«ECONOMIC PAPERS ISSN 1725-3187 N° 191 September 2003 Exchange rates are a matter of common concern: ...»
DIRECTORATE-GENERAL FOR ECONOMIC
AND FINANCIAL AFFAIRS
N° 191 September 2003 Exchange rates are a matter of common concern: policies in the run-up to the euro?
by Zenon Kontolemis* Directorate-General for Economic and Financial Affairs Economic Papers are written by the Staff of the Directorate-General for Economic and Financial Affairs, or by experts working in association with them. The "Papers" are intended to increase awareness of the technical work being done by the staff and to seek comments and suggestions for further analyses. Views expressed represent exclusively the positions of the author and do not necessarily correspond to those of the European Commission.
Comments and enquiries should be addressed to the:
European Commission Directorate-General for Economic and Financial Affairs Publications BU1 - -1/180 B - 1049 Brussels, Belgium *Author’s Email: Zenon.Kontolemis@cec.eu.int.
The author acknowledges useful comments from participants at the CEPR-Deutsche Bank conference on “Managed Floating-An Alternative to the Two Corner Solutions?”, particularly Richard Portes, as well as by Mike Artis, Johan Baras, Denis Redonnet, Luis Fau, Peter Grasmann, Martin Hallet, Alexander Italianer, Filip Keereman, Philip Sachinides, Werner Schuele, Siegfried Steinlein, Jan in’t Veld, Max Watson, and research assistance by Martin Alewijnse. The views in this paper are those of the author and not reflect the views of the European Commission.
ISBN 92-894-6195-0 KC-AI-03-012-EN-C ECFIN/357/03-EN This paper only exists in English.
©European Communities, 2003 Abstract This paper discusses the reasoning behind the exchange rate policies set out in the Maastricht Treaty of the European Union. The question of the appropriate exchange rate policies for new member states of the EU should be seen from the wider perspective of Economic and Monetary Union, and the creation of a single market. Four basic arguments are made in defence of the current exchange rate framework: (i) it is argued that exchange rate stability, per se, may be desirable if that is seen from the broader perspective of European integration, (ii) exchange rate stability is vital for countries attempting to lock permanently their exchange rate vis-à-vis the euro at a given parity, (iii) exchange rate stability prevents unilateral changes in the exchange rate that may delay partner countries’ convergence relative to the Maastricht criteria, and finally (iv) a period of “internship” inside the Exchange Rate Mechanism ensures that countries begin adjusting their behaviour/policies to the requirements of a common currency area.
A necessary condition for stability inside the ERM II is that countries maintain prudent, particularly fiscal, policies and proceed with structural reforms that enhance the flexibility of the economy. The analysis is a one-sided defence of limited exchange rate flexibility under the “current circumstances”: i.e., the process of convergence in terms of the Maastricht criteria and the final adoption of the euro.
Introduction Economic policy coordination lies at the heart of monetary unification in the European Union. Monetary union itself is considered a cornerstone to the more ambitious project, namely that of the creation of a common market in Europe. The establishment of a common market for goods and services within Europe must therefore be seen as the ultimate objective, and in this context free trade for goods and services, the adoption of a single currency, and enhanced policy coordination, are merely the foundations for achieving the ultimate, grand goal.
At the core of policy coordination in the EU is the Exchange Rate Mechanism, which sets out the formal framework for coordination of exchange rate policies. The ERM was formed in 1979 as an attempt to create a zone of exchange rate stability and enhanced policy coordination, which would prove essential prior to the introduction of a single currency in Europe. The ERM went through different phases since 1979, and the ERM II was set up in the 1990s in the run-up to the introduction of the euro to cope with the convergence of countries that did not (yet) join the euro area. The basic difference between the original system and the ERM II is that the latter is centered around the euro, rather than the ECU, while the official fluctuation bands are also considerably wider (see Box 1).
In addition to enhancing exchange rate stability in Europe, the ERM served an another valuable role during the high inflation years throughout the 1980s by providing a nominal anchor for countries and thereby strengthening their disinflation efforts. Overall, it is fair to say that the system was successful, especially after the turbulent first years after its inception, in pinning down inflationary expectations and creating a zone of exchange rate stability. Views of course differ and the topic has been extensively debated (see Giavazzi and Giovannini, 1989, and De Grauwe and Papademos, 1990, and references therein.) After the dramatic exit of the United Kingdom from the ERM in 1992—and the shift in
-5many countries to inflation targeting regimes,—and as a result of receding inflationary pressures in most ERM countries, the focus shifted toward more exchange rate flexibility (for a post-1992 discussion see Artis and Lewis, 1993, for example.) This is to be explained, to some extent, by the fact that inflation rates had come down considerably, thus providing room for exchange rates to adjust prior to the commencement of the third stage of EMU. The ERM II was seen as providing room for more flexibility, while at the same time continuing to shield countries from myopic exchange rate policies and, more importantly, large swings in exchange rates driven by speculative flows.
The current position of the EU is that participation in the ERM II “…will help to ensure that Member States that are outside the euro-area participating in the mechanism orient their policies to stability, foster convergence and thereby help them in the their efforts to adopt the euro…” More importantly, the Council’s decision of June 1997, on the establishment of the Exchange Rate Mechanism (ERM) in the third stage of EMU, states that “the single market must not be endangered by real exchange rate misalignments, or by excessive nominal exchange-rate fluctuations…” Exchange rate stability is therefore seen as important both in terms of achieving, and facilitating, a single European market, but is also regarded as an important test for participation in the euro zone. Countries must learn to live in an environment of exchange rate discipline and refrain from pursuing “beggar-thy-neighbour” policies that can slow down other countries’ convergence, and hence delay adoption of the euro. The Treaty states explicitly that “Member states shall regard their economic policies as a matter of common concern and shall coordinate them within the Council…” (Article 99 EC Treaty).
Implicit in these statements is also the opinion that sizeable changes in the value of the exchange rate of one country that are not supported by economic fundamentals (i.e., the emergence of speculative bubbles) are likely, and should be prevented in the run-up to the adoption of the euro. Hence, the ERM II can be thought of as an insurance policy for European Council, 16 June 1997.
-6countries wishing to join the euro zone at a desirable exchange rate parity. It is argued that participation in the ERM II may provide considerable exchange rate stability, especially given the provision for unlimited intervention at the margin by the ECB and the country in question.
In this paper we review the rationale behind the requirement that countries should participate in the ERM II for a period of, at least, two years prior to them adopting the euro. The analysis focuses on the 10 new members of the EU only, purely as the case for these countries joining the ERM II will become more pressing soon. We ask whether exchange rate stability, per se, is good and whether the participation in the exchange rate system should instead be seen as a learning period before the irrevocable fixing of exchange rates, and/or as a protection shield against irrational bubbles and speculative attacks. We also show that exchange rate flexibility, and in particular unilateral exchange rate actions by a country, or a group of countries, may interfere with other countries’ chances of meeting the Maastricht criteria. Needless to say that the ERM II is only a small, albeit important component, of the much broader policy coordination apparatus of the EU and it should also be interpreted along these lines.
Although we recognize that there are risks when adopting a fixed exchange rate we consider that these risks have diminished considerably, particularly as has become clear that these countries’ ultimate goal is the adoption of the euro. We further argue that these countries have also been exposed to sizeable capital flows during their recent histories, and have coped relatively well in terms of their policies. In addition, recent institutional changes (e.g., the establishment of independent central banks, the commitment to sound fiscal policies in the context of EU fiscal policy coordination) should also contribute to more macroeconomic stability and hence contribute to exchange rate stability inside the ERM II.
Needless to say that the success of this strategy rests on the commitment by countries to maintain prudent policies, and carry on with their structural reform programs. But it should also be noted that “participation in ERM-II should help achieve real and nominal
-7convergence, and should not be seen as a mere waiting room for the adoption of the euro” (Economic and Financial Committee, 2003). However, once it is deemed that enough progress has been achieved with regard to macroeconomic policies—particular fiscal consolidation—and structural reforms, participation in the ERM II will serve as a vehicle for preparing, and a criterion for readiness, for the adoption of the euro. Experience suggests that under such conditions exchange rate variability could decline significantly, facilitating greatly the adoption of the euro. Hence, participation in ERM II should not be considered as an ad hoc test for exchange rate stability, but instead should be seen as an opportunity to achieve meaningful macroeconomic, and policy, convergence prior to the adoption of the euro, prepare for the single monetary policy framework, and create conditions that are conducive to trade creation and growth inside the European Union.
(Statement by European Council, November 2000, See European Commission, 2001)
• Prior to accession, there are no formal restrictions on the choice of an exchange rate regime, with the exception of euroisation, which is explicitly prohibited.
• Upon accession, new Member states shall treat their exchange rate policy as a matter of common concern.
• After accession, although not necessarily immediately, accession countries are expected to join the ERM II.
Key Features of the ERM II
• Stable but adjustable central rates to the euro.
• Fluctuation bands of ±15 percent around central rate, although on a case-by-case basis, formally agreed fluctuation bands narrower than the standard one and backed up by official intervention and financing, may be set up.
• A new Member State may join ERM II, upon request, at any time after accession, subject to the agreement on the central parity and size of fluctuation bands.
• However, the ECB may decide to suspend interventions if it is deemed that these actions interfere with the primary objective of price stability.
Adoption of the Euro
• “The criterion on participation in the exchange rate mechanism …shall mean that a Member State has respected the normal fluctuation margins provided for the by the European Monetary System without severe tensions for at least the last two years before the examination.”