercial property• manufacturing output shows early signs of recovery• business confidence highest since 1983• competitiveness over recent past shows drop of 9 percent• export-led recovery doubtful as global recession still on

Economic and Financial OverviewHow long can John Major last as Prime-Minister? With the

unremarkable labour party recently posting 25 percent leads in various opinionsurveys, the government has had to contend with numerous self-inflicted crisesrecently. From the replacement of former Finance Minister Norman Lamontover the lack of confidence in his economic management, to the recent criticismof illegal conservative finances brought forward by the head of bankrupt PollyPeck International-Asil Nadir, conservative party members criticism of JohnMajor has registered record levels.

Aside from the political problems directly affected by economic decline,there still lies the possibility that the recent actions of Margaret Thatcher andNorman Tebbitt In the House of Lords could lead to a national referendum onthe Maastricht Treaty- one of the policy-pillars of the present government. Giventhe general dissatisfaction of the British public at this point in time, any defeatin such a contest would not only see to the quick exit of Mr. Major, but wouldalso bring down the Conservative government.

Although several commentators are optimistically pointing to recentnumbers showing that recovery Is well under way, the cold reality is that the U.K.will continue to go through very serious structural changes in the economy. At

44

Second Quarter 1993

this point In time, with the recovery of business investment confidence stilltenuous at best, and record consumer debt levels still very much affectingspending, coupled with recent record banking losses. The only way in whichgrowth would fall above the long term trend would be an incredible resurgencein exports. However, with the global recession and with the continentaleconomies in particular showing contraction, this goal will become ever moredifficult to attain.

Furthermore, with the prospect of a tax increase in the Novemberbudget now very real in response to the record deficit. Such a measure shouldadd unbearable pressures to the present economic situation, as any move tofurther cutting base rates would not cover the contraction that a tax increase wouldbring to aggregate demand. The dilemmas faced by the U.K. was recentlysuccinctly summarized by former Thatcher government Finance MinisterGeoffrey Howe: "Optimistic claims about British public-sector finances beinghyper-cyclical have been thought to justify the emergence of a Reaganomics-style budget deficit- which the U.K.'s exposed and trade-dependent economyis far less able to sustain than even the U.S." and... "People forgot that BlackWednesday was not a liberation, but a warning of recurrent weaknesses and ofthe hazards which still face countries unable to establish monetary discipline asthe basis of non-inflationary growth. Black Wednesday proved that the originalThatcher agenda of sound money, fiscal rectitude and supply-side reform hadnot bitten deep enough to consolidate the reversal of Britain's long-term decline".

Currency Outlook

Although Sterling has escaped the constraints of the E.R.M. on blackWednesday last September, 1992 and has brought about a resurgence In theexport base of the U.K. This positive development to U.K. economic affairsrecently is still overshadowed by large consumer debt, the 1.7 million householdsholding negative equity; not to mention the politi-cal problems of thegovernment.

The only possibility that the U.K. has In order to expand domesticgrowth Is through exporting abroad. This Is the prime factor, along with thevery real prospect of further base rate cuts that will not allow Sterling toappreciate above the 2.6 Mark level. In fact, given the still precarious state ofeconomies-economic and political stability in the U.K., It is a very real possibilitythat we see Sterling fall further. In fact, the probability of Sterling falling exceedsthe probability of it rising back toward the range in which it was bound to theGerman Mark through the E.R.M. Certainly, any rise in taxes to cover the fiscalshortfall will encourage further easing in monetary policy and base rates. Onthat basis, a range of 2.4 to 2.5 Marks to the Sterling is a very real possibility.

45

Second Quarter 1993

• Record small business failures registered • Defense spending to drop from 3.9% to 3.2% of GDP • 40% of budget deficit attributed to severity of recession • Unemployment stabilizes at 2.91 million 9 Producer prices rise by 4.3% • Retail sales rise for 6th consecutive month under heavy discounts • Europe remains a very weak market for manufacturing exports • Support for John Major and the Conservatives continues to fall • Conservatives lose important Christchurch by-election • Liberal Democratic party becomes biggest threat to Major• 9% of all home owners hold negative equity • Losses of Lloyds names severely damage domestic economy • Base rates remain at 6% • Automobile exports fall by 16% in July/93 • Tax increases may be inevitable in the upcoming November/93 budget • Interim results reported by manufacturers disappoint

Economic and Financial OverviewAs Politicians and Economists continually talk up recovery based

on unreliable data which is subjected to continuous revision, manufacturersdisappointing interim results confirm that any such hopes for a vigorousupturn are still far from reality. If the replacement orders cutback for defenseprocurements is added to the continuing recession from continental Europeancountries, the barriers that domestic manufacturers must overcome becomefar more formidable than what is captured in the recent mixed surveysreporting on the strength of order books.

In fact, the severity in defense cutbacks have prompted three formerlyprosperous south-western counties: Avon, Gloucestershire and Wiltshire tolobby for European Community (EC) regional aid. Such cutbacks continueto adversely affect some of the most blue-chip of British industries as British

46

Third Quarter 1993

Aerospace, Rolls-Royce and Dowty all operate plants in these three counties.The ending of the Cold War, as well as the severe deterioration in the domesticbudget due to the late 1980s property bubble effect continue to push thedeficit upwards. In addition to the lack of domestic investment spending bymanufacturers is the sorry state of personal finances, as there is now talk ofa tax increase in the November/93 budget that will be brought down byChancellor Kenneth Clarke. As the deficit hits record levels of Sterling 50 billionand as Gilts flood the markets in the hopes of financing it, the shortfall in bothpersonal and commercial revenues has prompted the Conservatives to proposesome kind of tax levy which is yet to be determined. Such a proposal hasprompted continuous revolts by the right-wing Conservative faction opposedto any taxes as it is being simultaneously frustrated by its virtual bankrupt statusfrom losses in the Lloyds insurance market. In addition, former ChancellorNorman Lamont, still very bitter about his forced resignation in May/93 fromthe top Treasury spot has written several vicious editorials mocking theleadership of John Major. Add in the unspectacular state of the domesticmanufacturing economy with the sorry state that British personal financesare in from the Lloyds debacle to the 9% of householders who find themselveswith negative equity and you can immediately see why the Liberal Democratsare on top of the opinion polls. With developments as they stand, the endmay soon be near for Mr. Major. If he tries to hang on to power at all costs,then a splintering of the Tory party may very well be a likely outcome. Thewild card in all of this is that the escalation of the Lloyds situation may forcea quick election as the Conservatives' majority is threatened. This scenariowas exposed in a recent issue of the New Yorker magazine by Julian Barnes:"The presence of so many Tory M.P.s in the catalogue of Names briefly raiseda merry scenario of political destabilization. A bankrupt M.P. is automaticallydisqualified from sitting in the House of Commons, and loses his or her seatafter six months."

In any case, the instability in the U.K. political system is mainly areflection of the changing times, as voters who used to support Politiciansstanding for stability are now venting their frustrations. Unfortunately, noPolitician is in a position to reverse the adverse economic malaise that has nowbeen on-going for the past two years. With the dramatic developments takingplace in the Asian markets and with the development of eastern Europealong with the financial challenge to London of cities such as Frankfurt andParis, the U.K. is fearful of becoming very marginalised over the medium tolonger term. The present depression only adds to these fears.

47

Third Quarter 1993

Currency Outlook

The present on-going stagnation in the manufacturing industry hasprompted a group of Chairmen from this sector to blame Economists andPoliticians for talking up a recovery "beyond the realms of reality". This groupcarries far more credibility than some of the surveys and statistics that havebeen submitted to the public in recent months showing the opposite. Asconsumers continue to be hard-pressed and consumption spending onlyregisters the barest of increases, and companies refrain from investing as a resultof this coupled by the poor performance in continental European countries.There is every reason to believe that a cut in the official base rate is a realpossibility. Since exports remain the only real way in which manufacturerscan do business in any vigorous way, the value of Sterling will need to beaccommodating. At this point in time, the growing rate of inflation and thesmall reduction in unemployment still cannot justify an increase in officialrates.

Furthermore, if the government opts to raise taxes in order to coverthe shortfall in the deficit, then there is more reason to believe that Sterlingwill not rise too far. If, as manufacturers have reported, profits continue to beunspectacular and do not nearly generate an acceptable rate of growth overthe next two quarters, pressure will be on to reduce base rates along withSterling.Any political drama will further serve to depress the value of Sterling as theConservative party must cope with very difficult times. In this respect, Sterlingrelative to the Deutsche Mark will fall within the 2.4 to 2.5 range. However,if the recovery on the European continent continues to be difficult, the valueof Sterling will shift from 2.4-2.5 to 2.3-2.4 Marks over the short term.

48


• Tory government of John Major buoyed by Clarke budget• budget deficit falls well within forecasts• London boroughs, and counties to receive EC aid• 1000 redundancies announced by British Aerospace as Defense cut• European economic downturn offsets Sterling devaluation• Defense expenditures to fall just over three percent of GDP by 1995• price drop becomes serious setback to mature North Sea oil wells• retail sales volumes rise due to aggressive discounting• Treasury cuts base rate by 0.5 percent to 5.5 percent

Economic and Financial OverviewOn November 30 Chancellor Kenneth Clarke presented the first ever

unified budget to the general relief of the government of John Major. Whilepresiding over a general economic decline in theU.K., and a Tory party thatcontinues to be split over fundamental philosophical issues, such as defensecutbacks and closer economic and political union with the EC. The chancellorwas able to deliver a well-balanced political document which called for:

• modest tax increases for year beginning April/94 and big increases in tax scheduled for fiscal1995-96 and 1996-97

• reductions in the public sector borrowing requirement (P.S.B.R.) in 1994-95 from f-44 billion to E38billion

• spending cuts in defence, transport, housing and local budgets• declarations of support for the welfare state• no changes in income tax or VAT rates• a freeze on relief for mortgage interest payments• a decrease in public spending from 45% now to 42.5% in 1996-97 • excise taxes on automobiles and fuel duties increased

Projections In Billions Of Sterling93/94 94/95 95/96 96/97

General Expenditure -1.0 -5.5 -3.5 -6.0GeneralReceipts -1.0 -4.5 -6.5P. S. B. R. -0.5 -6.5 -8.0 -13.0

Source: The Red Book

49

Fourth Quarter 1993

The following table presents a summary of changes in budgetexpenditures from that which has been previously forecast by ChancellorNorman Lamont in March, 1993.

For fiscal year 1994-95 the Chancellor levied a further £1.68 billionof new taxes to the existing £6.73 billion already tabled in March 1993 byprevious Chancellor Lamont. Furthermore, the budget will add a further£4.9 billion in taxes for 1995-96 to the £10.3 billion agreed to in March1993 and a further £6.08 billion for 1996-97.

Although the budget managed to skillfully balance numerous interestsin the Conservative party, the astute political observer woiuld have concludedthat it definitely furthered the political interests of Mr. Clarke. One suchastute observer in Financial Times of London correspondent Joe Rogaly:“The purpose of Mr. Kenneth Clarke’s speech was to unite the Conservatives-behind Mr. John Major is possible, behind himself if necessary. His first taskwas to save the government; his long-term aim to ensure a fifth Conservativevictory in a row.”

The reaction of the financial markets was very favourable, as thelong bonds fell below 7% for the first time in 25 years and Sterlingstrengthened on the foreign exchange markets vis-a-vis other Europeancurrencies. With monetary policy more or less in the background after thefloating of Sterling, recent attention has been focused on the continuingconflicting statistical signals on the real side of the economy.

The present day scenario continues to be one of confident assertionand immediate denial. The confident assertions of "recoveries just aroundthe comer" being usually made by politicians or economists followed up bythe immediate denials of practitioners such as the Confederation of BritishIndustry. So far the verdict favours the latter based on the following evidence:

• although the Clarke budget was well-balanced, it nonetheless reduces theP.S.B.R. to the extent that investors buying long bonds expect the economyto deflate further, hence dampening any hopes of recovery driven domestically

• first-time applicants for EC aid include the London Boroughs of Islington,Tower Hamlets, Newham and Hackney and the Counties of Kent, Essex,Sussex, Norfolk, Cambridgeshire and the Yorkshire Moors and Dales

• continuing protracted downturn in the EC economies, while the U.K.counts on 67% of its exports to have final destinations on the continent


50

• long-term decline in the financial services industry in the south-east, andan expected 33,000 redundancies over the next quarter in large companydown-sizings

• recent collapse in world oil prices will make many marginal North Sea oilwells uneconomical to operate, adversely impacting on the balance ofpayments

• continuing depression in both commercial and residential property markets,as Clarke scales back mortgage relief in the budget and demand for mortgageloans falls by 10% in the third quarter of 1993

• aggressive discounting in the retail sector where profit margins have beenseverely trimmed

Currency Outlook

Since monetary factors have been discounted in the value of Sterlingever since it was forced out of the European Exchange Rate Mechanism(E.R.M.), the focus must be centred on reversing the miserable state of thedomestic economy. At this point in time, any recovery in the U.K. will belargely determined by external factors invariably connected with exports.

The expectation is that once the post-budget euphoria wanes,investors will once again focus on the fundamentals listed above with aresulting downward bias in the value of Sterling. Recent gains in Sterlingwere more the result of weaknesses in the German economy, rather thanbased on anything good that has emerged out of the U.K. itself.

Consequently, it is in the best long term interests of U.K. industry ifSterling was not allowed to float beyond 2.5 German Marks. An appropriaterange over the next quarter would be 2.4 to 2.5 Marks to one pound Sterling.

51

Fourth Quarter 1993

• embattled prime-minister John Major loses authority• political upheaval over planned tax increases in April 1994• reversal of 1992 no tax promise puts Major on defensive• former minister Lamont labels Major as “weak and hopeless”• Major at mercy of upcoming local and European elections• unemployment rate drops below 10%• business failures drop to lowest levels since 1989• manufacturing unemployment continues to rise• Sterling surpasses Dm. 2.6 level• London commercial property gains from foreign investment• exports rise by 27% in value terms due to lower Sterling


Prime Minister John Major continues to display a remarkable degreeof resilience and staying power. If he is not facing up to various self- inflictedpolicy blunders imposed by the conservative party itself, then it is the never-forgotten and continuously reemerging broken promises made as far back asthe election campaign of 1992.

An issue in the latter category that goes down deep in mostconservatives' hearts is the now aborted promise to cut tax rates. In fact, theNovember/93 budget of Chancellor Clarke continues to generate controversythe closer the U.K. gets to the April/94 deadline which implements tax hikes,in addition to those already factored in by previous Chancellor NormanLamont.

As such, controversy continues to rattle the foundations of JohnMajor's conservatives, a series of upcoming elections for local constituenciesand the European Parliament could erupt into a full scale earthquake, and leadto a general election some time in the fall of 1994. Something that investorsin Sterling must consider over the medium term.

52

First Quarter 1994

Aside from the continuous political turmoil, the economy of theU.K. continues to slowly emerge from depression. In fact, it is the impendingtax increases which are causing all out consternation at this moment, as anymoves that will suppress the economy could risk any recent momentum thatresembles recovery. In that sense, the fiscal side is very much a factor, asmeasures that will reduce aggregate demand such as tax increases will endan-depression. However, the question is whether or not ger the potential of theeconomy to produce at its the external value of Sterling will still be dominatedcapacity. Subsequently, placing further downward by the exported sector?pressure on the base rate and Sterling.

Alternatively, since its liberation on September/92 from the EuropeanExchange Rate Mechanism (E.R.M.), monetary policy has delivered a seriesof rate reductions from a peak of 14% to the present 5.25% base rate. This,it can be argued, has helped in stabilizing some interest- sensitive sectorslike auto-mobiles and single family housing starts. Although the recentrecovery in commercial real- estate has solely been attributed to foreigninvestment from east Asia, Germany and the middle- east. The above tableis evidence of the recovery in these two sectors.

Therefore, the fiscal side is working to decrease capacity utilizationand adding downward pressure on Sterling, while monetary policy shows nocon-vincing evidence of tightening, as inflation continues to register marginalincreases. Together fiscal and monetary policy are moving in the samedirection and are showing a propensity to lower base rates and downwardpressure on Sterling.

The domestic policy environment is contradicted by the externaltraded sector, With recent gains to GDP largely coming from buoyant exports,the bal-ance of trade account is showing a much envied recovery. Alongwith the natural stabilization that is inherent in an economy over the long-term, the solid performance in exports only serves to underscore the factthat the U.K. has emerged from its prolonged depression. However, thequestion is whether or not the external value of Sterling will still be dominatedby the exported sector?

Currency Outlook

With Sterling presently fixed to the psychological level of DM 2.6,its recovery over the past quarter has been impressive to say the least. Thisin most part can be attributed to the aggressive recovery in exports. Nowthat exports have performed well, can the external argument still prevail in

53

First Quarter 1994

setting an appro-priate target for Sterling? Or will the depressive effects onproductive capacity by both the fiscal and monetary policies be the overridingfeature that will drive Sterling over the next one or two quarters?

At this moment, it Is still very difficult to foresee a trading range thatcan be fixed at 2.6 to 2.7 to the mark on a permanent basis. Since acombination of tax increases and a relative neutrality in the Bank of England'sstance over the appropriate base rate will still show a bias toward addingexcess capacity. It may very well be the case that the U.K. will continue tocount on the exported sector to stabilise the trend growth in the GDP. Inthat sense, short of any politi-cal upheavals to the Tory government of JohnMajor (a factor that can never be counted out), an appropri-ate trading rangewith respect to the Deutsche mark is 2.5 to 2.60.

Housing Starts Automobile Production1992:1V 10.8 1101993:1 15.6 1211993:11 16.3 1261993:111 15.2 n/a

Automobile Production: Passenger Cars in thousands Housing Starts: in thousandsSource: OECD

54


• Tory part split over European enlargement issue• Tory right wing increasingly critical of John Major• Bank of England moves to reduce base rates by 0.25% to 5.25%• business confidence of mid-size companies on the rise• narrow measure of monetary base exceeds 0-4% target range• receivership cases rise by 50% in February/94• majority of jobs created in 1993 were part-time and self-employed• investment shortage in plant capacity impedes growth potential• long-term rates rise as oversupply hits new bond and equity issues• disinflationary effects broadly spread across manufacturing sector• consumer spending falls in anticipation of April 1994 tax increases• privatisation proceeds reduce borrowing requirement for 1993-94

Economic OverviewThe question on the minds of most and federal by-elections, to be

held able resiliency, able to withstand hourly informed observers of Britishpolitics is between May 5 and June 9, 1994, will attacks by the British press,and the on whether a catastrophic showing by the signal the end of JohnMajor's leader- going internal squabbles between proruling Conservatives inthe upcoming ship? To this point, the beleaguered European moderate andthe right-wing local council, European parliamentary Prime-Minister hasdisplayed a remark- sceptics within the party.

Instead of tending to badly required, well thought-out policyinitiatives vital for an economic recovery, the ruling party continues to preferto squander valuable political capital on such trivial issues as voting rules foran expanded European Union. In fact, it is this rever-sal, after an initialcommitment to an extension of the existing rules, that made the right-wingEuro-sceptic faction of the party believe that their posi-tion was takingprecedence.

55

Second Quarter 1994

Mr. Majors' sudden reversal, although inevitable in the broaderEuropean political scheme, was taken by Tory right-wingers as a betrayal, buthas also alienated the left of centre tra-ditional supporters of the Prime-Minister. This left of centre, pro-European faction considers such an importantreversal as something that does not serve to strengthen the prime-ministers'overall credibility, and worse, drains domestic business and consumerconfidence further.

From the unrelenting recession in the U.K. economy, to the reversalof promises to cut taxes, to the sterling cri-sis and now the ever-recurringblunder on European policy- have all led a tired electorate to register thelowest approval rating for this Prime-Minister in modem times. Moreover, theLabour party stands at about 20 to 25 points above the Conservatives, eventhough a clear policy agenda has not as yet been articulated.

A political solution to the problem of credible leadership is expectedto come from a massive desertion by back-bench members of the conservativeparty, once they see that Mr. Major is a clear liability to their chances for re-election. Their support is expected to rally around the current Chancellor ofthe Exchequer Kenneth Clarke or Industry Secretary Michael Heseltine. Untilsuch a change is made, the political uncer-tainties will have a negative effecton the value of sterling.

Although recent figures show the narrow money supply exceedingthe tar-get zone of 0 to 4%, indicating a rise in retail activity, it still cannotbe said that a stable recovery has taken hold. In fact, tax increases whichhave gone into effect in April/94 are expected to reduce disposable incomefrom each household by E1000. Clearly, fiscal policy is working against astable recovery.

Furthermore, the long-term growth potential of the economy is alsoof some concern, given that recent credit market conditions have raised long-term yields which crowd out investment spending on industrial expansion.With focus on the inflation target of I to 4%, it does not take much of anincrease in demand before price pressures arise in an economy that ischronically affected by under-investment.

Such is the state of the long-term growth potential for the U.K. sincea shortage of business investment is the prevailing condition whichcontinuous-ly leads to premature increases in inter-est rates, when evidenceof price pres-sures surface. In this respect a solution would be an upwardrevision to the inflation target, or some combination of policy which would


56

reduce financing costs to deepen capital investment, while maintaining astrong level of aggregate demand.

A long-term consideration such as this must either reverse the presenttax increases, or institute a lower level of sterling. The survey below by theConfederation of British Industry shows that low aggregate demand and highcapital costs are two major reasons for a low level of business investment.

Currency Outlook

Demand conditions in the economy do not look promising, aschronic long-term under-investment by resident com-panies coupled byhigh personal debt burdens and new income tax increases, tend to favour lowerinterest rates. In addition, upcoming political uncertainty and the continuingsupport of an export-driven recovery should limit any upward tendencies inthe value of ster-ling. Consequently, the trading range with respect to themark will settle between 2.45 and 2.55.

Factors Limiting Manufacturing Capital Expenditures(% of firms answering yes)

Inadequate Lack of Lack of Cost of DemandNet Return Internal Fin. External Fin. Finance Uncertainty

1981:02(a) 35 22 3 11 531982:Q4(b) 36 26 2 4 521992:Q1 (a) 47 23 4 11 601993:Q3(b) 44 27 5 5 541993:Q4 49 26 3 4 551994:Ql 46 24 3 2 44

(a) Trough of Recession(b) Six Quarters After TroughSource: Bank of Englandinflation Report: February/94

57

Second Quarter 1994

• John Major survives outcome of European Parliamentary elections• Major’s use of veto in selection of European leader rallies party• cabinet re-shuffle shows marginal shift to the right• Tony Blair assumes the labour party leadership• defence cuts will reduce civilian payroll by 18,000• engineering industry to lose 40,000 jobs over next 12 months• manufacturing input prices rise by 4.4% since January 1994• excess building capacities leave construction industry flat• increase in part-time work and self-employed reduce jobless totals• yearly money supply increase of 6.7% shows rise in retail activity• invitations to tender fall from 43 to 27% in first quarter of 1994• business investment spending plays very minor role in recovery• commercial vehicle registrations increase by 24%

Economic OverviewBy exercising his veto over the French/German pre-selection of

Belgian prime-minister Jean-Luc Dehaene at the Corfu summit, John Majorhas effectively postponed what was to have become a certain leadershipchallenge. Given the lingering uncertainty in economic recovery, Mr. Majorhas performed the rational unifying act by repositioning the Conservativeparty as one of nationalism, as opposed to Europeanism. Followed up by aquick cabinet re-shuffle, that confirmed a marginal shift towards the right withthe promotions of "Eurosceptics" Michael Portillo and Jonathan Aitken.

On the balance, one cannot fault Mr. Major. He is only doing whata rational politician in any country would-reaching for the easiest safety-valve at a time of domestic uncertainty. And this case is no different, however,for the fact that it once again demonstrated the short-termism inherent in UKdecision-making.

58

Third Quarter 1994

Although recent evidence of rising employment numbers, strengthin consumer spending and a fall in the budget deficit to E2.86 billion in June,1994, from E4.3 billion in May, 1994 all point to partial recovery. Conflictingviews on export and business investment performance cloud what couldotherwise be termed a full recovery. What is now being felt in the service andretail side of the economy, could easily show reversal and a dip into recessiononce again, if the manufacturing- domestic manufacturing industry holdsing side of the economy does not co- to the overall picture of recovery in theoperate in the upturn.

Faced with increasing commodity prices since the start of 1994,manufacturing firms utilising raw material inputs are showing early signs ofprice pressure. What is just as serious, however, is the lack of additionalcapacity added to the m.anufacturing base over the last two years. The existingsituation in the manufacturing sector can be described as a recipe for disaster,given the stringent 0 to 4% inflationary guidelines as set out by the Treasury.

Not only is there a possibility of manufacturers trying to pass onrecent raw material price increases to end users, but the lack of investmentover the last two years, constrains the growth potential of non-inflationarydemand. The importance of this argument rests on the perception, of howimportant a role the domestic manufacturing industry holds to the overallpicture of recovery in the UK.

Currency Outlook

The affirmation of recovery in the UK must still confront the recentelimination of about 18,000 well-paying civilian jobs in the defence sector,not to mention the continuing overhang of debt on home owners.Furthermore, it is still doubtful as to whether the full tax increases from theLamont and Clarke budgets have as yet had their full impact on disposableincomes. In spite of the increase in National Insurance payments, and areduction in mortgage interest already deducted from wages, the 8.0% increasein VAT on fuel has not yet been factored in.

In addition, low business investment spending and a needed rise inexport demand (mentioned above) will both work against any appreciationin sterling over the next two quarters. Consequently, a trading range of 2.4to 2.5 Deutsche marks to one pound sterling can be expected.

59

Third Quarter 1994

•Treasury & Bank of England decide to raise base rates by 0.5%•Bank of England warning over high internal rates of return demanded by firms•commercial vehicle sales rise by 24.2% in July/94•consumer credit rises by 1.0% from last year due to low consumer confidence•housing sales continue downward trend falling by 10% in July/94•docklands commercial leasing shows signs of recovery•debt repayments & redundancies produce record corporate cash surplus•redundancies coupled by wage falls raise corporate profit margins•dividend payments at 20 year high in 1993 or 3.6% of GDP•manufacturing investment falls by 3.7% in first quarter of 1994•broad money supply falls to 4.8% in July/94 nearing bottom of policy range•machine tool sales rise by 11% in the second quarter of 1994•heavy retail discounting causes 0.5% fall in July/94 retail price index•Sterling achieves 17 month low against the mark•construction workload levels rise for the first time in over 4 years•July/94 inflation rate at 2.2% is lowest in 27 years •November/94 budget not expected to deliver tax cuts

Has the UK finally emerged from recession? If the recent increasein the official base rate is any indication, not only has recovery been firmlyentrenched, but more remarkably, inflation has become the sole concerndriving official policy.

The recent move to raise rates by 0.5 percent, represents a shift inthe long-term trend towards higher rates, and comes after a period spanningsome five years. Thus, can this recent reversal in policy signal a shift that canbe sustained over the medium to longer term, or can it be judged as comingtoo hastily, in light of recent evidence of continuing weakness in retail salesand acute discounting in most high street shops?

60

Fourth Quarter 1994

The current dilemma confronting the efforts of policy makers is thatthe present economic recovery is unique, in that it does not share many ofthe characteristics reminiscent of the recovery that followed the trough of 1980-81. For instance, the behaviour of corporations, the banking system, the debtprofile of consumers and the current posture adopted by the Treasury underChancellor Kenneth Clarke in conjunction with Bank of England GovernorEddie George, is very different from previous recoveries.

Focusing attention on corporate behaviour, it is useful to refer totable I. Although recent evidence produced by the engineering industrypoints to a striking improvement in order books for heavy capital goods,many are perplexed by the continuing low investment levels.

Instead of investing in productive activities, companies in the UK areawash in liquidity. Cost reductions coupled by low wage demands over thepast three year period, has resulted in higher profit margins that have beensolely used to pay down indebtedness. Compared to the last recovery overthe 1981 to 1983 period, corporations have:

• doubled their profit levels• increased their retained earnings by 30 percent • accelerated dividend payments• repaid bank debt as opposed to borrowing for investment.

In a recent article in the August 1994 release of the Bank of EnglandQuarterly Bulletin, official concern has been aroused by this shift in corporateinvestment patterns. It has been suggested that investment evaluation criteriahas not kept pace with the new low inflationary environment, with the wayin which an internal rate of return is determined. (See editorial: Disinflationto Reinflation) Not only have the high demands on investment returns heldindustrial expansion below trend. Recent pressures on retail margins andcontinuing low consumer confidence levels, depressed by high amounts ofindebtedness and often resulting in negative personal equity levels have alsoweighted domestic investment levels downwards. (See table II)

Judging by the different way in which corporations are nowapproaching investment decisions, it would be incorrect to criticise theChancellor’s recent move to raise base rates. Since any marginal declines inthe other direction, would not lead to any major spurts in capital expenditures.Whether any reduction would instill badly needed consumer confidence,or reduce the burden of negative equity would be subject to speculation, atbest. In addition, with the announcement by Mr. Clarke that the upcoming

61

Fourth Quarter 1994

November 1994 budget for the next year is unlikely to reduce the tax burdenimplemented by the last November 1993 budget, not to mention increasesfrom the Lamont tenure before that, it is unlikely that economic activity willbe lead by either consumers, corporations or by government spending.

Currency Outlook

Domestic factors will continue to deliver very uneven activity, as iswitnessed by the string of contradictory data releases over the past year. Therecent rise in base rates will only accelerate should there be signs in the pick-up in pent-up demand. However, exports will continue to play a major rolein driving the domestic economy. Hence, favouring a lower level of sterling.

With the US dollar expected to continue its downward trend inlight of recent political setbacks to the Clinton administration, any furtherprogress made towards a single European currency will continue to suppressany upward movement in sterling values. All factors considered, sterling isexpected to remain below 2.46 Deutsche marks over the medium term.

Measures of Performance(Table I)

Firms Below Capacity(%) Return(%)

1980 73 4.11981 80 3.01982 76 4.31983 70 5.11984 58 5.4

1990 49 7.51991 67 7.21992 69 6.91993 65 8.3

(1) (2)

(1) Source: CBI quarterly survey ofmanufacturing firms

(2) Pre-tax return on capital stock at replacementcost in non North Sea sector

Source: Bank of England Quarterly Bulletin,August, 1994


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Regional Profile of Negative Equity (Q1: 1994)(Table II)

Households with Average Amount ofnegative equity (000’s) Negative Equity Per

Household (£)Greater London 220 8,000South East 510 7,500South West 180 5,700East Anglia 80 6,700East Midlands 100 2,600West Midlands 90 1,400Other Regions 120 900Total 1,290 5,900

Source: Bank of England Quarterly Bulletin,August, 1994

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• Conservative Eurosceptics split the Tory party with defiance over increased contributions toBrussels

• Conservative party splits to defeat VAT increases in November, 1994 budget• UK becomes ever more a recipient of European Union aid transfers to depressed regions• manufacturers & retailers margins come under pressure as base rates rise by 0.5% to 6.25%• the UK economy heads towards a consumer crisis evidenced by a 10% fall in retailer margins• auto industries cut back on domestic production as expected sales far surpass actual sales• real estate prices continue their decline while property developer Stanhope edges towards

receivership• public sector borrowing requirement improves at the expense of consumers and retailers• economic activity narrowly restricted to the export sector• financial services industry experiences upheaval with the loss of 160,000 jobs over the last 5 years

Sterling has failed to convincingly breach the 2.45 mark level over thefourth quarter of 1994. After two consecutive increases in the base rate, shortterm capital inflows have not been able to keep pace with longer term outflows.Furthermore, since the economic recovery has been overwhelmingly dependenton exports, a high level of Sterling has become a very important psychologicalbarrier to investors. Any movement that would surpass the current trading rangewould become an immediate signal to sell-off exposure to Sterling, given theprecarious state in which the consumer and retail sector are currently embraced.

Evidence shows that both retailers and manufacturers are experiencinga margin squeeze, although of differing degrees as goods manufactured forexport are able to more easily pass on the price increases to the end buyers.Conversely, retailers are restricted to the budget constraints of the battereddomestic consumers. Overall, the supply side of the domestic economy hasperformed well, although restricted by the malaise in the final demand anddistribution side.

Nothing has been more disappointing than the recent trend in theautomotive sector. Ever since the collapse in the August 1994 sales base- amonth traditionally expected to perform well in the UK - the continuing

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December 1994

weakness has prompted many producers to question the durability of therecovery. Evidence points to the sharp deterioration in the sales figures ofNovember 1994, as the number of private buyers dropped by a 13.5 percentyearly rate. The danger of such a decline in a high value-added industry suchas the automotive sector, is that the current recovery in the engineering andmanufacturing sector will be in jeopardy, unless the domestic exposure isminimal and most production is exported. Overall, with declines in real estate,retail and automotive, the encouraging results in the manufacturing sector aresusceptible to abrupt changes in currency and cyclical swings in the businesscycle in the destination country. Hardly an appropriate foundation under whicha lasting domestic recovery can be based on.

Furthermore, the Chancellor of the Exchequer Kenneth Clarke hasjust tabled one of the most austere budgets in succession, after the tax increasestabled under former Chancellor Norman Lamont. Specifically, the Clarke budgetpromises to reduce the public sector borrowing requirement to £21.5 bn. in1995-96 from the previous target of £30 bn. The net result is that the fiscalguidelines under the Maastricht Treaty on debts and deficits are expected to bemet at the end of fiscal 1995, but at great cost to the domestic economy. Moreover,the Clarke budget is intent on eliminating the deficit by 1997-98, and the publicsector borrowing requirement by 1998-99.

Reductions in the debt and deficit is expected to come entirely fromspending reductions and excise tax levies. Although the proposed increase inthe full rate of VAT on domestic fuel was to have been applied at 17.5 percent,the defeat by rebel Conservative members opposed to the increase wasimmediately countered by the Chancellor through an increase in existing excisetaxes and by an aggressive reduction in spending on capital programs to makeup for the £1 bn. shortfall left bare from the defeat of the VAT increase. It isinteresting to note that both personal and corporate tax rates have been sparedin the budget. Leaving the scenario for tax cuts open, should political necessitieswarrant some form of emergency action as the election year approaches.

The overall deflationary climate of the 1990s will continue to place aheavy burden on exports to ensure that a basic level of growth can be sustained.Short of any sustained inflationary correction to the prevailing condition ofhousing price declines, and rampant negative equity in the domestic economy.The export sector can be said to be the “only game in town”. This condition isever more exacerbated by the stringent budget, coupled with a trend to higherbase interest rates. In short, the move toward a trade surplus in the internationalaccounts is essential.

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65

With a slowdown in North Sea oil revenues, a concerted effort toformulate an active industrial export policy is essential. The offsetting effect thatsuch a policy will have should ensure that the UK will continue to maintain asurplus in the trade balance. Since evidence points to an outflow in the long-term capital accounts (a situation not too dissimilar to the US), continued successin the foreign markets should ensure that no domestic pressures build forincreases in real interest rates. Anything short of this, and an already stagnantsituation would fall under worse conditions.

The table above illustrates an interesting development in the distributionof ownership on the London Stock Exchange. Overseas investors accountedfor a marginal increase in overall investment inflows, but on a short term basisas represented in the table. This marginal increase in U.K. equity investmentsby foreigners is troublesome, given the record increase registered by manycontinental European countries such as Germany, not to mention thediversification which has benefitted the “emerging markets.” In addition, therecurring in-fighting with the Conservatives is not helpful in attracting a long-term capital surplus position. Although Prime-Minister Major will probablyrecover in time for the next election, the inability to formulate a unified stanceon European issues has frightened investors from the UK markets.

The present talk of a series of referendums to be held on sensitive issuessuch as monetary union or increases in European budget contributions canonly harm a country that has left itself so vulnerably exposed to continentalexport markets. Consequently, the logical policy would be one of ever moreintegration with the most important export market- continental Europe.

Sterling cannot afford to rise much past the 2.45 Dm. range. Thereexists a direct relationship between how consumers and retailers perform andthe strength of the currency. If consumers continue to be dragged down by theso called “feel bad” factor, this will exert a downward drag on the value of thepound. Likewise, if the process of European integration stalls or backtracks inany which way or form, the currency will fall. In essence, it can be said that Sterlingtracks the only effective component of aggregate demand in the domestic sector,and that is the amount of goods and services in which the UK is successful inselling to continental Europe.

Over the first quarter of 1995, investors will initially look for any signsthat would show some degree of political unity once again in the rulingConservatives. Also, any slowdown or acceleration in the balance of tradeaccount will be of great importance in judging the effects on the domesticeconomy that the international accounts may have. Given that long term capital


66

outflows and the growing deterioration in the balance of trade will under normalcircumstances cause higher real interest rates, as in the case of the US, henceleading to an upward effect on Sterling. The situation cannot be judged as beingsimilar, since the US has virtual full employment and a very buoyant consumerand business investment sector lacking in the UK. Only under a situation wheredemand leads to capacity strains will a currency have the propensity to appreciatewhen confronted by increases in short-term rates.

Consequently, Sterling will be expected to stay within its current rangeof 2.40 to 2.45 Dm. Falling below should the government be placed under asituation where a call for a leadership review takes place. Or, marginally exceedingthe upper limit if the Tories are able to bring some semblance of order to theroutine of politics and continued signs of price pressures building in the primarymanufacturing sector.

November 1994 Budget Forecast1994/95 95/96 96/97 97/98 98/99 99/2000

Receipts 37.75 39.25 39.75 40.0 40.25 40.25Expenditures 42.0 41.25 40.5 39.5 38.75 38.0Current Balance -4.25 -2.0 -0.5 0.5 1.5 2.25PSBR(%) 5.0 3.0 1.75 0.75 0 -1.0

Source: FT

UK Equity OwnershipOwner 1963 69 75 81 89 90 91 92 93Pension Funds 6.4 9.0 16.8 26.7 30.6 31.6 31.3 35.1 34.2Insurance Co’s 10.0 12.2 15.9 20.5 18.6 20.4 20.8 16.7 17.3Unit Trusts 1.3 2.9 4.1 3.6 5.9 6.1 5.7 6.2 6.6Individuals 54.0 47.4 37.5 28.2 20.6 20.3 19.9 20.4 17.7Manufacturers 5.1 5.4 3.0 5.1 3.8 2.8 3.3 1.8 1.5Overseas 7.0 6.6 5.6 3.6 12.8 11.8 12.8 13.1 16.3

December 1994

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• Major continues to have difficulty in uniting Conservatives over Europe & Northern Ireland• base lending rates rise for the third consecutive time by 0.5 percent to 6.75 percent• durability of the Conservative party is dependent on 9 Ulster Unionist MPs • Unionist leader James Molyneaux rejects the direction of the negotiations with the Republic of

Ireland• falling oil exports & increasing imports cause visible balance of trade deficit to rise• Conservative party to set out new conditions in addition to Maastricht Treaty guidelines for a

single currency• manufacturing exports begin to overtake oil exports as the most important item in international

trade• GDP growth of 4.0 percent registered in 1994• 44 percent of the male labour force have been jobless from 1990• negative equity rises by more than 200,000 to 1.3 million in fourth quarter of 1994

Sterling continues to fluctuate at about the Dm. 2.4 level despite the0.5 percent increase in base rates, and the rise in the balance of payments deficit.However, what is more on the minds of investors is the durability of the presentgovernment. Ever since the re-election of Mr. Major in 1992, the severity of therecession and the political split within the Conservative party amongst theEurosceptic faction, has prompted most commentators to continually predictthe ultimate demise of his government. This has not happened, and there is avery good chance that Mr. Major will continue to lead the Conservatives in thenext election scheduled some time in 1997. Although the British public hasbecome bored and violently impatient with the current government, giving Mr.Major an approval rate of just 20 percent. The resilience and staying power ofthe current prime-minister, must however, be admired. The question on mostpeople’s minds is if the internal pressures building up with Europe and NorthernIreland, will tip the Conservatives into an early general election?

With the debate over a single currency, it is clear from Industry MinisterMichael Heseltine’s recent trip to Japan, that the Japanese- heavy automotive

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First Quarter 1995

investors in the UK, have asked for reassurances from the minister that the UKis committed to the deepening of a single market within the European Union.Despite record investment outflows by UK companies (outward investmentby UK companies represents 25 percent of total investment), the Japaneseautomotive companies direct investment in predominantly UK based plantshave become vital to the development of the domestic industrial base. Of theeight European-based assembly and production plants, five have been locatedin the UK, with direct investments somewhere in the range of £3.0 to £4.0billion. Needless to say, the present internal political squabble with “Eurosceptic”members is very unsettling to most sectors of industry.

Exports have become the most vital component to domestic economicactivity. Of this, automotive products, as in most countries, play a dominantrole. In 1994, automotive production has increased by 6.6 percent, representingthe highest volume in 20 years. Ever since sterling left the European ExchangeRate mechanism, the level of sterling has been, and continues to be very sensitiveto the needs of the export sector. This is not expected to change so long asgovernment expenditure, consumer spending and business investment remainweak domestically.

Furthermore, evidence of a structural shift in the international tradingaccounts, will tend to give underlying fundamental support to a lower level ofsterling relative to trading partners in the EU. The loss of North Sea oil revenues,and the continuing expected decline in reserves, will ensure that sterling willsettle to a new lower structural trading range. This will benefit UK manufacturersthat are beginning to export more and more, and will hurt consumers, as wellas bringing down a buoyant services sector.

Investment outflows require a volume inflow from sales ofmanufactured products and services overseas, in order to ensure that the rateof domestic inflation remains within the 2.5 percent cap inscribed in currentgovernment policy. Since any imbalance in the international accounts will entaila depreciation in sterling, placing upward pressures on domestic prices. A usualconcern of the German Bundesbank, but also one that is getting more attentionin the UK. Given that the economy is recovering slowly, a definite floor will beapplicable to sterling in the eyes of policy makers.

However, the fundamentals which would normally allow sterling totrade within the Dm. 2.35 to Dm. 2.45 trading band, will have an ingraineddownward bias, as long as political tensions remain over the issues of NorthernIreland, and more importantly to the run up to the 1996 MaastrichtIntergovernmental Conference. A split in the Conservative party over either of

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these issues will cause sterling to dip to the downside within the Dm. 2.35 toDm. 2.45 range. If Mr. Major survives the turmoil, a level closer to Dm. 2.45can be expected.


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Two Crises for the Conservatives:Europe & Northern Ireland

Europe

• John Major tries to balance two extreme interests with the pro and anti-Europe groups

• plans to introduce new conditions on top of the Maastricht Treaty guidelinesfor the UK to participate in a new single currency

• 9 Eurosceptic MPs hold key to survival of government if 9 Unionist MPsdecide that plan for an association of the two Ireland’s is insufficient & cannotbe supported along with the current government of John Major

• Themes for the 1996 Intergovernmental Conference will prove to bedefensive & lacking vision. Reform of agricultural & fishing policies, revisionto qualified majority voting & greater scrutiny of the EU budget has beenpromised by Mr. Major

• Michael Heseltine reassures Japanese investors of the UK’s support of theEU

Northern Ireland

• Dublin & London near completion of a framework document that “leakedportions” have alarmed the 9 Unionist Conservative MP’s that presentlyensure the survival of the current government

• framework document contains provisions to set up a pan-Ireland authoritywith powers extending to the EU & Ireland-wide industrial sectors

• James Molyneaux- leader of 9 Conservative member Unionists criticizes“secret negotiations” & calls for direct contact with the four main politicalparties in Northern Ireland. Any new all-Ireland bodies must be accountableto the people of Northern Ireland & must pass a referendum to hold legitimacy

• real progress depends on Mr. Major re-gaining support of Eurosceptic MP’s

71

£ Barings collapse places City of London under pressure£ Bank of England comes under scrutiny over regulatory lapse with Barings and internal sex scandal £ sterling continues to plunge to historic lows against the Deutsche mark£ manufacturing prices begin to rise as input costs attain highest level in 10 years£ Major re-asserts discipline on party members over comments on a single currency£ large budget surplus recorded in January 1995£ machine tool exports rise 96% in fourth quarter of 1994 & automotive exports rise to new

records£ retail sales drop 0.9% in January 1995 after brief surge in December 1994£ Institute of Directors survey posts business confidence at lowest level since collapse of ERM£ recent study concludes that financial services account for 20% of UK GDP

The combination of poor domestic economic activity, Baringsspectacular collapse and the robust economic recovery in Germany, pushedsterling to a historic low of 2.189 Deutsche marks. Most European currenciesgot caught up in the flight towards quality around the world, and sterlingwas no exception.

It cannot be denied that the Mexican peso crisis, and the subsequentevents that brought down Barings bank, harmed both the dollar and sterling.In the case of Barings, the entire affair is one that has global regulatoryconsequences against the backdrop of phenomenal technological progress.In short, can crises of these proportions be managed, or even prevented in aperiod of far-reaching technological progress? More broadly, is a globalproblem that affected Barings, something which only the City of Londonwill ultimately pay for in the long run?

The advancement of sophisticated trading products and their constantrefinement, is something that a regular commercial banker has a great dealof difficulty understanding. The traditional banker’s world of lending againstcash-flow has been under attack for the past ten years, if not longer. At theroot of the entire problem is the entire system of seniority, when it comes to

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Second Quarter 1995

human resource operations in the large clearing banks especially. Despitehaving spent a great deal of effort and money, in attempts to educate theold-style bankers on the new developments in financial derivative products.The constantly changing environment of innovation is quick to render suchefforts pointless. Ultimately, not only have these organisations squanderedvaluable resources on individuals that cannot be educated to fit into the newglobal environment, but the danger multiplies when the old-style, traditionalbanker truly believes that they now fully understand the new changes, andwhat is worse, try to act accordingly. This becomes even more dangerous, whena person in a regulatory role adopts this attitude of invincibility in the newfast changing environment. This scenario is most likely that which existedwithin Barings’ banking culture. The collapse of Barings has severely affectedconfidence in many small to medium sized merchant banks in the City ofLondon, and has most definitely been an element, among a list of many, thathas depressed the value of sterling.

Consumer confidence, real estate values and business investmentspending by British companies remains depressed, with early evidenceindicating further deterioration among both consumers and entrepreneurs.However, one positive to all of the negatives, has been the thriving automotiveindustry, with Japanese transplant companies operating in the UK playing aleading role. This factor has been greatly assisted by recent weakness insterling. To illustrate how robust external markets are to British products, asopposed to local markets, the broad category of machine tools exports rose96 percent in the fourth quarter of 1994, this is contrasted by the meagre10.8 percent increase on the domestic side.

Likewise, the automotive market was subjected to a similar patternin the UK. As domestic sales stagnated, and deep discounting set in to winover consumers, exports will account for the record output of vehicles,expected to surpass 1.5 million units for the first time since 1974.

In the second half of the 1990s, the UK is expected to become thethird largest producer of automobiles in the EU, behind only France andGermany. Recent positive events include: • Toyota is to introduce a second model range in 1998, doubling capacity to200,000 vehicles in one year• Ford’s Dagenham plant to produce 25,000 vehicles annually for its Mazdasubsidiary• Jaguar is expected to announce a £500 million investment to create a world-class luxury car manufacturing centre


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As is commonplace in most industrialised countries, the automotivesector is the only game in town. Unlike Canada and the US, domestic pent-up demand is not contributing to the expansion at this point in time. However,the pent-up demands that are being generated on the continent is what isdriving the record levels of production in the UK.

So depressed are local business conditions, that they are affecting awide cross-section of industries not involved in the export market in anygreat way. Difficulties in the luxury products market are exacerbated bydeflationary conditions, combined with a general climate of politicaluncertainty with the Conservative party.

The ensuing credit crunch that Barings collapse is bound to intensifywill ensure that a bad domestic situation becomes impossible. Already, thelarge conservative clearing banks are unwilling to even accept a simpledeposit, without going through rigorous extremes in investigating the originsof the money being left with them. If this bureaucratic exercise accompaniesthe act of injecting money into these institutions, one need not speculate onwhat it will take to secure a simple commercial loan.

Sterling has settled in a range of record lows with respect to theDeutsche mark. The extent of the weakness, just as in the case of the dollarwas unexpected. The existing climate of political uncertainty prior to theMaastricht intergovernmental conference in 1996; the on-going problemswith Unionist members of the Conservative party over the Irish peace processbrokered by Mr. Major; the general domestic weakness in business conditions,have all been factors which warrant a weak sterling on fundamental grounds.The recent plight of Barings bank has without doubt added an element to theprevailing pessimism. In that sense, it is not too dissimilar to the way inwhich the spectacular collapse in the peso caused a collapse in the dollar, andwhich remains the scenario from the ensuing fall-out. In addition uncertaintyin the French elections, scandals and weakness in Spain and the overall flightof capital back into quality have also weighed against sterling.

With consumer spending in a depressed state, and with an aggressivepush by British exporters into the international marketplace, there exists a farmore convincing case for a weak pound. The only event that may conceivablyoffset this is any move to raise base rates should external pressures on domesticprices be imposed. Although evidence does indicate early cost pressures,sterling is not expected to trade above 2.28 to the mark.


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City of London Survey•financial services compose 20% of GDP•financial services provide 150,000 jobs•insurance industry in decline•35% of global swaps activity•27% of global foreign exchange trading•European integration will help London•Frankfurt will not overtake London•Paris will not overtake London•main problems with transportation

Study conducted by the London Business School

Fallout From Barings Collapse• downward pressure on sterling• merchant banks issue statement of confidence• concern over effects in interbank market• interbank funds at premium to Merchant banks• Bank of England ready to add liquidity • general credit crunch in process• calls for investigation of Bank of England


75

£ Conservatives continue to suffer setbacks in local elections£ questions over John Major’s leadership credentials begin to re-emerge£ business failures rise sharply in first quarter of 1995£ sterling weakness exerts upward pressure on raw material costs£ Treasury & Bank of England begin to express concerns over weak sterling£ manufacturing recovery begins to stagnate in first quarter of 1995£ domestic business activity still reliant on export markets£ property values begin to fall again prompting developers to cancel stock dividends£ investment bank SG Warburg sold to Swiss Bank Corporation£ automotive production highest in 22 years as exports surge by 52% over one year

Will 1995 be a year of recession once again? If recent economic indicatorsare anything to go by, the UK domestic economy has not yet experienced recoveryfrom the troughs that were registered at the start of the decade. In fact, currentdevelopments on the homefront only tend to exacerbate the already plungingconsumer confidence levels.

Aside from poor results registered at the local polls by the rulingConservatives under Mr. Major, the UK has not experienced any type of resurgencein business activity on the retail side, nor have businesses bothered to invest in newequipment. In short, any success that the domestic economy has had in generatingprofitable business, has solely been dependent on exports by British companiesoverseas. This has become a familiar pattern over the past 18 months, and continuesto be the driving force behind any signs of positive business activity to this day.

The recent decision by Chancellor Kenneth Clarke to hold base lendingrates at the current rate of 6.75 percent, may reflect an impending slowdown,rather than the common argument submitted, of a politically inspired decision thatwas hastily implemented just shortly after the humiliating performance of theruling party in the local elections. All indications at this moment point to continuing“structural” shifts that go beyond the normal ups and downs within a business cycle.

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Third Quarter 1995

Ever since the pound sterling fell out of the European exchange ratemechanism, the direction has been downward ever since. The familiar peaksand troughs have not resurfaced, and convincing explanations have not beenforthcoming. A pattern very familiar to the dollar-bloc group of countriesthat includes the US and Canada, within the G-7. What has become veryclear, is that the short-lived “recovery” is on the verge of coming to an abrupthalt. Disturbing, since many have neither felt, nor participated in what hasbecome traditionally defined as a recovery.

As in most industrialised countries, the UK is no different whenlooking at the factors behind the increase in business activity in 1994. Theincreases in raw material prices came due to a combination of an alreadyweak sterling, and a rise in the pent-up demand for basic raw materials, suchas paper, steel and mined minerals. In all, the brief respite from recessionwas primarily generated by conditions of pent-up demand in the automotivesector in Europe and North America, fuelled by expectations of a moredurable policy-supported recovery. However, under the current conventionalwisdom, this has so far failed to materialise.

Recent statistics tend to support this view, as the manufacturingrecovery of 1994 has all but ended. Domestic automotive demand declinedby 7.2 percent in March 1995, as the decline in domestic production of 7.8percent was more than offset by the robust 52 percent growth in productionset aside for export purposes. Despite the positive trend in the export sector,businesses continue to display a reluctance to invest, that has been far fromthe normally dismal pattern in the UK. Unlike the Japanese automotivetransplant subsidiaries, whose plans are targeted towards the Europeancontinental markets, companies dealing with the domestic economy are farless likely to commit to long-term capital expenditure, in the face of suchuncertainty.

As the industrial sector tries to contend with weaker pent-up demandin 1995, other traditionally strong sectors lay dormant. Low consumerconfidence levels continue to depress a wide range of retail shops. Fromfashions to jewellery to books, all have been subjected to very lax demandfrom consumers. With no real ending to the depressed business conditionsin shops, the sector is poised to go through a radical structural change. Whatshape or form this structural change will ultimately take is very difficult toassess at this moment. However, with traditional margins being squeezed,efficiency-creating restructurings are inevitable. Consequently, upward pricepressures will be contained only to imported products, and especially ifsterling will remain on the low side for a prolonged period of time.

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At the root of the low confidence that consumers are currentlyexperiencing is the continuing commercial and residential property crises.Recent statistics show that prices for homes have once again levelled off toa lower price range. This was confirmed by the continuing decline in mortgagelending, down 10 percent over one year. In addition, the news was not anybetter with property development companies, as most have cancelled orpostponed their dividend payments to shareholders. Since property shares haveunderperformed the wider London stock market index by some 15 percent,even the remotest of expectations of any recovery is not on the horizon.

What may yet be the most troubling sign in the UK, is the abrupttransformation taking place in the City of London financial district. Afterthe spectacular collapse of the 232 year old Barings bank, merchant bank SGWarburg has agreed to become part of the Swiss Bank Corporation, bringingto an end another of Britain’s most honoured traditions. After the sale ofmerchant bank Morgan Grenfell to Deutsche bank, and the disposal of whatwas the remains of Barings to ING bank of the Netherlands, the trend for well-capitalised universal European banks is becoming very clear.

After Deutsche bank acquired Morgan Grenfell, it allowed theinvestment bank to maintain its independence in London, from anydistractions from its parent in Frankfurt. Not only has this been successful upto this point, but Morgan Grenfell has prospered under such an arrangement,and to this day attracts talented professionals from some of London’s mostreputable institutions. Likewise, most London-based subsidiaries of Swissbanks consider the city as their natural home. What all of this indicates, isthat competition for Europe’s three main financial centres: London, Paris andFrankfurt, has already de facto been decided in favour of London, and bypowerful European banks themselves. It cannot be denied that DeutscheBank has already decided that its investment banking operations ought to bebased in London.

What is troubling, however, to most Britons when thesedevelopments in the City are viewed subjectively, is that the “British disease”has now shifted from the manufacturing sectors, to the financial servicessector. Within the span of two months, some of the most legendary institutionsin British history, such as SG Warburg and Barings no longer exist. Thequestion on the minds of many now, is whether Lloyds insurance marketwill somehow meet a similar fate?

Already, there are numerous signs that once again bring Lloydssolvency into question. According to recent statements made by Lloyds


78

Chairman David Rowland, member’s personal finances and the Lloyds centralresources fund have experienced “severe strain.” Most recently, the results ofthe 1992 underwriting season shows an overall loss of some $2.4 billion inUS dollar terms. Informed rumours as reported by the Financial Times ofLondon, also report of a credit crunch directed at Lloyds by some largeLondon clearing banks, and pressure on agents to pursue legal action againstthose clients that are refusing to pay their debts.

In short, judging by these recent developments, the financial servicessector is experiencing profound structural change, even though it shouldmaintain its hegemony over Paris and Frankfurt in Europe.

Signs of an economic downturn will depress the value of the poundsterling. The truth of the matter is that only the export sector continues toperform respectably. Business conditions in the domestic economy aregenerally bad at this moment, and consumer confidence continues to sufferover the renewed attack on property values. The same story exists withbusiness investment, as the choppy recovery has prevented companies frommaking any major commitments in this area.

In a similar fashion, what has been formerly the sole preserve of theBritish manufacturing sector, massive forced foreign takeovers have occurredwith some of the UK’s most prized financial institutions, mostly throughnecessity. These effects from what is now occurring in the financial servicessector is at best highly speculative. However, since 20 percent of the UK’sbusiness activity emanates from the City of London, recent developmentscannot be dismissed.

As the UK has become a service-based economy, relying more andmore on such industries as estate agencies and banking, unstable events thatlevel some of history’s more enduring institutions as Barings, deserve to bescrutinised more carefully on the broader impact of the entire economy.Everyone knows that services suffer the most when a downturn occurs, andshould there be a period where business activity has been irreparably harmed,as it has from 1991 until the present day, the currency will trade within alower range, under circumstances where a country such as the UK is a netdebtor.

This is in direct contrast with the present position of Japan, sinceboth are experiencing profound domestic deflation. In the global scheme ofcapital movements, interest rates usually play a very important role, and asa debtor country such as the UK is in direct competition with other borrowers,

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the one that usually offers the best rate of return wins out. Such is not thecase, since the collapse in sterling to the lower range of 2.12 to 2.20 Deutschemarks, comes as the weak state of the domestic economy must justify alowering of rates, such that business activity may expand.

In contrast, when sterling was pegged at 2.75 Deutsche marks inthe European Exchange Rate Mechanism, prior to September 1992, highrates did irreparable damage to the domestic economy usurping the credibilityof the artificially-pegged exchange rate and leading to massive capital outflow,on the expectation that the weak domestic economy of a debtor countrydeserves both a lower rate of interest and weaker exchange rate among its maintrading partners.

Since its exit from the exchange rate mechanism almost three yearsago, the value of sterling vis-à-vis the Deutsche mark has depreciated almost25 percent, at its current trading range of 2.15 to 2.20 marks. In this period,it has failed to recover to its former level, or even to convincingly reversethe downward spiral. At this moment, the exchange rate is once again at aturning point. As a debtor country, the UK is reliant on the rate of interestin attracting portfolio investment and in promoting the only thing going forit at this time: exports. An ever lower exchange rate manages to generatemuch needed export-led business activity. It also discourages investors fromshifting capital into sterling-denominated investments. In essence, it has thebest of both worlds. Cheap domestic capital for the government to financeoutlays, and a much reduced exchange rate to maintain its only hope: exports.


80

£ John Major survives leadership challenge from right wing Eurosceptics led by John Redwood£ Major accuses homeowners of over-borrowing in the 1980s resulting in the current housing

recession£ record investment outflows recorded by British companies in fiscal 1994£ Bank of England Governor Eddie George admits that inflation outlook remains mixed£ earnings stagnate & unemployment stabilises while housing market deteriorates further£ 6600 more troop reinforcements sent to Bosnian conflict as military commitment equates with

Gulf War£ large disinvestment out of UK stock market by overseas portfolio managers pushes current

account to deficit£ UK assets being classified with Italy, Sweden & Spain£ automotive production for export markets exceeds production for domestic sales£ British merchant banks continue to be takeover targets for US & European firms

Once again, John Major has pulled himself through a politicalquagmire. Despite the voluminous outpouring of negative sentimentscontinually directed toward the leadership of the Conservative party by theBritish press, John Major’s instincts at political survival must by now have beenelevated to legendary status.

In the latest of a long line of potentially disastrous developmentswithin the ruling Conservative party over the past two years, John Major setout to once and for all put an end to the recurring theme of Britain’s role withinEurope. On the opposing side, only one challenger within the belligerentgrouping of “Eurosceptic” members of parliament, found it fitting to takeup the challenge presented by the prime-minister.

The losing candidate, former Welsh Secretary Mr. John Redwood, tookup the challenge with a naive sense of where Britain actually stood, and thedirection she ought to take, within a European Union that presented thebest economic alternatives in a fast changing geo-political and economicenvironment.

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Fourth Quarter 1995

Politically, the small grouping of European sceptics within theConservative party, represent a minority of doubters on the future course ofrelations within Europe. On the contrary, the majority of political parties sittingin the British Parliament, see a very clear future with Britain at the centre ofEuropean policy. The labour party under Tony Blair, to the Social Democratsof Paddy Ashdown, to even a good 75 percent of the current ruling Conservativeparty, all believe that closer relations with Germany, Italy, France and theBenelux countries is a positive and irreversible development for Britain.

Economic trends usually shape the political fall-out after the fact. Withthe clear ending of the special relationship with the US, British trade patternshave increasingly gravitated towards the European Union. In the worlds mostimportant wealth-creating sector-automobiles, the existence of the Europeanexport market for British-made Japanese cars, has been a lifeline to a sectorwhich was cast in a state of terminal decline.

There is no denial of the fact that the purchasing power in the Britishlocal economy just does not exist. If the Japanese transplants had to rely solelyon domestic factors, they would by now be well into a never-endingrestructuring mode. Reducing capacity according to what the British domesticmarketplace could afford to buy- very little!

If it were not for the European marketplace, the current buoyancy inthe automotive production market would not exist, dragging down the levelof sterling, since the trade balance would shrink into the negative figures. Inaddition, no possibilities would exist with trade towards the US or greaterNorth American market, this just would not be efficient or cost effective.Besides, the North American Free Trade Agreement, and various side-dealssince, have levered badly needed Japanese investment into North America.Any resort to the traditional relationship, would be a foolish venture within aworld that is increasingly divided into trade blocs.

Should there be any attempt to follow the prescription offered by theminority Euro-sceptic group within the Conservative party, the fall out wouldbe very deep and destructive in most sterling-denominated markets. If Britaineffectively resists a single currency and greater economic integration, withoutthe support of one large European country, such as France, domestic businessconditions would disintegrate even further. This is something that most respectedConservatives are quick to acknowledge.

Nothing can be more evident to this effect, than the on-goingrevolution within the British merchant banking sector. Over the past six


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month period, innovation and an increasingly borderless frontier for integratedfinancial services, has seen the demise of SG Warburg, Kleinwort Bensonand topped off by the Barings collapse. Ironically, all of the successful bidderswere large European firms up to now. The initial purchase of Morgan Grenfellin 1991 by Deutsche Bank, and the current acquisition of SG Warburg andKleinwort Benson by Swiss Bank Corporation and German-based DresdnerBank respectively, has left a clear signal of the powerful presence in Londonthat European institutions currently display. This trend is bound to accelerateover the next year, as technological progress leading to regulatory changes,will require financial institutions to offer a full-service range of products totheir prospective clients.

In such a competitive environment, technology will continue toupset traditional habits in the financial services industry, leading to continuouspressure on London to maintain its historic place as one of Europe’s mostprominent financial capitals. For this reason alone, it would be wise for theUK to participate in any future European currency. This is one pre-conditionthat must be achieved to successfully compete with Paris and Frankfurt.

Exports, and those of Japanese automobiles, still remain the mostvital catalysts to domestic business activity. With consumer and luxuryproduct retailers the worst hit, there are signs that the worst is yet to comein the retail property market. This sector continues to languish in suchdesperation, that prime-minister John Major still publicly denounces thespeculative binge of the late 1980s. It seems that this period of speculationhas exacted irreparable damage to personal wealth, leading consumers tofeel terminally depressed. This can be directly accountable for the diversionof productive capacity toward the export sector in vehicles. As more of thevehicles produced are sold to non-British citizens, as opposed to those thatfind buyers within the UK.

The leadership upheaval in June did not cause much panic in sterlingmarkets. Perhaps it was a sign that investors did not perceive that the challengebrought forth by John Redwood would be a serious setback to the longerterm trend toward Europe, that is inevitable.

Only an improvement in the domestic fundamental economy canimprove the current level of sterling. Images of political disputes have provennot to be effective in diverting investment flows. UK based industry has sentoffshore, a record volume of investment capital in recent months. This mustin some way be diverted back into domestic investment opportunities. Asuccessful diversion can only become reality if consumers begin to pick up


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their spending habits on large ticket items domestically. The UK presentlysuffers from the “Canadian effect”. This is when too much investment capitalon a domestic scale is chasing too few good ideas. In Canada, investmentcapital by default, goes into the stock market. In the UK, some may go intothe stock market, but a good deal more is exported. Such is the problem athand.

Unless a tax incentive policy can resurrect the domestic consumersector, investment will not be captive to the UK economy. Likewise, if itwere not for the European automotive markets, the domestic sector wouldwarrant a wholesale repatriation of Japanese investment capital. Time hascome for a tax incentive plan to reverse this malaise. If consumers are left tofend for their depressive situations for themselves, sterling will continue toslowly sink relative to the Deutsche mark. Only a strong domestic economycan replace the current reliance on external purchasing power. When clearevidence presents itself that such a turnaround has arrived, investors willturn into bullish buyers of sterling based financial products. Unfortunately,a range of Dm. 2.10 to Dm. 2.23 to one sterling continues to reflect reality.


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£ Sir James Goldsmith to launch new political party with an agenda to push for a referendum on asingle currency

£ record corporate profits begin to weaken as London stock market continues to break record highs£ unemployment shows signs of rising for the first time in over two years£ producer prices continue to surge achieving fastest annual increase in over four years£ July records largest summer monthly fall in clothing prices since records began in 1914£ prospects of increases in base rates diminish as clear signs of recession appear£ automotive distributors try to cope with one of the most difficult periods for retail sales ever£ lending margins in the City of London under attack as borrowing activity weakens£ business activity ceases to be export-led as oil exports fall by 33% due to maintenance

schedules£ stocks of inventories rise by largest amount for 7 years in second quarter of 1995

To the astonishment of very few, UK business conditions confirmanother downturn. The recent downgrading of analysts forecasts point towardslower profits across most industries previously performing well. This excludesthe permanently depressed property sector, as most contractors large enoughto evacuate the domestic UK economy have already done so, leaving only afew “transplant” industries that utilise the UK home base for overseas exports,largely to continental Europe.

Early signs of a reversal in employment prospects, from a steadilyimproving situation, to one that saw a July increase for the first time in overtwo years, follow in line with overwhelmingly dismal results posted byretailers. In contrast to the depressed business environment in the retailsector, and the declining opportunities presented in the export sector, producerprice increases hit a four year record in July by rising 4.5 percent. In addition,the continuing records being broken by London equities, sharply contrast thebusiness climate in the real industrial and retail sectors of the UK. In all,inventories of unsold goods registered their largest increase in seven years inthe second quarter of 1995, together with lower than expected output in theenergy sector and a fall in services.

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December 1995

Instead of increasing base rates to check the growth of inflation, adecrease is becoming far more likely. In the manufacturing sector, the hotsummer months brought only an increase in sales of food and beverageproducts. Most other sectors contributed a drop of 0.4 percent, with outputin the most important growth industry, the computer sector, falling 0.8percent.

Although inflation shows a slight breach of the upper 2.5 percent limit,Chancellor Kenneth Clarke has up to now been able to convincingly argueagainst any further increases. In contrast, Bank of England Governor EddieGeorge has argued in favour of an increase in base rates, on the premise thatmanufacturers cost increases were the highest in four years. In addition, theoverall weakness in Sterling has been of great concern to the Bank of England,as the risk of importing inflation consistently looms over the economy. Withwhat seems as a permanently depressed level of sterling, the dangers ofimporting inflation in an open economy as the UK, are ever more susceptibleto unexpected shocks externally.

Once again, the key to domestic recovery is dependent on a revivalof positive expectations in the real estate sector. Aside from the negativeimpact that demographic conditions will continue to have on the value ofhousing, a bold policy response is essential if a sustained recovery is tomaterialise. A rehabilitation of consumer confidence must be a central themeof the current government, even if this will result in a larger deficit. Only actionon the fiscal side, and preferably co-ordinated with member states of theEuropean Union, will revive badly-needed consumer confidence at a criticaltime. The longer the duration of the deflationary climate, the greater the fallin property prices. Which in turn will lead to a wholesale devastation in thedomestic retail sector, and increasing reliance on foreigners to purchaseBritish-made automobiles. A vicious circle that has been in evidence now forthree years, runs the danger of spiralling to even lower levels. Should such ascenario arise, real danger of a sustained collapse in equity prices and financialcrisis could come about.

Politically, the agenda of the increasingly marginalised governmentof John Major, continues to prescribe an inactive policy. Such was recentlyclarified by Chancellor Kenneth Clarke, as he confirmed that no tax cutswere in store prior to the spring 1997 call for elections, and that furtherspending cuts were still very much on the horizon for the British public. Inother words, the current government is willing to tolerate further falls in theprice of real-estate assets, more depressing news in the retail sector and asustained disposition towards a lack of the “feel-good” factor. It seems that


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any prospects of reversing the slide in real asset prices could only be takenon by a different government. However, for the time being, the governmentof John Major by continuing to advocate austerity, is headed towardsextinction.

The political horizon that is shaping up looks to present furtherobstacles for the Conservative government of John Major. In an almost RossPerot-type of fashion, billionaire industrialist and member of the EuropeanParliament in Strasbourg, James Goldsmith, has declared his intention topersonally fund a new political party to be named the “Referendum Party”in the forthcoming elections. The intention of the party is to solely push fora referendum on a single European currency in the UK. Consequently, theReferendum Party will take on a negative role and join the Conservatives intheir opposition to greater European integration. The referendum, shouldthey win, will judge if the British public is for or against, joining a singleEuropean currency.

In essence, the Referendum party can only appeal to the hard coresegment of anti-EU members within the existing Conservative party. A likelyscenario could have the Euro-sceptics within the Conservative party breakaway, and join the Referendum party. Moreover, should the labour partysucceed in obtaining a minority government, then the Referendum partycould hold the balance of power in pressing its vote over a single currency,in order for the Conservatives to seize power for an additional term. Alldepends on whether the pro-European Social Democrats and Labour areable to either win a majority, or form some sort of majority based coalitiongovernment. Anything short of this will inevitably lead to a referendum ona single currency in the UK. Something which has continued to split theruling Conservatives, and to which Prime-Minister Major has consistentlybeen opposed to.

Sterling continues to show signs of weakness against the dollar sector,falling to 1.54 US dollars to one pound sterling, from a consistent level of 1.60US dollars. In addition, a major drop in sterling was registered against theCanadian dollar, slipping from 2.20 to a level of 2.07. In contrast, sterling hasrecovered to trade from the 2.19 Deutsche mark range to the current 2.28 marklevel in relation to the German currency. In essence, sterling has becomecoupled with those within the European grouping such as the franc, lira andSpanish peseta. While doing so, it has become decoupled from the dollarsector, and has not been able to use the traditional momentum of the dollarsector to rise along with these currencies. A pattern that is very much newto the behavior of the British currency. Consequently, sterling has severed its


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psychological connection to the dollar sector, and has benefitted from theweakness in the Deutsche mark recently, just as most ERM based currencieshave with the addition of Italy.

At this moment, the severity of the downturn in the UK is morepronounced than in the US and Canada. A coupling with European currenciesmay be far more appropriate on fundamental grounds, since the severity indepressed business conditions in countries such as France have direct parallelsto the situation in the UK. Anything short of recovery in real-estate prices andretail sales will continue to suppress the value of sterling. A prospect whichwill be greatly needed to reverse the slower growth in exports- the lifelineto the UK economy over most of the past year.

When will sterling de-couple from the franc, lira and peseta, anddip to an even lower trading range vis-à-vis the Deutsche mark and the dollarsector? At this point in time, Mr. Major must begin to use the upcomingpreparations for the 1996 Maastricht conference on a single currency, as anopportunity to lead a co-ordinated response to continuously falling assetprices in Europe. Time has come for calls towards a single European currencyto turn into more urgent calls to joint co-ordinated action for recovery inEurope.


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£ Conservative party backbenchers begin to defect to the Labour party£ Prime Minister John Major’s majority in Parliament narrows to six members£ UK business communities enthusiasm for the EU strains relations with Euro-sceptic wing in

Conservative party£ Defense Minister Michael Portillo delivers anti-Brussels speech splitting Conservative party

further£ negative household equity on rise as 90,000 more homes fall prey in third quarter £ low domestic car sales call for government sponsored stimulus scheme£ first ever balance of payments surplus recorded with newly industrialising Asian tiger countries in

7 years£ prospects for sustained low oil prices put pressure on sterling£ raw material prices fall for first time since November 1993 as more jobs are lost than created £ largest fall in living standards for 14 years causes sterling to slump to record lows

Prospects for economic growth in the UK are beginning to lookgrimmer than what could have been imagined, in context with an alreadyacknowledged series of setbacks over the past year. Not only is the survivalof the Conservative party back in the headlines, but continuing dismaleconomic and business figures released only confirm the climate ofdesperation.

The ever elusive “recovery” in UK land and real estate markets, haveonce again been bombarded by new data released that points to highernegative equities for most. Households whose mortgages exceeded the valueof their homes rose by 90,000 in the third quarter of 1995, as house pricesrecorded a further drop of some 1to 3 percentage points in value. This slideis confirmed by the sharp drop in mortgages underwritten by UK buildingsocieties, as net new lending was 18 percent down in September from figuresposted in August. In short, the situation can be summarised in the words ofa senior banker, “property values are falling, rents are static and the normalautumn flurry of deals has failed to materialise. After a dismal October; the


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First Quarter 1996

sector has lost all the gains won in the aftermath of sterling’s exit from theERM (Exchange Rate Mechanism).”

The run up in raw materials prices in 1994 was the overwhelmingresult of a manufacturers’ response to pent-up demand conditions thatsurfaced from three years of gruelling recession, earlier in the decade. Thecontinuing debate between Chancellor Kenneth Clarke and Bank of EnglandGovernor Eddie George, centred on the timing of possible increases in thebase lending rate. A debate to which, upon reflection, the Chancellor was morethan right to resist demands for increases in rates to address the pressures onraw material prices throughout 1994. What surfaced in the periodicdiscussions between the government and the Bank of England, was theChancellor’s deep mistrust in the pricing of raw materials, as representingbusiness conditions on the average in the UK. In retrospect, the inability ofthe manufacturing sector to pass on most of the increases down the line towholesalers and ultimately the consumers, confirmed the Chancellor’ssuspicions over the durability of any recovery.

At this very moment, the robust manufacturing sector of 1994, isbeing restrained by a collapse in raw material and commodity prices, as theUK dips into a trade deficit in August. The trade surplus position of 1994, isnow a trade deficit. Slowing business conditions in Europe and the onset offurther isolationist tendencies in the US, will act to add further pressure ondomestic manufacturing. Once again, the only bright spot will be the abilityof Japanese automotive and original equipment parts manufacturers to leadthe UK export field. Ultimately, the Chancellor will be in a mood to reducebase rates periodically, and well into 1996.

Recently, a very significant announcement was made for the NorthSea oil and gas industry. Mr. John Jennings, Chairman of Shell Transport andTrading delivered a review of the industry at his company’s annualshareholders meeting. Looking into the very long term, he conceded the factthat the benchmark Brent Blend crude was unlikely to move out of the $12to $18 trading range for the next 10 year period. This was indirectly confirmedby the Organisation for Petroleum Exporting Countries (OPEC) appeals foroil supply cuts to non-OPEC producers like the UK. With Iraqi oil set to hitworld markets soon, and with the non-OPEC producers continuously meetingthe global rise in oil demand, price pressures will be on the downside.

The big question for the UK North Sea oil industry, is whetherincreasing production for export can offset the pressures on the pricing side?If not, and if North Sea supplies become more difficult to drill, then a negative


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impact will be felt in the balance of trade accounts. The oil card, althoughswept into the background over the recent past, will play a role in the futurelevel of sterling.

When current Prime-Minister John Major is not battling the Euro-sceptic wing of the Conservative party, he is continuously confronted bypoorly-judged and outdated policy stands that bring the government downon its knees. A recent case in point is the recent vote over disclosure ofMembers of Parliament outside earnings. Although in a majority position inparliament, the Conservative position of non-disclosure was defeated by aLabour party motion in support of full disclosure. The approval of the motionby 51 MPs further saw the authority of the Prime Minister diminish over oneof the most sensitive of issues accounting for the party’s low popularity rating.

With sterling bouncing around record lows, and with British livingstandards under attack, the prospects for entry into the first league of theEuropean single currency club is more remote now than ever before. Thecondition that all currencies must re-enter the fixed exchange rate mechanismin the European monetary system, before being considered for monetaryunion, does not seem to be an option for the UK. Despite the recent movesby Germany’s Finance Minister Theo Waigel to attach additional conditionson spending, the prospect of the UK being considered for monetary union,will be a contentious issue with France at this level of sterling. Not only haveFrench industrialists approached Brussels for compensation against businesslost from sterling and lira based exporters, but the mere suggestion thatGermany is pressing for greater control over political decisions on nationaleconomic policy is unacceptable to the British political hierarchy, be itConservative or Labour.

In essence, moves to introduce a system of fines on those violatingthe Maastricht Treaty guideline of 3 percent deficits to GDP, will ensure thatGermany will play a central monitoring role over the political decisions madeon economic policy at Whitehall. Since the Chancellor of the Exchequer isstill responsible for setting monetary policy, control over the fiscal apparatusof government in the UK, means control over monetary policy as well. Asituation that would not only turn the heads of devout Eurosceptics, but alsoan aspiring Labour government.

What then will it mean for a recession weary UK electorate to followthrough with a new mandate for Labour? Certainly, the new German resolveon monetary union would not make for a productive election issue. especiallyif James Goldsmith’s Referendum Party begins to agitate voters over the


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dangers of the single currency program. Labour can capitalise on its seeminglyinsurmountable 30 point lead over the conservatives, if it manages to seizethe agenda over domestic economic management issues. For instance, apolicy solution for the poor domestic sales performance in the UK automotivesector would be good government. To follow the initiatives in France withfirst the Balladur government, and now with the extension of the auto subsidyprogram under Alain Juppé, will revive the domestic auto market to a greatextent. Such policies designed to revive spending for important consumeritems, and to introduce the business investment incentives of Labour leaderTony Blair, would be good government and a welcome change in policy.

Prospects for falling oil prices and lower base lending rates to offsetdeteriorating business conditions, will join a slowing global economy tojustify even further record lows on foreign exchange markets. Moves in theupcoming budget to introduce sensible demand-creating policy measurescan only offset this decline.


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• Tony Blair’s Labour party continues to lead the Conservatives in public opinion by over 30 points• defections in the Conservative party raise the prospect of minority government status for John

Major• base rate reduction to 6.5 percent is the first downward move in over two years• sceptical response to Clarke budget causes sterling to fall to record low against the dollar• automotive sales pick up as retailers aggressively market high inventories• basic loan rates at retail banks fall to their lowest level since the late 1960s• Chancellor Kenneth Clarke admits that business conditions are well below their long term trend

rates• recent survey reveals that British workers are the most dissatisfied in Europe• Chairman of Conservatives Brian Mawhinney invokes fear of communism should labour achieve

victory• prospects of slow growth cause companies to raise profits through cost-cutting and redundancies

Business Outlook

The beginning of a new year in the UK holds a lot of promise. Asthe Christmas sales season worked itself through to exceed the expectationsof most retailers. Despite the lack of a "feel-good" factor, consumer spendinghas been captured by a sudden rise in the measured money in circulation.According to the Bank of England, notes and coins in circulation as based onretail activity rose by 5.9 percent in December. Although the distribution ofthe gains varied according to each individual store, the continued strengthin the new year was a cause for optimism in the battered retail sector.

Despite the signs of recovery, closer inspection of the trend inconsumer spending reveals that most of it was financed through a draw downin savings, as opposed to any rise in personal incomes. Evidence in the thirdquarter of 1995, shows that real disposable incomes fell by 0.2 percent, whileconsumer spending edged up by 0.6 percent. Furthermore, some of the bigticket items like automobiles have stabilised their sales, but at the expense ofvery aggressive discounting designed to clear dealer inventories.

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Second Quarter 1996

Business conditions currently reveal that although bankruptciesamong small and medium enterprises has subsided somewhat in 1995, ithas, nonetheless, become a feature among larger companies during the year.On the balance, those larger companies that managed to stay solvent,experienced more than adequate cash positions, as profit levels continued tofuel takeovers on the London Stock Exchange. Record cash positions in thecorporate sector were accumulated by companies aggressively cutting costsand introducing technology that enables a lesser number of employees do morework, hence raising productivity. In addition, although weakening somewhat,those companies involved in the export markets have greatly benefitted theirbottom line.

Greater productivity and technological efficiency that has producedthe record cash positions in companies, has lead to a large increase in bidsto take over listed companies on the London Stock Exchange. In fact, theprimary reason for the record performance on the LSE has been the cashused to finance acquisitions. This, in addition to the continuing consolidationsthat have been the hallmark of the British financial services sector throughout1995, with the merger between Lloyds bank and the TSB retail and savingsbank being a case in point.

Although some firms seem to be in a good position overall, thereremains the fundamental problem of distribution in the UK. This fundamentalproblem has been recently captured in the budget statement of ChancellorKenneth Clarke. Clarke openly admitted to the fact that: "the UK economyhas not been growing at the pace of its potential." Consequently, the trendto lower base rates throughout 1996 are inevitable, as sterling responded tothis by visiting record lows relative to the US dollar, while maintaining itshistoric low level with respect to the mark.

The reduction in the base rate was the first decrease in over twoyears. The one-quarter point reduction leaves the rate at 6.5 percent, withfurther prospects of failing throughout 1996. In addition, most banks andbuilding societies have now reduced their basic loan rates below 7.5 percent,which is the lowest point in over twenty-five years. Moreover, the trendtowards the higher rates over the last two years in the economic upturn,represents the smallest such increase since the 1950s. In all, a very discouragingset of statistics.

The prospect of having a far more restrictive business environmentunder the election of a labour government with Tony Blair as head, has alsoprompted the record acquisition activity on the London Stock Exchange.


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Furthermore, the increase in UK sourced foreign direct investment in foreignmarkets, rose to a five year high, as earnings from overseas assets andinvestment also stands at the highest level on record. Spending by UK basedcitizens and institutions surged, as non-UK held financial assets are at an all-time high. The surge in overseas investments, particularly in the US, hascaused a fall in capital going to fund the UK public sector borrowingrequirement (PSBR). In fact, recent evidence points to the uptake ofgovernment bonds and gilts at the lowest point in two years. A goodexplanation behind this record activity off-shore is always the prospect of areturn to a labour government in the near future. Such activity also accountsfor the c o n t i n u i n g pressure on sterling in the international currencymarkets.

With Tony Blair continuing to lead the hapless John Major by some30 points, visible divisions in the Conservative party have surfaced. Withthe election coming in May of 1997 at the latest, the Conservatives have only15 months to prepare. The divisive issue of Europe within the party, hascaused a rift among those that are on the extreme right wing of the party, andthose of whom believe in a more active European policy. The problem isthat John Major has not been able to bridge this gap, and has continually saton both sides of the fence.

Most recently, a prominent Conservative party womanparliamentarian, Miss Emma Nicholson, defected to the Liberal Democraticparty over her frustrations that the far right of the party has been winning overthe ear of the Prime Minister. With a combination of defections and of deathsof senior Conservative members, the Conservative majority is soon expectedto become a minority government. The defection of Miss Nicholson, will inall likelihood cause more prominent members to defect to the opposition. Thefall of the current government could be a lot quicker than is expected bymany.

With the fielding of candidates from industrialist James Goldsmith'sReferendum Party in the next election, a very interesting period in Britishpolitics is close at hand. The prospect of having a proclaimed opposition tofurther European integration, along with any introduction of a single currency,will act to split the Conservative right wing vote. After the election, thecombination of the existing right wing fringe with the Referendum Party, couldsee the eventual demise of the Conservatives altogether.

This will not be too dissimilar to the outcome of the last Canadianelection. The rise of a right wing grouping called the Reform Party split the


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conservative vote, and left merely two members of Parliament intact. Thepossibility of this happening to the Tories in the UK is very real.

Already signs of desperation are setting in. No matter what theConservatives do from now until the spring of 1997, will not be enough toresurrect the "feel good" factor among the British public. The bubble years inthe 1980s during the Thatcher government, together with the ridiculouslypremature entry of sterling in the European exchange rate mechanism, have beenunfortunate imprints that have hovered through the entire tenure of John Major.

Recently, Conservative party Chairman Brian Mawhinney displayedhis desperation, by invoking Cold War tactics into the debate. The claimwas that a labour party government would leave the UK vulnerable in a timewhen the threat of a resurgence in communism in the former Soviet Unionwas very real. Such bursts of rhetoric will only serve to hasten the decline ofJohn Major's government.

Currency Forecast

With the prospect of the UK not entering the first league of countriesthat aspire to.monetary union in Europe by 1999, sterling will come undereven greater pressure as the political situation in the UK worsens. A minorityConservativegovernment is close at hand, while business fundamentals andc o n s u in e r confidence remain uncertain at best. A I t h o u g h cynical,the recent turmoil on the streets of Paris brought some degree of hope forthe Conservative government, as some argued that such public displays ofchaos in France illustrate how difficult and painful the road to monetaryunion really is. If the Conservatives could at all recuperate from their dismalstanding, it is precisely through such events as the protracted strikes in France.Any enduring rift between the two monetary union anchor countries- Franceand Germany, is a good sign for sterling.

However, reality is that the Chancellor has signalled the government'sintent to continue with the policy of base lending rate reductions. As such,sterling had reached a 16 month low relative to the US dollar at $1.52 for onepound. Likewise, sterling continues to trade within a range of historic lowsrelative to the German mark.

The prospect of a Conservative minority leading up to a labourgovernment, at the latest by May 1997, has encouraged record capital flight.With investments in financial instruments offshore at record levels, and witha surge in foreign direct investment by British based companies, the onlyactive investors in the domestic British economy, remain the Japanese andGermans with a surge in American interest over the past two quarters.


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The UK government is placing great efforts in attracting foreigninvestment to the UK. However, over the next quarter, domestic politicaldevelopments with the prospect of even further defections from the rulingConservative party, will inspire greater outflows of investment. This, togetherwith a weakening export performance, and continued depressed consumerand business confidence, will cause sterling to reach new lows.


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• Chancellor Kenneth Clarke overrules Bank of England in favour of lower rates• slowing continental export markets undermine domestic business conditions• FT-SE stock market index continues record-breaking increases driven by lower interest rates• problems over monetary union in Europe unify Conservative party over possible referendum• prospect of a labour government raises acquisition deal flows• unemployment drops for 29th consecutive month to 7.9% or lowest level since April 1991• lower continental growth rates put downward pressure on sterling• low level of sterling has not been transmitted to wage inflation or retail price pressures• business confidence drops with profits as they hit sharpest drop in 5 years• incomes and wages grow at fastest rate since 1990

Business OutlookThe economic slowdown on continental Europe will adversely affect

business activity in the UK. Up to now, it has been the successes of UK firmsto export products to France and Germany, that has provided a badly-neededbasis for growth. The recent trend, however, has been for UK based firms witha large trading presence in Germany, to commit to an acquisition of a companyalready well-established in the German marketplace.

Over the past six months, no less than 15 major acquisitions havetaken place in Germany by UK based manufacturing companies. Even thoughthe logic for such acquisitions has not been sound, since a devalued currencyfavours exports instead of direct operations in Germany, forward-looking firmsin the UK are increasingly determined to leave behind a continuously depressedlocal market and anti-European rhetoric.

The climate for manufacturing operations in the UK is becomingincreasingly hostile. With a very poor domestic market for their products, andwith a plunging level of business confidence, profits have registered theirsteepest decline in five years in the fourth quarter of 1995. Whilemanufacturing Output declined by 0.2 percent, the output in the growingservices sector increased by 0.8 percent


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Third Quarter 1996

The only positive sign in manufacturing continues to be withJapanese automotive transplant operations. Although domestic prospects forautomotive purchases continue to be poor, the Japanese have taken advantageof the single European market and the tariff laws that govern its efficientfunctioning. Automotive production has increased by 13 percent in January,representing the highest level since the mid 1970s in the UK. With Nissan,Toyota and Honda producing 500,000 vehicles, they have been joined byFord, Vauxhall and PeugeotCitroen, who have decided to shift someproduction back to the UK.

This shift is a direct response to the devalued sterling policy of theMajor government, driven mainly by necessity. In the case of PeugeotCitroen,Chairman Jacques Calvet fears currency instability, as it severely impacts thebottom line of the entire group. A one percent fluctuation in the sterling-francexchange rate costs the group Ffr. 250,000,000. In 1995, sterling fluctuationattained a seven percent fluctuation margin. In the case of most European basedmanufacturing operations in strong currency countries, a real interest inacquiring productive assets in the UK to take advantage of a depressed levelof sterling has developed.

Although the Conservative government of John Major is stilloperating under a precarious majority, prospects seem to have improvedsomewhat. The crises on the continent with the single currency project havegiven new life to the embattled prime-minister. With problems in Europe,pro-European ministers of the likes of Michael Heseltine and Malcolm Rifkindhave begun to concede that the project may have been a little over-ambitiousfor introduction of a single currency by 1999. This has decreased the level oftension and infighting in the Tory party, and has given John Major new life.The sentiment at this very moment, is that the current government willprobably be able to endure until the official election date of May 1997.

Chancellor Kenneth Clarke has once again prevailed in discussionswith the Governor of the Bank of England, and has implemented a series ofreductions in the base rate. Mr. Clarke must be commended for these quickactions, after gloomy reports on business conditions on the continent, wouldlead to a drop in exports by UK based companies. The reductions in the baserate will maintain a depressed level of sterling for companies to take advantageof export opportunities, should they arise.

Although the Bank of England has always favoured the raising ofthe base rate during discussions with the Chancellor, broad money has beengrowing very rapidly. Fears at this moment are of the spillover effect which

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loose monetary policy will have under conditions of economic slowdown. Sofar there is no evidence of this, since the depressed value of sterling, togetherwith loose monetary policy has not been transmitted to wage and price inflation.

With the continued expansion in exports under attack, a recent reportby DHL/Gallup shows that companies reporting strong overseas sales

are at their lowest levels since 1993. Although exports to the continent haveslowed, the UK has, nonetheless, posted its first trade surplus in two and a halfyears, after imports from the continent to the UK fell by even more.

The importance of North Sea oil developments can not be discounted.1996 production levels are on the increase, as new technology and lower costs,along with the start up of fifteen new wells has caused a five percent rise inproduction to a record of 2.71 million barrels/day in 1996. This is expected toincrease incrementally, before reaching 3.0 million barrels/day by the year2000.

Oil exports are a major source of revenue, and give structural supportto the level of sterling exchange rate in the international accounts. It can be arguedthat North Sea petroleum products and Japanese automotive exports tocontinental Europe are the main items that pass through the UK internationalbooks.Mergers & Acquisitions

In the UK, most publicly listed companies experiencing a hostiletakeover of any sort, must enlist the support of institutional shareholders thatare in control of most of their stock. A textbook example of this was the recentsupport by pension fund manager Mercury Asset Management of Granada'sbid for the Forte hotels chain.

Issues that concern the regulation of mergers and acquisitions havebeen heating up between UK authorities and the European Commission. Whatis at stake to the British, is adherence to the entire principle of subsidiarityadopted by most European governments. With the appointment of Karel VanMiert to the competition directorate in Brussels, subsidiarity has been relegatedin favour of a lowering of the Commission's level of threshold for evaluatingacquisitions.

The proposal to lower the present threshold level in turnover fromEcu 5 billion in the combined entity, to Ecu 2 billion and from Ecu 250 millionin Europe to Ecu 100 million in Europe, is a direct challenge to one of London'smain industries.


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With most of the activity on the London Stock Exchange's FT-SE 100index, being driven by acquisitions over the past two years, it is expected tocontinue to rise even further. Recent activity in the banking sector with theacquisition of TSB bank by Lloyds, has started speculation on a possible mega-merger set of deals that would include the remaining large clearing banks,National Westminster, Barclay's, HSBC and the newly-merged Lloyds.

Although US acquisitions activity has recently taken on straight sharetransaction deals, driven by economics of scale emerging in specialised sectors,global credit supplies remain at their highest levels for 20 years. In the fourthquarter of 1995, half of all activity in the UK public and private markets camefrom the US, spending a six year record of F-4.1 billion. This was a directreversal from the first part of 1995, when most investment and acquisitionsactivity in the UK was targeted from continental Europe.

Currency Forecast

Sterling continues to trade in the narrow range of 2.20 to 2.25 toone Deutsche mark. With recent threats of an export slowdown over increasin g I y depressed conditions on the continent, the remaining manufacturingbase in the domestic UK economy is becoming increasingly a I a r m e d .Despite having some of the lowest labour costs in the European Union,British industry still requires the continuous assistance from a low currencyto make it viable for it to maintain a presence in the UK. Since the continually-depressed domestic marketplace cannot provide for a large enough salesbase, even with the new Japanese investment, exports are a must for survival.

With the on-going problems facing the prospect of successfullyintroducing a single European currency by 1999, the UK politicalestablishment has once again lowered their guard. The likelihood ofparticipating by 1999 is very remote. As former Chancellor of the TreasuryNigel Lawson recently argued, that sterling ought to be informally fixed toa possible single currency, should it come about. As this would signal a resolveto Europeans that the UK is serious about participating in the project at a laterdate.

The fixing of any soft currency, either sterling, the lira or the paseta,should they not participate in the first round of monetary union, will be a verycontroversial topic to those that will be part of the single currency at theoutset, most notably France. While the prospect may seem bright for a delayedparticipation, consistent with the pronouncements of Nigel Lawson, inpractice it may be even more difficult and even counter-productive. An


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immediate fall-out from participation in a "second round" for countries suchas the UK, would be the contention of immediate recession. Surely, theFrench and the Germans would not allow the British to enter a currencyunion at the current devalued exchange rate. At the moment, turmoil overthe single European currency on the continent ' will give support to sterlingalong with oil.


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£ UK isolated at Verona summit on the introduction of a single European currency£ Conservative party agrees to hold referendum on single currency if Cabinet approval is obtained£ referendum would not be held until after 1997 general election & only after Cabinet approval is

obtained£ chances that the UK will not participate in the first league of the single currency divides

Conservative party£ Conservative majority drops to one seat as another by-election in Staffordshire South East is lost£ tensions rise as European Union imposes ban on the export of beef afflicted by Mad Cow Disease£ domestic automotive sector in worst depression in history as consumers avoid high prices£ management buy-out & buy-in activity on the rise as credit availability is at an all-time high£ real-estate prices recover by 2.2% over the first quarter of 1996 as negative equity falls below

1.0 million£ Sir Roy Denman attacks monarchy as the main reason for continuing economic decline

Domestic consumer confidence shows no signs of recovery. Despitethe 2.2 percent increase in real-estate values in the first quarter of 1996, over1.0 million households must still contend with negative, or near negativeequity. In addition, while exports of automobiles to the European continentshow record levels of growth, there exist real problems with the domesticmarket.

As was the case during the Thatcher reign in the late 1980s, thefortunes of the British consumer, saver and investor are singly tied to thevalue of the family home. British people feel exceptionally good when thevalues of their real-estate rise, whether on a real or nominal trend upwards.As with the Thatcher experiment of the 1980s, housing price increases weremainly artificial and followed the inflated levels of income offered in the UKlabour markets, particularly for professionals. Once a downturn was evident,the entire house of cards collapsed. Except that debt levels remained very mucha reality.

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Consequently, consumers have been depressed throughout thedecade of the 1990s. Matters continue to worsen, as in the case of theirresistance to the retail prices on new automobiles, producers have come tothe realisation that most purchases recently have been in the re-sale market.Reflecting the real decline of the British consumer has been evidence thatgovernment finances are dramatically deteriorating. Such a signal was alsoevident during the steepest part of the downturn in 1993. Evidence of higherthan usual sales by the Bank of England of government bonds to cover thegovernment borrowing requirement in February, meant that bank loans tothe public sector declined, creating more of a glut in the credit markets.

An additional hazard carried over from the Thatcher years has beenthe recent outbreak of Mad Cow Disease in the UK. The devastating effecton exports and export revenues that this episode has caused can be directlytraced to the carelessness in producing animal feed at lower than requiredprocessing temperatures. During the Thatcher years, the animal feedingprocess was deregulated to the extent that producers of animal feed wereallowed to process at far lower temperatures, hence saving expenditures ontheir heating bills. The lower processing temperature has had a verydestabilising effect on the entire industry ten years after the fact.

The Mad Cow episode will have disastrous effects on the balance oftrade accounts, as milk would need to be imported from other EuropeanUnion countries. Although cattle over 30 months in age have been scheduledfor slaughter initially, this represents 4.5 million out of a total UK herd of11.0 million. The crucial aspect to the crisis is that milk production is usuallyonly available from cattle in excess of 30 months; the ones that will beslaughtered. Losing domestic supplies of dairy products would have a moredestructive effect than losing the export potential of beef. Each year, some£6.0 billion of dairy products are consumed as opposed to only £3.5 billionof beef. To import the additional dairy products required, entails a net additionto the trade deficit of £3.0 to £5.0 billion.

The impact on sterling, however, from such a net addition to the tradedeficit will be mitigated, as the EU will cover a good part of the shortfall throughsupport transfer grants to the UK. Despite this positive development, the longterm effects on the UK beef and dairy industry are incalculable at this stage.

Automotive Blues

The only reasons for foreign automotive producers to locate in theUK, all relate to the exceptional export opportunities offered, while


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simultaneously taking advantage of the European single market for trade.The attractiveness specifically offered to foreign producers, are the low levelsof sterling exchange rates and labour costs, rendering any product producedin the UK very competitive.

The domestic automotive market has died in 1996. The continuingdeterioration in consumer sentiments and the fact that UK automobiles arejust too over-priced has sparked a revolutionary change in spending habits,preferring to direct their purchases in the used car market, consumers havebegun to compare the excessive premiums demanded by UK dealers, toequivalent models priced in the US market.

When all factors are considered, it has been reported that UK pricesmust be cut by 20 percent or more, if Europe’s car makers are to avoid an all-out rebellion. For similar models that are sold in the US, prices were onaverage, some 30 to 40 percent cheaper. Reasons for the excessive prices inthe UK have varied from the costly distribution system and too many dealers,to producers offering far too many options on available vehicles.

Despite the malaise experienced on the domestic side, vehiclesproduced in the UK continue to reach record levels. The 1.2 millionproduction units in 1991, are expected to settle at 2.5 million by the year2001, all destined for export markets in Europe.

Mergers & Acquisitions

While industrial conglomerate BTR plans to divest itself from itsnon-manufacturing operations, a very complex potential merger in thetelecoms sector between British Telecom (BT) and Cable & Wireless (C&W)has surfaced. At the centre of controversy is the potential monopoly effectsof acquiring cellular phone operator from C&W subsidiary MercuryCommunications. Moreover, the authorities in Hong Kong, have also voicedtheir disapproval over the potential competition effects that a BT takeoverwould have on C&W’s operations in the former colony through its HongKong Telecom subsidiary.

To salvage the plan, a potential white-knight, Deutsche Telecom,has emerged as the potential suitor to Mercury Communications, in anattempt to satisfy the concerns of the UK monopolies and mergers panel.

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Single European Currency

After the April 14 meeting of European Finance Ministers and CentralBankers in Verona, Italy, a clearer blueprint for the next stage of the singlecurrency was established. After ruling out further moves against integratingsterling into a single European currency, the Conservative party obtained anagreement to conduct a referendum on the topic after the next election. Itis clear at this point that the next election, whenever it may occur, will befought over the single currency project in Europe, to the detriment of Britishconsumers and certain parts of industry.

By fully co-operating on the single currency issue in Verona, Franceand Germany have essentially ruled out the participation of sterling. In amajority decision, it was decided that all currencies not participating at theoutset, must become part of a new exchange rate mechanism, and mustremain so for at least two years. The UK is adamant, with both Labour andthe Conservatives, rejecting any immediate ties to the Euro. Moreover, Francehas proposed that countries with floating currencies be disciplined againstcompetitive devaluations.

The UK’s stance has prompted the individual responsible fornegotiating the UK’s initial membership in the European Community in1973, Sir Roy Denman, to respond in frustration to the lack of progress onthe single currency by stating; “Britain never had a serious, house-clearingrevolution...The result has been that Britain has largely become a cosybackwater, a back slapping, 18th century type oligarchy, its boardroomsstuffed with clapped-out politicians, Foreign Office retreads, and sundrycronies of the establishment.”The strength of British tradition with a constitutional monarchy to this day,along with her historical trans-Atlantic ties, are factors that naturally tend tokeep the UK away from any centralisation of decision-making powers oncontinental Europe.


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£ European Union prepares to offer a lifting of the beef export ban£ UK campaign of legal obstruction in Brussels coincides with calls for a complete withdrawal from the EU£ British Telecom & Cable & Wireless call off merger talks over complexities in the undertaking£ manufacturers report large declines in factory output & in new orders for more than 3 years£ Labour party backs early participation in the European single currency project£ export demand excluding motor vehicles in some main overseas markets has almost collapse£ government borrowing rises as the prospect of pre-election tax cuts dwindles£ rising government deficit has pushed bond yields 1.75% above comparable German bonds£ John Major tries to pre-empt a general election as long as he can in the hope that something positive

turns up£ fears over a strong sterling prompts the government to reduce rates by 0.25% to 5.75%

The imposition of a global trade ban on British beef exports by theEuropean Commission in Brussels has touched off a serious identity crisis inthe UK. Recent opinion polls taken show that a majority of the electoratefavour withdrawal of the UK’s membership in the European Union (EU).

Membership in the EU has always been an uneasy proposition atthe best of times for the UK. Acceptance of a loosely configured economicunion with the European continent is a concept that most of the British canlive with. However, the problem occurs when goals among continentalcountries conflict with the historical position the Britain has always enjoyedas a fringe island state on the northern fringes of the continent, only nowgeographically connected by a man-made tunnel under the channel.

The core of the dispute between the UK and continental countriescomes when moves towards greater political unity on the continent arearranged to counter historical tensions, between say, countries like France andGermany. The well known trade-off between these two bitter historicalenemies, is Germany’s willingness to replace the sturdy Deutsche mark bya single currency that has continually been the cornerstone of French policywithin the European Union. In return, the Germans have continuously

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demanded that monetary union must go together with political union inEurope.

The usual justification for Germany to press for greater political unionin Europe, has been its cruel history in the two world wars this century. It isargued that more centralised decision making authority, in the EuropeanParliament in Strasbourg, will ensure that no country will ever again dominateEuropean military affairs. This is the present wish of the Kohl governmentin Germany.

A single currency is much less of a foreign concept on continentalEurope, since its anarchic history of political conquests and border movementshave seen many varieties of currencies being circulated over time, hardlyany of which have endured past a single generation. Even the remarkableDeutsche mark has only been around since the late 1940s, and may verywell soon go in the same direction that other currencies have gone in Europe.The more that one travels to the east, the less stable and more varied are thecurrencies. Since the advent of free-market economies in many of the newlyemerging central and eastern European countries, there have been no less thanthree to four different currencies in as many years.

The UK’s history is slightly different. Culturally, their goals more closelyresemble those of North America, than they do the political agenda’s of thecontinent. Both the US and Canadian dollars have been in circulation since theyhave gained independence as countries. Similarly, UK sterling has been incirculation for many centuries. This history plays a very large role in the currentdiscussions of introducing an all encompassing European currency one day. Whatis worse for the UK, is that the continental Europeans have mechanically agreedto introduce the “Euro” by a set timetable inscribed within the Maastricht Treaty.

The problem that the UK currently has with the EU, is a problem thatthe EU has failed to resolve as well. It is a real pity that the concept of “subsidiarity”is not being effectively used to solve some recent crises with the Europeandecision-making process. If the EU is understood as a collection of countries,each with its very own centre of interest, then subsidiarity would solve manyproblems.

In the case of Bosnia, EU inaction could be directly blamed on theincompetent positions taken by France and the UK, which ultimately had to becorrected by US intervention. The fact of the matter was that countries withdirect historical interests in Bosnia, such as Germany, Austria and maybe Italy,


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should have broken away from the rest of the EU decision-making, and implementtheir own action plan on resolving the crisis, perhaps in conjunction with the US.This would have avoided the embarrassment that overall inaction brought to theEU.

Likewise, in the case of the British mad cow caper, the British peopleresent having an Austrian agricultural commissioner dictate what is right for theUK beef industry, when his own country has never been an active importer ofbeef from Britain. It may have been more effective for the countries that are therecipients of British beef within the geographical region of the UK, such asIreland, France and the Netherlands, impose corrective measures than have theentire Commission decide action. This would be far more politically acceptable,and we may have avoided the current impasse in Brussels with UK ministersvoting against measures in protest, even though they favour the legislation. To avoidfuture problems of this sort, the EU must become an effective regional decision-making authority, where countries make determinations on issues which aremore central to their interests.


British Telecom and Cable & Wireless called off their talks over apossible merger. At issue was the entire complexity of the deal, as well asdisagreements over pricing and risks. Moreover, the regulatory obstacles thatinvolved politicking faced a formidable challenge.

The merger in the insurance sector between Royal Insurance and SunAlliance has already created an extremely high solvency ratio that is abovenormal insurance industry standards. Savings on marketing, technology andrent has pushed up share prices by 10 percent for both groups. Pressuresfrom shareholders are growing for an immediate “merger” dividend, or ashare buy-back.

Overall acquisition activity continues to push stock prices higher,as a new round of rationalisation is expected in the UK manufacturing baseas recessionary conditions set in. A possible scenario is for UK firms to resumetheir flight to countries that are more sympathetic to manufacturing, such asGermany. Or, to areas that are in developing countries and which offer directbenefits through a lower cost structure.

More activity in the financial services sector is also imminent. Alarge scale retail banking merger can be expected, as can continued buy-outs of niche brokerages by foreign banks.

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Currency Forecast

Given that exports have all but collapsed over the past quarter andmanufacturing continues to contract, the level of sterling must come downwith respect to the mark.


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[Fourth Quarter: 1996]

£ USAir files law suit over proposed British Airways & American Airlines trans-Atlantic venture£ disappointing first half prompts businesses to issue multiple warnings over profits£ business criticises the government’s uncertain position over the adoption of the European single

currency£ consumer borrowing slows in June despite strong sales performances in the retail sector£ consumer confidence & the “feel-good” factor among the public has been at its highest point

since 1992£ Conservatives manage to close the gap with Tony Blair’s labour party in the latest opinion polls£ Labour party’s central themes for the 1997 election are investment in education & technology£ Tony Blair contemplates making the Bank of England more independent from the Treasury£ joint German-French plan to limit non-participating banks access to the “Euro” raises concerns in

London£ government finances continue to deteriorate as prospects for a tax cut in November budget

diminishes

Although most UK based media continue to favour a Labour partyvictory in next year’s general elections, recent evidence has emerged thatthe embattled John Major has narrowed the once 25 point gap to a mere 10points. Ominous flashbacks to the 1992 election immediately draw parallelsto the current situation. Just as in the present circumstances, the Conservativesunder Mr. Major were the definite underdogs going into the final day ofcampaigning, while the then Labour party leader Neil Kinnock, had held afive point lead. After believing that the Conservatives would wind up inopposition, they instead managed to snatch a majority government fromLabour. Can such drama come to repeat itself in 1997?

Currently, the UK economy and business prospects remain just asdepressed as in the last year. However, the miracle on which the hopes of John

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Major are resting on is the revival of consumer confidence and the elusive“feel-good” factor that was so much a part of the Thatcher years. Certainly,a recovery in the real-estate sector could be just the thing to secure aConservative majority once again.

Single Currency Update

The battle between moderate pro-European Conservatives and rightwing Eurosceptics will very soon come to a head. If it were solely up to JohnMajor, he would not have sterling participate in another exchange ratemechanism as a prelude to eventual “Euro” status, given the bad experiencein September of 1992 when sterling was bounced out of the exchange ratemechanism by the German Bundesbank.

However, a complete withdrawal from the prospect of joining thesingle currency in the next Parliament, will lose John Major the support oftwo most important ministers; Michael Heseltine and Kenneth Clarke. Thismay be inevitable, since both have agreed to support a referendum on thematter and accept the ultimate outcome. Should the public reject participation,resignations would be forthcoming, hence pushing the Conservative partyfurther to the right.

However, the delicate balancing act between the right and left wingsof the party that John Major must contend with almost on a daily basis, mayultimately become a pointless exercise with the formation of JamesGoldsmith’s Referendum Party. The billionaire financier’s chief aim of theReferendum Party is to keep the UK from participating in the single Europeancurrency. If the Referendum Party is successful in attracting the right of centrevotes in the upcoming election, Labour will lead to victory.

Tony Blair’s position on the single European currency up to nowcan be described as being pro-European, but cautious. Mr. Blair understandsthat to engage in a full-fledged debate over the terms of entry in the singlecurrency program would pre-occupy at least the first half of his mandate,should he get elected. Furthermore, he also has the benefit of theConservatives’ experience with the exchange rate mechanism and thedisastrous ejection of sterling in 1992. Such an event is the last thing thatMr. Blair would want to wind his party up in. However, should the firstgrouping of participants find that the single currency is working and beneficial,Labour would accelerate preparations for an early entry.


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By now, it has become common knowledge that the UK is not goingto become a part of the first group of participating countries in the singlecurrency. Although being politically and commercially unprepared, parliamentwould need to still pass three important acts:

• a bill granting independence to the Bank of England• modifications in the way in which the government funds its

public sector borrowing requirements • the transfer of foreign exchange reserves from the Treasury to the

Bank of England• referendum bill on the single currency

This, along with the Maastricht Treaty stipulations that requireparticipation in the current 15 percent wide exchange rate mechanism. Inaddition to the deteriorating deficit over the past six months, has placed theUK in the position of being a long-shot in the single currency game.

Deficit

The weak service-sector tax base in the UK has, to the surprise ofmany, increased the borrowing requirements for the current and comingyears. So serious is the revenue shortfall, that the customary election yearbudget tax cut bribe will need to be postponed, and perhaps even have sometaxes rise.

In specific terms, the borrowing requirement has been forecast torise next year by an additional £8.0 billion. Moreover, Chancellor KennethClarke has revealed that his government would need to borrow £23.1 billionin 1997-98, representing an upwards revision of more than fifty percent overthe original estimates. In retrospect, the optimistic forecasts in November1994, showed that the borrowing requirement for 1995-96 and 1996-97 wereto be 3.0 and 1.75 percent of gross domestic product respectively. Undercurrent revisions, the debt will have jumped from 27 percent in 1991 to 47percent at the end of 1996.


Acquisitions activity in the UK remains buoyant, as global stockmarket jitters could be more than offset by continuing sales and purchasesof companies in London. Although there is evidence of a calmer marketbefore a possible labour victory in the 1997 elections, the prospect of taxincreases in the pre-election November budget has unnerved potentialacquirors to a certain extent.

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The proposed code-sharing arrangement between British Airways andAmerican Airlines on the London to New York transAtlantic route has beenchallenged on many fronts. Most recently, British Airways US partner USAir,has launched a lawsuit against both airlines. USAir’s announcement of thepending lawsuit came as a surprise to both, since BA owns 24.6 percent ofUSAir and has three representatives on its board, including Chief ExecutiveRobert Ayling.

USAir has made references to the existing case in the federal districtcourt in New York brought against the monopolistic practices of BritishAirways by UK based Virgin Atlantic airways. In a letter to presiding judgeMiriam Cedarbaum, USAir claims that strong similarities exist between thetwo cases, as both accuse British Airways of monopolising air routes betweenthe US and the UK. USAir’s action was inspired to a great extent by US lawsrequiring a plaintiff to inform a judge when it wants to bring a case that issimilar in nature to the one that is already being heard. By linking its case toVirgin’s on-going campaign against privileged practices of BA, USAir standsa good chance of success judging by the rulings that were already made infavour of Virgin on separate occasions.

In addition to the lawsuit initiated by USAir, the EuropeanCommission has joined the growing scrutiny of the alliance. CompetitionCommissioner Karel Van Miert and Transportation Commissioner NeilKinnock have agreed to begin deliberations in a rare joint investigative effortbetween their respective directorates. Furthermore, the Commission has alsoannounced plans to include the British Airways and American Airlines link-up with a broader based investigation. Included in the review will be five othertrans-Atlantic alliances.

Currency Forecast

Much to the astonishment of many, sterling has continued to holdground against the Deutsche mark. Foreign investments and acquisitions ofUK based companies, along with a calmer evaluation of political prospectshas combined with tourism to support sterling. However, the deteriorationin public sector finances and the prospect of tax increases should lend evenmore support.


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[Fourth Quarter: 1996]

£ signs of recovery take hold in the UK as consumer confidence & retail sales show increases£ labour unrest rises as June 1996 becomes the worst month in over six years for strike action £ surge in house prices push the rate of inflation up to 2.2% & commercial property prices

prepare for recovery£ London prepares for stiff competition as the single currency program begins to take shape on

the continent£ non-UK banks in London warn government that opting out of currency union will damage

London’s reputation£ consumer confidence backed by record borrowing & mortgage lending registering a four year high£ service economy continues expansion as manufacturing struggles with surplus stocks £ Bank of England publishes inflation report stating that any improvement in unemployment is due

to inactivity£ Chancellor Kenneth Clarke stirs up controversy by stating that UK’s “opt out” of a single

currency is “pathetic”£ UK government rejects an “open skies” agreement with the US jeopardising the BA & American

Airlines plan

Although the data on the domestic economy’s economic performancestill remains subject to great efforts in interpreting the certainty of its direction,one must conclude that things must be improving as the present uncertaintyis much preferred over the definite gloom that has remained a fixture of theUK since the initial meltdown in property prices, together with the reign ofMargaret Thatcher in 1991.

The brief manufacturing recovery in 1994, is contrasted with on-going gloom and stagnation in this declining sector of economic and businessactivity. With inventories registering record highs and investment at all-timelows by UK-based companies. In fact, one in three of the UK’s 100 largestmanufacturers is now controlled by a non-British entity, and businesses in other

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countries account for a quarter of the nation’s manufacturing output. LargeFrench and German multinationals, together with Japanese automotivemanufacturers and some South Korean groups are leading the charge in UKmanufacturing. In all, the number of non-British owned companies amongthe 100 largest manufacturers in the UK has almost doubled between 1986and 1993.

Ironically, it may turn out to be the case that the strong consumer-led recovery in the domestic economy will trickle-down to positively give theslumping manufacturing sector a much-needed lift. Moreover, the deflationarybias that is currently becoming a familiar attribute on the continent, hasfurther acted to depress manufacturing activity in the UK. However, what isvery clear from the unfolding trend, is that consumer spending in the servicesector is the fuel driving UK domestic commerce. So prominent is the growingtrend to expansion in the service-sector, that it can be argued thatmanufacturing has been marginalised as a sub-sector in a very big way inthis decade.

The increasing activity in the service sector, has created high value-added jobs, while causing a large problem with the unemployed that formerlyheld high-paying, but very routine-oriented jobs in the declining UKmanufacturing sector. Samuel Brittan of the Financial Times of London hasconfirmed this trend recently in his weekly column: “The Bank of Englandinflation report is more interesting for its labour market survey, despite thelarge fall in claimant unemployment, the labour market has not tightened verymuch since the 1992 recession. While in the 1990s, claimant unemploymenthas been falling, while in the corresponding period of the 1980s recovery, itwas still rising. This difference can be accounted for by the rise in ‘inactivity’:people of working age, who were neither recorded as working nor as claimingunemployment benefit. The total of unemployed plus ‘inactive’ is sometimesknown as the ‘non-employed.’ The number of non-employed of workingage reached a peak in 1994 and has fallen only very slightly since. Thestagnation in the demand for labour is confirmed by estimates of total hoursworked, which after rising in the early export-led stages of the presentrecovery have hardly changed since the spring of 1995.”

Without doubt, the fortunes of the UK’s economic performancehave become hinged on the service economy, that has mainly centred on themetropolis of London, with financial services at the centre core. The increasingimportance of this will irresistibly pull the UK towards the single Europeancurrency project. The launch of the “Euro” in 1999, has taken on a vitallyimportant political inertia on the European continent, which has been recently


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confirmed by the Dublin meeting of Finance Ministers and European centralbank Governors.

In this meeting, the German plan that imposes continuous “fiscalrigour” on member states after monetary union, has been agreed to inprinciple by most members. Previously viewed as controversial, the plan isincreasingly becoming institutionalised in EU politics. So successful hasbeen the outcome of the Dublin meetings, that UK Chancellor of theExchequer, Kenneth Clarke, has labeled the ruling Conservative Party’sopposition to joining the first phase as being overall “pathetic.”

Certainly, the recent attempts by German and French banks toexclude UK banks from participating in the Euro overnight wholesale lendingmarket, if they do not join the project, has sent very nervous jitters throughoutthe City of London, as it becomes more fearful of competition from bothParis and Frankfurt.


Record activity in the market for acquisitions continued to hold upthroughout the days of summer. The traditional cross-border tie-ups betweenUS and UK firms continued unabated. However, a notable set-back occurredin the big plans of British Airways and American Airlines to share tickets onthe London to New York route. Intense lobbying by US competitors such asUnited Airlines and Delta in the US and UK, resulted in the UK governmentrejecting the “open skies” framework, recently negotiated by the US andGermany.

Basically, both countries differ over the meaning of “open skies” asthe US is demanding “beyond rights” for their airlines to continue to offerflights to various European destinations from the UK. As was rightly defendedby the UK government, such reciprocal rights do not exist for Europeanairlines in the US aviation market. At issue are also demands for cheap “landingrights” slots at London’s Heathrow airport, which normally carry very dearmarket values. In essence, unless some sort of compromise is found on theentire issue of “beyond rights,” the merger between the two airlines on thelucrative London-New York route will expire.

The opening of the Eurotunnel has exacted a heavy price for thetraditional English Channel ferry operators. Consequently, the world’s largestferry operator, Stena Line, has reported steep losses in the first half of theyear. In spite of steady volume growth, its margins continued to suffer. The

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price cuts have increased its Dover to Calais passenger volumes by 40 percent,the number of cars by 55 percent and freight by 26 percent. It is expectedthat Stena and cross-channel competitor P&O will enter negotiations oncross-channel co-operation. This is expected to take the form of a merger, asthe co-operation will fix a greater degree of rigidity in pricing and poolrevenues with P&O to help meet the challenge of Eurotunnel.

It is interesting to note that recent no-frills start-ups in the Europeanaviation market from firms such as “Easy Air” and “Debonair” based inLondon, can further upset the balance that once existed in the cross-channelpassenger and selective cargo markets. Aggressive discounting by suchcompanies will add to the pressure on margins that the Eurotunnel has beenable to exact up to now. Such a development in the aviation market, willserve to ensure that prices will continue to benefit consumers in cross-channeltravel.

In the financial services sector, UK merchant bank Hambros hasbecome the target of Hong Kong based vulture fund Regent Pacific. Itsacquisition of a 3 percent stake in this most traditional UK bank, has putenormous outside pressure on it to improve its “diabolical” managementrecord. By calling an emergency meeting to discuss the bank’s strategy, RegentPacific has aggressively positioned itself to reap the rewards of the inevitablechange of ownership in one of the last traditionally-structured organisationsin the UK merchant banking sector.

Financial Crisis

A potential billion dollar exposure problem has affected theinvestment banking operations of Deutsche Bank. The break-down incompliance and regulatory obligations in the Morgan Grenfell EuropeanGrowth Trust (a wholly-owned subsidiary of Deutsche Bank), has placedthe reputation of one of the most credible international financial names injeopardy. Not only did the parent Deutsche Bank need to calm the nerves ofthe 90,000 investors in these group of funds, but the oversight will also proveto be very costly.

The suspended and released fund manager, Mr. Peter Young, hasside-stepped the strict set of rules that govern the very conservative unit trustmarket in London. His investment holdings in a series of Scandinavian hightechnology companies, were made possible by channeling investment fundsthrough Luxembourg-registered companies that were established by himself.


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In essence, Deutsche Bank faces an unknown loss in buying out aportfolio of unlisted securities held by the funds, in which they control ablock of shares that oblige them to make an outright bid for the companies.Such a development is unprecedented in the UK unit trust market, which isregulated by the Securities & Investments Board, in addition to the InvestmentManagement Regulatory Organisation.

Currency Forecast

Sterling has shown a remarkable ability to go from Dm. 2.25 to theDm. 2.35 to 2.4 range. This strength has been mainly supported by thestrength in the service sector, which ironically is not highly traded out fromthe domestic economy. With manufacturing playing a smaller role, tradeconsiderations in currency politics hold less and less weight. Sterling has notonly made ground on the mark, but has also gained on the dollar, when thedollar has remained range-bound with respect to the mark. Any favourablerumours of early participation in the “Euro,” should strengthen sterling.

February 1997

119

•Labour Party wins election • politicians do not expect “euro” to be introduced by 1999 • base rates raised by 0.25% despite strong pound • inflation fears still prevalent in UK • sterling reaches old ERM level with respect to Deutsche mark • strong sterling will reduce income by 2% in 1997 • house prices rise 8% in 1996 or best since 1989 • auto exports best in 22 years • factory output lowest in 10 years • sterling begins to affect profitability as downgrades exceed upgrades by 5:1 • consumer confidence soars as credit card purchases rise by 17.5% • service sector produced most growth in wages & employment • slumping property prices & lingering effects of recession in the early 1990s cause real wealth to

fall by 20% since 1989 • Bank of England given operational independence • Chancellor Gordon Brown surrenders control of rates while retaining setting of inflation goal • Bank of England will evaluate monetary aggregates and house prices when setting rates • mini-

Budget to cut tax credit on dividends • long term investment incentives will be promoted by Blair government • first high-yielding junk bond issued by Castle Transmission

Newly-elected Prime Minister Tony Blair has inherited a boomingeconomy, based mainly on services. At issue is the pound sterling, which standsat 99 percent of the level that it occupied in 1990 relative to the Deutschemark.

The strength of sterling has also created a large imbalance in thedomestic economy with a booming service sector offset by relative decline in

120

First Quarter 1997

the heavy industrial manufacturing sector. A repeat of the scenario in 1992, whenspeculator George Soros successfully bounced sterling out of the EuropeanExchange Rate Mechanism, seems to be playing itself out once again.

The high level of sterling, is expected to reduce exports of UK mademachine tools by nearly 10 percent over 1997. In addition, the domesticconsumer boom has been fed to a large extent by a run up in consumer creditcard debt that currently stands dangerously high. Despite the favourableconditions for British consumers at this time, real wealth is still 20 percentbelow the levels that it was at in 1990, mainly driven by depreciating house prices.

The Blair government has moved quickly to give operationalindependence to the Bank of England in setting interest rates, and has beenwidely acclaimed for its new friendly approach to the European Union. Despitethis new improvement in relations, it remains highly unlikely that the UK willbecome one of the founding members of the single currency. However, it willmean that Tony Blair’s government will have enough influence to shape the futureintegration program in the interests of UK business.

The wait-and-see attitude towards the single currency program willbenefit sterling over the longer term, provided that this positive sentiment willnot be offset by difficulties faced by exporters to any large extent.

Over the shorter term, sterling will remain volatile, despite thefavourable development that the Bank of England is no longer subject to theshort-termism of party politics and popularity polls. Still, the rate differentialsbetween the UK, Germany and the US, favour investment flows into sterling-denominated paper investments.

According to a study conducted by the Bank of England, interest ratedifferentials accounted for about one third of the gains, while oil strength andthe UK as a safe haven over fears of a bad monetary union were marginallyaffecting a rise in sterling. A large part of the recent appreciation has beenerratic and could not be traced in terms of longer term fundamentals.

With no end in sight to the depressed business climate in Germanyand in France, a reversal in rates is not expected to come about until much laterin 1997, if at all. However, with a historically high sterling, and risks of anexport backlash, and evidence that the current boom was founded on debt, acorrection must be imminent over the summer.

First Quarter 1997

121

•single currency referendum could be won at the earliest opportunity after the timely launch onJanuary 1, 1999

• UK is two years ahead in its expansion over most continental European countries • sterling isexpected to enter monetary union at a rate of Dm. 2.6 to 2.7 or substantially lower than itscurrent market rate

• manufacturing firms begin to suffer skill shortages • sterling peaks in July at Dm. 3.08 • exporters cut prices at fastest rate since 1973 resulting in a squeeze in profit margins due to the

strong sterling effect on exports • mergers & acquisitions policy has become more scrutinised under ß • Tony Blair’s Labour party stages a complete overhaul of the British institutional infrastructure with

referendums on devolution conducted in Scotland and in Wales • FTSE 100 surges past 5,000 level for the first time on news of both a weaker sterling and on a

move to join European monetary union • consumer borrowing surges as it is joined by a “one-time” demutualisation windfall of £2,000 to

£4,000 per household • broad money supply or M4 has increased at an annual rate of 11.7% in June after 11.4% in May

• Jaguar sales rise to highest level since 1989

Sterling has settled lower after attaining a high of Dm. 3.08 in July,1997. The run up in sterling has benefitted mainly in three areas. Theuncertainty created over the single currency and the likelihood that the eurowill be a “soft” currency has adversely affected the deutsche mark, causingfright capital to flow to London. Secondly, the strength of the US dollar hasgiven sterling additional support, while lastly, the Bank of England, has raisedofficial base rates to levels unimaginable both in continental Europe as wellas in the United States.

The UK is currently in the grip of dramatic change, as it struggles toredefine its relationship with Scotland and Wales, along with a conceivably

122

Second Quarter 1997

new role for the Monarchy in the new era. Moreover, as it enters the newmillennium, it is also talking very seriously about joining the single Europeancurrency via referendum, shortly after it is determined who the initial countriesmight be that will participate in the monetary union.

Even still, despite the talk of a new era, sterling continues to behaveconspicuously like a solid member of the Anglo-saxon bloc of currenciesthat includes the likes of: the US and Canadian dollars and the New Zealandand the Australian dollar markets. It almost mirrored the moves in the US dollarover the past year.

The UK is undergoing a consumer boom at this very time, as a one-off windfall from building society demutualisation has rewarded many familieswith £2,000 to £4,000. This, coupled with an increase in overall credit carddebt has fuelled one of the strongest bouts of domestic expenditure sincethe 1980s.

The general openness of the UK investment climate has also beenof very great benefit to the development of the domestic economy. Both themassive re-investment of Japanese automotive industry participants, as wellas the preference for US firms to locate operations in the UK, has broughtabout a solid infrastructure in areas that were considered to be terminallydepressed.

London, as a preferred financial centre can only strengthen itsposition, especially after the Blair governments determined effort to be atthe forefront of the single currency project.

With all of the longer term trends pointing to a favourable impacton the UK domestic economy, sterling should be governed more by whathappens in the domestic and export sectors, with a minor effect from anyprogress or setbacks with the single currency project.

Investment flows have been driving sterling higher based on thehigh official short term base rates that have been set to counter the suddenconsumer boom encouraged by the demutualisation. Exporters have alsobeen demanding a lower level of sterling in relation to the mark, as profitmargins are beginning to be eroded. Although still strong, sterling will settlelower towards the Dm. 2.75 to Dm. 2.85 levels as the consumer boom beginsto subside.

Second Quarter 1997

123

•Sterling maintains its strength as evidence of a downturn sets in • London experiences boom in development comparable to that in the 1980s • Merrill Lynch acquires Mercury Asset Management• Labour government opts for a delayed entry into the single currency • FTSE hit by substantial stock buy back plans by Reuters & GEC• export orders fall to lowest since UK was bounced out of the ERM in 1992 • junk bond market & venture capital activities become more prominent as surplus of capital floods

Europe • 20 year record achieved for auto production in 1997 • Bank of England shows preference for policy based on domestic considerations despite concerns

over the high rate of sterling • Labour government launches review of financial offshore centres Jersey, Guernsey and the Isle of

Man • UK share buy back activity accounts for 55.2% of total European buy backs of $47.2 billion • 1997

share buy backs are more than triple executed in 1996 • new machine tool orders suffer a 21.5% fall in November 1997 • Prime Minister Blair only leader to fully support US plans to bomb Iraq • split surfaces in Labour party over timing of single currency participation

As a successful launch of the single European currency is now acertainty in the world of international finance, a growing split within theLabour party is becoming ever so apparent. The honeymoon that PrimeMinister Tony Blair has become so accustomed to after Labour ousted JohnMajor and the Conservatives just one year ago, is now under attack from adeteriorating domestic economy and the familiar lack of commitment to amore concrete European policy.

Having been elected on promises of better relations towards theEuropean Union, the once hoped for early commitment to join the single

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Third Quarter 1997

currency has all but been dashed in favour of a “wait-and-see” attitude. Tomany members of Parliament and prominent figures in the Labour party,this has become unacceptable. For one, Chancellor Gordon Brown, has madehis disapproval felt throughout with no uncertain effect on the Prime Ministerhimself.

Central to the growing impasse on European policy has been thelack of substance, yet only clear rhetoric. Despite almost unanimous supportfrom British industry at this time, Labour’s promise of possible participationin the single currency by perhaps 2002 or maybe 2004, will do great harmto the window of opportunity that the Prime Minister could have seized bycommitting to a definite early participation date, hence inheriting a leadingrole in regional European affairs. With the aging Chancellor Helmut Kohl ofGermany and the not so young Jacques Chirac of France, Tony Blair couldnaturally emerge as the driving force in European political and economicaffairs in the new millennium.

In the words of Julian Coman of The European, “Like many Britishprime ministers before him, Blair’s professed enthusiasm for the EuropeanUnion is long on rhetoric and short on specifics.” The European media hasgenerally echoed the sentiment recently proclaimed by the Italian influentialfinancial newspaper Il Sole 24 Ore, “There seems to be a growing disparitybetween proclaimed intentions and reality.” Under the leadership ofChancellor Gordon Brown, the UK would already commence with a formalcountdown for monetary union to begin. On that basis, a split in the Labourranks is inevitable.

With sterling at its highest point ever relative to the deutsche markin the past decade, industry’s argument for an early entry is now as strong asit ever will be. With exports under attack, and with Japanese auto producers;who send every two of three vehicles produced to continental markets,openly critical of delay tactics on the “euro” issue, the economic climatejustifies a commitment to an early entry date. As sterling comes under attack,pressed by less foreign money buying sterling investments and as theeconomic slowdown intensifies domestically, the danger is that the windowof opportunity that now exists could be lost. Once sterling falls back, industrysupport may wane on the basis of more exports.

Third Quarter 1997

125

•consumer spending continues to lend support to the domestic economy offsetting the collapse inexports that the manufacturing sector is experiencing

• base rates rise unexpectedly from 7.25 to 7.5% over signs of wage inflation pressures • policy makers at the Bank of England and Treasury show preference for a strong sterling to counter

imported inflation • interest rate policy is being driven by service industry sector “hotspots” • City of London is booming while most of the rest of the UK is in recession due to strong sterling

affecting manufacturing base • London is being driven by financial services and technological innovation connected to the single

currency and the Y2K problem • new car sales still show strength • low oil prices hit North Sea cash-flows as oil company stocks lag the overall FTSE index • fund managers become net sellers for the first time in 6 months • retail sales begin to show an unpredictable trend • inward investment from Asia falls due to turmoil • CBI survey of May manufacturing output shows weakest signs since 1983 • UK companies increase their M&A activity in US and continental Europe to escape the strong level

of sterling

The sterling is increasingly driven by the service sector of theeconomy. As British Steel reported a 30 percent impact that the strongexchange rate had on its earnings, similar “traditional” firms have begun toadopt an aggressive foreign merger and acquisition strategy in order to escapethe unsympathetic monetary policy of the Labour government of Tony Blair.

The attitude of most policy commentators in the UK mirrors thepolicy framework that is currently being pursued. With 25 percent of GDPbelonging to the manufacturing sector, it has become a minority among themore sexier preference for service-based industries that have sprung up inand around the City of London.

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Fourth Quarter 1997

With the year 2000 computer conversion problem a hot topic thesedays, the complementary single European currency project has been drivinga transformation among the financial services firms and banks in the City. Inaddition, the dramatic investments that are being made by firms in informationtechnology, has elevated the status of London as the prime “hotspot” in theUK. This, in contrast, to the traditional manufacturing sector that mainlycomposes the UKs second largest city, Birmingham, among others throughoutthe midlands and the northern part of the UK that are currently feeling thecold winds of sterling-induced recession.

In all, the current climate of imbalance within the UK, somewhatresembles the early Thatcher years of the 1980s, as the manufacturing sectoris poised for major changes. As in the case of British Steel, most firms in thissector are expected to follow German companies in the search for muchfriendlier climates in the US. Although different than their Germancounterparts with regards to the motivation for pursuing such an aggressiveacquisitions policy, they both are finding current conditions of operationextremely difficult. Germany, because of the high cost of labour, and theirBritish counterparts over a most unfriendly monetary policy stand.

The recent quarter percent increase in the base rate by the Bank ofEngland that took the City by complete surprise, was reasoned on the groundsof new evidence surfacing of wage pressures. However, these increases havenot yet been passed on to the final product, nor will they ever be judging bythe conditions in export markets for British-produced goods and services.Without a cost being passed on, the only thing that will be hit are profits bydomestic producers.

Forecast

Sterling will remain strong as long as the rate of return for investorsremains some three to five times greater, than what is currently on offer bythe other G7 countries. Any evidence of a political or economic setback tothe single currency project, will also cause fright capital to give even moresupport to sterling.

Forth Quarter 1997

127

•trade deficit begins to show signs of weakening after a long lag that resulted in overly optimisticdata

• from July 1996 sterling began its long march upwards from Dm. 2.3 to a record high of Dm. 3.10• value of exports fall by 2.5% in second quarter

• record high short term interest rates continue to attract capital inflows despite the worsening tradedeficit

• corporate profits as a percentage of GDP fall as cash-flow deficits become more common • British Petroleum in $50 billion bid to take over Amoco of the US • manufacturing slowdown has spread to a degree not seen in the recession of the early 1990s • weak export orders have been joined by a weakening domestic order base • Bank of England expects inflation to rise to 3% before falling back again • interest rate changes take one year to affect economic activity and two years to affect the rate of

inflation • lack of vision and not poor productivity is UK industry’s main handicap • Rupert Murdoch’s BSkyB in $1.03 billion deal to buy Manchester United football club • capital outflow as a result of merger and acquisition activity adding to recent weakness in sterling • UK economic slowdown is contrasted by a recovery in continental economies

Reports that the UK economy is in a worst state now than it was duringthe recession of 1991, has marginally weakened the value of sterling on foreignexchange markets. Despite this, inflation has overshot its upper policy limitprompting the Bank of England to maintain its existing fix on short term rates.

Once again, the UK finds itself in a paradoxical situation with respectto the timing of its economic cycle within its European economic sphere. Whilethe continent is experiencing a real growth in pent-up consumer demand,joining its already robust trade performance, the UKs domestic situation isbeginning to look bleak.

The high level of sterling that is being supported by a number offactors, has been behind the collapse in industrial competitiveness in many

128

First Quarter 1998

of the manufacturing sector’s traditional markets. However, interest ratepolicy is now being driven by the considerations of the service sector, whichaccounts for about 75 percent of the GDP in the UK economy. Mainly locatedin London and the southeast, the interest rate policy of the Bank of Englandhas created a fierce rivalry among the regions in the UK. Of particular notehas been the animosity between the two largest cities, London andBirmingham. With the latter being the base of manufacturers and Londonthe undisputed financial services capital in the world.

In addition to the favourable interest rate climate that favours a strongsterling, there have been several external forces that have driven the currencyto its historical highs. For one, the uncertainty surrounding the entire singlecurrency project on continental Europe, has caused some “fright capital” toarrive in London. This, coupled with the on-going crisis in Asia and nowspreading to emerging markets, has caused global investors to feverishlysearch for safe high-yielding secure investments. It so happens that sterling-denominated paper is yielding some of the highest rates of return amongthe countries of the G7.

Furthermore, in the recent stock market turmoil, it has beendemonstrated that the FTSE100 index has declined the least among all of themajor exchanges within the European economic area. Its performance hastracked the durable Dow Jones average in New York, adding further to investorconfidence.

Forecast

The recent marginal weakness in sterling is not expected to diveinto a free-fall. The actions of the Bank of England dictate that the complaintsof manufacturing have fallen of deaf ears when it comes to policyconsiderations. As global crisis spreads throughout emerging markets andhit stock markets, the ambitions of the single European currency begin to weighheavily on European investors. With US political problems and talks ofimpeachment, sterling may also benefit from frightful investors selling dollars.

First Quarter 1998

129

• Asian crisis reduces cross-border M&A deals by 40% • Recessionary conditions and launch of Euro add pressures to sterling • Blair government opposes proposal by France and Germany for majority tax voting in the EU • poor retail sales add more pressures to sterling • Bank of England reduces base rates by 0.5% to 6.25% for the 3rd consecutive month • UK gets ranked 15 out of 18 in a competitiveness survey focusing on innovation and R&D issues • UK engineering industry ranked by German based research group as 11th out of 14 EU countries in

terms of productivity • sharpest fall in 40 years for hard hit manufacturing sector • falling demand has forced retailers and manufacturers to run down stocks • clothing and textile prices fall by 1.5% representing the sharpest annual decline in 45 years • trading losses by foreign banks in City result in a £2.3 billion surplus on the current account • Government of Australia cautions companies that they face a “competitive disadvantage” investing in

the UK due to its non-participation in the first round of monetary union • sharp rise in corporatefailures as 200 companies are declaring bankruptcy every month resembling the climate existing in1992 recession

As the UK heads toward another steep “bust” the euro began itstrading debut at £0.705. Throughout the last two years, the pound sterlinghas acted as a proxy to the Swiss franc, attracting all of the fright money thatpanicked investors sent out of the countries participating in the single currency.This, together with some of the highest real interest rates at a time whenmost are frantically searching for yield, has acted to severely overvalue thepound sterling on global markets.

The preoccupation of the Bank of England with inflationary forces,coupled with the surprising intensity by which the Blair government hassupported the Bank on this matter, has missed the underlying reality beyondthe “bubble” economy created in the London region.

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Second Quarter 1998

Once again, it is cities like Birmingham, Leeds and Liverpool, whichlie beneath the service-driven prosperity created in London. In the remainingvestiges of manufacturing in the UK, the reality is the damage that theovervalued currency continues to exact to this very day.

Even participation in the single currency in the first round would nothave exacted the kind of damage to exports that the run up in sterling hasbeen able to do in the past several years. In that respect, the fears of UKbusiness are overstated. If the UK could manage to live with a sterling levelat 3.0 to one Deutsche mark, then it certainly could be competitive andflourish at a level of Dm. 2.70.(which was assumed to be the appropriateparticipation rate in the euro)

Since manufacturing accounts for just 25 percent of total GDP, theservice sector holds the balance of power in the policy halls of Whitehall, aswell as the Bank of England. The vibrant stock markets and the record levelsof mergers and acquisitions has brought an almost unprecedented prosperityto the City. In addition, the one-off boom for computer related talent toprepare for the millennium bug, or Y2K, as it is commonly known has beena one-off occurrence. The question that should be on the minds of UKpolicymakers is whether the service sector prosperity can continue after Y2Kand whether the M&A boom subsides to any great degree?

Most inward investors in the automotive sector have favoured anearly membership in the euro club. The Japanese have been the most vocalin their concerns over currency uncertainty, while the Government ofAustralia has just recently issued a warning to businesses that are involved withUK based companies.

Forecast

With the UK boom-bust cycle heading towards another bust, policywill be based on a deteriorating M&A cycle after the Russian default andAsian crisis sinks in even more. With most of the “fright” capital already insterling, base rate reductions after monetary union will cause a sterlingoutflow.

Second Quarter 1998

131

• IMF report calls for even more cuts in base rate • Bank of England cuts base rate for 6th time in 7 months to 5.25%• elections to devolve power to regional legislatures in Scotland and Wales could prove risky for

financial markets• UK initiatives with Germany on defense and financial services and trading side-step French interests

in the EU• one third of small and medium companies are unhappy with banking services and products on offer • venture capital below a £200,000 threshold remains difficult to access • 20 percent of trade with the EU is being invoiced in Euros • NATO campaign in Balkans lifts BAe and GKN shares • engineering groups have increased cross-border acquisitions by 100 percent in 1998 to escape

uncompetitive sterling pressures • venture capital for the technology sector is several years behind the US in its development • strong jump in average earnings growth recorded in first quarter • large mobile phone deal sees Vodafone acquire Air Touch of the US • regulatory reforms in North Sea oil fields designed to boost competitiveness to Gulf of Mexico • bankruptcies rise by 2000 over first quarter of 1998• sterling gains over weak euro and stabilises with US dollar

Continued strength in sterling has forced the export-dependentengineering sector to hedge their risks by acquiring plant and equipment inthe US or in continental Europe. The period over the past quarter showedconflicting signals of performance in the UK economy, as bankruptciesincreased by 2,000 over the first quarter in 1998, while average earningsincreased by 5 percent prompting the Bank of England to issue a warning overinflation.

In contrast to the unemployment and growth setbacks experiencedby the continental European economies, the UK continues to benefit fromher distance to the current instability in the Balkans. In fact, no member of

132

Third Quarter 1998

the G7 has been as hawkish and as forthcoming in its support of the NATOled campaign, than has the Labour government of Tony Blair. In fact, theUK has been far more a traditional ally of the US, than it has resembled themore “dovish” tone of the European Union based NATO members. Yet at thesame time, he continues to champion the cause of early entry into the Europroject, despite growing doubts over the dismal performance of the currencyin the first few months of its existence.

Despite the falling base rate and a visibly weaker domestic economy,sterling continues to perform with a high degree of strength on theinternational currency markets. This is surprising, and it categorises sterlingas a real “sleeper” among portfolio managers who often do not give the UKcurrency enough credit in its continued strength.

Since the service economy accounts for well over 80 percent ofdomestic GDP to now, manufacturers’ interests are carrying even less weightin monetary and fiscal policy than only last year. The few remainingengineering industries that are brave enough to maintain a presence in theUK, while relying on export revenues to raise their bottom line, have beenobliged to aggressively seek a hedging solution to their woes via cross-borderacquisitions strategies. This will enable them now to manage their companieswithout much concern over exchange rate risks, while at the same time itshould provide for more justification for a strong sterling over the longerterm.

Forecast

Record deals by UK based mobile phone group Vodafone buying AirTouch and by GEC acquiring Fore Systems and Reltec of the US, has resultedin a net capital outflow from the cross-border acquisitions accounts. However,this has certainly not had the adverse effect on sterling that such M&A activityusually does. Nor has sterling been sidelined by the trade account deficit inthe manufactured exports sector. The net capital inflows that have continuedto support the currency, and that will continue to support it into the nextquarter, will be destined from continental Europe.

Third Quarter 1998

133

•Repo rates were raised by one-quarter of a point sending sterling sharply higher after the US FederalReserve moved to raise its rates

• September’s 1.1 percent rise in inflation was the lowest increase in 36 years • Confederation of British Industry proclaims that the venture capital industry is failing small

companies in the UK • Venture Capital firm 3i is not making any investments in deals that are less that £5 million • Coal Pension Fund worth $37 billion is allocating five percent more money to hedge fund investments

Cross Border M&A Effects on SterlingUK companies acquiring foreign companies: 56Capital Outflows From UK From M&A: $89.4 billionForeign companies acquiring UK companies: 32Capital Inflows to the UK From M&A: $56.3 billionNet Capital Outflows From UK From M&A: $33.1 billionNet M&A Impact on Sterling in Global Markets

An equity gap exists and is getting larger in the UK. Recently, ColinPerry, Chairman of the Confederation of British Industry (CBI) went onrecord to criticise the UK venture capital establishment, of which venture firm3i took most of the criticism directly. Most venture capital activity that wasinspired by lofty stock market valuations in blue-chip stocks and by themiserably low rates of return on safe bank savings deposits, has beenchanneled into “private equity” investments.

Private Equity is not an activity that usually helps small companiesgrow. In fact, very few investments with the exception of high technologyare players in the pure venture capital sector. What private equity does is re-allocate the capital structure of companies balance sheets. Most of this activitycan be found via management buy-outs (MBOs), family succession planningsituations in mature companies, in addition to financing divestitures withinlarge conglomerates in Europe. A popular activity recently.

Many US venture capital and private equity firms that have recentlyestablished an operation in London have come to Europe in search of MBOs

134

Fourth Quarter 1998

and restructuring spoils. Few are really interested in making small companiesgrow that are not in the high tech sector.

On the flipside, the IPO that growing companies hope to launchafter about the fifth year of venture financing is also dead. With very fewfund managers wishing to devote any effort to following the Small Cap sectorin the UK, valuations on the stock markets have been falling over the pastseveral years. The City is not interested any more in small companies, butmerely follows very large groupings of shares.

The depressed prices of Small Caps is also a big disincentive forprivate equity firms to seriously look at financing the growth of smallercompanies, at the expense of their lucrative MBO activities. Recently, thegovernment of Tony Blair raised its concerns over the “equity gap.” A movewhich is expected to pass tax incentives for larger corporations to directly investin start-ups and early phase operations within their own sectors, hence by-passing the entire venture capital sector.

The strength of sterling is dependent on continued growth in hightech and services, along with newly-emerging small and medium sizedcompanies in the UK. It is not dependent upon what the larger engineeringcompanies are doing in terms of their export strategies. In fact, the neglectthat this once traditional sector has received over the past several years istestimony to their waning influence in the UKs political economy.

Forecast

Deteriorating trade balances do not affect the level of sterling inforeign exchange markets. The overall climate in domestic business conditionsdoes affect the value of the currency, transmitted to international investorsvia the prevailing rate of interest. Currently, business conditions are robustenought to justify the strong sterling against the dollar, and are expected tostay the course over the next quarter.

Forth Quarter 1998

135

•Shifting balance of power towards Capital Account will not affect dollar despite record $270 bn.trade deficit in 1999

• Interest in establishing presence in EU countries declines • Household and Corporate debts rise by 9.2 and 11.5% in 1999• Corporate debts at 45% of GDP highest in history • Fed raises rates to highest level in 4 years • Venture Capital Subsidiaries account for most of the profits of US banks• Nasdaq ends 1999 85% higher with P/E twice the peak of Tokyo market in 1989 • Greenspan re-

appointed

Cross Border M&A Effects on Dollar (Data for 4th quarter of 1999)US Companies Acquiring Foreign Companies: 25Capital Outflows From US From M&A: $13.28 bn.Foreign Companies Acquiring US Companies: 37Capital Inflows to US From M&A: $53.7 billionNet Capital Inflows to US From M&A: $40.46 bn.Net M&A Impact on US Dollar Value in Global Currency Markets isPositive (+)

With the re-appointment of Federal Reserve Chairman AlanGreenspan to another four year term, and continuing momentum propellingthe US economy to a record 108 months of business expansion, the dollarcontinues its surprising record run-up against the Euro.

With the Euro falling from the one-to-one parity level in relation tothe dollar, many have begun to take a long a critical look at what has beentranspiring recently among Euro-zone members. With no slowdown in sightin the US, the Fed has been slowly raising short-term rates out of inflationaryfears. This, despite definite signs of inversion in the bond yield curve as theTreasury announces its aggressive campaign to buy-up and retire 30 year T-bills.

136

First Quarter 2000

Recent moves to raise short-term rates by the European CentralBank (ECB), has resulted in greater scrutiny among investors in Euro assets.Such moves have been associated with a central bank that has been quicklylosing sovereignty over its monetary policy. Despite stating that it does notuse the exchange rate to determine monetary policy, any recent moves to raiseshort-term rates under a period of continuing sluggishness driven byunprecedented restructuring in the industrial landscape of Europe, has ledto the only logical reason for the recent increase of rates by 0.25 percent.

In short, to protect the Euro from further weakness, means thatsovereignty over monetary policy has been relinquished at the expense of thecredibility of the central bank. Only once this credibility has been re-gainedamong investors, can the Euro once again climb back above the parity levelwith respect to the dollar.

The yen, however, has encountered some recent weakness in tradeswith the dollar. Continuing weakness in the domestic Japanese economy,together with record bankruptcies and re-structuring activity, has spoiledthe strength that the currency has been exploiting from a tight monetarypolicy that has been executed by an ever more credible Bank of Japan. Afterliving through a decade aftermath from the “bubble” years of the late 1980s,the Bank of Japan has kept its word to never again re-inflate the financialsystem so as to re-create the conditions of a bursting “bubble” again.

The 50 percent overvaluation of the S&P500 is directly attributed tothe high flying technology sector. More and more the fortunes of the USdollar are linked to how well the US stock markets perform. This developmenthas made the growing trade deficit almost a non-issue in the latter half of the1990s. And any setback in the progress of stock market values has a directimpact on the value of the US dollar.

Forecast

Despite a historically high trade deficit, the dollar market has becomemainly dependent on cross-border acquisitions and portfolio investments.European companies are showing high levels of interest in establishing a USpresence via a buy-out of a US firm, and as long as the soaring high techstocks continue to drive up the benchmark indexes, the dollar should remainin a strong position.

First Quarter 2000

137

•Equity risk premiums impact currency values • the lower the risk premium or the more international a stock is the greater will be its effect in the

currency markets• savings rate rises from 1 to 1.4% in January

• Greenspan warns of further rate rises after quarter point rise to 6% in February and warnsbankers not to assume current boom represents a normal state of affairs

• trade deficit widens to $28 bn. from $24.6 bn. in December/99 • FTC asserts presence in large cross border M&A deals • venture capital quadruples in fourth quarter of 1999 • LBOs at all-time low while high-yield debt losses are at highest since 1991

Cross Border M&A Effects on Dollar(Data for January/February of 2000)US Companies Acquiring Foreign Companies: 16Capital Outflows From US From M&A: $24.37 bn.Foreign Companies Acquiring US Companies: 22Capital Inflows to US From M&A: $45.23 billionNet Capital Inflows to US From M&A: $20.90 bn.Net M&A Impact on US Dollar Value in Global Currency Markets isPositive (+)

Alan Greenspan has once again pushed up short term rates by onequarter of a percent to six percent, hence re-establishing the significance ofa yield spread that continues to power the dollar at record highs relative to theeuro. However, this relationship completely breaks down when the yen entersinto consideration, as the paradox of the Bank of Japan’s zero interest ratepolicy becomes ever more apparent against the surging short term US rates.

Notable developments that have affected the progress of the dollarhave been the short term rate inertia and the absence of any clear variablesthat are affecting the dollar/yen relationship. Furthermore, there currently existsentiments of a “soft-landing” which investors are confident that the Fedwill be able to engineer via its incremental interest rate policy.

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Second Quarter 2000

Developments in the short term have been in contrast to the fallinglonger term yields on the benchmark thirty year Treasury, and to a lesserextent on the ten year bond. Inflationary expectations seem to be at bay atthe current moment, as the recent move in short term rates by the Fed havecombined with an aggressive repurchase program that has been instigated bythe surging surplus position of the US budget, which have pushed inflationaryexpectations over the longer term lower. This, in addition to the recentturmoil on the Nasdaq market set off by the FTC’s ruling against Microsoft’smonopoly position on the internet browser issue, has caused fearful investorsto seek the security of Treasury bonds.

Without a doubt, inflationary expectations are on the way down asaccelerated competition in product markets is a good substitute for any furtheraction by the Fed. In fact, recent moves on short term rates are bound to bereversed as soon as convincing signs of a slow down have begun to set in. Anyadverse sentiments reflected through a prolonged stock market correction willlead the Fed into an accelerated reversal in its stance on rates and beliefs thatcentre on an overheating economy.

Forecast

The dollar is bound to head lower relative to the euro once signs oflower inflationary pressures begin to set in in the US economy. A lower eurohas begun to positively affect the balance of trade in the EU, and has createda risk of higher prices based on the cost of imported oil. The European CentralBank (ECB) is poised to raise short term rates, despite the opposition of theGerman Bundesbank to such a move. A narrowing of the short term spreadon dollar and euro assets will lend more support to the euro. In the case of theyen, a slowdown in capital repatriation will cause the dollar to gain ground.

Second Quarter 2000

139

Top News Stories Affecting the Dollar

•Investor Warren Buffet warns that the internet will create no more wealth than a chain letter andthat it is a net negative for capitalists

• S&P company profits are still up by 20% • FTC investigates online anti-trust issues • value of all M&A in 1999 is set at $1,100 billion • private investors regain appetite for Latin American stocks • LBOs surge among old economy firms taking them private once again • Investors still not making commitments to emerging market economies • IPO underwriting at second highest in first quarter • 65% of mergers fail to benefit acquiring company • dollar sentiment begins to fall

Cross Border M&A Effects on Dollar(Data for March/April of 2000)US Companies Acquiring Foreign Companies: 15Capital Outflows From US From M&A: $22.87 bn.Foreign Companies Acquiring US Companies: 22Capital Inflows to US From M&A: $73.22 billionNet Capital Inflows to US From M&A: $50.35 bn.Net M&A Impact on US Dollar Value in Global Currency Markets isPositive (+)

Judging by the actions of several prominent currency hedge funds,the dollar’s days as the strongest currency among G7 countries is numbered.Despite the stability in yen markets over the past several quarters, most fundsare making very large bets on the Euro, which has been severely oversold.This, combined with a heightened state of risk in the US economy after theFederal Reserve has opted to aggressively raise interest rates, could propel the

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Third Quarter 2000

US economy into a sudden recession far faster than most investors areprepared to admit.

Any correction that is unexpected among the leading high techstocks and the top Dow Jones performers, could reverse the record capitalinflows into the US. This, combined with a stubborn trade deficit, will divertattention from the positive fundamentals that have been so prevalent over thepast several years. Sentiments have favoured the US economic performanceso much, that fundamentals such as the record trade deficit have beenoverlooked as well as submerged under the record investment flows thathave been favouring dollar based assets.

This time around, it is the US economy that may easily fall underscrutiny, should there be an about face in investor sentiment spurned on bythe unexpected aggressiveness in Fed policy. No longer are dot.cominvestments and high tech stories so irresistible, after the Fed has pegged riskfree rates to levels that can no longer be overlooked by investors. With aEuro zone that is reaping the benefits of a record low currency and which isenjoying record low prices in the credit and money markets, a turn aroundin the region’s economic fortunes is just around the corner. This time, it is thelofty valuations of US stocks that will determine how far the dollar willcorrect should there be a puncture in the stock markets by the Fed.

Forecast

Go long the Euro. The European single currency has hit bottom-finally! Current parities between the old German mark and the US dollarhave not been so out of line since the early to mid 1980s, under RonaldReagan’s presidency. After realising the imbalance in the mid 1980s, thePlaza accords negotiated among G7 Finance Ministers, revalued both theDeutsche mark and the Japanese yen relative to the dollar. At that time, thedollar was overvalued based on the persistent and growing current accountdeficit in the US. This situation is once again being played out, yet this timearound the current account deficit has been smothered by the inflows fromportfolio as well as longer term direct investors that desire an exposure tothe US economy. In short, the makings are once again in place that signal theneed for a reversal in the value of the US dollar relative to the Euro.

Third Quarter 2000

141

Top News Stories Affecting the Dollar

•Chase Manhattan bank acquires fellow money centre bank J.P. Morgan in further signs of a bankingshake-up

• IMF Reports that the U.S. was the recipient of $180 billion in capital outflows from the EuropeanUnion in the year to the end of June explaining the historic weakness in the Euro

• $180 billion inflow of capital was made up of $70 billion in financial portfolio transfers and $110billion in direct investment and cross border acquisitions of U.S. companies

• Two-thirds of all current account capital inflows had been destined to the U.S. compared to twentypercent in 1992

Cross Border M&A Effects on Dollar(Data for July/August of 2000)US Companies Acquiring Foreign Companies: 14Capital Outflows From US From M&A: $22.94 billionForeign Companies Acquiring US Companies: 23Capital Inflows to US From M&A: $164.89 billionNet Capital Inflows to US From M&A: $142.95 billionNet M&A Impact on US Dollar in Global Currency Markets isPositive (+)

Has the technology bubble burst? Or are the poor earnings resultsbringing investor expectations back down to reality? The harsh impact of theformer event, may not be necessary to stem the record capital inflows fromthe Euro zone in search of productive U.S. corporate assets. With capitalinflows to the U.S. outpacing U.S. purchases of Euro zone based assets by aseven to one ratio, all that may be required is a mild setback in earnings in orderto correct the high value of the dollar back down to its fundamental reality.

Already, a general consolidation has been taking place in first the hightechnology sector, and evidence of a downturn in auto sales has co-incidedwith the problems affecting Bridgestone Tires on Ford Explorers. This hasreverberated down the entire supply-chain, as Dana, Eaton, Federal-Mogul

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Fourth Quarter 2000

and Rockwell, have collectively issued profit warnings amid pressures onmargins.

Most other sectors will not be spared as the downturn gathers pace.Once the Federal Reserve rightly moves to reduce short term interest rates,and the natural end to the unexpectedly high cross border acquisitions activityemanating from Europe subsides, the dollar will come under pressure.

Although the record trade deficit has not been an issue to now, it mayemerge so during a speculative crisis against the U.S. currency. The fact ofthe matter, as reported recently by the I.M.F., is that some two-thirds of allG•7 country surpluses have been recycled into U.S. dollar denominatedinvestments of one sort or another. Compared to just twenty percent in 1992,U.S. bond and stock issuers are exposed to the whims of international investorsmore than at any time in recent history. When all is said and done, this maynot be a factor when times are good, as they have been in the second half ofthe 1990s. However, once a potential downward spiral begins, perhaps whenthe record mega-deal activity begins to cease from the Euro zone, the momentof truth will arrive for the dollar.

The dynamic that may ensue, is a short term rate decrease by the Fed,followed by a levelling of the record net capital inflows from Europe, sendingthe dollar lower in global currency markets. Only to be exacerbated by theprecarious trade deficit and record exposure to G•7 surplus countries.

Forecast

Its all for the dollar to lose at this point. The Euro zone has beenbattered to the point where its currency had to be rescued by a consortiumof central banks, that included the Federal Reserve and the Bank of Japan.Now, the spotlight has turned to the strong U.S. currency which has enjoyedmassive capital inflows from mega-deal activity not entirely expected. Theonly way forward is down.

Fourth Quarter 2000

143

Top News Stories Affecting The PoundSterling

•Trade surplus recorded with Euro zone for second month since September despite the continuingstrength in the Pound Sterling

• Abbey National and the Bank of Scotland explore the prospects of a friendly merger in a fastconsolidating banking sector

• London Stock Exchange explores a friendly alliance with New York’s Nasdaq stock market • UK business leaders refuse to support calls for the adoption of the Euro• Sterling hits a peak against the Euro sending it above the old Dm. 3.40 level • profit warnings rise for the first time in two years for the quoted sector • companies decide to take public status private

Cross Border M&A Effects on SterlingUK companies acquiring foreign companies: 20Capital Outflows From UK From M&A: $9.88 billionForeign companies acquiring UK companies: 18Capital Inflows to the UK From M&A: $24.61 billionNet Capital Inflows to the UK From M&A: $14.73 billionNet M&A Impact on Sterling in Global Markets is Positive: +

Various developments in the past quarter have benefitted the progressof the pound sterling. While continuing to trade at record levels relative tothe Euro and at 3.2 Deutsche Marks, it was announced that the balance oftrade was in surplus for the second month in a row beginning in September.

The harsh effects on the trade accounts that a strong pound hasexacted on the manufacturing sector over the past five years, have nowbecome wholly attenuated through an aggressive reallocation program ofproductive capacity towards continental European destinations, leaving onlythose manufacturing sectors that are the most efficient as well as servicehybrid companies which are much less affected by the value of the pound.

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December 2000

Not only have UK based companies been involved in this record re-allocation activity in the manufacturing sector, but the mainstay of UK directinvestment; the Japanese automotive parts producers, have now been seriouslyharmed by “currency translation” effects in their daily operations.

Most recently, Toyota of Japan announced that currency effectsrelated to the weak Euro, will actually result in a yearly loss. Also, NissanMotor, now owned by France’s Renault, will begin to reallocate productionto their plants already existing in France. The Nissan Micra plant has alreadybeen targeted for possible shut-down.

In a positive development for sterling, a grouping of UK businessleaders refused to endorse a government sponsored initiative to promote thebenefits of the Euro. Most leaders, representing the business establishmenthave been averse to joining an initially weakened European currency. Theargument holds authority under the current circumstances of prosperity inthe domestic UK economy, supported by a growing trade surplus wheresterling is no longer the big issue that it once was.

In short, the factors supporting the pound sterling have been capitalinflows from cross border acquisitions directed to the UK domestic market,as some fifteen billion in net capital inflows have been evident throughoutthe months of August and September, along with a trade surplus together withpositive portfolio inflows into the region from fund manager asset allocations.

Forecast

The pound sterling has come off its recent highs in relation to theEuro, however, it continues to trade at a record low relative to the dollar.This can be wholly accounted by medium and longer term capital flows thathave been favouring the US over the past year. The pending reversal of theseflows will realign sterling.

December 2000

145

1996 Maastricht constitutional conference 23, 26, 69, 74, 88

AAbbey National 144Air Touch 132, 133Aitken, Jonathan 58American Airlines 111, 114, 115, 117Ashdown, Paddy 82Ayling, Robert 114

BBank of England 6, 8, 13, 14, 18, 19, 38, 54, 55, 57,

60, 61, 62, 63, 72, 75, 76, 81, 86, 90, 93, 98, 99, 104, 111, 113, 115, 116, 120, 121, 122, 124, 126, 127,

128, 129, 130, 131, 132Bank of Japan 137, 138, 143Bank of Scotland 144Barclays Bank 8, 36, 101Barings Bank 13, 15, 18, 19, 72, 73, 74, 75, 78, 79, 83Barnes, Julian 47Black Wednesday 45Blair, Tony 21, 58, 82, 92, 93, 94, 95, 111, 112, 120,

121, 122, 123, 124, 125, 126, 130, 133, 135Boesky, Ivan 10Brandt, Chancellor Willy 2Bretton Woods 1, 2, 3, 4Bridgestone 142British Airways 111, 114, 117British Petroleum 128British Steel 126, 127British Telecom 105, 107, 109Brittan, Sir Samuel 5, 16, 116Brittan, Sir Leon 5Brown, Gordon 120, 125Buffet, Warren 11, 140Bundesbank 3, 6, 24, 25, 32, 35, 38, 42, 69, 112, 139

CCable & Wireless 105, 107, 109Calvet, Jacques 99Canary Wharf 7, 10CBI 62, 126, 134Cedarbaum, Miriam 114

Central Statistical Office 33Charles, Prince of Wales 18Chase Manhattan Bank 142Chirac, Jacques 125City of London v, ix, 5, 13, 15, 22, 72, 73, 75, 78, 79,

85, 117, 126Clarke, Kenneth 44, 47, 49, 50, 51, 52, 56, 59, 61, 65,

76, 86, 90, 93, 94, 98, 99, 112, 113, 115, 117Clinton, President William J. 62Confederation of British Industry 41, 50, 57, 134

DDana 142DeGrauwe, Paul ix, 23Dehaene, Jean-Luc 58Delta Airlines 117Denman, Sir Roy 103, 106Deutsche Bank 78, 83, 118, 119Deutsche Telecom 105Dow Jones 129, 141

EE.R.M.. See Exchange Rate MechanismEaton 142Elizabeth II, Queen of England 17ERM 14, 19, 23, 25, 32, 72, 88, 90, 120, 124European Central Bank 3, 26, 117, 137, 139European Monetary Institute 13European Monetary System 1, 3, 28, 35, 91Eurosceptics 58, 64, 81, 91, 112Eurotunnel 117, 118Exchange Rate Mechanism viii, 3, 6, 7, 9, 10, 14, 19,

23, 30, 31, 32, 35, 38, 51, 53, 69, 77, 80, 90,91, 96, 106, 112, 113, 121

FFed, the. See also Federal Reserve BankFederal Reserve Bank 2, 13, 26, 134, 136, 140, 143Federal-Mogul 142Financial Times 5, 16, 35, 36, 50, 67, 79, 116Ford x, 41, 73, 99, 142Fore Systems 133Forte Hotels 100Fratianni, Michele vii

INDEX

147

Friedman, Benjamin ixFTC 139FTSE 122, 124, 126, 129

GGalbraith, John Kenneth viiGEC 124, 133George, Eddie 61, 81, 86, 90Giscard d’Estaing, President Valéry 2, 3Godley, Wynne 42Goldsmith, Sir James 85, 87, 91, 95, 112Granada Television 100Greenspan, Alan 136, 138

HHambros 118Honda 99Howe, Geoffrey 45HSBC 101

II.M.F.. See IMFIMF 132, 142ING Bank 18, 78Investment Management Regulatory Organisation 119

JJennings, Mr. John 90Juppé, Alain 92

KKeynes, John Maynard 1Kinnock, Neil 111, 114Kleinwort Benson 83Kohl, Chancellor Helmut 108, 125

LLamont, Norman 7, 8, 11, 28, 30, 31, 37, 41, 44, 47,

50, 52, 59, 62, 65Lamothe, Lee ixLawson, Nigel 5, 6, 32, 101Leeson, Nick 18Lloyds 46, 47, 78, 79, 94, 101London Stock Exchange 66, 94, 101, 144LSE. See London Stock Exchange

MMaastricht Treaty 14, 23, 24, 32, 35, 44, 65, 68, 71,

91, 108, 113Mad Cow Disease 103, 104, 107, 109Major, John 6, 8, 11, 13, 19, 28, 30, 31, 44, 46, 47,

49, 50, 52, 54, 55, 56, 58, 66, 68, 71, 74, 76, 81, 83,86, 87, 88, 89, 91, 93, 95, 96, 99, 107, 111, 112, 124

Manchester United 128McAllister, Ian 41Mercury Asset Management 100, 124Mercury Communications 105Merrill Lynch 13, 124Michael Heseltine 56, 68, 71, 99, 112Microsoft 139Milken, Michael 10Mitterrand, Francois viiiMolyneaux, James 68, 71Morgan Grenfell 78, 83, 118Murdoch, Rupert 128

NNadir, Asil 44Nasdaq 136, 139, 144National Union of Mineworkers 16National Westminster 101NATO 132, 133Nicaso, Antonio ixNicholson, Emma 95Nissan Motor 145Nixon, President Richard M. 2North American Free Trade Agreement 82North Sea oil 49, 51, 66, 69, 90, 100, 132Northern Ireland v, 68, 69, 71

OO.P.E.C. 2OPEC. See O.P.E.C.Organisation for Petroleum Exporting Countries 90

PP.S.B.R.. See Public Sector Borrowing RequirementPattison, Dr John ixPerry, Colin 134PeugeotCitroen 99Polly Peck International 44Portillo, Michael 58, 89PSBR. See Public Sector Borrowing Requirement


148

Public Sector Borrowing Requirement 28, 30, 36, 49,64, 65, 95

QQuinton, Sir John 8, 36

RReagan, President Ronald vii, 141Red Book, The 49Redwood, John 81, 83Referendum Party 87, 91, 95, 112Regent Pacific 118Reltec 133Renault 145Republic of Ireland 68Rifkind, Malcolm 99Rockwell 143Rogaly, Joe 50Rohatyn, Felix 10Rowland, David 79

SS&P 140Scargill, Arthur 16Schmidt, Chancellor Helmut 2, 3Securities & Investments Board 119SG Warburg 76, 78, 83Sir Samuel Brittan 5, 16

Soros, George v, viii, 7, 8, 10, 11, 12, 19, 121Stena Line 117Swiss Bank Corporation 76, 78, 83

TTebbitt, Norman 44Thatcher, Margaret 5, 6, 16, 17, 42, 44, 45, 96,

103, 104, 112, 115, 127Tihomir Mikulic 16Toyota 73, 99, 145TSB Retail & savings Bank 94, 101

UUnited Airlines 117USAir 111, 114Utermann, Andreas E.F. v, 13

VVan Miert, Karel 100, 114Vauxhall 99Verona Summit 103, 106Virgin Air 114Vodafone 132, 133

W YWaigel, Theo 91Y2K 126, 131Young, Peter 118

Index

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G7BOOKS

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the pound sterling chronicles - a ten year history by william b.z. vukson

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