Fresh challenge to UK over single currency opt-out

Countries that do not join the single currency will be expected to join the revamped Exchange Rate Mechanism, according to the European Monetary Institute. Its insistence on ERM membership for non-participants could prove controversial in the UK if it opts to remain outside when the decision is taken early next year.

In a strongly worded annual report, the forerunner of the European Central Bank also said countries that relied on one-off gimmicks to get their budget deficit below the 3 per cent of GDP ceiling would not qualify to join. The report meant the single currency was more likely to consist of a core group of countries excluding Italy, according to financial analysts.

"This says no to Italy without directly spelling it out," said Alison Cottrell at Paine Webber.

Richard Reid, chief economist at UBS, said: "It was a surprise the report was not terribly supportive of a broad monetary union. This is the EMI putting a down-payment on its future credibility."

Italian hopes were dealt a separate blow by the OECD's annual report on the economy, which said it would not hit the 3 per cent deficit target even with the one-off measures introduced in the last budget.

The EMI will report jointly with the European Commission a year from now on which countries satisfy the Maastricht criteria for membership of the single currency. The Commission's forecasts for 1997, due to be published next week, are expected not to play up the prospects for broad membership of the single currency.

The two will nevertheless have to reach agreement by next spring, and economists saw yesterday's report on developments in 1996 as a bid to temper the Commission's political priorities with economic realities.

The EMI said the new ERM mechanism would govern relations between the "ins" and the "outs". "Membership would be voluntary; nevertheless, EU member states with a derogation can be expected to join the mechanism," it said.

Ms Cottrell said: "These words were chosen carefully to be as strong as possible. It is presumed that countries will join."

Previously the EMI has insisted that countries would have to be ERM members before qualifying to join EMU, a somewhat less stringent demand. The new presumption would be difficult for the UK to swallow, especially if the Conservatives were re-elected.

British officials said the tone was not unduly alarming. The UK has always seen the Maastricht Treaty's insistence on ERM membership as a matter for political negotiation.

But economists said the pound's surge during the past six months had reinforced the EMI's position. "It would be perfectly reasonable to demand a period of stability in the exchange rate for the pound," said Graham Bishop, an adviser on European financial affairs at investment bank Salomons.

The EMI also said many countries' efforts to reduce government budget deficits in order to meet the criteria for membership of the single currency had been unsatisfactory. "Sustainable convergence can not be achieved by one-off and accounting measures," said Alexandre Lamfalussy, EMI chairman, in his foreword.

The report picked out Denmark, France, Italy and Portugal for special criticism, as the ratio of government spending to GDP in those countries has continued to rise.

But it said only three - Ireland, the Netherlands and UK - had simultaneously reduced spending, taxes and government borrowing.

The OECD predicted that Italy's budget deficit would fall sharply from last year's 6.8 per cent, but at 3.6 per cent this year would still exceed the Maastricht limit for membership of EMU in the first wave.