Should the UK join the Euro zone? Evidence from a synthetic OCA assessment.

• Author: Lee, Kang-Soek
• Position: Optimal currency area - Report

1. Introduction (3)

   The question of whether UK will join the Euro zone, at some stage, is predominantly a political issue. It is debated in political programs periodically and settled in pools. The historical alliance with the US, the singularity of the City as a global financial center explained the reluctance to join the European Union to begin with, and then to participate to the process of monetary union achieved with the adoption of the Euro.

   From a strictly economical point of view, the cost/benefit analysis of the joining of UK to the Euro zone has been thoroughly investigated in the so-called 'Euro report' commissioned by H.M. Treasury (2003), concluding prudently in favor of the 'Canadian solution'. The example of Canada apparently shows that a relatively small economy need not form a monetary union with a large and very close neighbor (i.e. the US) and can manage macro financial policies with a floating exchange rate regime. The same would consequently go for the UK with the Euro zone.

   A survey by Artis (2006) acknowledges the predominantly political nature of the issue, but somewhat mitigates the Treasury position by a counter examination of the report's discussion of optimal currency area (OCA) arguments that had been used to reach a negative conclusion. In particular, the conclusion that exchange rate flexibility would be a necessary adjustment mechanism to absorb asymmetric shocks is challenged.

   Another contribution by Pesaran et al. (2006) shows also that the joining of UK to the Euro zone could have positive effects in terms of output growth, interest rates and reduction of inflation, although results are dependent on the rate of exchange chosen for the entry and on the date of entry.

   On methodological grounds, the OCA analysis has been enriched by the use of macro econometric methods, such as global VAR (GVAR) or structural VAR (SVAR), providing new estimates on the effects for UK of joining or staying outside (Artis 2006), with no clear-cut conclusions.

   Obviously the question remains open for future debates. Moreover, recent financial and monetary disturbances affected both economies members of the Euro zone and outsiders, whether willing to join or to remain outside. Members of the Euro zone, deprived of the adjustment mechanism by an exchange rate of a national currency are severely constrained in the conduct of their macroeconomic policies, while on the other hand European countries outside the Euro zone experience dangerous instability of their exchange rates, menaces of uncontrollable speculation and risks of disruption of their links with countries of the Euro zone to which they are economically closely integrated.

   The dilemma between independence with instability and a strait jacket providing a more stable environment is present more than ever. The menace of a cumulative process of competitive devaluations increases uncertainty and probably justifies the willingness to participate to a bloc of stability, as provided by the Euro zone, even though it is surrounded by instability in its external relationships.

   Yet from an economic point of view, integration to a monetary union has also to be judged in terms of costs of adjustment born by the joining country when structural characteristics of both parts are too dissimilar. In fact the OCA theories often consider economic convergence as a prerequisite for regional monetary integration. In recent approaches based on economic shocks' characteristics, an OCA is defined as an economic block consisting of countries affected symmetrically by shocks. If this condition is not fulfilled, according to OCA approaches, it is exchange rate flexibility that absorbs asymmetric shocks. In this sense, observed exchange rate variability can be considered as a standard measure of the intensity of these shocks--von Hagen & Neumann (1994), De Grauwe & Heens (1993), Vaubel (1976). In other words, with free floating, a relative stability of observed exchange rate between two blocs (here UK and the Euro zone) would be an a priori indicator of the viability of the enlargement, while an important volatility of the observed exchange rate would reveal the necessity of exchange rate flexibility as adjustment tool.

   By looking only at exchange rates behavior one is yet probably missing essential structural characteristics that can be blurred by discretionary exchange rate policies in contradiction with macro-structural shocks. In order to assess the viability, from an OCA methodology point of view, of the joining of UK to the Euro zone, we therefore propose an empirical approach combining two analyses:

   * We observe on the long run (1970-2008) the characteristics of the Sterling Pound (GBP) effective exchange rate, as compared to the effective exchange rate of the monetary unit of the main commercial partners of UK, i.e. USA (USD) on the one hand, Germany and France (DM and then Euro, FF and then Euro) on the other hand. By using correlation method we measure the degree of co-movement between GBP and each of these three monetary units. These results, assumed to reflect indirectly symmetric or asymmetric structural shocks, can in fact be in discordance with the direct measure of the phenomenon.

   * We consequently propose to measure directly structural shocks over the same period, by using the structural vector autoregressive (SVAR) model proposed originally by Blanchard & Quah (1989) and comparing likewise co-movement of structural shocks between UK and its main partners.

   Comparison of both approaches provides information on the appropriateness of free floating of the Sterling or stabilization either with the USD or eventual fixity with the monetary unit of its two major continental partners (Germany and France), which means presently integration to the Euro zone.

   Over the period 1970-2008, the share of goods and services traded (X+M) with the USA in UK total trade declined from 15% to 11%, while the shares of trade with Germany and France increased respectively from 5.5% to 13.5% and from 4% to 8%. This indicates obviously a structural evolution disconnecting to some extent UK from its traditional link with the US and deepening integration with continental Europe, as represented by UK's major European partners. But it remains to confirm that macro-structural characteristics of both UK and its continental partners followed an evolution compatible with the joining of UK to the Euro zone.

   In section 2 we will discuss the methodology proposed to assess dynamically the evolution of structural characteristics of UK as compared to its main trade partners over the period 1970-2008. Empirical results are presented and discussed in section 3. Section 4 concludes on the contribution of OCA methodology to the debate over the joining of UK to the Euro zone, these conclusions requiring qualifications to take into accounts political issues, as well as economic dimensions not being dealt with by OCA approaches.

2. Methodology

   In order to examine if the UK would better join the Euro from an economic viewpoint, we measure the degree of disconnection of the Sterling Pound behavior from the UK's economic fundamentals. To measure this disconnection, correlation coefficients are estimated between variables of the UK on the one hand, the USA, Germany and France on the other hand. Based on these correlation coefficients, a synthetic approach is then presented. These steps being described later in this section, the correlation methodology used in this paper should be specified first.

   In this paper, correlation coefficients are used to measure co-movement between pairs of effective exchange rates, but also in order to assess similarity of macro-structural shocks. Among several correlation coefficients, Pearson's is often used. But this coefficient does not fit our present analysis, because it imposes the hypothesis of normal distribution of the series, which for exchange rate series is not likely to be the case generally. To avoid imposing an inappropriate hypothesis for our series, Spearman's rank-ordered correlation is preferred. To estimate this type of correlation, first, the value of each observation is reclassified in terms of rank. The differences between these ranks, D, and the number of observation pairs, N, are then used to estimate the correlation coefficient. Then, significance level is tested by a t-statistics {t = [rho][square root of N-2]/[[square root of 1 - [[rho].sup.2]]} which follows a distribution of Student with a degree of freedom equal to (N-2), under the null hypothesis of zero correlation. For example, Spearman's correlation coefficient between a variable of the UK and that of Germany, [[??].sub.uk.bd], can be...