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 or reproduced in any manner whatsoever without written permission except in the case of brief quotations embodied in critical articles and reviews. Published by G7 Books First published in 2001

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

ISBN: 1-894611-21-7

G7 Books Toronto, Ontario, Canada

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

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


The G•7 Report Project came about unexpectedly. After having spent many years in academia, trade and merchant banking, I felt that a new communications forum was needed that would bind together an inter-disciplinary approach to the new developments and challenges faced in this emerging new decade, the 1990s. As things turned out, the past decade proved to be one of the most revolutionary periods in the twentieth century, with an unprecedented combination of global markets and technological invention. All of this called for a fresh new start in media, research and documentary journalism that yearned for direction from a unique type of leader; perhaps one that brou--ght to the table a rare combination of both academic and theoretical grounding, combined with unequalled practical know-how. To be an effective leader or strategist in the 1990s, it was not enough to just be a specialist within a narrow area of expertise, nor was it sufficient to rely on just many years of “experience” within a particular sector of the economy. In this respect, the academic approach to economics and world business was deprived of what John Kenneth Galbraith once termed as “practical good sense” evident in great abundance throughout the revolutionary 1990s. Even within the confines of the “new high tech economy” a great deal is lost in trying to understand the longer term trends that are in play, let alone in predicting the rise and progress of this new high tech world. Very few Economists in the early years of this decade predicted what has transpired via the internet, nor has the profession been too adept at charting the long term trends that have been emerging in global stock markets, not to mention the currency markets. In fact, on the latter point, most have dismissed trends in currency markets as belonging within the sphere of the random walk. Asked where the dollar-yen parity may be tomorrow or one month from now, the quick reply would have been “the same as where the relationship has stood at the close of business today.” Asked where it would stand one or two years from today, the answer would amazingly have been the same. Yes, the new orthodoxy in the 1990s was the random walk. Under this method of analysing currency markets, there was no way to predict the short term daily or hourly parities between two currencies, nor was there any strategy to pursue long term risk management of fluctuating currencies. The name, “The G•7 Report,” was derived from an international monetary economics course that I attended and which was taught by Professor Michele Fratianni, an expert on exchange rates and interest rates and former Chief Economist of the European Commission in Brussels and a member of the Council of Economic Advisors in Ronald Reagan’s Administration, not to menvii

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tion a good friend of mine. Of interest was how both fiscal and monetary policy was formulated within the industrial grouping of the most powerful economies in the world, the interaction between them, and the effects a particular direction would have on the emerging market group of countries that border these powerful G•7 nations. In simple English, if all of the members of the G•7 were expanding fiscal spending or lowering interest rates in concert with one another, the disruption as reflected via fluctuating exchange rates would be kept to a minimum. This would be of particular benefit to all parties transacting international business, since strategy and planning within organisations find it most difficult to hedge the effects of gyrating exchange rates. On many occasions, the serious financial press is full of reports of disappointing earnings results due to financial hazards that have impacted subsidiaries in various parts of the world. The initial attempts to co-ordinate official demand-creation activities within the G•7 have been motivated to a large extent on purely trade grounds. Liberalised capital mobility and the burgeoning “herd-mentality” lead by some well known hedge-funds is a phenomenon that arose in the early 1990s, through George Soros’ glorious victory in ejecting the pound sterling out of the European Exchange Rate Mechanism, which was the prelude to the present day single currency- the Euro. However, in the mid 1980s, the hey-day of G•7 policy co-ordination exercises, it was trade concerns which were at the forefront of the policy debates. After Francois Mitterrand’s Socialist Party took power in 1981, politicians in France broke with their G•7 counter-parts in order to pursue a massive re-inflation which ultimately proved very short-lived. To break from the pack in such a manner, the French franc nose-dived in global currency markets as inflation skyrocketed upwards. The Mitterrand government quickly learned that individualistic approaches to policy were dead ends, and that the short-lived expansion quickly made the exchange rate attractive to foreign buyers, but that the ensuing price increases, or inflation, choked off the gains that buyers would have had from the lower franc. In short, the “Mitterrand experiment” exacted great inefficiencies on fellow member G•7 nations and had limited real impacts on the domestic French economy. Mitterrand quickly retreated from this approach and agreed to become a team player thereafter. Not only were such policy directions between the world’s most powerful economies vital in understanding how business cycles interact between these countries, but a collective decision to increase spending or to lower interest rates exacted a real impact on the global economy, and the emerging market countries

in particular. During the transformation of Russia and the former communist countries of central and eastern Europe, many have argued in favour of a concerted G•7 expansion in spending and their creation of a more global demand that would in turn assist in the transformation to a market system. This criticism remains valid as trade and investment flows from the G•7 to the newly emerging market economies and vice-versa, has been disappointing, hence prolonging the transformation process and creating more hardship than what would have been otherwise necessary. The G•7 Report project was not just about economics and business, but was a new vehicle that introduced a number of journalists and commentators unfamiliar to the readers of the daily news in major North American cities. We retained some leading contributors over the years, such as Harvard Professor Benjamin Friedman, Belgian Senator and leading international trade Economist Paul DeGrauwe and compliance and regulatory expert Dr John Pattison, but also introduced numerous writers that would normally not have had the opportunity in the commercialised or market-driven media to express their views and communicate with our readers. We became known as a media that was made available to some leading European based journalists such as Italian based organised 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 newspaper. The G•7 Report project attained a small “niche” circulation in major North American cities such as New York, Boston, Miami, San Francisco, Los Angeles, Toronto and Montreal, but was never able to develop a following in places such as Vancouver or Atlanta. Moreover, throughout 1995 and 1996 we were also available over the retail newstrade in the City of London at selective newsagents. Furthermore, The G•7 Report project was not something that was developed by marketers residing in New York, Toronto or Los Angeles. In fact, I would be the first to stick my neck out and say that this was among very few recent 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•7 Report made and shaped its own following and market over the years. It was a leader which was embraced by a very loyal grouping of reader, that felt that we had important things to say about global trends and the rising “new economy.” The G•7 Report project was particularly foreign to advertisers, especially among the agencies in Toronto. We counted very limited success in soliciting advertising support, and agency calls and presentations tended to border on the absurd. In short, The G•7 Report was simply not a concept that was welcomed within this realm. Most of the major corporate supporters were much


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appreciated, yet very rare. Among this select group, we are very grateful to Ford Motor Company, the Montreal Stock Exchange, NatWest Markets and Kapital Trade as our core group of advertisers. The problem that any “niche” publisher must go through is retaining a core group of supporters over the long term. If this can not be maintained, then the publication either dies or gets transformed over the 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 core group of readers, regardless of the format of The G•7 Report. Since 1992, we went from an academic-looking journal to an expensive full-glossy magazine, to a newsprint version and ending with the current newsletter look. We found that the constant throughout this entire process of transformation in design were our core readers over the years, and for this we thank them for their ongoing and unbending support. William B.Z. Vukson


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 always been a fiscal and monetary policy information forum. Only for a very brief period of time since its creation, did the G•7 actually co-operate to co-ordinate the direction of economic activity. Central to the whole concept of policy coordination is controlling wildly fluctuating exchange rates among the world’s major industrialised countries. Adverse exchange rate movements distort international investments, as well as strategic planning initiatives, while creating uncertainty and project delays. Based on the premise that it is good to control the fluctuation of exchange rates, a good beginning would be to co-ordinate fiscal and monetary expansions among a grouping of countries. If the G•7 moved in tandem to expand money supply by ten percent, meaning that money supplies in dollars, euros, yen and pounds sterling went up by ten percent, inflationary expectations would be the same in all of the G•7 countries and there would be no real effect on exchange rates. However, if the G•7 decided to expand money supply by ten percent, with the exception of Japan; preferring to hold its growth to zero, then the yen could appreciate by ten percent relative to the dollar, pound sterling and the euro. This latter unco-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 towards the development of the Bretton Woods System of pegged exchange rates after the second world war, and was influenced by one of the most well known economists in modern times, John Maynard Keynes. Where Bretton Woods ended off in 1972, during the peak of the Vietnam crisis, the European Monetary System tried to take over the function of coordinating monetary policies. Both the Bretton Woods system and the European Monetary System are fundamentally different from the G•7. Whereas the former two are formal agreements to coordinate monetary policies and inflation rates by fixing exchange 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 three different trading blocs throughout the world. However, there is no enforcement mechanism that forces its members to pursue monetary policies based on some form of pre-arranged fluctuation band for the group of currencies, and there is no assurance of success, given that no member is obliged to follow the final communique’s that are issued at the yearly summits and through the more informal gatherings of Finance Ministers throughout the year.


The Pound Sterling Chronicles
In Europe, monetary policy coordination has a long history that predates the famous Schmidt-Giscard d’Estaing agreement to formally establish fluctuation bands in 1978. It was as early as 1959, that the European Parliament proposed the formation of an institution patterned after the U.S. Federal Reserve system for the purpose of coordinating monetary policies in Europe. The European Monetary Agreement of 1958 strengthened the provisions of the Bretton Woods system, which was already in place and functioning. However, the Monetary Agreement of 1958, proposed that the bilateral margins of fluctuation among the EC currencies be limited to three percent. At the same time that the European Community decided to “harden” its commitment to monetary coordination practices alongside its commitment to the Bretton Woods system of pegged exchange rates, the Bretton-Woods system was under severe strains. The gold standard under which its central currency, the dollar was based on, began to slowly unravel in the 1960s at the height of the Vietnam war and the spending commitments made for the arms race, together with the strains of Lyndon Johnson’s Great Society programs, proved to be too much for the system to bear. By 1968, gold convertibility at $35 per ounce had virtually ceased, when President Richard M. Nixon moved to formally end it on August 15, 1971. In 1969, the French franc was devalued and Germany allowed the mark to appreciate, while a wholesale unravelling began the process that would see the eventual demise of the Bretton Woods system. In 1973, the United States itself, the anchor currency in the Bretton Woods system, announced a ten percent devaluation of the dollar, hence formally ending the international experiment of currency management which held together since the second world war. The demise of monetary co-ordination in the 1960s, culminating with the French devaluation and the German revaluation, put enormous strains on the European Community, which considered monetary coordination a vital element in furthering the twin goals of political and economic union. After the crisis with the franc, mark and dollar began to appear, German Chancellor Willy Brandt, put forward an idea for monetary union at the summit of the European Council in the Hague in 1969. This lead to 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. oil embargo and the general inflationary environment during the 1970s, caused severe fluctuations in exchange rates, chaotic policy initiatives and desperate political manoeuvring in Europe, to cope with the rising energy costs.

The G•7 and Exchange Rates
In 1978, German Chancellor Helmut Schmidt and French President Valéry Giscard d’Estaing, created a new initiative that would establish the enduring European Monetary System and a formal Exchange Rate Mechanism (ERM), which would govern fluctuations among European member currencies tied to fluctuation bands of 2.25 percent on either side of the central parity for some countries, and six percent trading bands for other countries that were not considered to have a good inflation record. This was the final solution that eventually yielded a single currency and one European Central Bank. The G•7 has at its core this incredible accomplishment among its European members, that moved a loose framework for policy coordination, into outright monetary union. Certainly, the G•7 never moved to replicate what had existed in the Bretton Woods framework of pegged exchange rates prior to 1969. For whatever reason, the G•7’s agenda was a far more informal mandate to loosely exchange information and to act only when periodic financial crises arise in the global financial system. In essence, the G•7 has admitted that what has worked among its European members, can not necessarily be extended to include countries located among three diverse trading 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 Louvre summit in France in 1987. The growing trade deficit in the U.S. automotive accounts with Japan, required a revaluation of the yen and Deutsche mark and the devaluation of the U.S. dollar, which lead to a new trade equilibrium in this turbulent period. Never again has such a high level of cooperation been noticeable, as the new era of globalisation presented an interesting new set of challenges. With deflationary conditions prevalent in the early 1990s, the “Anglo-saxon” grouping of countries that included the U.S., Canada and the U.K. were experiencing a sharp adjustment and a severe downturn, while the continental European members were experiencing a boom from German reunification. Under such a period of “structural” change, it was difficult for these two groupings of G•7 countries to be on the same point in their respective business cycles, hence unwilling to pursue any coherent form of policy coordination that made any sense. For example, if the “Anglo-saxon” group of countries had argued for an expansion in the money supply or in fiscal spending, it would be, and was countered with a negative response from the inflation-conscious German Bundesbank. The fact that globalisation brought naturally diverging responses in the 1990s, made the whole mandate of the G•7 somewhat redundant.

The Pound Sterling Chronicles
How could policy be effectively coordinated in light of each country being at opposite ends with respect to its business cycle? Moreover, there did not seem to be any room for any compromise or middle ground either, which was probably the most disappointing part of the failure to take an active role in policy coordination among the members of the G•7 during this period. The 1990s have become a decade of open capital flows, budgetary surpluses and less active monetary policies. The role of the G•7 is now more important than it was ever before, during the closed economic era of the Cold War. Speculative pressures are now far more prevalent than at any time after the second world war, and many respected world leaders have called for some form of control in global currency markets. Many have even called for a reinstatement of the old Bretton Woods system, that would be much more far-reaching than the European Union was in establishing the Euro. The difficulty with any such moves, however, has to do with the divergence of interests of members in terms of where they are in their respective business cycles. As in the early 1990s, Germany wanted to see a decrease in spending, while most other recession-plagued countries called for an expansion. This kind of coordination is redundant in the world of growing global capital flows, which would create severe speculative pressures on currencies if such an imbalance were allowed to proceed at the policy end. The hope that remains in coordinating business cycles, is the expansion of the information economy, even in countries on continental Europe which have realised that the rigid labour structures that have come to define this region, will inevitably need to disappear over time. These are the kinds of “structural” impediments which make co-ordination of policies very difficult, but which have the potential to lay a framework for a successful G•7 agenda over the next five to ten years.


Sterling Circus
For a very long period of time, the pound sterling was supported by a 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 powerful labour union. In many cases, union demands on industry in the 1970s were very much anti-technological change and advancement in orientation. The long time Assistant Editor of the Financial Times of London newspaper, Sir Samuel Brittan, recounted to us in detail the days of publishing under the siege of powerful labour. In the case of the printing press, British unions still insisted in performing tasks a second time, despite the fact that these activities were already being absorbed by automation. For example, the process of bundling or bagging a newspaper or magazine, when it came off the printing press and into its final product stage, was often repeated over again by a worker standing at the end of the printing press. The printers union in this case, resisted any modifications in its age-old production practices, but which were becoming a real detriment to the advancement of the U.K. out of its old industrial age. The ascent of Margaret Thatcher’s Conservatives in 1978, was almost manufactured in order to change the balance of power back in the favour of capital, and away and out of the control of the increasingly powerful labour unions of the 1970s. In this period, the U.K. economy went through oscillating boom-bust cycles that were very much prone to inflation. Consequently, sterling fluctuated wildly on global currency markets, reflecting the open nature of this island economy, as well as the price competitiveness of its exports. Margaret Thatcher’s government came to define the 1980s, as the fiscal position of the government came closer to balance over time, and the momentum gained on the continent via a system of pegged exchange rates, began to gather political momentum in the U.K as well. Very soon, open discussion was engaged by commentators, journalists and opinion formulators in the U.K. on the likely benefits of the U.K. joining this currency peg, and ultimately one day participating in the crowning achievement; a single currency itself in the whole of Europe. Within the Thatcher Cabinet, there were several high profile Ministers that were pro-European, and more importantly, pro-single currency. Their arguments were justifiably based on the need to even out the constant boombust nature of the U.K. economy. These Ministers were Nigel Lawson at the Treasury, and Sir Leon Brittan, who was the Home Secretary at that time, and

The Pound Sterling Chronicles
who after his tenure in the government, went on to play a very prominent role 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 middle 1980s, the Thatcher government became the focal point of the pro-single currency lobbying efforts. Influential Ministers such as Lawson and Brittan, tried to convince the Prime-Minister and many who were considered to be marginally sceptical about the entire project, to join the European Exchange Rate Mechanism. The argument for doing so, was that the Bank of England and the Treasury would buy credibility from the Deutsche Bundesbank in conducting monetary policy, and would thus be able to count on external factors in reducing inflationary spirals, and at the same time curtail union power in negotiating wage increases. A fixing of the sterling exchange rate would effectively reduce the options on what the non-independent Bank of England could do in terms of its monetary policy choices and inflation rate. As mentioned, sterling throughout the 1970s and the 1980s followed a boom-bust cycle. When inflation was driven higher by a combination of price pressures and union negotiating power, the Treasury, which controlled a non-independent Bank of England, moved to raise rates and puncture the inflationary bubble. Likewise, when property prices went up during boom times, mortgage rates were raised, sending them spiralling downwards. Many advocates of the single currency during these years, felt that a peg was the only way in which the Bank of England could achieve an independent policy stance, after so many years under the control of the Treasury and political influence. The fastest and most sound way in doing so, would be to buy the existing credibility from the highly successful Deutsche Bundesbank; probably the best managed central bank in the history of the European region. Only then, 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 Prime Minister Margaret Thatcher that participation in the Exchange Rate Mechanism was a good thing for just this fact. A sterling peg would ensure that labour negotiating power would be kept in check, and that incompetent politicians at the Treasury, would not be able to re-inflate out of tight situations that required hard choices for the country. This was exactly the kind of prescription for the U.K. that Margaret Thatcher liked to hear, thereby allowing the Treasury Minister to manage sterling in such a way so that it was allowed to float at a parity of three Deutsche Marks since 1987. Ultimately, Great Britain 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

The Sterling Circus
limit on each side of the central rate, meaning that it was allowed to fluctuate by twelve percent, without being devalued or revalued in some way. It was thought that since Sterling was highly successful in the late 1980s in tracking the Deutsche mark and the Exchange Rate Mechanism, this success would continue 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 with activity in U.S. cities during the massive boom. Expanding ambitious new projects such as Canary Wharf in the Docklands district, was a symbol of the aspirations that London held as an expanding global financial centre. Already, it had a large share of international financial transactions, as well as the Eurobond markets. Moreover, it was poised to become a leading player in financing the newly-emerging countries of central and eastern Europe. However, the success of London in attracting global financial investment in the important commercial property sector came under attack, as the new decade began, and both deflation and disinflation were in the air after the opening of markets that were closed during the Cold War. The Gulf War in 1991, added to the general uncertainties, and soon investment dried up when the Canary Wharf project filed for bankruptcy, and became a symbol of the excesses during this period. The “bust” in the commercial property sector hit London hard, and was enough to dislodge sterling from its newly-obtained Exchange Rate Mechanism membership. The G•7 Report, published on July 22, 1992, sent out the following warning to subscribers: “... as soon as markets become uncertain as to the political resolve of maintaining the parity, as is the present case with the U.K., faced with a deteriorating economy. Then Sterling will and has come under speculative attack. Ever since the election majority was gained by the Conservatives, the aspirations were such that the newly won political stability supplemented with a pro-business environment, would immediately provide economic benefits through this election “dividend.” This has proved false, as Sterling has fallen from the immediate post-election high of 2.95 to the Deutsche 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 sentiment has been broken and the commitment to a fixed parity increasingly questioned.” Enter George Soros, and the announcement by Finance Minister Norman Lamont, that sterling is suspended from the European Exchange Rate Mechanism with immediate effect, on September 17, 1992, and the

The Pound Sterling Chronicles
planned base rate increase to fifteen percent in its defense is irrevocably cancelled. One week before this crisis, The G•7 Report published the following advisory: “The worsening economic conditions in the U.K. are a testimony to the real pressures that can build-up when a government pre-commits to an overvalued fixing of the exchange rate level. As inflation falls further, real rates rise having serious repercussions on real economic activity and employment. ... The situation has so deteriorated that one industry leader after another has urged intervention by the government. The latest being Sir John Quinton- Chairman of Barclays Bank who did not see any end to the downturn until well into 1994. ... The great pressure of the real economic downturn in the U.K. has affected their credibility to commit themselves to the E.R.M. Consequently, the opportunity cost of investment in Sterling denominated financial instruments increased over the past month. This can be seen as yields on 10 year gilts rose from one percent to 1.3 percent vis-àvis German bunds, leaving a perception that devaluation of Sterling is more likely.” 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 an increase, the Treasury was virtually defenseless in trying to fend off currency speculators and George Soros. The casualty in the entire affair was Treasury Minister Norman Lamont, as the humiliated government of John Major was forced to reduce base rates to eight percent on October 16, 1992, followed by yet another drop to seven percent, after the tabling of the mini-budget on November 12. Base rates were now at their lowest point since 1978, and the U.K. has completely washed its hands from its experiment with a pegged sterling 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 of inflation targeting. The Bank of England was now formally independent from the Treasury, and it chose to target an inflation rate between one and four percent per annum, as measured by the retail price index, excluding mortgage payments. As The G•7 Report reported on December 9, 1992: “The government has, however, announced that it would like to formulate its interest rate decisions around a basket of financial indicators such as money supply figures, asset prices and the exchange rate. ... the inflation rate will be targeted between one and four percent...” With London being the most vital global financial centre, and with globalisation creating record capital flows, a fixed exchange rate is an extremely difficult prospect during periods of erratic volumes. This occurred

The Sterling Circus
in the early 1990s, and the timing for joining a pegged system of exchange rates could not have been worse. As foreign direct investment and cross border mergers and acquisitions accelerated in the latter half of the decade, the U.K’s historical record of being a jurisdiction where capital could come and leave as it wished, created intense direct investment interest from U.S. and Japanese firms. They also were convinced that the early Exchange Rate Mechanism experiment with Sterling would ultimately lead to participation in the single currency, hence removing all export concerns and uncertainties from their currency risk models. As it happened, the prelude to the launch of the single European currency in January of 1999, drove sterling back up to a level of three Deutsche marks, based on “fright capital” from the continent taking refuge in London. As it happens, those investors who were sceptical at the start have been right in the short term. The new Euro has underperformed all expectations, and those that moved assets into sterling have had a net currency gain in excess of thirty percent. Moreover, the higher rate of return on sterling assets as well as the emergence of direct investment and cross border mergers and acquisitions, have also tendered a net gain to sterling holders. London is also becoming the true focal point in the Euro zone, as it moves to consolidate its leading position by merging its capital market operations with institutions based in Frankfurt, or even Stockholm? The traditional advantages of London in the capital and Euro markets, has combined with its unchallenged advantage when it comes to the quality of life and interest that the city has to offer; a very difficult combination for an emerging financial centre such as Frankfurt to beat on its own.


Soros and the “Big Picture”
On the rare occasion, the “boring” financial industry tends to produce celebrities of its own. During the 1970s, it was Felix Rohatyn, the former Partner of Wall Street investment bank, Lazard Brothers, that was credited in saving New York City from inevitable bankruptcy. The 1980s was synonymous with the notorious Wall Street corporate raiders, Michael Milken and Ivan Boesky, while the collapse of the pound sterling in 1992, netted hedge fund operator George Soros a massive fortune. To this day, the patriotic English still grumble at the mention of Soros’ name. What George Soros has accomplished by breaking the fixing of Sterling in the Exchange Rate Mechanism, was to signal to the world that the new era of free capital mobility, coupled with the ease in communication, has the ability to cripple governments and eminent institutions in a matter of minutes, or even seconds. The growing global capital pool and the speed in which it can be invested in various countries, and then re-patriated, has produced a system that can be lethal to those that are elected to formulate policy. Any government that desires a higher standard of living, cannot escape foreign portfolio investment 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 vestiges remaining that control foreign exchange. What this means to policy makers, is that a new level of efficiency has been placed on their shoulders. With this highly efficient system that sends money spinning around the world, comes the obligations to restructure the local banking system and stock market so that transparency is never in doubt. The catch-phrase in the 1990s, has been that if investors perceive a country to be open and transparent, such that money can flow in and out at the click of a mouse, then the country in question will be the ultimate beneficiary over the longer term. Just look at Hong Kong, the U.K. and the U.S. George Soros made a fortune in hedging situations that were inconsistent with the general trend towards open and efficient markets. Anytime when evidence existed of a fundamental overshoot in one market, he would leverage 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 inflated price, in relation to the Deutsche mark and the general basket of European currencies. The hard landing in the U.K. in the early part of the 1990s, was no different 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 by the problems at Canary Wharf, wiped out most private developers in London.

Soros and the “Big Picture”
It sent the local, intensely real estate-oriented economy into a deep recession, meanwhile, rates were based on the over-inflated conditions in Germany shortly after re-unification. George Soros made a common-sense bet that sterling could not continue at such an inflated level, with inflated interest rates serving to keep it artificially propped-up in the E.R.M. With the help of the London market’s liquidity, he was able to effectively sell it short, by selling the sterling that he did not hold in the hopes of buying it back at a later date at a far cheaper price. This scenario materialised, sterling was dropped from the E.R.M., and the former Minister of the Exchequer, Norman Lamont, was made the scapegoat in British politics and had to tender a reluctant resignation to the Prime Minister at the time, John Major. Soros’ bet paid off handsomely; created a historical event in the process and elevated him to celebrity status, which he uses to great effect even today. It is interesting to note, however, that this same George Soros, has gone on record in communicating to his investors that returns of the type made during the sterling debacle, are much harder to make as globalisation advances further. In essence, Soros is a “fundamental” investor, or one that arbitrages situations that are not rational or consistent with free market ideology. In the case of sterling, it was not consistent with its natural free market level, since the E.R.M. propped it up artificially, creating great misery and financial distress in the British economy in the early part of the decade. As the 1990s progressed, and the internet added even more transparency to financial markets, it overshot its point where financial valuations were true reflections of real economic activity. In other words, does the stock market make sense where it currently rests? What can we make of the wild valuations 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 make returns in excess of thirty percent for his funds, when the current gyrations in the markets are very difficult to value on a sensible or fundamental basis? Capital markets and the global flows of money have become overly transparent in many ways. In fact, the culture of investment has spread so rapidly, that traders are no longer buying and selling based on fundamental values, but are doing so 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 and understands this, as does U.S. investor Warren Buffet, who openly admits his shortcomings in understanding the new high tech economy. The click of the mouse has made it possible to shuffle the deck globally. There are no more barriers in buying stocks anywhere in the world, and as stock markets form “electronic” alliances, the prospect of twenty-four

The Pound Sterling Chronicles
hour trading is at hand. Under such a system, the creation of a huge electronic herd of investors will wreak havoc on governments everywhere, which are deemed as being untrustworthy or not open to the concept of quick entry and exit of capital. The challenges that will come about under such a fastpaced system of investing, will ensure that more and more regions of the world that were perceived as once being “closed,” will be connected and making a pitch to powerful pension fund managers in hoping to attract their share of this growing pool of global money. George Soros is right in that fundamentals don’t mean too much any more when it comes to the valuation of currencies or stocks. What is most important now, in order to arbitrage gains in the markets, is the investors’ or money managers’ nerve in timing the trend in this new casino economy. The fund managers job has become harder as the decade has progressed. So much so that venture capital investing in risky biotechnology ventures has now become commonplace, and will only continue to expand as more and more money will be added to this internationally mobile pool of capital. In essence, it seems that the time to have benefited from playing the fundamentals game passed when George Soros hammered sterling out of the E.R.M. Shortly thereafter, opportunities for hedge funds to score big became less and less apparent as the 1990s progressed. The time to have gotten in and played the “fundamentalist” game in investing seems to have been long gone, as more emerging market countries adopt a common managerial standard and move ever more closer to the standard of transparency evident among the G•7.


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 to continuing challenges posed by Frankfurt and Paris as European capitals of banking and finance. London continues to confront the unexpected under a climate of domestic political instability Has there been any notable financial developments in the City of London over the past while? The main concerns about the City’s competitive position in Europe as a financial centre, have had to do with terrorist bombings in the early 1990s. However, with recent negotiations over re-unifying Ireland, these have been reduced. Additional security measures have also helped to allay fears. Moreover, concerns over financial institutions withdrawing from London to re-locate on the 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 precedent exists in the US, where the Federal Reserve bank headquarters in Washington D.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 present UK government? Broadly speaking, the present mix is appropriate concerning the inflation target. However, greater attention should be focused on the external value of sterling, especially in relation to European currencies. A greater push for more independence for the Bank of England must develop. Greater independence would ultimately produce lower interest rates and lower nominal bond yields. It should also reduce the current risk premium existing on various UK 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.

The Pound Sterling Chronicles
Having said that could the UK be a participant in a single European currency? A single currency cannot include the UK under the current statutes of the Bank of England. Also, under the Maastricht Treaty for monetary union, currencies must be stable for a two year period before joining a single currency. In its current form, is the Maastricht Treaty good or bad? I believe that the Maastricht Treaty is a bad one, because it allows for too many compromises. However, under the circumstances, it is the best we could probably have hoped for. Without initiatives such as Maastricht, the EU is prone to back-pedaling and a re-installation of all types of barriers to trade in the EU, could conceivably re-surface. Is the Exchange Rate Mechanism (ERM) approach to a single currency good or bad? I would state it a little differently. I don’t think the ERM was ever an approach to a single currency, but was created to remove instability in European currencies. At the end of the 1980s, it was widely recognised that the ERM itself would not be sufficient to guarantee the long-term stability of exchange rates in Europe, leading to sufficient convergence in each of its member economies, hence making the single market a success. This is why the European Union membership decided to take the entire process somewhat further and create a plan for a single currency. The ERM itself was never intended to be the primary and only means for the EU to introduce a single currency anyway. How can we introduce a single currency if exchange rates are not sufficiently locked in together? It is more important to have a general trend moving towards macroeconomic convergence in each EU country. For example, this condition has existed for many years in countries like Germany, Austria, the Benelux and possibly France and Denmark. Within this group, monetary and fiscal policies are tightly linked, and deficits are being reduced continually. If we ever see a single currency emerge, it will be by a quick move in this core group of countries 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 permanent upward shift in rates across the entire yield curve.

City of London Interview
Were you surprised to hear of Barings misfortune? Yes, it was very surprising and tragic at the same time. What it illustrates is that the increasing size of deals on international capital markets and the complexity of derivatives, should heighten everyone’s attention to the increasing risks, and all of us in the City must work extra hard to contain these 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 open futures positions needed to be squared. The longer term affects are extremely difficult to judge. Has the Barings affair weakened sterling? Although difficult to judge, the psychological fall-out from the episode certainly could not have helped.


For Monarchy & Single European Currency
British Political Traditions Will Endure Under a New Economic Order Interview with: Sir Samuel Brittan, Assistant Editor Financial 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 period than what the statistics represent to be the case. Prior to Margaret Thatcher, we were really in the grip of trade union Barons. This meant that we had a lot of unemployment although most of the unemployed showed up for work. Many restrictive practices were implemented by labour unions and management was afraid to manage. Worst of all, we had a tiny union (the National Union of Mineworkers) in a tiny industry, led by an agitator (Arthur Scargill) that brought down two successive Conservative governments. That was about enough. It also looked as though he would bring down the Thatcher government early on in its tenure, however, hers was the first to stand its ground and rally the police force to enable miners that wanted to work to safely go to work, and ensure that coal was delivered. In retrospect, the action was regarded by all statesmanlike people as provocative, but in fact had worked quite well. Something similar had also happened in my own industry with several newspaper proprietors exhibiting the courage to face down very strong print unions. Newspaper print unions at that time were used to obstructing any modern developments in the production process. In particular, they became very well known for something called Spanish practices. This meant that unions would insist on being paid for wrapping newspapers which were already wrapped by machinery. It also meant that there were constant

For Monarchy & the Single Currency
stoppages where one never knew whether next morning’s newspaper would at all appear. All of these practices came to an end under the Thatcher government. Contrary to the common view, public spending was not cut very much and the tax burden actually rose, since the public sector deficit was kept down. There was also a small reduction in the dependency culture. It became less easy to draw benefit while not attempting to obtain work. I think that all of these were quite great achievements. In retrospect, how damaging was the speculative bubble that was built up under Thatcher during the latter part of the 1980s? It looked very damaging just afterwards in the early 1990s, but compare the outcome with what has materialised in Japan. One can say that the effect was a minnow in the UK. Did Margaret Thatcher harm the Monarchy? There was no more of a supporter of the Monarchy than Margaret Thatcher. 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 hear anyone ridiculing the Royal family. It was more a coincidence that we had both a queen and the first woman Prime-Minister. There was a feeling around mainly fueled by the media, that the queen did not approve of all of Margaret Thatchers attitudes. The Monarchy has always traditionally stood to unify the country. It tends to stick up for people very different from themselves, who they believe may have in some way been left out of the ruling establishment. For instance, they had great sympathy for the miners which was very romantic and 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 stand the hypocrisy that circles the Royal family, often disguised as criticism. The obsession with one family, as if they either were or ought to be miraculous if 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 of a city not being acceptable to a particular President, because in the UK, the

The Pound Sterling Chronicles
queen does not take part in politics. She is very much advised by her private Secretary of what the constitutional precedents are. Basically, her guiding principle is not to get involved in politics. Very few Presidents can behave this way, and you can not really expect them to, because even the most respected Presidents have usually got a career in party politics behind them. In your view, what is the prime reason for preserving the institution of the Monarchy? There is an advantage in having someone that is above politics and is a point of continuity between governments. There are duties for a President to perform. In Italy, for example, a President is sometimes not regarded as being entirely 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 in substantial tourist dollars. However, the disadvantage of it is that it tends to divert attention from the more difficult and perhaps less glamorous issues in the UK. It is much easier to discuss the affairs of Diana and Charles, than to discuss the discount rate policy of the Bank of England.

Bankers to the Queen
What has been the link between the Monarchy and the collapse of Barings bank? Has not the queen been forced to open up castles and various 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. They really only keep petty cash in the bank. In any case, the assumption of Barings by Dutch based ING bank, has preserved all of Barings former deposits. There is no reason to believe that the Royal family had a major proportion of its assets managed by Barings at all. I may be wrong, but I cannot think of any additional Royal residences that were opened to the public as a result of the Barings crisis. The opening of Buckingham Palace to tourists began well before the Barings crisis. I do not understand how Nick Leeson was able to acquire such uncontested powers to destroy a bank? The analogy would be one where you had an individual not academically talented, but one that had great ability in making money, nonetheless. It would be most tempting to give him a great deal of

For Monarchy & Single European Currency
independence. Before the crash, they were reporting profits from this one individual in Singapore that were greater than in all other activities in which Barings was engaged in. In the end, he was not doing anything that complicated; he was simply betting on the Tokyo Stock Exchange.

The Bank of England
In a period of independent central banking, why has the UK not followed suit with the overall European trend? Mainly because of the confrontation between the two main political parties. According to the mythology, the government is responsible for everything that happens. John Major is terrified that somebody will criticise him over the direction of interest rates and he will have no choice but to respond: “I can’t do anything about it.” I favour central bank independence myself, but its probably easier for a country with a written constitution after World War II like Germany, to write out formally. Has the lack of central bank independence affected the value of sterling 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 of England were to be independent, or not subject to a directive of the Chancellor over monetary policy, I think that bonds and sterling would go up and would go up even more if the Labour party were to proclaim full support for such a move and refrain from any policy reversals.

Contemporary Issues of Concern
How do you view George Soros speculative power that was attributed to 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 was blowing and made some very wise investments accordingly. He did not, however, cause the wind to blow. In retrospect, when the UK joined, it had no idea that the German interest rate would stay so high for so long. At the time, there was some support in the UK treasury for a general re-alignment in the ERM, which also would have involved France, which was not prepared to have a depreciation against the mark, since they were already focusing their sights on monetary union.


The Pound Sterling Chronicles
How do you respond to the constant criticism that the UK has hardly a manufacturing base left? I do not lose any sleep over it at all. In the 18th century there were a group of economists known as the Physiocrats that thought that agriculture was the most important activity. The ones that talk about manufacturing currently, belong in a similar category. Manufacturing is just one sector in the economy and activity has been moving away from manufacturing in many advanced economies quite recently. The whole process seems pretty natural to me. Is it not the UKs unofficial policy to de-face what is left of its industrial base? It is not a policy, but can be more accurately described as allowing the natural course to run and just letting things happen. The US has a far smaller proportion of its population in manufacturing than does the UK. If we look at a trend of Gross National Product (GNP) per head in a given country, what we will find is that the higher the GNP per head; the smaller is the proportion of the economy in manufacturing. The UK is exactly on this trend, but Germany is very much off of trend, which may make it a bit vulnerable as change takes place.

Policy Suggestions
What in particular excites you about the UK economy at this moment? If you asked me what could excite me? I would respond by saying that I do not think that economies are unique. For the first time, we seem to be combining reasonable growth, falling unemployment and no visible inflation pressures. It seems to be the first time in about thirty years that we have developed such a positive combination of macro-economic aggregates. Although UK GNP is rising, it is rising very slowly. I think there are two reasons for that, one is that markets on continental Europe are very sluggish and that statistics under rate GNP growth rates. For instance, the effect 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 entire class of jobs. For example, there is currently a big shortage of science teachers,

For Monarchy & Single European Currency
however, a surplus exists in the field of art instruction. It would be very much against popular culture to allow schools to pay more for science instructors. Also, a great divergence exists between insiders and outsiders. Those that have jobs try to keep up their wage at the expense of outsiders, who are prepared to work for a lower pay. One way around this would be for firms to hire outsiders at a lower wage. In other words, I would like to rid the UK of the fixed wage construct. Do you favour a Labour government under Tony Blair, or would you like to see an extension of the tenure of the Conservatives? One party has been in office for far too long, but I would prefer a change based on economic policy. I find that these Conservative politicians are rather 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. I think that it is very likely that the government will like to join later on, which has 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 its monetary policy, but a very poor record in business. One disadvantage of the German corporate model is that there exists only one point of pressure to conform- and that is from the banks, which is not always enough. It may not be 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 exports would find it hard to adapt to the new changing environment among all industrial economies? Yes, the German model is in great trouble. German companies are exporting investment to countries where labour costs are much less. Would not the UK’s participation in a single European currency somewhat strain its historical trans-Atlantic commercial relations? Only to those business people who have always been opposed to a single European currency for the UK from the very beginning.


The Pound Sterling Chronicles
Are there more business people against, as opposed to being in favour of a single currency? Not in the manufacturing sector, which still composes some 20 to 25 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, the biggest opposition exists in the City of London, as opposed to the general overall business community in the UK. The attitude in the City is based more on 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 single currency is working, then a Blair government may opt to join immediately. The other event that may cause Britain to change its mind would be yet another sterling crisis. After which the prevailing sentiment which may emerge, would be one that questions our ability to solve our problems through devaluation yet again? Faced with a choice of devaluation, yet again, and raising interest rates to punitive levels, and joining a single currency, the latter option may emerge as the least worst of the three evils. Therefore, we would need to have a climate where the single currency is shown to be working, or a sterling disaster is in the works, or some sort of combination of these two events.


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 constitutional conference? It is becoming clearer that the present strategy towards monetary union simply will not work. There exists just too much turbulence in the currency markets at this time, in order to pursue the framework as was envisioned in the Maastricht Treaty towards European monetary union (single currency). Specifically, what is the strategy that must be changed? The present strategy calls for a long time period in order to reach the ultimate goal of monetary union, together with economic “convergence conditions” on a number of economic variables such as deficits, debts, inflation and long term interest rates among a majority of European countries, which are basically irrelevant to monetary union. In fact, economic convergence can only come after a successful introduction of a single currency, which is the opposite to the strategy that is presently being followed by European governments. In that respect, one of the visions that must be addressed is the softening of this criteria. Would this also call for a complete revision in the current role of the European Exchange Rate Mechanism (ERM)? The ERM must be revised completely, especially within the current mood of speculative pressures in the currency markets. Moreover, the turbulence witnessed presently should become even more pronounced as the final date of 1999, inscribed in the Maastricht Treaty approaches. Why is that? One fundamental reason is that a guessing game of what country will be in or out is continually on the minds of investors, and world money markets just cannot cope with this kind of uncertainty. The solution will either shorten the transition period significantly, or allow maximum flexibility in our managed system of exchange rates.

The Pound Sterling Chronicles
What would you propose to be the correct road to monetary union in Europe? First, it would not be a good idea to attempt a monetary union with the entire European Union as it presently stands with 15 members. The reason being that many member states are still very different structurally and institutionally, such that they have to maintain as an option, flexible exchange rates 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 based on the individual countries themselves- they are the ones that would know if monetary union would be in their best interests. Regardless of their economic fundamentals? No, but the current criteria that has been imposed touching on such concerns as debts and deficits is not the right way to go either. This scientific approach to European monetary union as per the Maastricht Treaty has gone too far. Many of the criteria, such as the one on inflation convergence are completely irrelevant. For example, when east and west Germany were united, no one referred to inflation differences, yet the monetary union is holding to this day rather successfully. Why has the Maastricht criteria been introduced?

The Germans imposed this on the entire European Union to restrict access 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 of financial management since the second World War. Nonetheless, I believe monetary union in Europe will be a very difficult idea to successfully implement if the Germans insist on imposing their terms. In essence, the entire program depends on Germany, which is why I am relatively pessimistic because my reading is that the opposition within Germany will only increase to monetary union. The German government will continue to insist on the rigid implementation of the strict convergence criteria as per the Maastricht Treaty. Since monetary union in Europe means throwing away the German mark.


One Market One Money
Is the French economy fundamentally different from the German? All European economies are different, but the question is whether these differences will be an obstacle to monetary union? I believe that structural 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 France on issues concerning monetary policy. They are a direct result from policies introduced by the Socialist government elected in the early 1980s, such as minimum wages, large increases in social security costs, and so on. However, I would agree with you that restrictive monetary policies practised thus far in the 1990s, have added to the overall problem of unemployment needlessly. Much of the problem was imported by overly restrictive policies in Germany which the French slavishly followed and which intensified the recession in France. Would you agree that the active pursuit of restrictive monetary policy over the past 14 years, together with the movement making central banks independent or unaccountable to the political process has contributed to the current problem of demand deficiency in industrialised countries? I’m not so sure that central bank deflation is the major cause of the current deflationary climate, but I would argue that it has been caused in the way in which the ERM has functioned. For example, in the recession of 1991 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 to its commitment to a relatively fixed exchange rate within the ERM to maintain 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 French political authorities to maintain a relatively fixed parity with an appreciating mark, than it is with regards to the independence of the Bank of France. It would have been far wiser for French policy-makers to allow the franc to float during this period of severe imbalances in the German domestic economy. Do you agree that inflation must exist in a market economy for it to function effectively? Yes, it could be a valid objective to pursue. The recent experience with respect to the pursuit of monetary policy from 1991 to 1993 was a repeat

The Pound Sterling Chronicles
of the errors that the US Federal Reserve made during the years of the 1930s great depression. When the depression began, the Federal Reserve restricted money and credit formation, when indeed the opposite should have occurred. This entire episode was repeated in the 1990s in Europe. Germany convinced most European Union members that inflation was about the only important policy goal to be concerned with. Can it be viewed as a unique scenario that built up as a direct result of the 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 a single currency ought to be pursued, how must the banking system prepare for it? I think that transitional problems will exist, but it really should not change too much. The inter-bank market will grow dramatically, since all national wholesale credit markets will become one larger European based market, with lower transactions costs and perhaps with cheaper credit over the 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 recent past, London was open and Frankfurt very heavily regulated. If a single currency comes about and regulations become standardised, those not participating in the single currency project may end up the losers. If the UK exercises its opt-out clause, it will lose ground to both Frankfurt and Paris. Will London not be the loser anyway, since regulatory standardisation across all financial centres in the European Union will result in its losing this advantage that it has always held claim to? Yes, but London does have a unique access and availability of financial talent that is very unique to the three financial centres. From this perspective, London may become even more attractive in a monetary union. Even though the European central bank will be located in Frankfurt, there is no guarantee that Frankfurt will become the major financial centre in Europe. We can only look to the US, where New York is the major financial centre, but Washington D.C. is where the major financial policy decisions are made.


One Market One Money
What is the attraction of Paris as the main financial centre? I see very few attractions to Paris as a financial centre. If the UK participates in a single European currency, there is no question of London remaining the pre-eminent financial centre. If the UK stays out, the issue becomes 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 system across Europe? It will all depend on the regulatory framework in the individual countries, more so than through the actual presence of a single currency circulating in the economy. If we look at the US example once again, a single currency and common monetary policy did not prevent the development of one 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 such a determination. If a single currency comes about, debts will be denominated in the same currency, but will still be identified with their respective government 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. For example, 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 priced according to its default potential reflected through its rating and interest rates. Why would this not be workable? Do you foresee an acceleration in currency crises as we approach the Maastricht constitutional conference in 1996?

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


First Quarter 1992
The European Monetary System (E.M.S.) defines a maximum fluctuation band of 2.25 percent for Germany, Italy and France and six percent for Great Britain. The two month trend has continued to show a weakening in Sterling relative to the strongest currency- the Spanish Peseta. What is most surprising is the weakness that the German mark has experienced due to a mixture of the general domestic downturn in production and the pressures of the wage-negotiating rounds at the moment. France and Britain, while both experiencing politically sensitive unemployment figures edging up towards three million, and deteriorating Gross Domestic Product (GDP), must now face upcoming elections. The political impacts on the economies, with Britain on the verge of a national election campaign and France an important regional election, will work against Britain more than France, since the results are expected to be opposite to one another. As of March 19, 1992, the labour party had a small lead of approximately five percentage points. A conceivable labour government, even if in a minority, may require a rate increase and heavy intervention in sterling markets to maintain standing within the six percent band of the (E.R.M.) British political effects on sterling are compounded by deteriorating exports, which is on e area that the Tory government of John Major was counting on to boost the country out of its worst recession since the second world war. Exportsto the EC fell from £794 million in December 1991 to 409 in January 1992. In addition, exports to a recessionary US economy fell by eight percent over this period. Adding to the gloom, unemployment doubled in January 1992 to 53,000; twice the number expected by analysts, with an additional 40,000 redundancies recorded for February 1992. The pre-election budget presented by Treasury Chancellor Norman Lamont delivered an across the board tax break, which is designed to create an illusion that the government is fighting the recession with the election called for April 9, 1992. The result of the cutwill produce a large deficit, resulting in the Public Sector Borrowing Requirement (P.S.B.R.) reaching £12 billion this year, and expected at £25 billion in 1992-93, or 4.5 percent of GDP.


First Quarter 1992
This figure will add upward pressure to the discount rate with corresponding downward pressure to the domestic gilts market and equities. Investors and the City may not be too hostile to the outcome, as the fixed level of 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 rate devaluation is no longer available.

Currency Outlook
Unless sterling is supported by massive interventions by fellow members participating in the (E.R.M.), the political uncertainty at this point in time along with a serious recession will force a devaluation or re-alignment in the grid. And with the present inflationary climate gripping the domestic German economy, together with evidence of continued buoyancy in the Gross Domestic Product (GDP), it can be expected that the current high levels will remain, if not increase. As the central bank is quite wary concerning the transmission of further inflationary pressures from a weaker mark vis-avis the U.S. dollar. However, the risk of having the Lira fall outside of the grid is negligible compared to the precarious position that Sterling will find itself in.


Second Quarter 1992
The trend of voting out the ruling parties or coalitions on the continent stood out from the outcome in Great Britain, with the ruling conservatives under John Major winning a majority that should implant valuable political stability in U.K. markets for the upcoming five years. The uncertainty associated with daily opinion polls from early March to the final day when voting took place, was the prime information that moved the financial markets on a daily basis. The distressing effects of first a hung parliament, as the early opinion polls predicted, down to a possible scenario where the labour government was thought likely to obtain a majority, or at least a working majority under a coalition with the Liberal Democratic Party was all too much to bear for investors. Given the precarious circumstances of having sterling tied to the exchange rate mechanism (E.R.M.) and for the last two months being consistently on the bottom of the grid with the possibility of devaluation, coupled with one of the worst domestic economic downturns for over forty years led the informed observer to conclude that this would not be an opportune time to be weighted towards sterling-denominated financial assets in the short term. A financial overview of the markets prior to the run-up to election day on April 9, 1992, brought downward pressure on the gilts market. This was accomplished initially by the impact of the Lamont budget with the magnitude of the Public Sector Borrowing Requirement (P.S.B.R.) reaching £28.1 billion, and exceeding the expectations of analysts by £3 to £4 billion for fiscal year 1992-93 or 4.5 percent of GDP. This compares with a 1991-92 P.S.B.R. of £13.8 billion or 2.25 percent of G.D.P., and represents a serious rise in government indebtedness which will see a flood of new issue activity in the domestic and international capital markets over the year to come. The dramatic rise can be attributed to the conservative government adopting many of the Labour Party’s initiatives on re-distribution to lower income voters, while at the same time maintaining the basic tax rate at 25 percent. The negativity that gripped investors and bond traders at the beginning of March 1992, concerning the doubling of the deficit from the budget was not long afterwards displaced by negative sentiments that emanated from opinion polls. Sterling continuously was relegated to the lower band of the E.R.M., while gilts were under a downward bias throughout, as weakness in sterling raised fears of a post-election devaluation or increase in the discount rate.

Second Quarter 1992
A Reuters opinion poll taken by London City economists indicated that expectations were already in place of a hung parliament as the most likely outcome. Furthermore, sterling did not obtain any assistance from the real side of the economy, as commercial property continued to be in one of the worst slumps ever and the unemployment rate for the first quarter stood at 9.4 percent or 2.65 million, showing a rise for the 22nd consecutive month and representing the highest level since September 1987. The miracle of a Tory majority, once again revealed the creativity behind the art of forecasting or polling, and for the first time in over five months, sterling was displaced by the Danish Kroner from the lower band of the E.R.M., entirely based on the euphoric sentiments of investors. As talk now of controlling inflation and the timing of bringing sterling into the narrow E.R.M. bands of 2.25 percent instead of the existing six percent range wholly replaced the pessimism that persisted prior to the dramatic majority victory. Thoughts of either raising rates, realigning the E.R.M. to account for pressures on sterling or outright abandonment in the form of devaluation were the pervading themes prior to the outcome of the vote. This powerful sentiment had sustained positive effects in the gilts market, and more or less overshadowed the rise of 1.1 percent in industrial production and the 0.8 percent increase in the output price index for February and March of 1992. The gains from an investors view point to a steady progression in sterling from a pre-election parity of 2.89 Deutsche marks to 2.945 as at May 8, 1992 (the narrow bands beginning at 2.95 Dm.). In addition, a balanced portfolio of gilts returned 4.8 percent on the month, in contrast to a 0.8 percent return that an equally weighted portfolio of German Bunds would have yielded.

Currency Outlook
British sterling should continue to strengthen vis-a-vis the Deutsche mark, based purely on continued positive sentiment and resolve of the Major government to remain within the Exchange Rate Mechanism (E.R.M.). The fact that there is now a right of centre stable government for the next five years should ensure that sterling will be protected regardless of whether or not the domestic real economic fundamentals continue to deteriorate. In this day and age of reputations and sentiments becoming the conventional wisdom of contemporary financial markets, the Tory election “dividend” will persist for quite some time. With sterling on the edge of the narrow band over the last week, it may very well be late in the third quarter when Chancellor Lamont decides to officially adopt the 2.25 percent range as the future anchor for the currency. In all, the election has reversed the fortunes of sterling.

Third Quarter 1992
Pressure on the European exchange rate grid was once again caused by political events. First with the dramatic victory of the Conservative government in the U.K., followed by the unexpected rejection of the Maastricht blueprint for European economic and monetary union by a referendum in Denmark and the inability of the Italian four party coalition to agree on a candidate for Prime Minister. All were events which encouraged wild speculative swings that could have severe perercussions on not only the stability of the Exchange Rate Mechanism (E.R.M.), but more importantly on the progress towards eventual economic and monetary union. However, newer entrants to the ERM- which was designed primarily for them to borrow credibility from members with proven reputations, such as the Bundesbank. Will initially find it difficlt to convince investors of their resolve towards price-stability over the longer term. Hence, the possibility of eliminating currency risk by pegging it to the deutsche mark, still will over the short to mid-term provide investors high yields. Presently, the situation with France is a perfect example of how a member has used the system of fixed exchange rates to its advantage. As the present French inflation rate is lower than the usually lower German rate, it has managed to convince investors of their solid commitment to price-stability over the long term, with a resulting convergence in French-German bond yields. Another case in point is the late formal entry of the U.K. in the six percent wider band of the E.R.M. This case also shows benefits in reducing the 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 deutsche marks to one pound sterling. This performance has convinced investors of the resolve that the present government has toward domestic price stability over the longer term based on the political commitment to indirectly forfeit their control over monetary policy to the Bundesbank. However, as soon as markets become uncertain as to the political resolve of maintaining the parity, as is the present case with the U.K. faced with a deteriorating economy. Then sterling will and has come under speculative attack. Ever since the election majority was gained by the

Third Quarter 1992
Conservatives, the aspirations were such that the newly won political stability supplemented with a pro-business environment, would immediately provide economic benefits through this election “dividend.” This has proved false, as sterling has fallen from the immediate post-election high of 2.95 to one Deutsche 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 sentiment has been broken and the commitment to a fixed parity increasingly questioned. Therefore, it is this political commitment to the E.R.M. that binds the domestic monetary lever to the Central bank having the best record on price-stability and creating the highest level of investor confidence, which is vital to making the entire system function properly. Any deviation from this commitment of tying the monetary hands with the resultant abandonment of stable prices domestically will re-order the expectations of borrowers and investors. The outcome of which will most certainly result in higher-yielding debt instruments. The economic fundamentals over the past two months confirmed that the European region is in a period of deflation. The U.K. continued to record dismal economic figures, as the April 1992 unemployment rate rose by 42,600 reaching 2.7 million, its highest level since August 1987 or 9.5 percent while the May 1992 figures went above the 2.7 million mark. The deterioration in domestic demand was further exacerbated by the savings ratio increasing to 11.5 percent of personal disposable income during the first quarter and the highest in over a decade. As consumers burdened by debt and unwilling to make major purchases were attributes to the weakness. In addition, the Central Statistical Office reported a 0.6 percent decline in manufacturing in May 1992 and a 0.4 percent fall in overall industrial production from the March 1992 to May 1992 period. The persistently high rates of interest were harming in a serious way planned investment in the industrial base which would have long term consequences for the U.K. economy. This was confirmed by the six percent fall that was recorded over the first quarter. The severity of this economic downturn has prompted several respected organizations such as the London Business School to call outright for a devaluation in sterling. As mentioned above in the overview, the sacrifice of monetary policy to the E.R.M. has relinquished the stimulative effects that a devaluation may have brought to the domestic economy at this point.


The Pound Sterling Chronicles
Currency Outlook
The resolve of the U.K. government to maintain membership in the E.R.M. will win over in the end, although at great cost to the domestic real economy. The Treasury will not tolerate any parity that dips below 2.85 deutsche marks to one pound sterling and will be prepared to raise base rates in order to protect the currency. This will further add political pressure on the government, as a much needed recovery will not materialise causing great economic and social pressures. Therefore, further devaluation in sterling should not be expected.


Fourth Quarter 1992
Throughout the past month we witnessed a series of negative events which seriously tested the foundations of the European Monetary System. Of the most notable were the collapse of the Dollar markets leading to intense speculation against sterling, coupled by the advance of the Deutsche mark to the top of the grid of the Exchange Rate Mechanism (ERM) and the continuing problems in Italian dometic fiscal finances. All have yet to face what will prove to be the final test to the entire process of European economic and monetary union according to the guidelines set out in the Maastricht Treaty when the French hold their referendum on September 20, 1992. Doubts about further European progress are presently so high that ECU- denominated debt markets have occasionally ceased trading due to the thinness in the volume of bids. Moreover, the doubting sentiments have hit hard domestic gilt markets in the U.K.; and what has over the last several months become a familiar fixture- large capital shifts out of the high-yielding currency areas (Sterling, Paseta, Lira, Escudo) into the Deutsche mark. In fact, the economic justification for further European economic integration has become so questionable that Financial Times of London correspondent Ian Rodger wrote of the resurrection in the Swiss Franc as a safe haven: “For many Swiss analysts, however, the explanation is simple. The European Community is in such a state of turmoil that Switzerland and the Swiss franc have recovered their safe-haven status.” Emerging out from the present impasse in EC relations with even more status and power will be the German Bundesbank. In fact, with the U.S. Dollar in free-fall over the past month, any increase in the Federal Funds rate or discount rate will be construed as being an act that will portray the Fed as a de facto member of the E.R.M., dictated to by the powerful Bundesbank. A situation by itself, which will clearly instill powerful incentives for further easing in domestic U.S. rates. The worsening economic conditions in the U.K. are a testimony to the real pressures that can build-up when a government pre-commits to an overvalued fixing of the exchange rate level. As inflation falls further, real rates rise having serious repercussions on real economic activity and employment. In fct, the only policy lever that is momentarily available to confront this grave situation is fiscal policy. The situation has so deteriorated that one

The Pound Sterling Chronicles
industry leader after another has urged intervention by the government. The latest being Sir John Quinton- Chairman of Barclays Bank who did not see any 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 demand in June 1992. With M0 up 2.4 percent in July 1992, and M4 (representing bank and building society deposits) up 5.7 percent in July 1992, it clearly indicates that consumers are opting to save more of their incomes and shying away from purchases of durables. This behavioral effect has had a profound effect on the deepening 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 this year should add an additional £4 billion to the gilts financing program. The cumulative (PSBR) for the first four months of 1992-93 will be £11.3 billion compared with £5.9 billion during the same period last year. This comes as the unemployment rate rose to a five year high in July 1992, the figure representing the 27th consecutive increase or 2.75 million in total, almost 1 million of whom are long-term redundancies. Presently, the official unemployment rate stands at 9.7 percent. With this additional increase in the (PSBR) attributed to a large extent to large shortfalls in expected receipts, the deficit/GDP ratio exceeds the three percent Maastricht guideline for European economic and monetary union. The deteriorating public finances prompted economist David Hale to make the following comment in the Financial Times of London: “The deflation occurring in the British economy will ultimately create the preconditions for improved competitiveness and economic recovery, but probably 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 year and remain there for much longer.” The great pressure of the real economic downturn in the U.K. has affected their credibility to commit themselves to the E.R.M. Consequently, the opportunity cost of investment in sterling-denominated financial instruments increased over the past month. This can be seen as yields on ten year gilts rose from one to 1.3 percent vis-à-vis German bunds leaving a perception that devaluation of sterling is more likely. The Treasury repeatedly tried 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

Fourth Quarter 1992
£8 billion in deutsche marks in order to fend off any further attacks. This last act seems to have convinced speculators of the government’s resolve to maintain sterling within the six percent E.R.M. bands.

Currency Outlook
Without the French vote on Maastricht hanging over the currency markets, the Franc relative to the Deutsche mark would not be affected. However, if rejection is the outcome of the referendum, the franc would enter a free-fall along with most of the other high-yielding currencies that are tied 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 subsequent rise in interest rates to stabilise the franc would be far less than what would be needed in the case of the other three. Sterling without the Maastricht vote would be able to weather investors’ expectations of impending devaluation and be true to the resolve of messrs. Major and Lamont. While facing a debilitating domestic economy with recovery nowhere in sight, any increase in the base rate would produce irreparable damage. Therefore, as was the case just recently, the government borrowed approximately £8 billion in deutsche marks in order to support the currency. They will continue to use such creative financing to stave off any potential to devalue since a number of senior Ministers have staked their political careers on their commitments to the E.R.M.


Year End 1992
Having brought both the Treasury and the Bank of England into submission, currency speculators were prevented from doing the same to the Bank of France through heavy support from the German Bundesbank. Was it the case that Sterling was unable to hold its position in the E.R.M. because of miscommunication, incompetence or simply a lack of support from other member banks? To apportion blame to any of these reasons would assume that under perfect capital mobility, fixed currency parities could be maintained. However, to observe the volume of turnover in the foreign exchange markets would lead informed observers and participants to conclude otherwise. The following chart powerfully displays the volume of Dollar turnover in the main financial centres over the past six year period:

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


Year End 1992
As the table indicates, there has been a tripling of the volumes that pass through the main foreign exchange centres in the world. Clearly, such a development easily can overcome any intervention that may be planned by central banks. The fact of the matter is that only the scale of currency hedging is producing investment flows which rival the reserves that Central banks hold. The emerging importance of a global strategy in pension and investment funds 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 direct proportion to the movement to remove capital controls. For instance, a typical U.K. fund now is 20% exposed compared to 6% in 1980. With this recent development in mind, it becomes virtually impossible for countries such as Britain to get away with an unrealistic fixing of Sterling. If the fiscal and real economic fundamentals continue to deteriorate, as they most certainly have in the case of Britain, any attempts by the Treasury to reverse this by raising base rates will only have a short term effect, if any. The entire currency episode was a culmination to pressures that were building up in the foreign exchange markets since the Conservative victory in April/92, and even beforehand. These pressures reflected the doubtful voices of market participants, as corporate profits tumbled and redundancies 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 double the expectations. This pushed the figure to a five year high of 2.8 million which increased even further in October/92 to 2.87 million. In addition, informed sources have revealed that 1 in 5 households in Britain have a negative equity position, with an average deficit of Sterling 6,000. And business failures in the third quarter increased by 53% over last year, with a continuation of losses reported across numerous industrial sectors. Now that the policy of fighting Inflation by pegging Sterling to the Mark has unravelled as the central focus of government policy. The government still to this day has not fully been able to account for having to substitute It by a policy that emphasizes growth and employment. This shift away 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 decisions around a basket of financial Indicators such as money supply figures, asset prices and the exchange rate. Undoubtedly, asset prices seem to be diverting most of their attention span at this moment, but the Inflation rate will be targeted between 14% as measured by the yearly rate in the retail price index,

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

Currency Outlook
With the value of Sterling overcome by domestic economic fundamentals and the recent position of government fiscal finances, the inability of the government to articulate a coherent and credible economic policy post-E.R.M. generates negative sentiments about Sterling on the currency markets. As the government tries hard to get back on track and overcome its present confusion, fiscal finances continue to deteriorate to the point where the gilts markets find it difficult to attract Investors. A F,28 billion deficit that was projected In the last budget, Is now forecast to be L37 billion In 1992-1993 and L44 billion in 1993-1994. Since reaching a historic low at 2.38 Deutsche Marks, Sterling has recovered and settled in the 2.4-2.5 range to the Mark over the past two months. With the base rate set to decrease further and the continuing crisis of confidence within the ruling Conservatives, the only positive sign is that the severe devaluation will allow British industry to once again become competitive in International markets. However, unless the government can regain the confidence of Investors by proposing credible policy options over the short to medium term, and attending to the growing budget deficit, then Sterling will once again challenge Its historic lows. The gain in competitiveness from the devaluation will be felt over the longer term, but will take time until 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 2.42.5 range to the Mark, with an even chance of falling between 2.3-2.4 to the Mark.


First Quarter 1993
• 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 mediumterm • 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 Economic and Financial Overview
The only sign of an end to the worst downturn in Britain since the second world war has been reflected In the rising export orders due to the record devaluation in Sterling. The casing in domestic monetary conditions was recently reported in the Confederation of British Industry's latest monthly industrial trends survey. As manufacturers' order books were at their best levels for more than two and a half years and for the second consecutive month, manufacturers were planning to raise production over the next quarter. Expectations of further record cuts in the base rates to perhaps the 5% 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 revive the economy reflect a complete neglect in appropriate industrial policy throughout the 1980s. These were exactly the sentiments that were expressed by the Chairman of Ford of Britain- Ian McAllister recently. The neglect of industrial competitiveness in the U.K. in favour of the mythical idea that wealth could be generated on purely the support of a service-oriented economy was sharply criticized. Moreover, as the service sector attempted to

The Pound Sterling Chronicles
increase its efficiency recently, over-reliance on this sector was beginning to escalate redundancies. This lack of competitiveness in British industry, and the failure in which an indifferent Thatcher government throughout the 1980s held the virtues of promoting a mixed economy in contempt is a main reason for Britain's present problems, as well as the prime reason for Sterling falling out of the E.R.M. last September. To have still remained tied to the Deutsche Mark at about 2.95 would have brought serious repercussions to export markets, which are now back on the road to recovery. In fact, several independent advisors to the Treasury are urging that the government encourages industry to invest in proven export-enhancing sectors. This according to one of the advisors- Wynne Godley, suggests that sustained growth in the economy can only be achieved if an expansion in exports occurs through investing in sectors that produce internationally tradable goods and services. Such long-term considerations as shifting investment resources to the tradable sector, along with adopting a fundamentally realistic economic strategy by the Treasury over the short to medium term is what is now required. Hopefully, the upcoming budget speech on March 17, 1993 will address the concerns that business leaders have been preoccupied with ever since 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 German Bundesbank by allowing it to set money targets for the Treasury have been totally inadequate as appropriate policy prescriptions over the recent past. Although the present targeting of inflation between 1-4% will likely not generate an acceptable decrease in unemployment, it is, nevertheless, one of the remaining untried options. The only question is whether further deteriorations in the social conditions will take precedence when deciding on the appropriate base rates and value of Sterling.

Currency Outlook
At time of writing, Sterling has attained a historic low of 2.3125 Marks. This reflects expectations that the base rate will be further reduced to new historic lows of 5%. Although we do not yet know the contents of the upcoming budget, encouragement can be taken from the increasing growth 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,

First Quarter 1993
exports at the moment seem to be the only game in town for economic revival. The importance of addressing an industrial strategy in the upcoming budget will be vital to the continuing growth in exportable goods and services over the medium to long-term. For the moment, the benefits of a historic low in Sterling will last given that the French or similar such industrial competitors do not match the devaluation in the hope of winning back lost markets. As the French economy deteriorates further, the risk of some downward realignment in the Franc becomes very real. Should the Franc fall, Sterling will need to break new record lows, since most of the exports have gone to formerly French markets within France. The risk of having such competitive devaluations dominate the European industrial scene, and the fact that the export component in the U.K. is what most are placing their bets on to generate a long awaited recovery, are both factors that will maintain Sterling within the 2.30 to 2.40 range vis-A-vis the Deutsche Mark.


Second 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 Overview
How long can John Major last as Prime-Minister? With the unremarkable labour party recently posting 25 percent leads in various opinion surveys, the government has had to contend with numerous self-inflicted crises recently. From the replacement of former Finance Minister Norman Lamont over the lack of confidence in his economic management, to the recent criticism of illegal conservative finances brought forward by the head of bankrupt Polly Peck International-Asil Nadir, conservative party members criticism of John Major 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 and Norman Tebbitt In the House of Lords could lead to a national referendum on the Maastricht Treaty- one of the policy-pillars of the present government. Given the general dissatisfaction of the British public at this point in time, any defeat in such a contest would not only see to the quick exit of Mr. Major, but would also bring down the Conservative government. Although several commentators are optimistically pointing to recent numbers 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

Second Quarter 1993
this point In time, with the recovery of business investment confidence still tenuous at best, and record consumer debt levels still very much affecting spending, coupled with recent record banking losses. The only way in which growth would fall above the long term trend would be an incredible resurgence in exports. However, with the global recession and with the continental economies in particular showing contraction, this goal will become ever more difficult to attain. Furthermore, with the prospect of a tax increase in the November budget now very real in response to the record deficit. Such a measure should add unbearable pressures to the present economic situation, as any move to further cutting base rates would not cover the contraction that a tax increase would bring to aggregate demand. The dilemmas faced by the U.K. was recently succinctly summarized by former Thatcher government Finance Minister Geoffrey Howe: "Optimistic claims about British public-sector finances being hyper-cyclical have been thought to justify the emergence of a Reaganomicsstyle budget deficit- which the U.K.'s exposed and trade-dependent economy is far less able to sustain than even the U.S." and... "People forgot that Black Wednesday was not a liberation, but a warning of recurrent weaknesses and of the hazards which still face countries unable to establish monetary discipline as the basis of non-inflationary growth. Black Wednesday proved that the original Thatcher agenda of sound money, fiscal rectitude and supply-side reform had not 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 black Wednesday last September, 1992 and has brought about a resurgence In the export base of the U.K. This positive development to U.K. economic affairs recently is still overshadowed by large consumer debt, the 1.7 million households holding negative equity; not to mention the politi-cal problems of the government. The only possibility that the U.K. has In order to expand domestic growth Is through exporting abroad. This Is the prime factor, along with the very real prospect of further base rate cuts that will not allow Sterling to appreciate above the 2.6 Mark level. In fact, given the still precarious state of economies-economic and political stability in the U.K., It is a very real possibility that we see Sterling fall further. In fact, the probability of Sterling falling exceeds the probability of it rising back toward the range in which it was bound to the German Mark through the E.R.M. Certainly, any rise in taxes to cover the fiscal shortfall will encourage further easing in monetary policy and base rates. On that basis, a range of 2.4 to 2.5 Marks to the Sterling is a very real possibility.

Third 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 Overview
As Politicians and Economists continually talk up recovery based on unreliable data which is subjected to continuous revision, manufacturers disappointing interim results confirm that any such hopes for a vigorous upturn are still far from reality. If the replacement orders cutback for defense procurements is added to the continuing recession from continental European countries, the barriers that domestic manufacturers must overcome become far more formidable than what is captured in the recent mixed surveys reporting on the strength of order books. In fact, the severity in defense cutbacks have prompted three formerly prosperous south-western counties: Avon, Gloucestershire and Wiltshire to lobby for European Community (EC) regional aid. Such cutbacks continue to adversely affect some of the most blue-chip of British industries as British

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 domestic budget due to the late 1980s property bubble effect continue to push the deficit upwards. In addition to the lack of domestic investment spending by manufacturers is the sorry state of personal finances, as there is now talk of a tax increase in the November/93 budget that will be brought down by Chancellor Kenneth Clarke. As the deficit hits record levels of Sterling 50 billion and as Gilts flood the markets in the hopes of financing it, the shortfall in both personal and commercial revenues has prompted the Conservatives to propose some kind of tax levy which is yet to be determined. Such a proposal has prompted continuous revolts by the right-wing Conservative faction opposed to any taxes as it is being simultaneously frustrated by its virtual bankrupt status from losses in the Lloyds insurance market. In addition, former Chancellor Norman Lamont, still very bitter about his forced resignation in May/93 from the top Treasury spot has written several vicious editorials mocking the leadership of John Major. Add in the unspectacular state of the domestic manufacturing economy with the sorry state that British personal finances are in from the Lloyds debacle to the 9% of householders who find themselves with negative equity and you can immediately see why the Liberal Democrats are on top of the opinion polls. With developments as they stand, the end may 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. The wild card in all of this is that the escalation of the Lloyds situation may force a quick election as the Conservatives' majority is threatened. This scenario was 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 raised a merry scenario of political destabilization. A bankrupt M.P. is automatically disqualified from sitting in the House of Commons, and loses his or her seat after six months." In any case, the instability in the U.K. political system is mainly a reflection of the changing times, as voters who used to support Politicians standing for stability are now venting their frustrations. Unfortunately, no Politician is in a position to reverse the adverse economic malaise that has now been on-going for the past two years. With the dramatic developments taking place in the Asian markets and with the development of eastern Europe along with the financial challenge to London of cities such as Frankfurt and Paris, the U.K. is fearful of becoming very marginalised over the medium to longer term. The present depression only adds to these fears.


The Pound Sterling Chronicles
Currency Outlook
The present on-going stagnation in the manufacturing industry has prompted a group of Chairmen from this sector to blame Economists and Politicians for talking up a recovery "beyond the realms of reality". This group carries far more credibility than some of the surveys and statistics that have been submitted to the public in recent months showing the opposite. As consumers continue to be hard-pressed and consumption spending only registers the barest of increases, and companies refrain from investing as a result of 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 real possibility. Since exports remain the only real way in which manufacturers can do business in any vigorous way, the value of Sterling will need to be accommodating. At this point in time, the growing rate of inflation and the small reduction in unemployment still cannot justify an increase in official rates. Furthermore, if the government opts to raise taxes in order to cover the shortfall in the deficit, then there is more reason to believe that Sterling will not rise too far. If, as manufacturers have reported, profits continue to be unspectacular and do not nearly generate an acceptable rate of growth over the next two quarters, pressure will be on to reduce base rates along with Sterling. Any political drama will further serve to depress the value of Sterling as the Conservative party must cope with very difficult times. In this respect, Sterling relative 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 value of Sterling will shift from 2.4-2.5 to 2.3-2.4 Marks over the short term.


Fourth Quarter 1993
• 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 Overview
On November 30 Chancellor Kenneth Clarke presented the first ever unified budget to the general relief of the government of John Major. While presiding over a general economic decline in theU.K., and a Tory party that continues to be split over fundamental philosophical issues, such as defense cutbacks and closer economic and political union with the EC. The chancellor was 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 fiscal 1995-96 and 1996-97 • reductions in the public sector borrowing requirement (P.S.B.R.) in 1994-95 from f-44 billion to E38 billion • 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 Sterling 93/94 94/95 95/96 96/97 -5.5 -3.5 -6.0 -1.0 General Expenditure -6.5 -4.5 -1.0 GeneralReceipts P. S. B. R. -0.5 -6.5 -8.0 -13.0 Source: The Red Book

The Pound Sterling Chronicles
The following table presents a summary of changes in budget expenditures from that which has been previously forecast by Chancellor Norman Lamont in March, 1993. For fiscal year 1994-95 the Chancellor levied a further £1.68 billion of new taxes to the existing £6.73 billion already tabled in March 1993 by previous 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 March 1993 and a further £6.08 billion for 1996-97. Although the budget managed to skillfully balance numerous interests in the Conservative party, the astute political observer woiuld have concluded that it definitely furthered the political interests of Mr. Clarke. One such astute observer in Financial Times of London correspondent Joe Rogaly: “The purpose of Mr. Kenneth Clarke’s speech was to unite the Conservativesbehind Mr. John Major is possible, behind himself if necessary. His first task was to save the government; his long-term aim to ensure a fifth Conservative victory in a row.” The reaction of the financial markets was very favourable, as the long bonds fell below 7% for the first time in 25 years and Sterling strengthened on the foreign exchange markets vis-a-vis other European currencies. With monetary policy more or less in the background after the floating of Sterling, recent attention has been focused on the continuing conflicting statistical signals on the real side of the economy. The present day scenario continues to be one of confident assertion and immediate denial. The confident assertions of "recoveries just around the comer" being usually made by politicians or economists followed up by the immediate denials of practitioners such as the Confederation of British Industry. So far the verdict favours the latter based on the following evidence: • although the Clarke budget was well-balanced, it nonetheless reduces the P.S.B.R. to the extent that investors buying long bonds expect the economy to 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

Fourth Quarter 1993
• long-term decline in the financial services industry in the south-east, and an expected 33,000 redundancies over the next quarter in large company down-sizings • recent collapse in world oil prices will make many marginal North Sea oil wells uneconomical to operate, adversely impacting on the balance of payments • continuing depression in both commercial and residential property markets, as Clarke scales back mortgage relief in the budget and demand for mortgage loans falls by 10% in the third quarter of 1993 • aggressive discounting in the retail sector where profit margins have been severely trimmed

Currency Outlook
Since monetary factors have been discounted in the value of Sterling ever 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 the domestic economy. At this point in time, any recovery in the U.K. will be largely 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 a resulting downward bias in the value of Sterling. Recent gains in Sterling were more the result of weaknesses in the German economy, rather than based 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 if Sterling was not allowed to float beyond 2.5 German Marks. An appropriate range over the next quarter would be 2.4 to 2.5 Marks to one pound Sterling.


First Quarter 1994
• 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 Economic and Financial Overview
Prime Minister John Major continues to display a remarkable degree of resilience and staying power. If he is not facing up to various self- inflicted policy blunders imposed by the conservative party itself, then it is the neverforgotten and continuously reemerging broken promises made as far back as the election campaign of 1992. An issue in the latter category that goes down deep in most conservatives' hearts is the now aborted promise to cut tax rates. In fact, the November/93 budget of Chancellor Clarke continues to generate controversy the closer the U.K. gets to the April/94 deadline which implements tax hikes, in addition to those already factored in by previous Chancellor Norman Lamont. As such, controversy continues to rattle the foundations of John Major's conservatives, a series of upcoming elections for local constituencies and the European Parliament could erupt into a full scale earthquake, and lead to a general election some time in the fall of 1994. Something that investors in Sterling must consider over the medium term.

First Quarter 1994
Aside from the continuous political turmoil, the economy of the U.K. continues to slowly emerge from depression. In fact, it is the impending tax increases which are causing all out consternation at this moment, as any moves that will suppress the economy could risk any recent momentum that resembles recovery. In that sense, the fiscal side is very much a factor, as measures that will reduce aggregate demand such as tax increases will endandepression. However, the question is whether or not ger the potential of the economy to produce at its the external value of Sterling will still be dominated capacity. Subsequently, placing further downward by the exported sector? pressure on the base rate and Sterling. Alternatively, since its liberation on September/92 from the European Exchange Rate Mechanism (E.R.M.), monetary policy has delivered a series of 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 sectors like auto-mobiles and single family housing starts. Although the recent recovery in commercial real- estate has solely been attributed to foreign investment from east Asia, Germany and the middle- east. The above table is evidence of the recovery in these two sectors. Therefore, the fiscal side is working to decrease capacity utilization and adding downward pressure on Sterling, while monetary policy shows no con-vincing evidence of tightening, as inflation continues to register marginal increases. Together fiscal and monetary policy are moving in the same direction and are showing a propensity to lower base rates and downward pressure on Sterling. The domestic policy environment is contradicted by the external traded sector, With recent gains to GDP largely coming from buoyant exports, the bal-ance of trade account is showing a much envied recovery. Along with the natural stabilization that is inherent in an economy over the longterm, the solid performance in exports only serves to underscore the fact that the U.K. has emerged from its prolonged depression. However, the question is whether or not the external value of Sterling will still be dominated by 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. This in most part can be attributed to the aggressive recovery in exports. Now that exports have performed well, can the external argument still prevail in

The Pound Sterling Chronicles
setting an appro-priate target for Sterling? Or will the depressive effects on productive capacity by both the fiscal and monetary policies be the overriding feature that will drive Sterling over the next one or two quarters? At this moment, it Is still very difficult to foresee a trading range that can be fixed at 2.6 to 2.7 to the mark on a permanent basis. Since a combination of tax increases and a relative neutrality in the Bank of England's stance over the appropriate base rate will still show a bias toward adding excess capacity. It may very well be the case that the U.K. will continue to count on the exported sector to stabilise the trend growth in the GDP. In that sense, short of any politi-cal upheavals to the Tory government of John Major (a factor that can never be counted out), an appropri-ate trading range with respect to the Deutsche mark is 2.5 to 2.60. Housing Starts 1992:1V 1993:1 1993:11 1993:111 10.8 15.6 16.3 15.2 Automobile Production 110 121 126 n/a

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


Second Quarter 1994
• 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 Overview
The question on the minds of most and federal by-elections, to be held able resiliency, able to withstand hourly informed observers of British politics 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 John Major's leader- going internal squabbles between proruling Conservatives in the upcoming ship? To this point, the beleaguered European moderate and the right-wing local council, European parliamentary Prime-Minister has displayed a remark- sceptics within the party. Instead of tending to badly required, well thought-out policy initiatives vital for an economic recovery, the ruling party continues to prefer to squander valuable political capital on such trivial issues as voting rules for an expanded European Union. In fact, it is this rever-sal, after an initial commitment to an extension of the existing rules, that made the right-wing Euro-sceptic faction of the party believe that their posi-tion was taking precedence.


The Pound Sterling Chronicles
Mr. Majors' sudden reversal, although inevitable in the broader European political scheme, was taken by Tory right-wingers as a betrayal, but has also alienated the left of centre tra-ditional supporters of the PrimeMinister. This left of centre, pro-European faction considers such an important reversal as something that does not serve to strengthen the prime-ministers' overall credibility, and worse, drains domestic business and consumer confidence further. From the unrelenting recession in the U.K. economy, to the reversal of promises to cut taxes, to the sterling cri-sis and now the ever-recurring blunder on European policy- have all led a tired electorate to register the lowest approval rating for this Prime-Minister in modem times. Moreover, the Labour party stands at about 20 to 25 points above the Conservatives, even though a clear policy agenda has not as yet been articulated. A political solution to the problem of credible leadership is expected to come from a massive desertion by back-bench members of the conservative party, once they see that Mr. Major is a clear liability to their chances for reelection. Their support is expected to rally around the current Chancellor of the Exchequer Kenneth Clarke or Industry Secretary Michael Heseltine. Until such a change is made, the political uncer-tainties will have a negative effect on the value of sterling. Although recent figures show the narrow money supply exceeding the tar-get zone of 0 to 4%, indicating a rise in retail activity, it still cannot be said that a stable recovery has taken hold. In fact, tax increases which have gone into effect in April/94 are expected to reduce disposable income from each household by E1000. Clearly, fiscal policy is working against a stable recovery. Furthermore, the long-term growth potential of the economy is also of some concern, given that recent credit market conditions have raised longterm 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 an increase in demand before price pressures arise in an economy that is chronically affected by under-investment. Such is the state of the long-term growth potential for the U.K. since a shortage of business investment is the prevailing condition which continuous-ly leads to premature increases in inter-est rates, when evidence of price pres-sures surface. In this respect a solution would be an upward revision to the inflation target, or some combination of policy which would

Second Quarter 1994
reduce financing costs to deepen capital investment, while maintaining a strong level of aggregate demand. A long-term consideration such as this must either reverse the present tax increases, or institute a lower level of sterling. The survey below by the Confederation of British Industry shows that low aggregate demand and high capital costs are two major reasons for a low level of business investment.

Currency Outlook
Demand conditions in the economy do not look promising, as chronic long-term under-investment by resident com-panies coupled by high personal debt burdens and new income tax increases, tend to favour lower interest rates. In addition, upcoming political uncertainty and the continuing support of an export-driven recovery should limit any upward tendencies in the value of ster-ling. Consequently, the trading range with respect to the mark will settle between 2.45 and 2.55. Factors Limiting Manufacturing Capital Expenditures (% of firms answering yes) 1981:02(a) 1982:Q4(b) 1992:Q1 (a) 1993:Q3(b) 1993:Q4 1994:Ql
Inadequate Lack of Lack of Cost of Demand Net Return Internal Fin. External Fin. Finance Uncertainty

35 36 47 44 49 46

22 26 23 27 26 24

3 2 4 5 3 3

11 4 11 5 4 2

53 52 60 54 55 44

(a) Trough of Recession (b) Six Quarters After Trough Source: Bank of England inflation Report: February/94


Third 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 Overview
By exercising his veto over the French/German pre-selection of Belgian prime-minister Jean-Luc Dehaene at the Corfu summit, John Major has effectively postponed what was to have become a certain leadership challenge. Given the lingering uncertainty in economic recovery, Mr. Major has performed the rational unifying act by repositioning the Conservative party as one of nationalism, as opposed to Europeanism. Followed up by a quick cabinet re-shuffle, that confirmed a marginal shift towards the right with the promotions of "Eurosceptics" Michael Portillo and Jonathan Aitken. On the balance, one cannot fault Mr. Major. He is only doing what a rational politician in any country would-reaching for the easiest safetyvalve 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 UK decision-making.


Third Quarter 1994
Although recent evidence of rising employment numbers, strength in 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. Conflicting views on export and business investment performance cloud what could otherwise be termed a full recovery. What is now being felt in the service and retail side of the economy, could easily show reversal and a dip into recession once again, if the manufacturing- domestic manufacturing industry holds ing side of the economy does not co- to the overall picture of recovery in the operate in the upturn. Faced with increasing commodity prices since the start of 1994, manufacturing firms utilising raw material inputs are showing early signs of price pressure. What is just as serious, however, is the lack of additional capacity added to the m.anufacturing base over the last two years. The existing situation 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 on recent raw material price increases to end users, but the lack of investment over the last two years, constrains the growth potential of non-inflationary demand. The importance of this argument rests on the perception, of how important a role the domestic manufacturing industry holds to the overall picture of recovery in the UK.

Currency Outlook
The affirmation of recovery in the UK must still confront the recent elimination 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 the Lamont and Clarke budgets have as yet had their full impact on disposable incomes. In spite of the increase in National Insurance payments, and a reduction in mortgage interest already deducted from wages, the 8.0% increase in VAT on fuel has not yet been factored in. In addition, low business investment spending and a needed rise in export demand (mentioned above) will both work against any appreciation in sterling over the next two quarters. Consequently, a trading range of 2.4 to 2.5 Deutsche marks to one pound sterling can be expected.


Fourth 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 increase in the official base rate is any indication, not only has recovery been firmly entrenched, but more remarkably, inflation has become the sole concern driving official policy. The recent move to raise rates by 0.5 percent, represents a shift in the long-term trend towards higher rates, and comes after a period spanning some five years. Thus, can this recent reversal in policy signal a shift that can be sustained over the medium to longer term, or can it be judged as coming too hastily, in light of recent evidence of continuing weakness in retail sales and acute discounting in most high street shops?


Fourth Quarter 1994
The current dilemma confronting the efforts of policy makers is that the present economic recovery is unique, in that it does not share many of the characteristics reminiscent of the recovery that followed the trough of 198081. For instance, the behaviour of corporations, the banking system, the debt profile of consumers and the current posture adopted by the Treasury under Chancellor Kenneth Clarke in conjunction with Bank of England Governor Eddie George, is very different from previous recoveries. Focusing attention on corporate behaviour, it is useful to refer to table I. Although recent evidence produced by the engineering industry points 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 are awash in liquidity. Cost reductions coupled by low wage demands over the past three year period, has resulted in higher profit margins that have been solely used to pay down indebtedness. Compared to the last recovery over the 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 England Quarterly Bulletin, official concern has been aroused by this shift in corporate investment patterns. It has been suggested that investment evaluation criteria has not kept pace with the new low inflationary environment, with the way in which an internal rate of return is determined. (See editorial: Disinflation to Reinflation) Not only have the high demands on investment returns held industrial expansion below trend. Recent pressures on retail margins and continuing low consumer confidence levels, depressed by high amounts of indebtedness and often resulting in negative personal equity levels have also weighted domestic investment levels downwards. (See table II) Judging by the different way in which corporations are now approaching investment decisions, it would be incorrect to criticise the Chancellor’s recent move to raise base rates. Since any marginal declines in the 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, at best. In addition, with the announcement by Mr. Clarke that the upcoming

The Pound Sterling Chronicles
November 1994 budget for the next year is unlikely to reduce the tax burden implemented by the last November 1993 budget, not to mention increases from the Lamont tenure before that, it is unlikely that economic activity will be lead by either consumers, corporations or by government spending.

Currency Outlook
Domestic factors will continue to deliver very uneven activity, as is witnessed by the string of contradictory data releases over the past year. The recent rise in base rates will only accelerate should there be signs in the pickup in pent-up demand. However, exports will continue to play a major role in driving the domestic economy. Hence, favouring a lower level of sterling. With the US dollar expected to continue its downward trend in light of recent political setbacks to the Clinton administration, any further progress made towards a single European currency will continue to suppress any upward movement in sterling values. All factors considered, sterling is expected to remain below 2.46 Deutsche marks over the medium term. Measures of Performance (Table I) Firms Below Capacity(%) 1980 1981 1982 1983 1984 1990 1991 1992 1993 73 80 76 70 58 49 67 69 65

Return(%) 4.1 3.0 4.3 5.1 5.4 7.5 7.2 6.9 8.3

(1) Source: CBI quarterly survey of manufacturing firms (2) Pre-tax return on capital stock at replacement cost in non North Sea sector Source: Bank of England Quarterly Bulletin, August, 1994


Fourth Quarter 1994
Regional Profile of Negative Equity (Q1: 1994) (Table II) Households with negative equity (000’s) Greater London South East South West East Anglia East Midlands West Midlands Other Regions Total 220 510 180 80 100 90 120 1,290 Average Amount of Negative Equity Per Household (£) 8,000 7,500 5,700 6,700 2,600 1,400 900 5,900

Source: Bank of England Quarterly Bulletin, August, 1994


December 1994
• Conservative Eurosceptics split the Tory party with defiance over increased contributions to Brussels • 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 the fourth quarter of 1994. After two consecutive increases in the base rate, short term capital inflows have not been able to keep pace with longer term outflows. Furthermore, since the economic recovery has been overwhelmingly dependent on exports, a high level of Sterling has become a very important psychological barrier to investors. Any movement that would surpass the current trading range would become an immediate signal to sell-off exposure to Sterling, given the precarious state in which the consumer and retail sector are currently embraced. Evidence shows that both retailers and manufacturers are experiencing a margin squeeze, although of differing degrees as goods manufactured for export are able to more easily pass on the price increases to the end buyers. Conversely, retailers are restricted to the budget constraints of the battered domestic consumers. Overall, the supply side of the domestic economy has performed well, although restricted by the malaise in the final demand and distribution side. Nothing has been more disappointing than the recent trend in the automotive sector. Ever since the collapse in the August 1994 sales base- a month traditionally expected to perform well in the UK - the continuing

December 1994
weakness has prompted many producers to question the durability of the recovery. Evidence points to the sharp deterioration in the sales figures of November 1994, as the number of private buyers dropped by a 13.5 percent yearly rate. The danger of such a decline in a high value-added industry such as the automotive sector, is that the current recovery in the engineering and manufacturing sector will be in jeopardy, unless the domestic exposure is minimal and most production is exported. Overall, with declines in real estate, retail and automotive, the encouraging results in the manufacturing sector are susceptible to abrupt changes in currency and cyclical swings in the business cycle in the destination country. Hardly an appropriate foundation under which a lasting domestic recovery can be based on. Furthermore, the Chancellor of the Exchequer Kenneth Clarke has just tabled one of the most austere budgets in succession, after the tax increases tabled under former Chancellor Norman Lamont. Specifically, the Clarke budget promises to reduce the public sector borrowing requirement to £21.5 bn. in 1995-96 from the previous target of £30 bn. The net result is that the fiscal guidelines under the Maastricht Treaty on debts and deficits are expected to be met 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 public sector borrowing requirement by 1998-99. Reductions in the debt and deficit is expected to come entirely from spending reductions and excise tax levies. Although the proposed increase in the 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 was immediately countered by the Chancellor through an increase in existing excise taxes and by an aggressive reduction in spending on capital programs to make up for the £1 bn. shortfall left bare from the defeat of the VAT increase. It is interesting to note that both personal and corporate tax rates have been spared in the budget. Leaving the scenario for tax cuts open, should political necessities warrant some form of emergency action as the election year approaches. The overall deflationary climate of the 1990s will continue to place a heavy burden on exports to ensure that a basic level of growth can be sustained. Short of any sustained inflationary correction to the prevailing condition of housing 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 is ever more exacerbated by the stringent budget, coupled with a trend to higher base interest rates. In short, the move toward a trade surplus in the international accounts is essential.


The Pound Sterling Chronicles
With a slowdown in North Sea oil revenues, a concerted effort to formulate an active industrial export policy is essential. The offsetting effect that such a policy will have should ensure that the UK will continue to maintain a surplus in the trade balance. Since evidence points to an outflow in the longterm capital accounts (a situation not too dissimilar to the US), continued success in the foreign markets should ensure that no domestic pressures build for increases in real interest rates. Anything short of this, and an already stagnant situation would fall under worse conditions. The table above illustrates an interesting development in the distribution of ownership on the London Stock Exchange. Overseas investors accounted for a marginal increase in overall investment inflows, but on a short term basis as represented in the table. This marginal increase in U.K. equity investments by foreigners is troublesome, given the record increase registered by many continental European countries such as Germany, not to mention the diversification which has benefitted the “emerging markets.” In addition, the recurring in-fighting with the Conservatives is not helpful in attracting a longterm capital surplus position. Although Prime-Minister Major will probably recover in time for the next election, the inability to formulate a unified stance on European issues has frightened investors from the UK markets. The present talk of a series of referendums to be held on sensitive issues such as monetary union or increases in European budget contributions can only harm a country that has left itself so vulnerably exposed to continental export markets. Consequently, the logical policy would be one of ever more integration with the most important export market- continental Europe. Sterling cannot afford to rise much past the 2.45 Dm. range. There exists a direct relationship between how consumers and retailers perform and the strength of the currency. If consumers continue to be dragged down by the so called “feel bad” factor, this will exert a downward drag on the value of the pound. Likewise, if the process of European integration stalls or backtracks in any which way or form, the currency will fall. In essence, it can be said that Sterling tracks 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 in selling to continental Europe. Over the first quarter of 1995, investors will initially look for any signs that would show some degree of political unity once again in the ruling Conservatives. Also, any slowdown or acceleration in the balance of trade account will be of great importance in judging the effects on the domestic economy that the international accounts may have. Given that long term capital

December 1994
outflows and the growing deterioration in the balance of trade will under normal circumstances cause higher real interest rates, as in the case of the US, hence leading to an upward effect on Sterling. The situation cannot be judged as being similar, since the US has virtual full employment and a very buoyant consumer and business investment sector lacking in the UK. Only under a situation where demand leads to capacity strains will a currency have the propensity to appreciate when confronted by increases in short-term rates. Consequently, Sterling will be expected to stay within its current range of 2.40 to 2.45 Dm. Falling below should the government be placed under a situation where a call for a leadership review takes place. Or, marginally exceeding the upper limit if the Tories are able to bring some semblance of order to the routine of politics and continued signs of price pressures building in the primary manufacturing sector.

November 1994 Budget Forecast
Receipts Expenditures Current Balance PSBR(%) 1994/95 95/96 37.75 39.25 42.0 41.25 -4.25 -2.0 5.0 3.0 96/97 39.75 40.5 -0.5 1.75 97/98 40.0 39.5 0.5 0.75 98/99 99/2000 40.25 40.25 38.75 38.0 1.5 2.25 0 -1.0 Source: FT

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


First Quarter 1995
• 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 the 0.5 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 present government. Ever since the re-election of Mr. Major in 1992, the severity of the recession and the political split within the Conservative party amongst the Eurosceptic faction, has prompted most commentators to continually predict the ultimate demise of his government. This has not happened, and there is a very good chance that Mr. Major will continue to lead the Conservatives in the next election scheduled some time in 1997. Although the British public has become bored and violently impatient with the current government, giving Mr. Major an approval rate of just 20 percent. The resilience and staying power of the current prime-minister, must however, be admired. The question on most people’s minds is if the internal pressures building up with Europe and Northern Ireland, will tip the Conservatives into an early general election? With the debate over a single currency, it is clear from Industry Minister Michael Heseltine’s recent trip to Japan, that the Japanese- heavy automotive

First Quarter 1995
investors in the UK, have asked for reassurances from the minister that the UK is committed to the deepening of a single market within the European Union. Despite record investment outflows by UK companies (outward investment by UK companies represents 25 percent of total investment), the Japanese automotive companies direct investment in predominantly UK based plants have become vital to the development of the domestic industrial base. Of the eight European-based assembly and production plants, five have been located in the UK, with direct investments somewhere in the range of £3.0 to £4.0 billion. 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 economic activity. Of this, automotive products, as in most countries, play a dominant role. In 1994, automotive production has increased by 6.6 percent, representing the highest volume in 20 years. Ever since sterling left the European Exchange Rate mechanism, the level of sterling has been, and continues to be very sensitive to the needs of the export sector. This is not expected to change so long as government expenditure, consumer spending and business investment remain weak domestically. Furthermore, evidence of a structural shift in the international trading accounts, will tend to give underlying fundamental support to a lower level of sterling 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 will settle to a new lower structural trading range. This will benefit UK manufacturers that are beginning to export more and more, and will hurt consumers, as well as bringing down a buoyant services sector. Investment outflows require a volume inflow from sales of manufactured products and services overseas, in order to ensure that the rate of domestic inflation remains within the 2.5 percent cap inscribed in current government policy. Since any imbalance in the international accounts will entail a depreciation in sterling, placing upward pressures on domestic prices. A usual concern of the German Bundesbank, but also one that is getting more attention in the UK. Given that the economy is recovering slowly, a definite floor will be applicable to sterling in the eyes of policy makers. However, the fundamentals which would normally allow sterling to trade within the Dm. 2.35 to Dm. 2.45 trading band, will have an ingrained downward bias, as long as political tensions remain over the issues of Northern Ireland, and more importantly to the run up to the 1996 Maastricht Intergovernmental Conference. A split in the Conservative party over either of

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


Two Crises for the Conservatives: Europe & Northern Ireland
• John Major tries to balance two extreme interests with the pro and antiEurope groups • plans to introduce new conditions on top of the Maastricht Treaty guidelines for the UK to participate in a new single currency • 9 Eurosceptic MPs hold key to survival of government if 9 Unionist MPs decide that plan for an association of the two Ireland’s is insufficient & cannot be supported along with the current government of John Major • Themes for the 1996 Intergovernmental Conference will prove to be defensive & lacking vision. Reform of agricultural & fishing policies, revision to qualified majority voting & greater scrutiny of the EU budget has been promised by Mr. Major • Michael Heseltine reassures Japanese investors of the UK’s support of the EU

Northern Ireland
• Dublin & London near completion of a framework document that “leaked portions” have alarmed the 9 Unionist Conservative MP’s that presently ensure the survival of the current government • framework document contains provisions to set up a pan-Ireland authority with 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 political parties in Northern Ireland. Any new all-Ireland bodies must be accountable to 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


Second Quarter 1995
£ 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, Barings spectacular collapse and the robust economic recovery in Germany, pushed sterling to a historic low of 2.189 Deutsche marks. Most European currencies got caught up in the flight towards quality around the world, and sterling was no exception. It cannot be denied that the Mexican peso crisis, and the subsequent events that brought down Barings bank, harmed both the dollar and sterling. In the case of Barings, the entire affair is one that has global regulatory consequences against the backdrop of phenomenal technological progress. In short, can crises of these proportions be managed, or even prevented in a period of far-reaching technological progress? More broadly, is a global problem that affected Barings, something which only the City of London will ultimately pay for in the long run? The advancement of sophisticated trading products and their constant refinement, is something that a regular commercial banker has a great deal of difficulty understanding. The traditional banker’s world of lending against cash-flow has been under attack for the past ten years, if not longer. At the root of the entire problem is the entire system of seniority, when it comes to

The Pound Sterling Chronicles
human resource operations in the large clearing banks especially. Despite having spent a great deal of effort and money, in attempts to educate the old-style bankers on the new developments in financial derivative products. The constantly changing environment of innovation is quick to render such efforts pointless. Ultimately, not only have these organisations squandered valuable resources on individuals that cannot be educated to fit into the new global environment, but the danger multiplies when the old-style, traditional banker truly believes that they now fully understand the new changes, and what is worse, try to act accordingly. This becomes even more dangerous, when a person in a regulatory role adopts this attitude of invincibility in the new fast changing environment. This scenario is most likely that which existed within Barings’ banking culture. The collapse of Barings has severely affected confidence in many small to medium sized merchant banks in the City of London, and has most definitely been an element, among a list of many, that has depressed the value of sterling. Consumer confidence, real estate values and business investment spending by British companies remains depressed, with early evidence indicating further deterioration among both consumers and entrepreneurs. However, one positive to all of the negatives, has been the thriving automotive industry, with Japanese transplant companies operating in the UK playing a leading role. This factor has been greatly assisted by recent weakness in sterling. To illustrate how robust external markets are to British products, as opposed to local markets, the broad category of machine tools exports rose 96 percent in the fourth quarter of 1994, this is contrasted by the meagre 10.8 percent increase on the domestic side. Likewise, the automotive market was subjected to a similar pattern in the UK. As domestic sales stagnated, and deep discounting set in to win over 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 the third largest producer of automobiles in the EU, behind only France and Germany. Recent positive events include: • Toyota is to introduce a second model range in 1998, doubling capacity to 200,000 vehicles in one year • Ford’s Dagenham plant to produce 25,000 vehicles annually for its Mazda subsidiary • Jaguar is expected to announce a £500 million investment to create a worldclass luxury car manufacturing centre


The Pound Sterling Chronicles
As is commonplace in most industrialised countries, the automotive sector is the only game in town. Unlike Canada and the US, domestic pentup 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 is driving the record levels of production in the UK. So depressed are local business conditions, that they are affecting a wide cross-section of industries not involved in the export market in any great way. Difficulties in the luxury products market are exacerbated by deflationary conditions, combined with a general climate of political uncertainty with the Conservative party. The ensuing credit crunch that Barings collapse is bound to intensify will ensure that a bad domestic situation becomes impossible. Already, the large conservative clearing banks are unwilling to even accept a simple deposit, without going through rigorous extremes in investigating the origins of the money being left with them. If this bureaucratic exercise accompanies the act of injecting money into these institutions, one need not speculate on what it will take to secure a simple commercial loan. Sterling has settled in a range of record lows with respect to the Deutsche mark. The extent of the weakness, just as in the case of the dollar was unexpected. The existing climate of political uncertainty prior to the Maastricht intergovernmental conference in 1996; the on-going problems with Unionist members of the Conservative party over the Irish peace process brokered 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 the prevailing pessimism. In that sense, it is not too dissimilar to the way in which the spectacular collapse in the peso caused a collapse in the dollar, and which remains the scenario from the ensuing fall-out. In addition uncertainty in the French elections, scandals and weakness in Spain and the overall flight of capital back into quality have also weighed against sterling. With consumer spending in a depressed state, and with an aggressive push by British exporters into the international marketplace, there exists a far more convincing case for a weak pound. The only event that may conceivably offset this is any move to raise base rates should external pressures on domestic prices be imposed. Although evidence does indicate early cost pressures, sterling is not expected to trade above 2.28 to the mark.


The Pound Sterling Chronicles

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


Third Quarter 1995
£ 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 indicators are anything to go by, the UK domestic economy has not yet experienced recovery from the troughs that were registered at the start of the decade. In fact, current developments on the homefront only tend to exacerbate the already plunging consumer confidence levels. Aside from poor results registered at the local polls by the ruling Conservatives under Mr. Major, the UK has not experienced any type of resurgence in business activity on the retail side, nor have businesses bothered to invest in new equipment. In short, any success that the domestic economy has had in generating profitable business, has solely been dependent on exports by British companies overseas. This has become a familiar pattern over the past 18 months, and continues to be the driving force behind any signs of positive business activity to this day. The recent decision by Chancellor Kenneth Clarke to hold base lending rates at the current rate of 6.75 percent, may reflect an impending slowdown, rather than the common argument submitted, of a politically inspired decision that was hastily implemented just shortly after the humiliating performance of the ruling 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.

Third Quarter 1995
Ever since the pound sterling fell out of the European exchange rate mechanism, the direction has been downward ever since. The familiar peaks and troughs have not resurfaced, and convincing explanations have not been forthcoming. A pattern very familiar to the dollar-bloc group of countries that includes the US and Canada, within the G-7. What has become very clear, is that the short-lived “recovery” is on the verge of coming to an abrupt halt. Disturbing, since many have neither felt, nor participated in what has become traditionally defined as a recovery. As in most industrialised countries, the UK is no different when looking at the factors behind the increase in business activity in 1994. The increases in raw material prices came due to a combination of an already weak sterling, and a rise in the pent-up demand for basic raw materials, such as paper, steel and mined minerals. In all, the brief respite from recession was primarily generated by conditions of pent-up demand in the automotive sector in Europe and North America, fuelled by expectations of a more durable policy-supported recovery. However, under the current conventional wisdom, this has so far failed to materialise. Recent statistics tend to support this view, as the manufacturing recovery of 1994 has all but ended. Domestic automotive demand declined by 7.2 percent in March 1995, as the decline in domestic production of 7.8 percent was more than offset by the robust 52 percent growth in production set aside for export purposes. Despite the positive trend in the export sector, businesses continue to display a reluctance to invest, that has been far from the normally dismal pattern in the UK. Unlike the Japanese automotive transplant subsidiaries, whose plans are targeted towards the European continental markets, companies dealing with the domestic economy are far less likely to commit to long-term capital expenditure, in the face of such uncertainty. As the industrial sector tries to contend with weaker pent-up demand in 1995, other traditionally strong sectors lay dormant. Low consumer confidence levels continue to depress a wide range of retail shops. From fashions to jewellery to books, all have been subjected to very lax demand from consumers. With no real ending to the depressed business conditions in shops, the sector is poised to go through a radical structural change. What shape or form this structural change will ultimately take is very difficult to assess at this moment. However, with traditional margins being squeezed, efficiency-creating restructurings are inevitable. Consequently, upward price pressures will be contained only to imported products, and especially if sterling will remain on the low side for a prolonged period of time.

The Pound Sterling Chronicles
At the root of the low confidence that consumers are currently experiencing is the continuing commercial and residential property crises. Recent statistics show that prices for homes have once again levelled off to a lower price range. This was confirmed by the continuing decline in mortgage lending, down 10 percent over one year. In addition, the news was not any better with property development companies, as most have cancelled or postponed their dividend payments to shareholders. Since property shares have underperformed 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 abrupt transformation taking place in the City of London financial district. After the spectacular collapse of the 232 year old Barings bank, merchant bank SG Warburg has agreed to become part of the Swiss Bank Corporation, bringing to an end another of Britain’s most honoured traditions. After the sale of merchant bank Morgan Grenfell to Deutsche bank, and the disposal of what was the remains of Barings to ING bank of the Netherlands, the trend for wellcapitalised universal European banks is becoming very clear. After Deutsche bank acquired Morgan Grenfell, it allowed the investment bank to maintain its independence in London, from any distractions from its parent in Frankfurt. Not only has this been successful up to this point, but Morgan Grenfell has prospered under such an arrangement, and to this day attracts talented professionals from some of London’s most reputable institutions. Likewise, most London-based subsidiaries of Swiss banks consider the city as their natural home. What all of this indicates, is that competition for Europe’s three main financial centres: London, Paris and Frankfurt, has already de facto been decided in favour of London, and by powerful European banks themselves. It cannot be denied that Deutsche Bank has already decided that its investment banking operations ought to be based in London. What is troubling, however, to most Britons when these developments in the City are viewed subjectively, is that the “British disease” has now shifted from the manufacturing sectors, to the financial services sector. Within the span of two months, some of the most legendary institutions in British history, such as SG Warburg and Barings no longer exist. The question on the minds of many now, is whether Lloyds insurance market will somehow meet a similar fate? Already, there are numerous signs that once again bring Lloyds solvency into question. According to recent statements made by Lloyds

Third Quarter 1995
Chairman David Rowland, member’s personal finances and the Lloyds central resources fund have experienced “severe strain.” Most recently, the results of the 1992 underwriting season shows an overall loss of some $2.4 billion in US dollar terms. Informed rumours as reported by the Financial Times of London, also report of a credit crunch directed at Lloyds by some large London clearing banks, and pressure on agents to pursue legal action against those clients that are refusing to pay their debts. In short, judging by these recent developments, the financial services sector is experiencing profound structural change, even though it should maintain its hegemony over Paris and Frankfurt in Europe. Signs of an economic downturn will depress the value of the pound sterling. The truth of the matter is that only the export sector continues to perform respectably. Business conditions in the domestic economy are generally bad at this moment, and consumer confidence continues to suffer over the renewed attack on property values. The same story exists with business investment, as the choppy recovery has prevented companies from making any major commitments in this area. In a similar fashion, what has been formerly the sole preserve of the British manufacturing sector, massive forced foreign takeovers have occurred with some of the UK’s most prized financial institutions, mostly through necessity. These effects from what is now occurring in the financial services sector is at best highly speculative. However, since 20 percent of the UK’s business activity emanates from the City of London, recent developments cannot be dismissed. As the UK has become a service-based economy, relying more and more on such industries as estate agencies and banking, unstable events that level some of history’s more enduring institutions as Barings, deserve to be scrutinised more carefully on the broader impact of the entire economy. Everyone knows that services suffer the most when a downturn occurs, and should 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 a lower range, under circumstances where a country such as the UK is a net debtor. This is in direct contrast with the present position of Japan, since both are experiencing profound domestic deflation. In the global scheme of capital movements, interest rates usually play a very important role, and as a debtor country such as the UK is in direct competition with other borrowers,

The Pound Sterling Chronicles
the one that usually offers the best rate of return wins out. Such is not the case, since the collapse in sterling to the lower range of 2.12 to 2.20 Deutsche marks, comes as the weak state of the domestic economy must justify a lowering of rates, such that business activity may expand. In contrast, when sterling was pegged at 2.75 Deutsche marks in the European Exchange Rate Mechanism, prior to September 1992, high rates did irreparable damage to the domestic economy usurping the credibility of the artificially-pegged exchange rate and leading to massive capital outflow, on the expectation that the weak domestic economy of a debtor country deserves both a lower rate of interest and weaker exchange rate among its main trading partners. Since its exit from the exchange rate mechanism almost three years ago, the value of sterling vis-à-vis the Deutsche mark has depreciated almost 25 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 reverse the downward spiral. At this moment, the exchange rate is once again at a turning point. As a debtor country, the UK is reliant on the rate of interest in attracting portfolio investment and in promoting the only thing going for it at this time: exports. An ever lower exchange rate manages to generate much needed export-led business activity. It also discourages investors from shifting capital into sterling-denominated investments. In essence, it has the best of both worlds. Cheap domestic capital for the government to finance outlays, and a much reduced exchange rate to maintain its only hope: exports.


Fourth Quarter 1995
£ 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 political quagmire. Despite the voluminous outpouring of negative sentiments continually directed toward the leadership of the Conservative party by the British press, John Major’s instincts at political survival must by now have been elevated to legendary status. In the latest of a long line of potentially disastrous developments within the ruling Conservative party over the past two years, John Major set out to once and for all put an end to the recurring theme of Britain’s role within Europe. On the opposing side, only one challenger within the belligerent grouping of “Eurosceptic” members of parliament, found it fitting to take up the challenge presented by the prime-minister. The losing candidate, former Welsh Secretary Mr. John Redwood, took up the challenge with a naive sense of where Britain actually stood, and the direction she ought to take, within a European Union that presented the best economic alternatives in a fast changing geo-political and economic environment.

The Pound Sterling Chronicles
Politically, the small grouping of European sceptics within the Conservative party, represent a minority of doubters on the future course of relations within Europe. On the contrary, the majority of political parties sitting in the British Parliament, see a very clear future with Britain at the centre of European policy. The labour party under Tony Blair, to the Social Democrats of Paddy Ashdown, to even a good 75 percent of the current ruling Conservative party, all believe that closer relations with Germany, Italy, France and the Benelux countries is a positive and irreversible development for Britain. Economic trends usually shape the political fall-out after the fact. With the clear ending of the special relationship with the US, British trade patterns have increasingly gravitated towards the European Union. In the worlds most important wealth-creating sector-automobiles, the existence of the European export market for British-made Japanese cars, has been a lifeline to a sector which was cast in a state of terminal decline. There is no denial of the fact that the purchasing power in the British local economy just does not exist. If the Japanese transplants had to rely solely on domestic factors, they would by now be well into a never-ending restructuring mode. Reducing capacity according to what the British domestic marketplace could afford to buy- very little! If it were not for the European marketplace, the current buoyancy in the automotive production market would not exist, dragging down the level of sterling, since the trade balance would shrink into the negative figures. In addition, no possibilities would exist with trade towards the US or greater North American market, this just would not be efficient or cost effective. Besides, the North American Free Trade Agreement, and various side-deals since, have levered badly needed Japanese investment into North America. Any resort to the traditional relationship, would be a foolish venture within a world that is increasingly divided into trade blocs. Should there be any attempt to follow the prescription offered by the minority Euro-sceptic group within the Conservative party, the fall out would be very deep and destructive in most sterling-denominated markets. If Britain effectively resists a single currency and greater economic integration, without the support of one large European country, such as France, domestic business conditions would disintegrate even further. This is something that most respected Conservatives are quick to acknowledge. Nothing can be more evident to this effect, than the on-going revolution within the British merchant banking sector. Over the past six

The Pound Sterling Chronicles
month period, innovation and an increasingly borderless frontier for integrated financial services, has seen the demise of SG Warburg, Kleinwort Benson and topped off by the Barings collapse. Ironically, all of the successful bidders were large European firms up to now. The initial purchase of Morgan Grenfell in 1991 by Deutsche Bank, and the current acquisition of SG Warburg and Kleinwort Benson by Swiss Bank Corporation and German-based Dresdner Bank respectively, has left a clear signal of the powerful presence in London that European institutions currently display. This trend is bound to accelerate over the next year, as technological progress leading to regulatory changes, will require financial institutions to offer a full-service range of products to their prospective clients. In such a competitive environment, technology will continue to upset traditional habits in the financial services industry, leading to continuous pressure on London to maintain its historic place as one of Europe’s most prominent financial capitals. For this reason alone, it would be wise for the UK to participate in any future European currency. This is one pre-condition that must be achieved to successfully compete with Paris and Frankfurt. Exports, and those of Japanese automobiles, still remain the most vital catalysts to domestic business activity. With consumer and luxury product retailers the worst hit, there are signs that the worst is yet to come in the retail property market. This sector continues to languish in such desperation, that prime-minister John Major still publicly denounces the speculative binge of the late 1980s. It seems that this period of speculation has exacted irreparable damage to personal wealth, leading consumers to feel terminally depressed. This can be directly accountable for the diversion of productive capacity toward the export sector in vehicles. As more of the vehicles produced are sold to non-British citizens, as opposed to those that find buyers within the UK. The leadership upheaval in June did not cause much panic in sterling markets. Perhaps it was a sign that investors did not perceive that the challenge brought forth by John Redwood would be a serious setback to the longer term trend toward Europe, that is inevitable. Only an improvement in the domestic fundamental economy can improve the current level of sterling. Images of political disputes have proven not to be effective in diverting investment flows. UK based industry has sent offshore, a record volume of investment capital in recent months. This must in some way be diverted back into domestic investment opportunities. A successful diversion can only become reality if consumers begin to pick up

The Pound Sterling Chronicles
their spending habits on large ticket items domestically. The UK presently suffers from the “Canadian effect”. This is when too much investment capital on a domestic scale is chasing too few good ideas. In Canada, investment capital by default, goes into the stock market. In the UK, some may go into the stock market, but a good deal more is exported. Such is the problem at hand. Unless a tax incentive policy can resurrect the domestic consumer sector, investment will not be captive to the UK economy. Likewise, if it were not for the European automotive markets, the domestic sector would warrant a wholesale repatriation of Japanese investment capital. Time has come for a tax incentive plan to reverse this malaise. If consumers are left to fend for their depressive situations for themselves, sterling will continue to slowly sink relative to the Deutsche mark. Only a strong domestic economy can replace the current reliance on external purchasing power. When clear evidence presents itself that such a turnaround has arrived, investors will turn 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.


December 1995
£ Sir James Goldsmith to launch new political party with an agenda to push for a referendum on a single 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 confirm another downturn. The recent downgrading of analysts forecasts point towards lower profits across most industries previously performing well. This excludes the permanently depressed property sector, as most contractors large enough to evacuate the domestic UK economy have already done so, leaving only a few “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 steadily improving situation, to one that saw a July increase for the first time in over two years, follow in line with overwhelmingly dismal results posted by retailers. In contrast to the depressed business environment in the retail sector, and the declining opportunities presented in the export sector, producer price 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 the business climate in the real industrial and retail sectors of the UK. In all, inventories of unsold goods registered their largest increase in seven years in the second quarter of 1995, together with lower than expected output in the energy sector and a fall in services.

The Pound Sterling Chronicles
Instead of increasing base rates to check the growth of inflation, a decrease is becoming far more likely. In the manufacturing sector, the hot summer months brought only an increase in sales of food and beverage products. Most other sectors contributed a drop of 0.4 percent, with output in the most important growth industry, the computer sector, falling 0.8 percent . Although inflation shows a slight breach of the upper 2.5 percent limit, Chancellor Kenneth Clarke has up to now been able to convincingly argue against any further increases. In contrast, Bank of England Governor Eddie George has argued in favour of an increase in base rates, on the premise that manufacturers cost increases were the highest in four years. In addition, the overall weakness in Sterling has been of great concern to the Bank of England, as the risk of importing inflation consistently looms over the economy. With what seems as a permanently depressed level of sterling, the dangers of importing inflation in an open economy as the UK, are ever more susceptible to unexpected shocks externally. Once again, the key to domestic recovery is dependent on a revival of positive expectations in the real estate sector. Aside from the negative impact that demographic conditions will continue to have on the value of housing, a bold policy response is essential if a sustained recovery is to materialise. A rehabilitation of consumer confidence must be a central theme of the current government, even if this will result in a larger deficit. Only action on the fiscal side, and preferably co-ordinated with member states of the European Union, will revive badly-needed consumer confidence at a critical time. The longer the duration of the deflationary climate, the greater the fall in property prices. Which in turn will lead to a wholesale devastation in the domestic retail sector, and increasing reliance on foreigners to purchase British-made automobiles. A vicious circle that has been in evidence now for three years, runs the danger of spiralling to even lower levels. Should such a scenario arise, real danger of a sustained collapse in equity prices and financial crisis could come about. Politically, the agenda of the increasingly marginalised government of John Major, continues to prescribe an inactive policy. Such was recently clarified by Chancellor Kenneth Clarke, as he confirmed that no tax cuts were in store prior to the spring 1997 call for elections, and that further spending cuts were still very much on the horizon for the British public. In other words, the current government is willing to tolerate further falls in the price of real-estate assets, more depressing news in the retail sector and a sustained 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 taken on by a different government. However, for the time being, the government of John Major by continuing to advocate austerity, is headed towards extinction. The political horizon that is shaping up looks to present further obstacles for the Conservative government of John Major. In an almost Ross Perot-type of fashion, billionaire industrialist and member of the European Parliament in Strasbourg, James Goldsmith, has declared his intention to personally fund a new political party to be named the “Referendum Party” in the forthcoming elections. The intention of the party is to solely push for a referendum on a single European currency in the UK. Consequently, the Referendum Party will take on a negative role and join the Conservatives in their opposition to greater European integration. The referendum, should they win, will judge if the British public is for or against, joining a single European currency. In essence, the Referendum party can only appeal to the hard core segment of anti-EU members within the existing Conservative party. A likely scenario could have the Euro-sceptics within the Conservative party break away, and join the Referendum party. Moreover, should the labour party succeed in obtaining a minority government, then the Referendum party could 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. All depends on whether the pro-European Social Democrats and Labour are able to either win a majority, or form some sort of majority based coalition government. Anything short of this will inevitably lead to a referendum on a single currency in the UK. Something which has continued to split the ruling Conservatives, and to which Prime-Minister Major has consistently been 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 1.60 US dollars. In addition, a major drop in sterling was registered against the Canadian dollar, slipping from 2.20 to a level of 2.07. In contrast, sterling has recovered to trade from the 2.19 Deutsche mark range to the current 2.28 mark level in relation to the German currency. In essence, sterling has become coupled with those within the European grouping such as the franc, lira and Spanish peseta. While doing so, it has become decoupled from the dollar sector, and has not been able to use the traditional momentum of the dollar sector to rise along with these currencies. A pattern that is very much new to 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 the weakness in the Deutsche mark recently, just as most ERM based currencies have with the addition of Italy. At this moment, the severity of the downturn in the UK is more pronounced than in the US and Canada. A coupling with European currencies may be far more appropriate on fundamental grounds, since the severity in depressed business conditions in countries such as France have direct parallels to the situation in the UK. Anything short of recovery in real-estate prices and retail sales will continue to suppress the value of sterling. A prospect which will be greatly needed to reverse the slower growth in exports- the lifeline to the UK economy over most of the past year. When will sterling de-couple from the franc, lira and peseta, and dip to an even lower trading range vis-à-vis the Deutsche mark and the dollar sector? At this point in time, Mr. Major must begin to use the upcoming preparations for the 1996 Maastricht conference on a single currency, as an opportunity to lead a co-ordinated response to continuously falling asset prices in Europe. Time has come for calls towards a single European currency to turn into more urgent calls to joint co-ordinated action for recovery in Europe.


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First Quarter 1996
£ 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 look grimmer than what could have been imagined, in context with an already acknowledged series of setbacks over the past year. Not only is the survival of the Conservative party back in the headlines, but continuing dismal economic and business figures released only confirm the climate of desperation. The ever elusive “recovery” in UK land and real estate markets, have once again been bombarded by new data released that points to higher negative equities for most. Households whose mortgages exceeded the value of their homes rose by 90,000 in the third quarter of 1995, as house prices recorded a further drop of some 1to 3 percentage points in value. This slide is confirmed by the sharp drop in mortgages underwritten by UK building societies, as net new lending was 18 percent down in September from figures posted in August. In short, the situation can be summarised in the words of a senior banker, “property values are falling, rents are static and the normal autumn flurry of deals has failed to materialise. After a dismal October; the

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sector has lost all the gains won in the aftermath of sterling’s exit from the ERM (Exchange Rate Mechanism).” The run up in raw materials prices in 1994 was the overwhelming result of a manufacturers’ response to pent-up demand conditions that surfaced from three years of gruelling recession, earlier in the decade. The continuing debate between Chancellor Kenneth Clarke and Bank of England Governor Eddie George, centred on the timing of possible increases in the base lending rate. A debate to which, upon reflection, the Chancellor was more than right to resist demands for increases in rates to address the pressures on raw material prices throughout 1994. What surfaced in the periodic discussions between the government and the Bank of England, was the Chancellor’s deep mistrust in the pricing of raw materials, as representing business conditions on the average in the UK. In retrospect, the inability of the manufacturing sector to pass on most of the increases down the line to wholesalers and ultimately the consumers, confirmed the Chancellor’s suspicions over the durability of any recovery. At this very moment, the robust manufacturing sector of 1994, is being restrained by a collapse in raw material and commodity prices, as the UK dips into a trade deficit in August. The trade surplus position of 1994, is now a trade deficit. Slowing business conditions in Europe and the onset of further isolationist tendencies in the US, will act to add further pressure on domestic manufacturing. Once again, the only bright spot will be the ability of Japanese automotive and original equipment parts manufacturers to lead the UK export field. Ultimately, the Chancellor will be in a mood to reduce base rates periodically, and well into 1996. Recently, a very significant announcement was made for the North Sea oil and gas industry. Mr. John Jennings, Chairman of Shell Transport and Trading delivered a review of the industry at his company’s annual shareholders meeting. Looking into the very long term, he conceded the fact that the benchmark Brent Blend crude was unlikely to move out of the $12 to $18 trading range for the next 10 year period. This was indirectly confirmed by the Organisation for Petroleum Exporting Countries (OPEC) appeals for oil supply cuts to non-OPEC producers like the UK. With Iraqi oil set to hit world markets soon, and with the non-OPEC producers continuously meeting the global rise in oil demand, price pressures will be on the downside. The big question for the UK North Sea oil industry, is whether increasing 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, although swept into the background over the recent past, will play a role in the future level of sterling. When current Prime-Minister John Major is not battling the Eurosceptic wing of the Conservative party, he is continuously confronted by poorly-judged and outdated policy stands that bring the government down on its knees. A recent case in point is the recent vote over disclosure of Members of Parliament outside earnings. Although in a majority position in parliament, the Conservative position of non-disclosure was defeated by a Labour party motion in support of full disclosure. The approval of the motion by 51 MPs further saw the authority of the Prime Minister diminish over one of the most sensitive of issues accounting for the party’s low popularity rating. With sterling bouncing around record lows, and with British living standards under attack, the prospects for entry into the first league of the European single currency club is more remote now than ever before. The condition that all currencies must re-enter the fixed exchange rate mechanism in the European monetary system, before being considered for monetary union, does not seem to be an option for the UK. Despite the recent moves by Germany’s Finance Minister Theo Waigel to attach additional conditions on 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 have French industrialists approached Brussels for compensation against business lost from sterling and lira based exporters, but the mere suggestion that Germany is pressing for greater control over political decisions on national economic policy is unacceptable to the British political hierarchy, be it Conservative or Labour. In essence, moves to introduce a system of fines on those violating the Maastricht Treaty guideline of 3 percent deficits to GDP, will ensure that Germany will play a central monitoring role over the political decisions made on economic policy at Whitehall. Since the Chancellor of the Exchequer is still responsible for setting monetary policy, control over the fiscal apparatus of government in the UK, means control over monetary policy as well. A situation that would not only turn the heads of devout Eurosceptics, but also an aspiring Labour government. What then will it mean for a recession weary UK electorate to follow through with a new mandate for Labour? Certainly, the new German resolve on monetary union would not make for a productive election issue. especially if 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 seemingly insurmountable 30 point lead over the conservatives, if it manages to seize the agenda over domestic economic management issues. For instance, a policy solution for the poor domestic sales performance in the UK automotive sector would be good government. To follow the initiatives in France with first the Balladur government, and now with the extension of the auto subsidy program under Alain Juppé, will revive the domestic auto market to a great extent. Such policies designed to revive spending for important consumer items, and to introduce the business investment incentives of Labour leader Tony Blair, would be good government and a welcome change in policy. Prospects for falling oil prices and lower base lending rates to offset deteriorating business conditions, will join a slowing global economy to justify even further record lows on foreign exchange markets. Moves in the upcoming budget to introduce sensible demand-creating policy measures can only offset this decline.


Second Quarter 1996
• 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. As the Christmas sales season worked itself through to exceed the expectations of most retailers. Despite the lack of a "feel-good" factor, consumer spending has 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 on retail activity rose by 5.9 percent in December. Although the distribution of the gains varied according to each individual store, the continued strength in the new year was a cause for optimism in the battered retail sector. Despite the signs of recovery, closer inspection of the trend in consumer spending reveals that most of it was financed through a draw down in savings, as opposed to any rise in personal incomes. Evidence in the third quarter of 1995, shows that real disposable incomes fell by 0.2 percent, while consumer spending edged up by 0.6 percent. Furthermore, some of the big ticket items like automobiles have stabilised their sales, but at the expense of very aggressive discounting designed to clear dealer inventories.

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Business conditions currently reveal that although bankruptcies among small and medium enterprises has subsided somewhat in 1995, it has, 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 to fuel takeovers on the London Stock Exchange. Record cash positions in the corporate sector were accumulated by companies aggressively cutting costs and introducing technology that enables a lesser number of employees do more work, hence raising productivity. In addition, although weakening somewhat, those companies involved in the export markets have greatly benefitted their bottom line. Greater productivity and technological efficiency that has produced the record cash positions in companies, has lead to a large increase in bids to take over listed companies on the London Stock Exchange. In fact, the primary reason for the record performance on the LSE has been the cash used to finance acquisitions. This, in addition to the continuing consolidations that have been the hallmark of the British financial services sector throughout 1995, with the merger between Lloyds bank and the TSB retail and savings bank being a case in point. Although some firms seem to be in a good position overall, there remains the fundamental problem of distribution in the UK. This fundamental problem has been recently captured in the budget statement of Chancellor Kenneth Clarke. Clarke openly admitted to the fact that: "the UK economy has not been growing at the pace of its potential." Consequently, the trend to lower base rates throughout 1996 are inevitable, as sterling responded to this by visiting record lows relative to the US dollar, while maintaining its historic low level with respect to the mark. The reduction in the base rate was the first decrease in over two years. The one-quarter point reduction leaves the rate at 6.5 percent, with further prospects of failing throughout 1996. In addition, most banks and building societies have now reduced their basic loan rates below 7.5 percent, which is the lowest point in over twenty-five years. Moreover, the trend towards the higher rates over the last two years in the economic upturn, represents the smallest such increase since the 1950s. In all, a very discouraging set of statistics. The prospect of having a far more restrictive business environment under the election of a labour government with Tony Blair as head, has also prompted the record acquisition activity on the London Stock Exchange.

The Pound Sterling Chronicles
Furthermore, the increase in UK sourced foreign direct investment in foreign markets, rose to a five year high, as earnings from overseas assets and investment also stands at the highest level on record. Spending by UK based citizens and institutions surged, as non-UK held financial assets are at an alltime high. The surge in overseas investments, particularly in the US, has caused a fall in capital going to fund the UK public sector borrowing requirement (PSBR). In fact, recent evidence points to the uptake of government bonds and gilts at the lowest point in two years. A good explanation behind this record activity off-shore is always the prospect of a return to a labour government in the near future. Such activity also accounts for the c o n t i n u i n g pressure on sterling in the international currency markets. With Tony Blair continuing to lead the hapless John Major by some 30 points, visible divisions in the Conservative party have surfaced. With the election coming in May of 1997 at the latest, the Conservatives have only 15 months to prepare. The divisive issue of Europe within the party, has caused a rift among those that are on the extreme right wing of the party, and those of whom believe in a more active European policy. The problem is that John Major has not been able to bridge this gap, and has continually sat on both sides of the fence. Most recently, a prominent Conservative party woman parliamentarian, Miss Emma Nicholson, defected to the Liberal Democratic party over her frustrations that the far right of the party has been winning over the ear of the Prime Minister. With a combination of defections and of deaths of senior Conservative members, the Conservative majority is soon expected to become a minority government. The defection of Miss Nicholson, will in all likelihood cause more prominent members to defect to the opposition. The fall of the current government could be a lot quicker than is expected by many. With the fielding of candidates from industrialist James Goldsmith's Referendum Party in the next election, a very interesting period in British politics is close at hand. The prospect of having a proclaimed opposition to further European integration, along with any introduction of a single currency, will act to split the Conservative right wing vote. After the election, the combination of the existing right wing fringe with the Referendum Party, could see the eventual demise of the Conservatives altogether. This will not be too dissimilar to the outcome of the last Canadian election. 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. The possibility of this happening to the Tories in the UK is very real. Already signs of desperation are setting in. No matter what the Conservatives do from now until the spring of 1997, will not be enough to resurrect the "feel good" factor among the British public. The bubble years in the 1980s during the Thatcher government, together with the ridiculously premature entry of sterling in the European exchange rate mechanism, have been unfortunate imprints that have hovered through the entire tenure of John Major. Recently, Conservative party Chairman Brian Mawhinney displayed his desperation, by invoking Cold War tactics into the debate. The claim was that a labour party government would leave the UK vulnerable in a time when the threat of a resurgence in communism in the former Soviet Union was very real. Such bursts of rhetoric will only serve to hasten the decline of John Major's government.

Currency Forecast
With the prospect of the UK not entering the first league of countries that aspire to.monetary union in Europe by 1999, sterling will come under even greater pressure as the political situation in the UK worsens. A minority Conservativegovernment is close at hand, while business fundamentals and c 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 for the Conservative government, as some argued that such public displays of chaos in France illustrate how difficult and painful the road to monetary union really is. If the Conservatives could at all recuperate from their dismal standing, it is precisely through such events as the protracted strikes in France. Any enduring rift between the two monetary union anchor countries- France and Germany, is a good sign for sterling. However, reality is that the Chancellor has signalled the government's intent 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 one pound. Likewise, sterling continues to trade within a range of historic lows relative to the German mark. The prospect of a Conservative minority leading up to a labour government, at the latest by May 1997, has encouraged record capital flight. With investments in financial instruments offshore at record levels, and with a surge in foreign direct investment by British based companies, the only active investors in the domestic British economy, remain the Japanese and Germans with a surge in American interest over the past two quarters.

The Pound Sterling Chronicles
The UK government is placing great efforts in attracting foreign investment to the UK. However, over the next quarter, domestic political developments with the prospect of even further defections from the ruling Conservative party, will inspire greater outflows of investment. This, together with a weakening export performance, and continued depressed consumer and business confidence, will cause sterling to reach new lows.


The Pound Sterling Chronicles

Third Quarter 1996
• 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 Outlook
The economic slowdown on continental Europe will adversely affect business activity in the UK. Up to now, it has been the successes of UK firms to export products to France and Germany, that has provided a badly-needed basis for growth. The recent trend, however, has been for UK based firms with a large trading presence in Germany, to commit to an acquisition of a company already well-established in the German marketplace. Over the past six months, no less than 15 major acquisitions have taken place in Germany by UK based manufacturing companies. Even though the logic for such acquisitions has not been sound, since a devalued currency favours exports instead of direct operations in Germany, forward-looking firms in the UK are increasingly determined to leave behind a continuously depressed local market and anti-European rhetoric. The climate for manufacturing operations in the UK is becoming increasingly hostile. With a very poor domestic market for their products, and with a plunging level of business confidence, profits have registered their steepest decline in five years in the fourth quarter of 1995. While manufacturing Output declined by 0.2 percent, the output in the growing services sector increased by 0.8 percent


Third Quarter 1996
The only positive sign in manufacturing continues to be with Japanese automotive transplant operations. Although domestic prospects for automotive purchases continue to be poor, the Japanese have taken advantage of the single European market and the tariff laws that govern its efficient functioning. 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 by Ford, Vauxhall and PeugeotCitroen, who have decided to shift some production back to the UK. This shift is a direct response to the devalued sterling policy of the Major government, driven mainly by necessity. In the case of PeugeotCitroen, Chairman Jacques Calvet fears currency instability, as it severely impacts the bottom line of the entire group. A one percent fluctuation in the sterling-franc exchange rate costs the group Ffr. 250,000,000. In 1995, sterling fluctuation attained a seven percent fluctuation margin. In the case of most European based manufacturing operations in strong currency countries, a real interest in acquiring productive assets in the UK to take advantage of a depressed level of sterling has developed. Although the Conservative government of John Major is still operating under a precarious majority, prospects seem to have improved somewhat. The crises on the continent with the single currency project have given new life to the embattled prime-minister. With problems in Europe, pro-European ministers of the likes of Michael Heseltine and Malcolm Rifkind have begun to concede that the project may have been a little over-ambitious for introduction of a single currency by 1999. This has decreased the level of tension and infighting in the Tory party, and has given John Major new life. The sentiment at this very moment, is that the current government will probably be able to endure until the official election date of May 1997. Chancellor Kenneth Clarke has once again prevailed in discussions with the Governor of the Bank of England, and has implemented a series of reductions in the base rate. Mr. Clarke must be commended for these quick actions, after gloomy reports on business conditions on the continent, would lead to a drop in exports by UK based companies. The reductions in the base rate will maintain a depressed level of sterling for companies to take advantage of export opportunities, should they arise. Although the Bank of England has always favoured the raising of the base rate during discussions with the Chancellor, broad money has been growing 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. So far there is no evidence of this, since the depressed value of sterling, together with loose monetary policy has not been transmitted to wage and price inflation. With the continued expansion in exports under attack, a recent report by DHL/Gallup shows that companies reporting strong overseas sales are at their lowest levels since 1993. Although exports to the continent have slowed, the UK has, nonetheless, posted its first trade surplus in two and a half years, 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 in production to a record of 2.71 million barrels/day in 1996. This is expected to increase incrementally, before reaching 3.0 million barrels/day by the year 2000. Oil exports are a major source of revenue, and give structural support to the level of sterling exchange rate in the international accounts. It can be argued that North Sea petroleum products and Japanese automotive exports to continental Europe are the main items that pass through the UK international books.

Mergers & Acquisitions
In the UK, most publicly listed companies experiencing a hostile takeover of any sort, must enlist the support of institutional shareholders that are in control of most of their stock. A textbook example of this was the recent support by pension fund manager Mercury Asset Management of Granada's bid for the Forte hotels chain. Issues that concern the regulation of mergers and acquisitions have been heating up between UK authorities and the European Commission. What is at stake to the British, is adherence to the entire principle of subsidiarity adopted by most European governments. With the appointment of Karel Van Miert to the competition directorate in Brussels, subsidiarity has been relegated in favour of a lowering of the Commission's level of threshold for evaluating acquisitions. The proposal to lower the present threshold level in turnover from Ecu 5 billion in the combined entity, to Ecu 2 billion and from Ecu 250 million in Europe to Ecu 100 million in Europe, is a direct challenge to one of London's main industries.

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With most of the activity on the London Stock Exchange's FT-SE 100 index, being driven by acquisitions over the past two years, it is expected to continue to rise even further. Recent activity in the banking sector with the acquisition of TSB bank by Lloyds, has started speculation on a possible megamerger 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 share transaction deals, driven by economics of scale emerging in specialised sectors, global credit supplies remain at their highest levels for 20 years. In the fourth quarter of 1995, half of all activity in the UK public and private markets came from the US, spending a six year record of F-4.1 billion. This was a direct reversal from the first part of 1995, when most investment and acquisitions activity in the UK was targeted from continental Europe.

Currency Forecast
Sterling continues to trade in the narrow range of 2.20 to 2.25 to one Deutsche mark. With recent threats of an export slowdown over increasi n g I y depressed conditions on the continent, the remaining manufacturing base 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 currency to make it viable for it to maintain a presence in the UK. Since the continuallydepressed domestic marketplace cannot provide for a large enough sales base, even with the new Japanese investment, exports are a must for survival. With the on-going problems facing the prospect of successfully introducing a single European currency by 1999, the UK political establishment has once again lowered their guard. The likelihood of participating by 1999 is very remote. As former Chancellor of the Treasury Nigel Lawson recently argued, that sterling ought to be informally fixed to a possible single currency, should it come about. As this would signal a resolve to Europeans that the UK is serious about participating in the project at a later date. 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 very controversial topic to those that will be part of the single currency at the outset, most notably France. While the prospect may seem bright for a delayed participation, consistent with the pronouncements of Nigel Lawson, in practice it may be even more difficult and even counter-productive. An

The Pound Sterling Chronicles
immediate fall-out from participation in a "second round" for countries such as the UK, would be the contention of immediate recession. Surely, the French and the Germans would not allow the British to enter a currency union at the current devalued exchange rate. At the moment, turmoil over the single European currency on the continent ' will give support to sterling along with oil.


Fourth Quarter 1996
£ 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. Despite the 2.2 percent increase in real-estate values in the first quarter of 1996, over 1.0 million households must still contend with negative, or near negative equity. In addition, while exports of automobiles to the European continent show record levels of growth, there exist real problems with the domestic market. As was the case during the Thatcher reign in the late 1980s, the fortunes of the British consumer, saver and investor are singly tied to the value of the family home. British people feel exceptionally good when the values of their real-estate rise, whether on a real or nominal trend upwards. As with the Thatcher experiment of the 1980s, housing price increases were mainly artificial and followed the inflated levels of income offered in the UK labour markets, particularly for professionals. Once a downturn was evident, the entire house of cards collapsed. Except that debt levels remained very much a reality.


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Consequently, consumers have been depressed throughout the decade of the 1990s. Matters continue to worsen, as in the case of their resistance to the retail prices on new automobiles, producers have come to the realisation that most purchases recently have been in the re-sale market. Reflecting the real decline of the British consumer has been evidence that government finances are dramatically deteriorating. Such a signal was also evident during the steepest part of the downturn in 1993. Evidence of higher than usual sales by the Bank of England of government bonds to cover the government borrowing requirement in February, meant that bank loans to the public sector declined, creating more of a glut in the credit markets. An additional hazard carried over from the Thatcher years has been the recent outbreak of Mad Cow Disease in the UK. The devastating effect on exports and export revenues that this episode has caused can be directly traced to the carelessness in producing animal feed at lower than required processing temperatures. During the Thatcher years, the animal feeding process was deregulated to the extent that producers of animal feed were allowed to process at far lower temperatures, hence saving expenditures on their heating bills. The lower processing temperature has had a very destabilising effect on the entire industry ten years after the fact. The Mad Cow episode will have disastrous effects on the balance of trade accounts, as milk would need to be imported from other European Union countries. Although cattle over 30 months in age have been scheduled for slaughter initially, this represents 4.5 million out of a total UK herd of 11.0 million. The crucial aspect to the crisis is that milk production is usually only available from cattle in excess of 30 months; the ones that will be slaughtered. Losing domestic supplies of dairy products would have a more destructive 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 billion of beef. To import the additional dairy products required, entails a net addition to the trade deficit of £3.0 to £5.0 billion. The impact on sterling, however, from such a net addition to the trade deficit will be mitigated, as the EU will cover a good part of the shortfall through support transfer grants to the UK. Despite this positive development, the long term 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 the UK, all relate to the exceptional export opportunities offered, while

FOurth Quarter 1996
simultaneously taking advantage of the European single market for trade. The attractiveness specifically offered to foreign producers, are the low levels of sterling exchange rates and labour costs, rendering any product produced in the UK very competitive. The domestic automotive market has died in 1996. The continuing deterioration in consumer sentiments and the fact that UK automobiles are just too over-priced has sparked a revolutionary change in spending habits, preferring to direct their purchases in the used car market, consumers have begun to compare the excessive premiums demanded by UK dealers, to equivalent models priced in the US market. When all factors are considered, it has been reported that UK prices must be cut by 20 percent or more, if Europe’s car makers are to avoid an allout rebellion. For similar models that are sold in the US, prices were on average, some 30 to 40 percent cheaper. Reasons for the excessive prices in the 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, vehicles produced in the UK continue to reach record levels. The 1.2 million production units in 1991, are expected to settle at 2.5 million by the year 2001, all destined for export markets in Europe.

Mergers & Acquisitions
While industrial conglomerate BTR plans to divest itself from its non-manufacturing operations, a very complex potential merger in the telecoms sector between British Telecom (BT) and Cable & Wireless (C&W) has surfaced. At the centre of controversy is the potential monopoly effects of acquiring cellular phone operator from C&W subsidiary Mercury Communications. Moreover, the authorities in Hong Kong, have also voiced their disapproval over the potential competition effects that a BT takeover would have on C&W’s operations in the former colony through its Hong Kong Telecom subsidiary. To salvage the plan, a potential white-knight, Deutsche Telecom, has emerged as the potential suitor to Mercury Communications, in an attempt to satisfy the concerns of the UK monopolies and mergers panel.


The Pound Sterling Chronicles
Single European Currency
After the April 14 meeting of European Finance Ministers and Central Bankers in Verona, Italy, a clearer blueprint for the next stage of the single currency was established. After ruling out further moves against integrating sterling into a single European currency, the Conservative party obtained an agreement to conduct a referendum on the topic after the next election. It is clear at this point that the next election, whenever it may occur, will be fought over the single currency project in Europe, to the detriment of British consumers and certain parts of industry. By fully co-operating on the single currency issue in Verona, France and Germany have essentially ruled out the participation of sterling. In a majority decision, it was decided that all currencies not participating at the outset, must become part of a new exchange rate mechanism, and must remain so for at least two years. The UK is adamant, with both Labour and the Conservatives, rejecting any immediate ties to the Euro. Moreover, France has proposed that countries with floating currencies be disciplined against competitive devaluations. The UK’s stance has prompted the individual responsible for negotiating the UK’s initial membership in the European Community in 1973, Sir Roy Denman, to respond in frustration to the lack of progress on the single currency by stating; “Britain never had a serious, house-clearing revolution...The result has been that Britain has largely become a cosy backwater, a back slapping, 18th century type oligarchy, its boardrooms stuffed with clapped-out politicians, Foreign Office retreads, and sundry cronies 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 to keep the UK away from any centralisation of decision-making powers on continental Europe.


December 1996
£ 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 the European Commission in Brussels has touched off a serious identity crisis in the UK. Recent opinion polls taken show that a majority of the electorate favour withdrawal of the UK’s membership in the European Union (EU). Membership in the EU has always been an uneasy proposition at the best of times for the UK. Acceptance of a loosely configured economic union with the European continent is a concept that most of the British can live with. However, the problem occurs when goals among continental countries conflict with the historical position the Britain has always enjoyed as a fringe island state on the northern fringes of the continent, only now geographically connected by a man-made tunnel under the channel. The core of the dispute between the UK and continental countries comes when moves towards greater political unity on the continent are arranged to counter historical tensions, between say, countries like France and Germany. The well known trade-off between these two bitter historical enemies, is Germany’s willingness to replace the sturdy Deutsche mark by a single currency that has continually been the cornerstone of French policy within the European Union. In return, the Germans have continuously

The Pound Sterling Chronicles
demanded that monetary union must go together with political union in Europe. The usual justification for Germany to press for greater political union in Europe, has been its cruel history in the two world wars this century. It is argued that more centralised decision making authority, in the European Parliament in Strasbourg, will ensure that no country will ever again dominate European military affairs. This is the present wish of the Kohl government in Germany. A single currency is much less of a foreign concept on continental Europe, since its anarchic history of political conquests and border movements have seen many varieties of currencies being circulated over time, hardly any of which have endured past a single generation. Even the remarkable Deutsche mark has only been around since the late 1940s, and may very well 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 the currencies. Since the advent of free-market economies in many of the newly emerging central and eastern European countries, there have been no less than three to four different currencies in as many years. The UK’s history is slightly different. Culturally, their goals more closely resemble those of North America, than they do the political agenda’s of the continent. Both the US and Canadian dollars have been in circulation since they have gained independence as countries. Similarly, UK sterling has been in circulation for many centuries. This history plays a very large role in the current discussions of introducing an all encompassing European currency one day. What is worse for the UK, is that the continental Europeans have mechanically agreed to 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 that the 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 European decision-making process. If the EU is understood as a collection of countries, each with its very own centre of interest, then subsidiarity would solve many problems. In the case of Bosnia, EU inaction could be directly blamed on the incompetent positions taken by France and the UK, which ultimately had to be corrected by US intervention. The fact of the matter was that countries with direct historical interests in Bosnia, such as Germany, Austria and maybe Italy,

December 1996
should have broken away from the rest of the EU decision-making, and implement their own action plan on resolving the crisis, perhaps in conjunction with the US. This would have avoided the embarrassment that overall inaction brought to the EU. Likewise, in the case of the British mad cow caper, the British people resent having an Austrian agricultural commissioner dictate what is right for the UK beef industry, when his own country has never been an active importer of beef from Britain. It may have been more effective for the countries that are the recipients of British beef within the geographical region of the UK, such as Ireland, France and the Netherlands, impose corrective measures than have the entire Commission decide action. This would be far more politically acceptable, and we may have avoided the current impasse in Brussels with UK ministers voting against measures in protest, even though they favour the legislation. To avoid future problems of this sort, the EU must become an effective regional decisionmaking authority, where countries make determinations on issues which are more central to their interests.

Mergers & Acquisitions
British Telecom and Cable & Wireless called off their talks over a possible merger. At issue was the entire complexity of the deal, as well as disagreements over pricing and risks. Moreover, the regulatory obstacles that involved politicking faced a formidable challenge. The merger in the insurance sector between Royal Insurance and Sun Alliance has already created an extremely high solvency ratio that is above normal insurance industry standards. Savings on marketing, technology and rent has pushed up share prices by 10 percent for both groups. Pressures from shareholders are growing for an immediate “merger” dividend, or a share buy-back. Overall acquisition activity continues to push stock prices higher, as a new round of rationalisation is expected in the UK manufacturing base as recessionary conditions set in. A possible scenario is for UK firms to resume their flight to countries that are more sympathetic to manufacturing, such as Germany. Or, to areas that are in developing countries and which offer direct benefits through a lower cost structure. More activity in the financial services sector is also imminent. A large scale retail banking merger can be expected, as can continued buyouts of niche brokerages by foreign banks.

The Pound Sterling Chronicles
Currency Forecast
Given that exports have all but collapsed over the past quarter and manufacturing continues to contract, the level of sterling must come down with respect to the mark.


January 1997
[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 party victory in next year’s general elections, recent evidence has emerged that the embattled John Major has narrowed the once 25 point gap to a mere 10 points. Ominous flashbacks to the 1992 election immediately draw parallels to the current situation. Just as in the present circumstances, the Conservatives under Mr. Major were the definite underdogs going into the final day of campaigning, while the then Labour party leader Neil Kinnock, had held a five point lead. After believing that the Conservatives would wind up in opposition, they instead managed to snatch a majority government from Labour. Can such drama come to repeat itself in 1997? Currently, the UK economy and business prospects remain just as depressed as in the last year. However, the miracle on which the hopes of John

The Pound Sterling Chronicles
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 a Conservative majority once again.

Single Currency Update
The battle between moderate pro-European Conservatives and right wing Eurosceptics will very soon come to a head. If it were solely up to John Major, he would not have sterling participate in another exchange rate mechanism as a prelude to eventual “Euro” status, given the bad experience in September of 1992 when sterling was bounced out of the exchange rate mechanism by the German Bundesbank. However, a complete withdrawal from the prospect of joining the single currency in the next Parliament, will lose John Major the support of two most important ministers; Michael Heseltine and Kenneth Clarke. This may be inevitable, since both have agreed to support a referendum on the matter and accept the ultimate outcome. Should the public reject participation, resignations would be forthcoming, hence pushing the Conservative party further to the right. However, the delicate balancing act between the right and left wings of the party that John Major must contend with almost on a daily basis, may ultimately become a pointless exercise with the formation of James Goldsmith’s Referendum Party. The billionaire financier’s chief aim of the Referendum Party is to keep the UK from participating in the single European currency. If the Referendum Party is successful in attracting the right of centre votes in the upcoming election, Labour will lead to victory. Tony Blair’s position on the single European currency up to now can be described as being pro-European, but cautious. Mr. Blair understands that to engage in a full-fledged debate over the terms of entry in the single currency program would pre-occupy at least the first half of his mandate, should he get elected. Furthermore, he also has the benefit of the Conservatives’ experience with the exchange rate mechanism and the disastrous ejection of sterling in 1992. Such an event is the last thing that Mr. Blair would want to wind his party up in. However, should the first grouping of participants find that the single currency is working and beneficial, Labour would accelerate preparations for an early entry.

January 1997
By now, it has become common knowledge that the UK is not going to become a part of the first group of participating countries in the single currency. Although being politically and commercially unprepared, parliament would 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 require participation in the current 15 percent wide exchange rate mechanism. In addition to the deteriorating deficit over the past six months, has placed the UK in the position of being a long-shot in the single currency game.

The weak service-sector tax base in the UK has, to the surprise of many, increased the borrowing requirements for the current and coming years. So serious is the revenue shortfall, that the customary election year budget tax cut bribe will need to be postponed, and perhaps even have some taxes rise. In specific terms, the borrowing requirement has been forecast to rise next year by an additional £8.0 billion. Moreover, Chancellor Kenneth Clarke has revealed that his government would need to borrow £23.1 billion in 1997-98, representing an upwards revision of more than fifty percent over the original estimates. In retrospect, the optimistic forecasts in November 1994, showed that the borrowing requirement for 1995-96 and 1996-97 were to be 3.0 and 1.75 percent of gross domestic product respectively. Under current revisions, the debt will have jumped from 27 percent in 1991 to 47 percent at the end of 1996.

Mergers & Acquisitions
Acquisitions activity in the UK remains buoyant, as global stock market jitters could be more than offset by continuing sales and purchases of companies in London. Although there is evidence of a calmer market before a possible labour victory in the 1997 elections, the prospect of tax increases in the pre-election November budget has unnerved potential acquirors to a certain extent.

The Pound Sterling Chronicles
The proposed code-sharing arrangement between British Airways and American Airlines on the London to New York transAtlantic route has been challenged on many fronts. Most recently, British Airways US partner USAir, has launched a lawsuit against both airlines. USAir’s announcement of the pending lawsuit came as a surprise to both, since BA owns 24.6 percent of USAir and has three representatives on its board, including Chief Executive Robert Ayling. USAir has made references to the existing case in the federal district court in New York brought against the monopolistic practices of British Airways by UK based Virgin Atlantic airways. In a letter to presiding judge Miriam Cedarbaum, USAir claims that strong similarities exist between the two cases, as both accuse British Airways of monopolising air routes between the US and the UK. USAir’s action was inspired to a great extent by US laws requiring a plaintiff to inform a judge when it wants to bring a case that is similar in nature to the one that is already being heard. By linking its case to Virgin’s on-going campaign against privileged practices of BA, USAir stands a good chance of success judging by the rulings that were already made in favour of Virgin on separate occasions. In addition to the lawsuit initiated by USAir, the European Commission has joined the growing scrutiny of the alliance. Competition Commissioner Karel Van Miert and Transportation Commissioner Neil Kinnock have agreed to begin deliberations in a rare joint investigative effort between their respective directorates. Furthermore, the Commission has also announced plans to include the British Airways and American Airlines linkup with a broader based investigation. Included in the review will be five other trans-Atlantic alliances.

Currency Forecast
Much to the astonishment of many, sterling has continued to hold ground against the Deutsche mark. Foreign investments and acquisitions of UK based companies, along with a calmer evaluation of political prospects has combined with tourism to support sterling. However, the deterioration in public sector finances and the prospect of tax increases should lend even more support.


February 1997
[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 performance still remains subject to great efforts in interpreting the certainty of its direction, one must conclude that things must be improving as the present uncertainty is much preferred over the definite gloom that has remained a fixture of the UK since the initial meltdown in property prices, together with the reign of Margaret Thatcher in 1991. The brief manufacturing recovery in 1994, is contrasted with ongoing gloom and stagnation in this declining sector of economic and business activity. With inventories registering record highs and investment at all-time lows by UK-based companies. In fact, one in three of the UK’s 100 largest manufacturers is now controlled by a non-British entity, and businesses in other

The Pound Sterling Chronicles
countries account for a quarter of the nation’s manufacturing output. Large French and German multinationals, together with Japanese automotive manufacturers and some South Korean groups are leading the charge in UK manufacturing. In all, the number of non-British owned companies among the 100 largest manufacturers in the UK has almost doubled between 1986 and 1993. Ironically, it may turn out to be the case that the strong consumerled recovery in the domestic economy will trickle-down to positively give the slumping manufacturing sector a much-needed lift. Moreover, the deflationary bias that is currently becoming a familiar attribute on the continent, has further acted to depress manufacturing activity in the UK. However, what is very clear from the unfolding trend, is that consumer spending in the service sector is the fuel driving UK domestic commerce. So prominent is the growing trend to expansion in the service-sector, that it can be argued that manufacturing has been marginalised as a sub-sector in a very big way in this decade. The increasing activity in the service sector, has created high valueadded jobs, while causing a large problem with the unemployed that formerly held high-paying, but very routine-oriented jobs in the declining UK manufacturing sector. Samuel Brittan of the Financial Times of London has confirmed this trend recently in his weekly column: “The Bank of England inflation report is more interesting for its labour market survey, despite the large fall in claimant unemployment, the labour market has not tightened very much since the 1992 recession. While in the 1990s, claimant unemployment has been falling, while in the corresponding period of the 1980s recovery, it was 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 claiming unemployment benefit. The total of unemployed plus ‘inactive’ is sometimes known as the ‘non-employed.’ The number of non-employed of working age reached a peak in 1994 and has fallen only very slightly since. The stagnation in the demand for labour is confirmed by estimates of total hours worked, which after rising in the early export-led stages of the present recovery have hardly changed since the spring of 1995.” Without doubt, the fortunes of the UK’s economic performance have become hinged on the service economy, that has mainly centred on the metropolis of London, with financial services at the centre core. The increasing importance of this will irresistibly pull the UK towards the single European currency project. The launch of the “Euro” in 1999, has taken on a vitally important political inertia on the European continent, which has been recently

February 1997
confirmed by the Dublin meeting of Finance Ministers and European central bank Governors. In this meeting, the German plan that imposes continuous “fiscal rigour” on member states after monetary union, has been agreed to in principle by most members. Previously viewed as controversial, the plan is increasingly becoming institutionalised in EU politics. So successful has been the outcome of the Dublin meetings, that UK Chancellor of the Exchequer, Kenneth Clarke, has labeled the ruling Conservative Party’s opposition to joining the first phase as being overall “pathetic.” Certainly, the recent attempts by German and French banks to exclude UK banks from participating in the Euro overnight wholesale lending market, if they do not join the project, has sent very nervous jitters throughout the City of London, as it becomes more fearful of competition from both Paris and Frankfurt.

Mergers & Acquisitions
Record activity in the market for acquisitions continued to hold up throughout the days of summer. The traditional cross-border tie-ups between US and UK firms continued unabated. However, a notable set-back occurred in the big plans of British Airways and American Airlines to share tickets on the London to New York route. Intense lobbying by US competitors such as United Airlines and Delta in the US and UK, resulted in the UK government rejecting the “open skies” framework, recently negotiated by the US and Germany. Basically, both countries differ over the meaning of “open skies” as the US is demanding “beyond rights” for their airlines to continue to offer flights to various European destinations from the UK. As was rightly defended by the UK government, such reciprocal rights do not exist for European airlines in the US aviation market. At issue are also demands for cheap “landing rights” slots at London’s Heathrow airport, which normally carry very dear market values. In essence, unless some sort of compromise is found on the entire issue of “beyond rights,” the merger between the two airlines on the lucrative London-New York route will expire. The opening of the Eurotunnel has exacted a heavy price for the traditional English Channel ferry operators. Consequently, the world’s largest ferry operator, Stena Line, has reported steep losses in the first half of the year. In spite of steady volume growth, its margins continued to suffer. The

The Pound Sterling Chronicles
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 expected that Stena and cross-channel competitor P&O will enter negotiations on cross-channel co-operation. This is expected to take the form of a merger, as the co-operation will fix a greater degree of rigidity in pricing and pool revenues with P&O to help meet the challenge of Eurotunnel. It is interesting to note that recent no-frills start-ups in the European aviation market from firms such as “Easy Air” and “Debonair” based in London, can further upset the balance that once existed in the cross-channel passenger and selective cargo markets. Aggressive discounting by such companies will add to the pressure on margins that the Eurotunnel has been able to exact up to now. Such a development in the aviation market, will serve to ensure that prices will continue to benefit consumers in cross-channel travel. In the financial services sector, UK merchant bank Hambros has become the target of Hong Kong based vulture fund Regent Pacific. Its acquisition of a 3 percent stake in this most traditional UK bank, has put enormous outside pressure on it to improve its “diabolical” management record. By calling an emergency meeting to discuss the bank’s strategy, Regent Pacific has aggressively positioned itself to reap the rewards of the inevitable change of ownership in one of the last traditionally-structured organisations in the UK merchant banking sector.

Financial Crisis
A potential billion dollar exposure problem has affected the investment banking operations of Deutsche Bank. The break-down in compliance and regulatory obligations in the Morgan Grenfell European Growth Trust (a wholly-owned subsidiary of Deutsche Bank), has placed the reputation of one of the most credible international financial names in jeopardy. Not only did the parent Deutsche Bank need to calm the nerves of the 90,000 investors in these group of funds, but the oversight will also prove to be very costly. The suspended and released fund manager, Mr. Peter Young, has side-stepped the strict set of rules that govern the very conservative unit trust market in London. His investment holdings in a series of Scandinavian high technology companies, were made possible by channeling investment funds through Luxembourg-registered companies that were established by himself.

February 1997
In essence, Deutsche Bank faces an unknown loss in buying out a portfolio of unlisted securities held by the funds, in which they control a block 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 is regulated by the Securities & Investments Board, in addition to the Investment Management Regulatory Organisation.

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


First Quarter 1997
•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 • miniBudget 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 booming economy, based mainly on services. At issue is the pound sterling, which stands at 99 percent of the level that it occupied in 1990 relative to the Deutsche mark. The strength of sterling has also created a large imbalance in the domestic economy with a booming service sector offset by relative decline in

First Quarter 1997
the heavy industrial manufacturing sector. A repeat of the scenario in 1992, when speculator George Soros successfully bounced sterling out of the European Exchange Rate Mechanism, seems to be playing itself out once again. The high level of sterling, is expected to reduce exports of UK made machine tools by nearly 10 percent over 1997. In addition, the domestic consumer boom has been fed to a large extent by a run up in consumer credit card debt that currently stands dangerously high. Despite the favourable conditions for British consumers at this time, real wealth is still 20 percent below the levels that it was at in 1990, mainly driven by depreciating house prices. The Blair government has moved quickly to give operational independence to the Bank of England in setting interest rates, and has been widely acclaimed for its new friendly approach to the European Union. Despite this new improvement in relations, it remains highly unlikely that the UK will become one of the founding members of the single currency. However, it will mean that Tony Blair’s government will have enough influence to shape the future integration program in the interests of UK business. The wait-and-see attitude towards the single currency program will benefit sterling over the longer term, provided that this positive sentiment will not be offset by difficulties faced by exporters to any large extent. Over the shorter term, sterling will remain volatile, despite the favourable development that the Bank of England is no longer subject to the short-termism of party politics and popularity polls. Still, the rate differentials between the UK, Germany and the US, favour investment flows into sterlingdenominated paper investments. According to a study conducted by the Bank of England, interest rate differentials accounted for about one third of the gains, while oil strength and the UK as a safe haven over fears of a bad monetary union were marginally affecting a rise in sterling. A large part of the recent appreciation has been erratic and could not be traced in terms of longer term fundamentals. With no end in sight to the depressed business climate in Germany and in France, a reversal in rates is not expected to come about until much later in 1997, if at all. However, with a historically high sterling, and risks of an export backlash, and evidence that the current boom was founded on debt, a correction must be imminent over the summer.


Second Quarter 1997
•single currency referendum could be won at the earliest opportunity after the timely launch on January 1, 1999 • UK is two years ahead in its expansion over most continental European countries • sterling is expected to enter monetary union at a rate of Dm. 2.6 to 2.7 or substantially lower than its current 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. The uncertainty created over the single currency and the likelihood that the euro will be a “soft” currency has adversely affected the deutsche mark, causing fright capital to flow to London. Secondly, the strength of the US dollar has given sterling additional support, while lastly, the Bank of England, has raised official base rates to levels unimaginable both in continental Europe as well as in the United States. The UK is currently in the grip of dramatic change, as it struggles to redefine its relationship with Scotland and Wales, along with a conceivably

Second Quarter 1997
new role for the Monarchy in the new era. Moreover, as it enters the new millennium, it is also talking very seriously about joining the single European currency via referendum, shortly after it is determined who the initial countries might be that will participate in the monetary union. Even still, despite the talk of a new era, sterling continues to behave conspicuously like a solid member of the Anglo-saxon bloc of currencies that includes the likes of: the US and Canadian dollars and the New Zealand and the Australian dollar markets. It almost mirrored the moves in the US dollar over the past year. The UK is undergoing a consumer boom at this very time, as a oneoff windfall from building society demutualisation has rewarded many families with £2,000 to £4,000. This, coupled with an increase in overall credit card debt has fuelled one of the strongest bouts of domestic expenditure since the 1980s. The general openness of the UK investment climate has also been of very great benefit to the development of the domestic economy. Both the massive re-investment of Japanese automotive industry participants, as well as the preference for US firms to locate operations in the UK, has brought about a solid infrastructure in areas that were considered to be terminally depressed. London, as a preferred financial centre can only strengthen its position, especially after the Blair governments determined effort to be at the forefront of the single currency project. With all of the longer term trends pointing to a favourable impact on the UK domestic economy, sterling should be governed more by what happens in the domestic and export sectors, with a minor effect from any progress or setbacks with the single currency project. Investment flows have been driving sterling higher based on the high official short term base rates that have been set to counter the sudden consumer boom encouraged by the demutualisation. Exporters have also been demanding a lower level of sterling in relation to the mark, as profit margins are beginning to be eroded. Although still strong, sterling will settle lower towards the Dm. 2.75 to Dm. 2.85 levels as the consumer boom begins to subside.


Third Quarter 1997
•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 a certainty in the world of international finance, a growing split within the Labour party is becoming ever so apparent. The honeymoon that Prime Minister Tony Blair has become so accustomed to after Labour ousted John Major and the Conservatives just one year ago, is now under attack from a deteriorating domestic economy and the familiar lack of commitment to a more concrete European policy. Having been elected on promises of better relations towards the European Union, the once hoped for early commitment to join the single

Third Quarter 1997
currency has all but been dashed in favour of a “wait-and-see” attitude. To many members of Parliament and prominent figures in the Labour party, this has become unacceptable. For one, Chancellor Gordon Brown, has made his disapproval felt throughout with no uncertain effect on the Prime Minister himself. Central to the growing impasse on European policy has been the lack of substance, yet only clear rhetoric. Despite almost unanimous support from British industry at this time, Labour’s promise of possible participation in the single currency by perhaps 2002 or maybe 2004, will do great harm to the window of opportunity that the Prime Minister could have seized by committing to a definite early participation date, hence inheriting a leading role in regional European affairs. With the aging Chancellor Helmut Kohl of Germany and the not so young Jacques Chirac of France, Tony Blair could naturally emerge as the driving force in European political and economic affairs in the new millennium. In the words of Julian Coman of The European, “Like many British prime ministers before him, Blair’s professed enthusiasm for the European Union is long on rhetoric and short on specifics.” The European media has generally echoed the sentiment recently proclaimed by the Italian influential financial newspaper Il Sole 24 Ore, “There seems to be a growing disparity between proclaimed intentions and reality.” Under the leadership of Chancellor Gordon Brown, the UK would already commence with a formal countdown for monetary union to begin. On that basis, a split in the Labour ranks is inevitable. With sterling at its highest point ever relative to the deutsche mark in the past decade, industry’s argument for an early entry is now as strong as it 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 climate justifies a commitment to an early entry date. As sterling comes under attack, pressed by less foreign money buying sterling investments and as the economic slowdown intensifies domestically, the danger is that the window of opportunity that now exists could be lost. Once sterling falls back, industry support may wane on the basis of more exports.


Fourth Quarter 1997
•consumer spending continues to lend support to the domestic economy offsetting the collapse in exports 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 the economy. As British Steel reported a 30 percent impact that the strong exchange rate had on its earnings, similar “traditional” firms have begun to adopt an aggressive foreign merger and acquisition strategy in order to escape the unsympathetic monetary policy of the Labour government of Tony Blair. The attitude of most policy commentators in the UK mirrors the policy framework that is currently being pursued. With 25 percent of GDP belonging to the manufacturing sector, it has become a minority among the more sexier preference for service-based industries that have sprung up in and around the City of London.

Forth Quarter 1997
With the year 2000 computer conversion problem a hot topic these days, the complementary single European currency project has been driving a transformation among the financial services firms and banks in the City. In addition, the dramatic investments that are being made by firms in information technology, has elevated the status of London as the prime “hotspot” in the UK. This, in contrast, to the traditional manufacturing sector that mainly composes the UKs second largest city, Birmingham, among others throughout the midlands and the northern part of the UK that are currently feeling the cold winds of sterling-induced recession. In all, the current climate of imbalance within the UK, somewhat resembles the early Thatcher years of the 1980s, as the manufacturing sector is poised for major changes. As in the case of British Steel, most firms in this sector are expected to follow German companies in the search for much friendlier climates in the US. Although different than their German counterparts with regards to the motivation for pursuing such an aggressive acquisitions policy, they both are finding current conditions of operation extremely difficult. Germany, because of the high cost of labour, and their British counterparts over a most unfriendly monetary policy stand. The recent quarter percent increase in the base rate by the Bank of England that took the City by complete surprise, was reasoned on the grounds of new evidence surfacing of wage pressures. However, these increases have not yet been passed on to the final product, nor will they ever be judging by the 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 by domestic producers.

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


First Quarter 1998
•trade deficit begins to show signs of weakening after a long lag that resulted in overly optimistic data • 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 trade deficit • 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 during the recession of 1991, has marginally weakened the value of sterling on foreign exchange markets. Despite this, inflation has overshot its upper policy limit prompting the Bank of England to maintain its existing fix on short term rates. Once again, the UK finds itself in a paradoxical situation with respect to the timing of its economic cycle within its European economic sphere. While the continent is experiencing a real growth in pent-up consumer demand, joining its already robust trade performance, the UKs domestic situation is beginning to look bleak. The high level of sterling that is being supported by a number of factors, has been behind the collapse in industrial competitiveness in many

First Quarter 1998
of the manufacturing sector’s traditional markets. However, interest rate policy is now being driven by the considerations of the service sector, which accounts for about 75 percent of the GDP in the UK economy. Mainly located in London and the southeast, the interest rate policy of the Bank of England has created a fierce rivalry among the regions in the UK. Of particular note has been the animosity between the two largest cities, London and Birmingham. With the latter being the base of manufacturers and London the undisputed financial services capital in the world. In addition to the favourable interest rate climate that favours a strong sterling, there have been several external forces that have driven the currency to its historical highs. For one, the uncertainty surrounding the entire single currency project on continental Europe, has caused some “fright capital” to arrive in London. This, coupled with the on-going crisis in Asia and now spreading to emerging markets, has caused global investors to feverishly search for safe high-yielding secure investments. It so happens that sterlingdenominated paper is yielding some of the highest rates of return among the countries of the G7. Furthermore, in the recent stock market turmoil, it has been demonstrated that the FTSE100 index has declined the least among all of the major exchanges within the European economic area. Its performance has tracked the durable Dow Jones average in New York, adding further to investor confidence.

The recent marginal weakness in sterling is not expected to dive into a free-fall. The actions of the Bank of England dictate that the complaints of manufacturing have fallen of deaf ears when it comes to policy considerations. As global crisis spreads throughout emerging markets and hit stock markets, the ambitions of the single European currency begin to weigh heavily on European investors. With US political problems and talks of impeachment, sterling may also benefit from frightful investors selling dollars.


Second Quarter 1998
• • • • • • • • • • • • 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 corporate failures as 200 companies are declaring bankruptcy every month resembling the climate existing in 1992 recession

As the UK heads toward another steep “bust” the euro began its trading debut at £0.705. Throughout the last two years, the pound sterling has acted as a proxy to the Swiss franc, attracting all of the fright money that panicked investors sent out of the countries participating in the single currency. This, together with some of the highest real interest rates at a time when most are frantically searching for yield, has acted to severely overvalue the pound sterling on global markets. The preoccupation of the Bank of England with inflationary forces, coupled with the surprising intensity by which the Blair government has supported the Bank on this matter, has missed the underlying reality beyond the “bubble” economy created in the London region.


Second Quarter 1998
Once again, it is cities like Birmingham, Leeds and Liverpool, which lie beneath the service-driven prosperity created in London. In the remaining vestiges of manufacturing in the UK, the reality is the damage that the overvalued currency continues to exact to this very day. Even participation in the single currency in the first round would not have exacted the kind of damage to exports that the run up in sterling has been able to do in the past several years. In that respect, the fears of UK business are overstated. If the UK could manage to live with a sterling level at 3.0 to one Deutsche mark, then it certainly could be competitive and flourish at a level of Dm. 2.70.(which was assumed to be the appropriate participation rate in the euro) Since manufacturing accounts for just 25 percent of total GDP, the service sector holds the balance of power in the policy halls of Whitehall, as well as the Bank of England. The vibrant stock markets and the record levels of mergers and acquisitions has brought an almost unprecedented prosperity to the City. In addition, the one-off boom for computer related talent to prepare for the millennium bug, or Y2K, as it is commonly known has been a one-off occurrence. The question that should be on the minds of UK policymakers is whether the service sector prosperity can continue after Y2K and whether the M&A boom subsides to any great degree? Most inward investors in the automotive sector have favoured an early membership in the euro club. The Japanese have been the most vocal in their concerns over currency uncertainty, while the Government of Australia has just recently issued a warning to businesses that are involved with UK based companies.

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


Third Quarter 1998
• 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-dependent engineering sector to hedge their risks by acquiring plant and equipment in the US or in continental Europe. The period over the past quarter showed conflicting signals of performance in the UK economy, as bankruptcies increased by 2,000 over the first quarter in 1998, while average earnings increased by 5 percent prompting the Bank of England to issue a warning over inflation. In contrast to the unemployment and growth setbacks experienced by the continental European economies, the UK continues to benefit from her distance to the current instability in the Balkans. In fact, no member of

Third Quarter 1998
the G7 has been as hawkish and as forthcoming in its support of the NATO led campaign, than has the Labour government of Tony Blair. In fact, the UK has been far more a traditional ally of the US, than it has resembled the more “dovish” tone of the European Union based NATO members. Yet at the same time, he continues to champion the cause of early entry into the Euro project, despite growing doubts over the dismal performance of the currency in 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 the international currency markets. This is surprising, and it categorises sterling as a real “sleeper” among portfolio managers who often do not give the UK currency enough credit in its continued strength. Since the service economy accounts for well over 80 percent of domestic GDP to now, manufacturers’ interests are carrying even less weight in monetary and fiscal policy than only last year. The few remaining engineering industries that are brave enough to maintain a presence in the UK, while relying on export revenues to raise their bottom line, have been obliged to aggressively seek a hedging solution to their woes via cross-border acquisitions strategies. This will enable them now to manage their companies without much concern over exchange rate risks, while at the same time it should provide for more justification for a strong sterling over the longer term.

Record deals by UK based mobile phone group Vodafone buying Air Touch and by GEC acquiring Fore Systems and Reltec of the US, has resulted in 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 activity usually does. Nor has sterling been sidelined by the trade account deficit in the manufactured exports sector. The net capital inflows that have continued to support the currency, and that will continue to support it into the next quarter, will be destined from continental Europe.


Fourth Quarter 1998
•Repo rates were raised by one-quarter of a point sending sterling sharply higher after the US Federal Reserve 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 Sterling
UK companies acquiring foreign companies: Capital Outflows From UK From M&A: Foreign companies acquiring UK companies: Capital Inflows to the UK From M&A: Net Capital Outflows From UK From M&A: Net M&A Impact on Sterling in Global Markets 56 $89.4 billion 32 $56.3 billion $33.1 billion

An equity gap exists and is getting larger in the UK. Recently, Colin Perry, Chairman of the Confederation of British Industry (CBI) went on record to criticise the UK venture capital establishment, of which venture firm 3i took most of the criticism directly. Most venture capital activity that was inspired by lofty stock market valuations in blue-chip stocks and by the miserably low rates of return on safe bank savings deposits, has been channeled into “private equity” investments. Private Equity is not an activity that usually helps small companies grow. In fact, very few investments with the exception of high technology are players in the pure venture capital sector. What private equity does is reallocate the capital structure of companies balance sheets. Most of this activity can be found via management buy-outs (MBOs), family succession planning situations in mature companies, in addition to financing divestitures within large conglomerates in Europe. A popular activity recently. Many US venture capital and private equity firms that have recently established an operation in London have come to Europe in search of MBOs

Forth Quarter 1998
and restructuring spoils. Few are really interested in making small companies grow that are not in the high tech sector. On the flipside, the IPO that growing companies hope to launch after about the fifth year of venture financing is also dead. With very few fund managers wishing to devote any effort to following the Small Cap sector in the UK, valuations on the stock markets have been falling over the past several years. The City is not interested any more in small companies, but merely follows very large groupings of shares. The depressed prices of Small Caps is also a big disincentive for private equity firms to seriously look at financing the growth of smaller companies, at the expense of their lucrative MBO activities. Recently, the government of Tony Blair raised its concerns over the “equity gap.” A move which is expected to pass tax incentives for larger corporations to directly invest in start-ups and early phase operations within their own sectors, hence bypassing the entire venture capital sector. The strength of sterling is dependent on continued growth in high tech and services, along with newly-emerging small and medium sized companies in the UK. It is not dependent upon what the larger engineering companies are doing in terms of their export strategies. In fact, the neglect that this once traditional sector has received over the past several years is testimony to their waning influence in the UKs political economy.

Deteriorating trade balances do not affect the level of sterling in foreign exchange markets. The overall climate in domestic business conditions does affect the value of the currency, transmitted to international investors via the prevailing rate of interest. Currently, business conditions are robust enought to justify the strong sterling against the dollar, and are expected to stay the course over the next quarter.


First Quarter 2000
•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 reappointed Cross Border M&A Effects on Dollar
(Data for 4th quarter of 1999) US Companies Acquiring Foreign Companies: 25 Capital Outflows From US From M&A: $13.28 bn. Foreign Companies Acquiring US Companies: 37 Capital Inflows to US From M&A: $53.7 billion Net Capital Inflows to US From M&A: $40.46 bn. Net M&A Impact on US Dollar Value in Global Currency Markets is Positive (+) With the re-appointment of Federal Reserve Chairman Alan Greenspan to another four year term, and continuing momentum propelling the US economy to a record 108 months of business expansion, the dollar continues its surprising record run-up against the Euro. With the Euro falling from the one-to-one parity level in relation to the dollar, many have begun to take a long a critical look at what has been transpiring recently among Euro-zone members. With no slowdown in sight in the US, the Fed has been slowly raising short-term rates out of inflationary fears. This, despite definite signs of inversion in the bond yield curve as the Treasury announces its aggressive campaign to buy-up and retire 30 year Tbills.


First Quarter 2000
Recent moves to raise short-term rates by the European Central Bank (ECB), has resulted in greater scrutiny among investors in Euro assets. Such moves have been associated with a central bank that has been quickly losing sovereignty over its monetary policy. Despite stating that it does not use the exchange rate to determine monetary policy, any recent moves to raise short-term rates under a period of continuing sluggishness driven by unprecedented restructuring in the industrial landscape of Europe, has led to the only logical reason for the recent increase of rates by 0.25 percent. In short, to protect the Euro from further weakness, means that sovereignty over monetary policy has been relinquished at the expense of the credibility of the central bank. Only once this credibility has been re-gained among investors, can the Euro once again climb back above the parity level with respect to the dollar. The yen, however, has encountered some recent weakness in trades with the dollar. Continuing weakness in the domestic Japanese economy, together with record bankruptcies and re-structuring activity, has spoiled the strength that the currency has been exploiting from a tight monetary policy that has been executed by an ever more credible Bank of Japan. After living 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 financial system so as to re-create the conditions of a bursting “bubble” again. The 50 percent overvaluation of the S&P500 is directly attributed to the high flying technology sector. More and more the fortunes of the US dollar are linked to how well the US stock markets perform. This development has made the growing trade deficit almost a non-issue in the latter half of the 1990s. And any setback in the progress of stock market values has a direct impact on the value of the US dollar.

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


Second Quarter 2000
•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 warns bankers 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: 16 Capital Outflows From US From M&A: $24.37 bn. Foreign Companies Acquiring US Companies: 22 Capital Inflows to US From M&A: $45.23 billion Net Capital Inflows to US From M&A: $20.90 bn. Net M&A Impact on US Dollar Value in Global Currency Markets is Positive (+) Alan Greenspan has once again pushed up short term rates by one quarter of a percent to six percent, hence re-establishing the significance of a yield spread that continues to power the dollar at record highs relative to the euro. However, this relationship completely breaks down when the yen enters into consideration, as the paradox of the Bank of Japan’s zero interest rate policy becomes ever more apparent against the surging short term US rates. Notable developments that have affected the progress of the dollar have been the short term rate inertia and the absence of any clear variables that are affecting the dollar/yen relationship. Furthermore, there currently exist sentiments of a “soft-landing” which investors are confident that the Fed will be able to engineer via its incremental interest rate policy.

Second Quarter 2000
Developments in the short term have been in contrast to the falling longer term yields on the benchmark thirty year Treasury, and to a lesser extent on the ten year bond. Inflationary expectations seem to be at bay at the current moment, as the recent move in short term rates by the Fed have combined with an aggressive repurchase program that has been instigated by the surging surplus position of the US budget, which have pushed inflationary expectations over the longer term lower. This, in addition to the recent turmoil on the Nasdaq market set off by the FTC’s ruling against Microsoft’s monopoly position on the internet browser issue, has caused fearful investors to seek the security of Treasury bonds. Without a doubt, inflationary expectations are on the way down as accelerated competition in product markets is a good substitute for any further action by the Fed. In fact, recent moves on short term rates are bound to be reversed as soon as convincing signs of a slow down have begun to set in. Any adverse sentiments reflected through a prolonged stock market correction will lead the Fed into an accelerated reversal in its stance on rates and beliefs that centre on an overheating economy.

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


Third Quarter 2000
Top News Stories Affecting the Dollar
•Investor Warren Buffet warns that the internet will create no more wealth than a chain letter and that 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: 15 Capital Outflows From US From M&A: $22.87 bn. Foreign Companies Acquiring US Companies: 22 Capital Inflows to US From M&A: $73.22 billion Net Capital Inflows to US From M&A: $50.35 bn. Net M&A Impact on US Dollar Value in Global Currency Markets is Positive (+) 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 funds are 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 the Federal Reserve has opted to aggressively raise interest rates, could propel the

Third Quarter 2000
US economy into a sudden recession far faster than most investors are prepared to admit. Any correction that is unexpected among the leading high tech stocks and the top Dow Jones performers, could reverse the record capital inflows into the US. This, combined with a stubborn trade deficit, will divert attention from the positive fundamentals that have been so prevalent over the past several years. Sentiments have favoured the US economic performance so much, that fundamentals such as the record trade deficit have been overlooked as well as submerged under the record investment flows that have been favouring dollar based assets. This time around, it is the US economy that may easily fall under scrutiny, should there be an about face in investor sentiment spurned on by the unexpected aggressiveness in Fed policy. No longer are investments and high tech stories so irresistible, after the Fed has pegged risk free rates to levels that can no longer be overlooked by investors. With a Euro zone that is reaping the benefits of a record low currency and which is enjoying record low prices in the credit and money markets, a turn around in the region’s economic fortunes is just around the corner. This time, it is the lofty valuations of US stocks that will determine how far the dollar will correct should there be a puncture in the stock markets by the Fed.

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


Fourth Quarter 2000
Top News Stories Affecting the Dollar
•Chase Manhattan bank acquires fellow money centre bank J.P. Morgan in further signs of a banking shake-up • IMF Reports that the U.S. was the recipient of $180 billion in capital outflows from the European Union 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 $110 billion 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 twenty percent in 1992 Cross Border M&A Effects on Dollar
(Data for July/August of 2000) US Companies Acquiring Foreign Companies: 14 Capital Outflows From US From M&A: $22.94 billion Foreign Companies Acquiring US Companies: 23 Capital Inflows to US From M&A: $164.89 billion Net Capital Inflows to US From M&A: $142.95 billion Net M&A Impact on US Dollar in Global Currency Markets is Positive (+) Has the technology bubble burst? Or are the poor earnings results bringing investor expectations back down to reality? The harsh impact of the former event, may not be necessary to stem the record capital inflows from the Euro zone in search of productive U.S. corporate assets. With capital inflows to the U.S. outpacing U.S. purchases of Euro zone based assets by a seven to one ratio, all that may be required is a mild setback in earnings in order to correct the high value of the dollar back down to its fundamental reality. Already, a general consolidation has been taking place in first the high technology sector, and evidence of a downturn in auto sales has co-incided with the problems affecting Bridgestone Tires on Ford Explorers. This has reverberated down the entire supply-chain, as Dana, Eaton, Federal-Mogul

Fourth Quarter 2000
and Rockwell, have collectively issued profit warnings amid pressures on margins. 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 activity emanating from Europe subsides, the dollar will come under pressure. Although the record trade deficit has not been an issue to now, it may emerge so during a speculative crisis against the U.S. currency. The fact of the matter, as reported recently by the I.M.F., is that some two-thirds of all G•7 country surpluses have been recycled into U.S. dollar denominated investments 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 investors more than at any time in recent history. When all is said and done, this may not be a factor when times are good, as they have been in the second half of the 1990s. However, once a potential downward spiral begins, perhaps when the record mega-deal activity begins to cease from the Euro zone, the moment of 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, sending the dollar lower in global currency markets. Only to be exacerbated by the precarious trade deficit and record exposure to G•7 surplus countries.

Its all for the dollar to lose at this point. The Euro zone has been battered to the point where its currency had to be rescued by a consortium of 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 enjoyed massive capital inflows from mega-deal activity not entirely expected. The only way forward is down.


December 2000
Top News Stories Affecting The Pound Sterling
•Trade surplus recorded with Euro zone for second month since September despite the continuing strength in the Pound Sterling • Abbey National and the Bank of Scotland explore the prospects of a friendly merger in a fast consolidating 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 Sterling
UK companies acquiring foreign companies: 20 Capital Outflows From UK From M&A: $9.88 billion Foreign companies acquiring UK companies: 18 Capital Inflows to the UK From M&A: $24.61 billion Net Capital Inflows to the UK From M&A: $14.73 billion Net M&A Impact on Sterling in Global Markets is Positive: + Various developments in the past quarter have benefitted the progress of the pound sterling. While continuing to trade at record levels relative to the Euro and at 3.2 Deutsche Marks, it was announced that the balance of trade was in surplus for the second month in a row beginning in September. The harsh effects on the trade accounts that a strong pound has exacted on the manufacturing sector over the past five years, have now become wholly attenuated through an aggressive reallocation program of productive capacity towards continental European destinations, leaving only those manufacturing sectors that are the most efficient as well as service hybrid companies which are much less affected by the value of the pound.

December 2000
Not only have UK based companies been involved in this record reallocation activity in the manufacturing sector, but the mainstay of UK direct investment; the Japanese automotive parts producers, have now been seriously harmed by “currency translation” effects in their daily operations. Most recently, Toyota of Japan announced that currency effects related to the weak Euro, will actually result in a yearly loss. Also, Nissan Motor, now owned by France’s Renault, will begin to reallocate production to their plants already existing in France. The Nissan Micra plant has already been targeted for possible shut-down. In a positive development for sterling, a grouping of UK business leaders refused to endorse a government sponsored initiative to promote the benefits of the Euro. Most leaders, representing the business establishment have been averse to joining an initially weakened European currency. The argument holds authority under the current circumstances of prosperity in the domestic UK economy, supported by a growing trade surplus where sterling is no longer the big issue that it once was. In short, the factors supporting the pound sterling have been capital inflows from cross border acquisitions directed to the UK domestic market, as some fifteen billion in net capital inflows have been evident throughout the months of August and September, along with a trade surplus together with positive portfolio inflows into the region from fund manager asset allocations.

The pound sterling has come off its recent highs in relation to the Euro, 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 that have been favouring the US over the past year. The pending reversal of these flows will realign sterling.



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

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

Central Statistical Office 33 Charles, Prince of Wales 18 Chase Manhattan Bank 142 Chirac, Jacques 125 City of London v, ix, 5, 13, 15, 22, 72, 73, 75, 78, 79, 85, 117, 126 Clarke, Kenneth 44, 47, 49, 50, 51, 52, 56, 59, 61, 65, 76, 86, 90, 93, 94, 98, 99, 112, 113, 115, 117 Clinton, President William J. 62 Confederation of British Industry 41, 50, 57, 134

Bank 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, 132 Bank of Japan 137, 138, 143 Bank of Scotland 144 Barclays Bank 8, 36, 101 Barings Bank 13, 15, 18, 19, 72, 73, 74, 75, 78, 79, 83 Barnes, Julian 47 Black Wednesday 45 Blair, Tony 21, 58, 82, 92, 93, 94, 95, 111, 112, 120, 121, 122, 123, 124, 125, 126, 130, 133, 135 Boesky, Ivan 10 Brandt, Chancellor Willy 2 Bretton Woods 1, 2, 3, 4 Bridgestone 142 British Airways 111, 114, 117 British Petroleum 128 British Steel 126, 127 British Telecom 105, 107, 109 Brittan, Sir Samuel 5, 16, 116 Brittan, Sir Leon 5 Brown, Gordon 120, 125 Buffet, Warren 11, 140 Bundesbank 3, 6, 24, 25, 32, 35, 38, 42, 69, 112, 139

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

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

See also Federal Reserve Bank 2, 13, 26, 134, 136, 140, 143 142 5, 16, 35, 36, 50, 67, 79, 116 x, 41, 73, 99, 142 133 100 vii 147

Cable & Wireless Calvet, Jacques Canary Wharf CBI Cedarbaum, Miriam

Fed, the. Federal Reserve Bank Federal-Mogul 105, 107, 109 Financial Times 99 Ford 7, 10 Fore Systems 62, 126, 134 Forte Hotels 114 Fratianni, Michele

The Pound Sterling Chronicles
Friedman, Benjamin FTC FTSE ix 139 122, 124, 126, 129

Maastricht Treaty 14, 23, 24, 32, 35, 44, 65, 68, 71, 91, 108, 113 Mad Cow Disease 103, 104, 107, 109 Major, 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 128 McAllister, Ian 41 Mercury Asset Management 100, 124 Mercury Communications 105 Merrill Lynch 13, 124 Michael Heseltine 56, 68, 71, 99, 112 Microsoft 139 Milken, Michael 10 Mitterrand, Francois viii Molyneaux, James 68, 71 Morgan Grenfell 78, 83, 118 Murdoch, Rupert 128

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

Hambros Honda Howe, Geoffrey HSBC 118 99 45 101

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

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

Jennings, Mr. John Juppé, Alain 90 92

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

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

Lamont, Norman 7, 8, 11, 28, 30, 31, 37, 41, 44, 47, 50, 52, 59, 62, 65 Lamothe, Lee ix Lawson, Nigel 5, 6, 32, 101 18 Leeson, Nick 46, 47, 78, 79, 94, 101 Lloyds London Stock Exchange 66, 94, 101, 144 LSE. See London Stock Exchange

P.S.B.R.. See Public Sector Borrowing Requirement Pattison, Dr John ix 134 Perry, Colin PeugeotCitroen 99 44 Polly Peck International Portillo, Michael 58, 89 PSBR. See Public Sector Borrowing Requirement


Public Sector Borrowing Requirement 28, 30, 36, 49, 64, 65, 95 Soros, George v, viii, 7, 8, 10, 11, 12, 19, 121 Stena Line 117 Swiss Bank Corporation 76, 78, 83

Quinton, Sir John 8, 36

Tebbitt, Norman Thatcher, Margaret 44 5, 6, 16, 17, 42, 44, 45, 96, 103, 104, 112, 115, 127 Tihomir Mikulic 16 Toyota 73, 99, 145 TSB Retail & savings Bank 94, 101

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

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

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

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

Waigel, Theo Y2K Young, Peter 91 126, 131 118



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