| Parliamentary Assembly Assembl�e parlementaire |
 |
The euro and the Greater Europe
Doc. 10188
26 May 2004
Report
Committee on Economic Affairs and Development
Rapporteur: Mr Robert Walter, United Kingdom, European Democrat Group
Summary
The present report is the Assembly’s third in commenting on the European Union’s Economic and Monetary Union (EMU) and the latter’s implications for the wider Europe. It forms part of the Assembly’s duty, in the words of its Recommendation 1195 (1992) [to] “enhance a constructive co-operation between member states of the European Community and the rest of Europe”.
The first five years of the euro have yielded many trade and investment benefits, as well as greater price transparency, but have also witnessed sluggish growth of major EMU countries and difficulties for them to adhere to the terms of a Stability and Growth Pact whose functioning and practical application the report sees as being susceptible to improvement. The report highlights the considerable work undertaken by the ten new European Union members to prepare for eurozone membership and calls on present EMU members to show corresponding understanding in facilitating their early entry, even as each request will have to be judged on its own merits.
The recently stronger euro may limit exports but will also reduce inflation and hence in time permit an even more accommodating monetary stance by the European Central Bank that can make for higher economic growth. However, the report warns, without determined structural reform in many slower-growing EMU countries, growth risks being short-lived and below potential even under the most benign circumstances. This would be a pity, it concludes, since “everybody has an interest in a eurozone of strong and lasting growth” which would be seen as a “sign of soundness of the project and the best way to make the entire EU membership join”.
I. Draft resolution [Link to the adopted text]
1. As the euro concludes its first five years of serving as the single currency for twelve of the European Union’s fifteen member states and as the EU has successfully completed its enlargement from fifteen to twenty five member states, the Parliamentary Assembly of the 45-member state Council of Europe recalls its earlier statements on the Economic and Monetary Union (EMU), in particular Recommendation 1195 (1992) and Resolution 1109 (1997), and reaffirms its duty, in the words of the former, to “enhance a constructive co-operation between members states of the European Community and the rest of Europe”.
2. The first five years of the euro have seen considerably increased price transparency and greater integration of financial markets. Meanwhile, however, sluggish growth over several years in the major EMU economies is a source of concern.
3. The Assembly welcomes the considerable preparations by the new EU member states to join the eurozone at the earliest opportunity and hopes that every effort will be made by the existing EMU members to facilitate this process, in the interest of European solidarity and continued economic integration and growth.
4. The procedure of joining the EMU promises, however, to be anything but easy, especially for the new EU members, placing great strain on their currency stability and public finances. It is therefore vital that the terms for joining the EMU be made sufficiently flexible, for instance by having the permitted range of fluctuation in the Exchange Rate Mechanism II(ERM-II) – meant to “lock” the joining currency to the euro - be the wider range used at the currency’s launch in 1999.
5. The Assembly expresses its concern over the problems encountered by France, Germany, Greece, Italy, the Netherlands and Portugal with the provisions of the Stability and Growth Pact and fears that, unless speedily addressed, any violations will lead not only to diminished confidence in the currency but also to reduced prospects of seeing the three pre-existing EU members Denmark, Sweden and the United Kingdom join the EMU at an early date, and to complications for the joining by the ten countries that became members of the EU in 2004. These tensions are inherent in a Pact that relies solely on contemporary data, and fails to assess member states' compliance over a full economic cycle. As long as the Pact exists in its current form, it should be respected. However, urgent thought must be given to ways of improving the Pact, both to make it better heeded and to improve its functioning.
6. The pronounced strengthening of the euro vis-�-vis the dollar poses a particular challenge, as it threatens to weaken the emerging recovery in the major EMU economies by reducing exports to the US and to other countries whose currencies have weakened along with it. It would be reasonable to expect those other countries – especially Japan and China – to share with the euro the burden of appreciation vis-�-vis the dollar.
7. The euro’s strength will, on the one hand, further dampen eurozone inflation and so permit an earlier easing of monetary conditions by the European Central Bank than would otherwise have been possible. In the meantime, EMU countries must do their utmost to revive domestic demand on the part of consumers and industry, by pursuing structural reform in all areas, in consideration of the fact that remaining market imperfections add to inflation and hamper economic activity. This includes completing the EU’s Internal Market, whose provisions some EMU members have been particularly slow in implementing.
8. The Assembly, in conclusion, stresses the importance of (1) ensuring observance of the Stability and Growth Act, (2) reviving economic activity in the eurozone through structural reform and (3) facilitating for new EU members to join the EMU as rapidly as possible. If these measures succeed, the euro can fulfil the mission for which it was created, namely to permit the European Union to play a political role in the world commensurate with its other achievements.
II. Explanatory Memorandum by Mr Walter, Rapporteur
Contents
I. Introduction and background
III. Advantages and potential disadvantages of the euro
Advantages
Potential disadvantages or risks
IV. Preparing for EMU enlargement
The three ‘pre-existing’ EU members which do not form part of the EMU
The ten new EU member countries, following the 2004 enlargement
V. The interesting case of Lithuania
I. Introduction and background
1. The present report on “The euro and the Greater Europe” is the fourth dealing with this subject prepared by the Committee on Economic Affairs and Development for the attention of the Parliamentary Assembly of the Council of Europe.
2. It is only natural that the Assembly with its 45 member parliaments should take up a subject of such paramount importance for the future, not only of the European Union, but of the whole of the continent. Already in its Recommendation 1195 (1992) on “European Economic and Monetary Union”, the Assembly noted that the EMU would “greatly affect all other countries in Europe and beyond” and pointed to the Assembly’s duty to “enhance a constructive co-operation between the member states of the European Community and the rest of Europe”.
3. Similarly, in its Resolution 1109 (1997) on “The implications for Europe of Economic and Monetary Union”, the Assembly considered that the EMU “should have as its goal to heal … the economic divisions in Europe”. Now the European Union has just successfully completed a major enlargement in 2004 with ten new countries joining – Cyprus, the Czech Republic, Estonia, Latvia, Lithuania, Hungary Poland, Malta, Slovakia, Slovenia - and three more countries - Bulgaria, Romania and Turkey – are preparing to join at a later stage, the Committee on Economic Affairs and Development of the Assembly considers it vital again to take up this topic, in conformity with the Assembly’s mandate to it as given in its Order No. 481 (1992).
4. The Rapporteur is grateful to his colleagues on the Committee on Economic Affairs and Development for the comments they gave in the course of his work. He is also greatly indebted to the European Central Bank in Frankfurt and to its President, Mr Jean-Claude Trichet, whom he visited in March 2004 for a highly interesting exchange of views. It is clear from this visit how deeply the ECB feels about its mission and about the importance of smooth monetary integration for our continent’s well-being, a sentiment fully shared by the Rapporteur.
5. The Treaty of Rome was ratified in 1958, establishing the European Economic Community (EEC). The objective of the EEC was to reduce trade barriers, re-organise economic policies, coordinate transportation and agriculture, remove barriers restricting free competition, as well as movement of labour and capital among Member States.
6. During this time, the monetary exchange rate between countries was guarded by the Bretton Woods system. Connecting currencies to the U.S. dollar, it allowed for only a one point fluctuation around designated values. This was referred to as the "pegged rate" and was largely based on the gold backing of the dollar. Helping to stabilize exchange rates and restore economic growth in the post-war period, the system worked well for some twenty years. By 1960, however, it began to flounder, and exchange-rate agreements became an important topic among European political and economic leaders.
7. Already in 1969, Luxembourg Prime Minister Pierre Werner was asked to write an EC (European Community) report covering the need for a complete monetary union among the European economies. The so-called Werner Report was published in 1970 and detailed the idea of a single European currency as part of a combined monetary effort. For the first time, the term Economic and Monetary Union (EMU) was used.
8. Although the plan seemed promising, it lost momentum with President Nixon's 1971 policy of "benign neglect", which put an end to U.S. backing (via its gold reserve) of the predefined exchange rates against the dollar, a decision which ultimately led to the collapse of the Bretton Woods system. Other foreign central banks also were not willing to support the dollar, which would have provided the equivalent of deposit insurance. These developments eventually led in 1979, to the creation of the European Monetary System (EMS), which locked exchange rates among the participating countries within predefined trading zones. This was known as the Exchange Rate Mechanism (ERM), a system which stabilized currencies by creating predictable trading zones.
9. The next step toward a unified European economy came with the 1986 Single European Act. This Act called for the systematic removal of barriers and restrictions affecting trade between European countries. As a result, border checks, tariffs, customs, labour restrictions and other hurdles to free trade were dismantled. (However, it must be remembered that the so called Internal Market is not yet completed, with some countries lagging behind, or even dropping further and further behind, in implementation.)
10. After many false starts, the process of creating the euro began in earnest in 1989, when the so-called Delors Report was published by European Union President Jacques Delors. This important paper outlined a three-stage transition plan to create a single European currency.
11. Stage one began on 1 July 1990, when all restrictions on the movement of capital between the EC Member States were in principle abolished. It also began the identification of issues that needed to be dealt with and the development of a working program to implement the upcoming changes. Stage two began on 1 January 1994, and was marked by the establishment of the European Monetary Institute (EMI), the precursor to the present European Central Bank (ECB). The EMI was responsible for coordinating the monetary policy and strengthening cooperation between EC central banks, as well as making preparations for the establishment of the European System of Central Banks (ESCB), a single monetary policy and a single currency.
12. In December 1995 at the European Council meeting in Madrid, EC leaders voted on the name "euro" for the single currency of the European Monetary Union.
13. Finally, on 1 January 1999, the euro became the currency of eleven European countries: Germany, Austria, Belgium, Spain, Finland, France, Italy, Ireland, Luxembourg, Netherlands and Portugal. During the European Council held in Portugal in June 2000, it was decided that Greece would join the EMU as from 2001. An event of immense historical proportion, strengthening the image of Europe and affirming its identity as a cohesive body, it gave a common currency to 290 million people living in the new ‘eurozone’. Although the EMU started in 1999, the euro over the next three years did not exist in physical form, but was expressed in the component national currencies whose value was fixed vis-�-vis each other and the euro. As from the beginning of 2002, euro notes and coins were introduced, replacing those of the component countries.
14. In March 2000, Europe’s leaders at the Lisbon European Council Summit committed themselves to a ten-year process of reform of Europe’s labour, capital and product markets. This ambitious commitment was inspired by the decade-long process of creating the EC-EU Internal Market (the so-called 1992 project).
III. Advantages and potential disadvantages of the euro
Advantages
15. Elimination of Exchange Rate Fluctuations: In the pre-euro days, any time consumers or businesses made a commitment to buying something in another EU member state for future delivery, they risked paying more, or less, than they had predicted due to currency fluctuations. The euro has eliminated this type of fluctuation of currency values across borders.
16. Price Transparency: Both consumers and businesses benefit from being able to see which country offers the best value for money (provided they will care to check). As a result, businesses have had to become more competitive.
17. Transaction Costs: Before conversion to the euro, people crossing borders within the EU had to exchange their money when entering a new country. These exchanges often added up to significant transaction costs which, with the launch of the euro, have of course disappeared.
18. Increased Trade across Borders: All of the above have contributed to increased trade amongst countries forming part of the ‘eurozone’.
19. Simplified Billing: Payments for services and products across borders have been simplified with the launch of the euro.
20. Expanding Markets for Business: Businesses can now expand into other EU Member States more easily, as they do not have to keep separate accounting systems or work through separate banks.
21. Financial Market Stability: Finally, financial and stock exchanges can now list every financial instrument and transaction in a single currency. This also promotes trade.
Potential disadvantages or risks
22. Economic Shock—Adjustment of Interest Rates: On a macro-economic level, fluctuations are no longer controllable by individual member states. Countries can no longer adjust their own interest rates in order to encourage investment or consumption. The interest rate for all of the ‘eurozone’ is now exclusively controlled by the European Central Bank.
23. Economic Shock—Adjustment of Exchange Rates: With the loss of exchange rate fluctuations for the individual EMU countries, member states can no longer overcome an economic downturn by devaluation of their (now extinct) individual currencies.
24. Economic Shock—Adjustment of Government Spending: Due to the Stability and Growth Pact, governments are restricted to keeping their budget deficits within the requirements of the Pact, limiting their freedom of spending in difficult times and thereby pulling their economies out of recession through Keynesian deficit spending. However, some bigger EMU countries finding themselves in near or actual recession or in difficult financial circumstances – such as Germany and France - have more recently indicated their desire to interpret the Stability and Growth Pact’s (SPG) restrictions more flexibly, by allowing their budget deficits to rise beyond the 3% of GDP upper limit allowed by it.
25. Insufficient labour mobility and fiscal transfers: Comparing the euro area with the criteria for an optimal currency area as defined in economic literature, it is generally recognised that the euro area still enjoys relatively low labour mobility and low price and wage flexibility, and that there is no fiscal transfer system on the level of that of the United States permitting countries in difficulties to receive more funds from the political centre.
IV. Preparing for EMU enlargement
The three ‘pre-existing’ EU members which do not form part of the EMU
26. The twelve EU member countries currently forming part of the eurozone are meant to be followed in due course by, firstly, the three ‘pre-existing’ EU member states not forming part of the EMU – Denmark, Sweden and the United Kingdom – and, secondly, by any and all countries joining the European Union, such as the ten countries that became members in 2004.
United Kingdom
27. The current situation as far as the first group of countries is that the United Kingdom, under the Labour government of Tony Blair, has indicated its intention to hold a referendum on whether or not to join the EMU, on condition that five economic tests outlined by Chancellor Gordon Brown in 1997 are met. In June 2003, the British government established that not all criteria were as yet satisfiedand therefore no decision to organise a referendum could be taken at this stage.A ‘road map’ for entry has, however, been promised, outlining policy initiatives. These include changing Bank of England inflation targets to a new Europe-wide measure which does not include mortgage interest rate costs, part of the government’s plan for encouraging British borrowers to switch from variable to fixed rate mortgages. These moves, it is hoped, will lead to further convergence between the UK and the eurozone by reducing some of the UK’s more unique sensitivities to inflation and interest rates.
Table 1: 5 Economic Tests for UK EMU Membership
|
Economic Test
|
Current Conclusion |
|
1. Is the British Economy converging with that of Euroland? |
X (though improving) |
|
2. Under EMU membership would the UK economy remain capable of responding flexibly to outside shocks? |
X |
|
3. Would EMU membership promote private investment? |
X |
|
4. Can it be demonstrated that EMU membership would assist financial services and especially the city of London? |
YES |
|
5. Would EMU membership promote employment? |
X |
28. Looking beyond the technicalities of British membership, it is interesting to consider attitudes towards the single currency within the UK, for example the attitude of British business. According to one survey1 only 40% of UK firms are currently in favour of the euro, down from 52% three years ago. Business organizations furthermore do not appreciate the uncertainty which they feel has been created by seeming government hesitation on the issue. Though ‘euro-sceptics’ argue that the decision to postpone EMU membership makes no difference and British business is currently performing well, euro supporters claim that the government’s position involves ‘opportunity costs’ which they say could add up to �120bn over the next two decades - or �100 for every Briton every year2. The country could, they maintain, face a risk of long term un-employment, as some large multi-nationals have warned that they only chose to invest in Britain on the assumption that it would eventually join the euro.
29. Opinion polls suggest there is little chance that the British electorate will vote to adopt the single currency in the near future. Aside from the long standing British concerns in relation to the EU over sovereignty, the strength of the British economy when compared to the low growth rates, hesitant recovery, slow reform process and breaches against the Stability and Growth Pact in Euroland look set to dissuade British voters, however passionately politicians may argue for the longer term gains which EMU membership would supposedly bring.
30. There have also been warnings that Britain could be left out in the cold if it does not merge its currency with Euroland, and that the British will miss out on being included in key decisions by the European Union, particularly after enlargement. The euro’s supporters say the EU needs economic reform - and that the UK must be a euro member in order to influence that reform so that it best suits British interests. Yet there are many who argue that it is possible to be pro-EU and have an influential voice within the Union, and yet be against euro membership.
Sweden
31. In September 2003 Sweden was the second country to vote on whether to join the EMU since its introduction. Membership was rejected by a vote of 56% to 42% (on an 81% turnout) in a referendum marred by the tragic assassination Foreign Minister Anna Lindh a few days before.
32. Like the British, the Swedish electorate seemed to believe that signing up for the single currency would do their robust economy more harm than good, and that a loss of sovereignty was more important than any alleged loss of influence within the EU. Klaus Eklund, chief economist with the SEB bank summed up the situation rather well when he said: “We on the yes side did not convince people that the long-term growth benefits of increasing trade outweigh the increased risk of having a one-size fit all monetary policy. “ The European Commission seemed to agree when it issued a statement saying the world's second currency was still young, and that its benefits were not yet clear to all quarters in the European Union. Campaign strategists are now reported to mull over the thought that perhaps the only way to win a referendum is first to lose one, following which you might be able to show sceptics that you lose by staying out.
33. Swedish business leaders were unhappy with the result, with some threatening to demand compensation from the government for the income lost as a result of staying outside the eurozone. However, most economists believe that the impact on the economy will be minimal. US trade is still more important than with the EMU area and four of the five most important trading partners for Sweden are outside the eurozone (the US, Great Britain, Norway and Denmark). The ‘no’ vote may mean a slightly higher interest rate, even though that has not yet come true, as the Swedish crown has since firmed against the euro even after the latter’s strengthening against the dollar.3. The previously mentioned Klaus Eklund of SEB, said that "the long-term impact [of voting against the euro] will depend on what kind of long-term growth policies we adopt, because we will lose the push from an increase in trade,"
34. How important is the Swedish vote for the rest of Europe? The British government claims that it will have little impact on opinion in their country, but it is hard to argue that it will be a boost to an already sceptical public (as discussed above). The effect may be felt more strongly in other smaller European states, which are already uneasy with both the proposed European Draft Constitution and the flouting of the rules of the Stability and Growth Pact by larger states. The wider lesson to be taken from the Swedish result is in the way in which the EU conducts its business. There is a certain ‘disconnect’ between large parts of the political and business elites and the people, who still feel disconnected from the projects. The message from Sweden is that the EU in general, and the EMU in particular, are still having problems explaining themselves.
Denmark
35. Denmark in September 2001 organised a referendum in which a majority of voters rejected EMU membership.The Danish Krone still, however, closely shadows the euro within a +/- 2.25range. Opinion polls suggest that support in Denmark for the euro was shared by a majority before the Swedish vote. It will be interesting to see the impact on Danish feelings of the Swedish result, as well as of the current debates over the Stability and Growth Pact and the new European Constitution.
The ten new EU member countries, following the 2004 enlargement
36. Turning now to the second group of countries, that is, the ten countries that joined in 2004 and those to follow - they do not, unlike Denmark and the United Kingdom, have an ‘opt out’ clause providing for them to remain outside the EMU4.The question for this group of countries is therefore not whether they will join, but when.
37. It is of great help in the preparation for accession to the EMU that the trade of the ten new EU member countries in the ‘first wave’ in 2004 is now so intense with the EMU area (as well, of course, with the whole of European Union and with the countries of European Free Trade Association). Furthermore, there are few remaining restrictions on capital flows between the two regions. This also means that monetary and exchange rate policies within the EMU area have a direct impact on the economies of the new member countries. Moreover, many of them show impressive economic growth, in the vicinity of 5 per cent or more annually, while other countries in the region are not far behind.
38. Following the launch of the euro in 1999, there has been a clear acceleration of the economic and institutional unification of the European continent. Most of the ten new EU member countries and the remaining candidate countries have outwardly expressed confidence in the euro through a substantial increase in financial, economic and institutional links with the European Union. The euro is in fact rapidly becoming the currency of choice for these countries, to levels historically superseding those enjoyed by the D-Mark at the time, which currency traditionally performed this role - especially in many of the Eastern European countries. (The euro is already the official currency in Montenegro, though not in Serbia, the other part of Serbia and Montenegro.)
39. Financial links between the euro area and the new member and remaining candidate countries have also grown substantially. Euro-denominated bank deposits, whilst still small compared with the euro area itself, are rising and they are significant for the countries concerned. Countries with a sizable share of euro-denominated deposits are more likely to cooperate with financial operators abroad, as this fraction of deposits can be re-invested more easily, especially in the euro area. Furthermore, the more customers that become used to the euro, the greater the incentive for banks to offer euro-denominated services and to take part in larger regional networks that encourage cross-border financial services.
40. The cash changeover has also facilitated the orientation of exchange rate regimes in eastern Europe towards the euro. Thus, Bulgaria, Estonia and Lithuania have already shown their trust in the euro by fully backing the value of their domestic currency with an equivalent amount of euros under a currency board regime. In the case of Croatia, Romania, Slovakia and Slovenia, the exchange rate arrangement chosen consists in a ‘managed float’ with the euro as the major reference currency. This orientation of exchange rate regimes to the euro is rooted in the new economic and trade relations — already in the late 1990s foreign direct investment from euro-area countries approached 70% in this region. Such relations are now increasingly supported institutionally, as many central and eastern European countries are hoping to join the EMU at an early date.
41. No doubt the EMU will be subjected to certain strains as these countries join, but one should not overlook the dynamic effects of having a larger single currency area stretching increasingly into Central and Eastern Europe.
42. The ECB during the Rapporteur’s visit was at pains to point out that the euro should not be seen in any way as a rival or competitor to the dollar. Both currencies, together with the many others in existence, all have complementary roles in assisting world economic development. This being said, use of the euro is spreading in many parts of central, eastern and south-eastern Europe, including Russia. This is due in part to increasing trade links with the EU and the eurozone. For example, Russia’s trade with the EU today stands at close to 40% of its total external trade, while the percentage is expected to rise to over 50% following the May 2004 enlargement. The same holds for most countries in south-eastern Europe, while CIS countries in central Asia are still more dollar-oriented, not least due to their exports of oil and gas denominated in that currency.
43. In 2000, the finance ministers of the European Union told countries seeking EU membership not to adopt the euro unilaterally but instead to comply with the EU’s treaty conditions for joining the EMU. The ECOFIN Council said that candidate countries would not be able to join the euro immediately after accession to the EU, but that “euro-isation” will have to respect the conditions laid out in the Maastricht Treaty on European Union. Finally, the Stability and Growth Pact will continue to apply to all EMU countries, whether present or future.
44. All the new EU member countries are expected to adopt the euro after meeting the various convergence criteria, which also include participating during at least two years in the so-called ERM II (Exchange Rate Mechanism). The ERM II is still considered to serve its purpose, even after the considerable widening of the permitted fluctuation range introduced in the 1990s. As to the timing of joining the EMU following the 2004 enlargement, the earliest possible date for the new members will, from a technical viewpoint, be 2007.
45. Each country’s joining the euro will be examined on its own merits. The exchange rate policies of the new EU members will become ‘a matter of common interest’ as between EU members. The new member states will participate in EU-wide economic policy coordination and are expected to make further progress toward nominal and real convergence. The European Commission in May 2004 issued a report on the budgetary situation in those six among its new EU member states which in 2003 showed a budgetary deficit exceeding the so-called ‘Maastricht limit’ of 3 per cent of GDP. They are: the Czech Republic, Cyprus, Hungary, Malta, Poland and the SlovakRepublic. The situation varied widely between the countries in question, from 3.6 per cent in the SlovakRepublic to 12.9 per cent in the CzechRepublic. All the six countries are expected to remain above 3 per cent also in 2004. In none of the six cases, said the Commission, could the excessive deficit be explained by a serious economic downturn or an extraordinary event – the two exceptional grounds mentioned in the Stability and Growth Pact. However, the Commission in its report showed a degree of flexibility, in recognizing that the fact of joining the EU could require an adaptation of the deficit over several years due to the “special circumstances” connected with the membership.
46. A so-called “Policy Position of the Governing Council of the European Central Bank on Exchange Rate Issues Relating to the acceding countries”, published in December 2003, is set out in the Appendix to this report. The ‘policy position’ merits careful scrutiny, since it is clear that every step taken by each country toward EMU membership will be scrutinised, and the EU and the ECB will be highly prudent as they guide each EMU candidate toward this goal. This pragmatic policy is rendered necessary by the high stakes involved for the economic and monetary well-being of both the acceding country and the EMU area as a whole.
47. Thus, for example, it is not enough for a country simply to have participated in ERM II for the minimum two years, or for that matter to have pegged its currency to the euro via a currency board for a given time. Additional requirements include demonstrated fiscal responsibility, a well-functioning banking system and public institutions, good governance, reliable statistics and the like, not to mention the so-called Maastricht convergence criteria as they relate to such things as inflation, interest rates, public deficits and debt levels.
48. Members of the Economic Committee of our Assembly seemed to agree on the need for the new EU members to ‘hurry slowly’ toward EMU membership. However, they also stressed that scrutiny by the present EMU countries of the EMU candidates should not be any stricter than was the case when they themselves joined, or more severe than it is now as regards their respect for the Stability and Growth Pact.
49. Against this background it is impossible to say with any certainty when individual new EU members might join EMU. Immediately following their accession in May 2004, Estonia and Lithuania stated their intention to join ERM II already in August 2004, with Slovenia and Cyprus hoping to do the same before the end of the year. Latvia and Malta are likely to follow suit shortly thereafter, while the Czech Republic, Poland and Hungary may wait somewhat longer in order first to reduce their budget deficits.
50. Several members of the Economic Committee coming from the new EU member countries asked why these should be subjected to such critical scrutiny when current EMU members seem to get away with so many deviations from EMU orthodoxy. This, they felt, is demoralising to the new EU member states. These colleagues were joined by Committee members from some smaller current EMU members who felt that the EMU Stability and Growth Pact should under no circumstances be changed just to accommodate the ‘sinners’ amongst some of the larger current EMU members.
51. A meeting of the finance ministers of the ten new EU members held in Bratislava in March 2004 could not agree on whether the Stability and Growth Pact needed modification or not, but said in a communiqu� that any change should at any rate not lead to any weakening of budgetary discipline among present and future EMU members, and that all should be subjected to the same rules of scrutiny as regards observance of EMU principles.
52. Table 2 below shows that only Lithuania at present meets all four criteria laid out at Maastricht for convergence with the eurozone, while Estonia and Latvia meet all but one.
Table 2. The new EU member states and the Maastricht Convergence Criteria
|
|
Inflation rate (%) |
Long-term interest rate (%) |
Fiscal balance (% of GDP) |
General debt (% of GDP) |
|||
|
|
2001 |
2002 |
Early 2003 |
2001 |
2002 |
2001 |
2002 |
|
Convergence criteria (EU-12) |
<3.5 |
<3 |
<7.1 |
>-3 |
>-3 |
<60 |
<60 |
|
Cyprus |
2.0 |
2.8 |
n/a |
n/a |
n/a |
n/a |
61.1 |
|
CzechRepublic |
4.5 |
1.4 |
4.8 |
-5.2 |
-9.3 |
23.7 |
34.7 |
|
Estonia |
5.6 |
3.6 |
4.4 |
0.4 |
-1.0 |
4.8 |
3.3 |
|
Hungary |
9.1 |
5.2 |
7.8 |
-4.7 |
-6.0 |
53.1 |
61.9 |
|
Latvia |
2.5 |
2.0 |
9.3 |
-1.9 |
-2.5 |
16.0 |
22.0 |
|
Lithuania |
1.3 |
0.4 |
6.4 |
-1.9 |
-1.4 |
23.1 |
23.0 |
|
Malta |
2.5 |
2.2 |
n/a |
n/a |
n/a |
65.7 |
70.0 |
|
Poland |
5.3 |
1.9 |
7.7 |
-6.0 |
-5.0 |
38.7 |
44.8 |
|
SlovakRepublic |
7.0 |
3.3 |
7.4 |
-3.9 |
-4.5 |
44.1 |
46.4 |
|
Slovenia |
8.6 |
7.5 |
11.1 |
-1.2 |
-2.9 |
27.5 |
27.3 |
|
Bulgaria |
7.4 |
5.8 |
6.4 |
-0.9 |
-0.8 |
66.3 |
45.3 |
|
Romania |
34.5 |
22.5 |
29.7 |
-3.5 |
-3.0 |
23.3 |
22.8 |
|
Turkey |
57.6 |
32.2 |
n/a |
-28.4 |
n/a |
103.0 |
82.8 |
Note 1: Shaded figures indicate convergence criteria not met.
Note 2: Some figures are only provisional / preliminary estimates.
Note 3: Inflation rate is measured as the annual rate of change in Harmonized Indices of Consumer Prices (HICPs). Figures for Malta and Turkey are not yet HICP.
Note 4: The long-term interest rate is generally that on 10-year government bonds. Shorter maturities have, however, been used for Bulgaria, Estonia, Latvia, Lithuania, Romania, the SlovakRepublic, and Slovenia.
Sources: Inflation rate and General debt – Eurostat; Long-term interest rate - Center for Strategic and International Studies5; and Fiscal balance – EBRD for CEE countries and Enlargement Statistics for Cyprus, Malta and Turkey.
53. With regard to the fifth Maastricht convergence criterion - the prescribed minimum of two years in the so-called ERM II (Exchange Rate Mechanism) - several policymakers and academics6 see this regime as an outdated framework which could well trigger a currency crisis in countries preparing for EMU membership. They claim that the obligation to participate in ERM II after the dismantling of remaining capital controls when entering the EU could throw the new EU member countries into “an interim period [of] enhanced vulnerability before the safety of monetary union”. One of the problems is that the new members can anticipate large capital inflows as investors bet on their convergence with the rest of Europe, which is likely to put upward pressures on the exchange rates of the currencies in question. The inflows might then also be reversed, bringing the exchange rate down again and causing wild fluctuations. Once within the ERM II, the new member countries could ask for assistance from the European Central Bank (ECB) in order to ward off speculative attacks and keep their exchange rates within the set fluctuation limits, but “without an institutional obligation for intra-marginal intervention, ERM II does not fully protect the currencies of ‘outs’ from currency crises”7.
54. In 2003 Mr. Pedro Solbes, the EU’s monetary affairs Commissioner, stated that, prior to joining EMU, the new EU members must keep their currencies within a narrow +/-2.25% band on either side of a central parity against the euro, rather than the wider, and more speculation-resistant, +/-15% range agreed after the old +/-2.5% regime collapsed in the early 1990s8 However, this raised the question why a narrower regime should be observed in respect of the countries seeking EMU membership than was the case for the current EMU-12 as they progressed toward EMU membership in the 1990s. What is good for the goose must surely be good for the gander.The Rapporteur was at any rate assured during his visit to the ECB that the ERM II that will apply to any of the new participants will employ the wider rather than the narrower band.
55. As has been mentioned, the exchange rate policies vary among the new EU members, with some opting to float their currency, others choosing currency boards, and others again observing wider or narrower fluctuation ranges vis-�-vis the euro. The ERM II also allows for some exchange rate flexibility, via the possibilities for exchange rate fluctuations that it offers.
56. New EU members using currency boards will in principle, based on a case-by-case assessment, be able to retain these arrangements as unilateral commitments supplementing ERM II participation. This assessment will extend to judging the appropriateness of the nominal exchange rate, which will have to be agreed mutually.
57. Further efforts to make the euro-area economies more flexible are desirable in order to minimise the risk of adverse effects in the event of asymmetric shocks. Increased capital mobility can be expected to create more diversified financial portfolios, which in turn may act as shock absorbers in any future crisis. Labour mobility and wage/price flexibility are also likely to change in response to increasing competition within the Internal Market. It is important to take a long-term view when judging the EMU, since its very workings can be expected to lead to improvements in areas now seen as preventing its advantages from fully coming to the fore.
58. Monetary policy in the EMU is, by definition, not able to address regional economic divergences or differences in inflationary pressure among participating countries. National economic policies and wage developments will have to adjust in order to correct for such differences.
59. Meanwhile, the European Union is preparing for a streamlining of the membership on the bodies of the European Central Bank (Governing Council and Executive Board). The reform in the inner functioning of the ECB’s decision-making bodies will enter into a force after more than three additional countries have joined the EMU9 A decision, now awaiting ratification by EU member states, has recently been taken to introduce a system of rotating membership and ‘weighted voting’ according to factors such as the size of a member country’s economy, its contribution to the resources of the ECB, and a sub-division into two – and with further enlargement eventually three - ‘groups’ of countries with a differing say in decisions.
V. The interesting case of Lithuania
60. The case of Lithuania is interesting, in that it has chosen the currency board option of a firm exchange rate, first in 1994 vis-�-vis the USD and, after a successful re-pegging in 2002, vis-�-vis the euro. This policy has apparently served the country well, when one considers its high growth rate, sizeable foreign reserves and low inflation. The economy has also remained surprisingly resilient and flexible in the recent context of global economic difficulties. Indeed, its macroeconomic condition has continued to improve.
61. Pegging to the euro reflects a reorientation of trade towards its new European Union co-members and the EMU area. The main objective of the Bank of Lithuania has been to maintain price stability. Reserve requirements are more than met. There is unrestricted exchange between the euro and the Litas, and the Central Bank offers lending facilities to commercial banks.
62. The fixed exchange rate regime has been accompanied by tight fiscal policies and openness to the world economy. The country is fully focussing on joining the EMU as soon as possible. The aim is to adhere to the ERM II very quickly and then to join the EMU after the required two years of ERM II membership.
63. The current Litas - euro exchange rate is felt to be appropriate also for the final ‘lock-in’. The country would prefer to have zero fluctuation around the ERM II central rate, well within the permitted fluctuation range. It fears that any change in the exchange rate from the one presently observed could have serious consequences. The Bank of Lithuania follows a pragmatic, prudent and reliable monetary and exchange rate policy, favouring a steady and lasting economic development. The country is not overly concerned about the impact of any so-called ‘asymmetric shocks’ that might befall parts of the EMU area. The economy is believed to be sufficiently diversified to likely withstand any such shock, as was indeed proved by all the Baltic countries after the 1989 Russian financial crisis.
64. It is possible to point to some tangible advantages since the introduction of the euro, as EMU member countries have used the convergence criteria to tackle debt levels, bring inflation under control. A similar discipline has been introduced for the new EU members. Some areas have seen greatly increased trade10
65. However, despite the euro’s remarkably smooth introduction, there are major economic challenges ahead for the currency.The first complication is that three major economies in the EMU area – Germany, France and Italy – have shown relatively slow growth in recent times. This is the case in particular for Euroland’s biggest economy, that of Germany, which has been in virtual stagnation for the last two years. Slowed export growth and diminished foreign direct investment, a result of dampened economic performance in the wider Europe, have all negatively impacted many of the countries with close ties to the European Union.
66. The OECD’s November 2003 growth forecasts for 2004 and 200511 imply an improvement for the eurozone economies – largely assisted by a pick-up in the United States and South-East Asia - which should spill over intothe EU area, including the new EU members, which greatly depend on their exports to the EU in general and the eurozone in particular. It must therefore be hoped that long overdue structural reform in the major EMU economies will now accelerate. The Rapporteur notes in this context the pension reform recently undertaken in France and the health insurance reform now under way in Germany.
67. The European Commission in April 2004 forecast eurozone growth of only 1.7% in 2004, compared with projections of 4.2% in the United States, 3.4% in Japan and around 7% in the rest of Asia. The European Commission blamed the slow growth on a lack of progress in reforming labour markets, pensions and health care systems in a number of especially major EMU countries. A rise in the price of oil, a stronger euro and the impact of the March 11 terrorist bombings in Madrid are also believed to weigh on economic growth in the euro area.
68. The slow growth in Germany is attributed to two additional factors, namely weak consumer demand and real interest rates higher by up to half a percentage point when compared with the rest of Euroland, and in particular when compared to countries with higher inflationary pressure such as Ireland or Spain. The higher real interest rate in Germany, it is argued, will affect investment in that country negatively. Given the importance of the German economy in the eurozone, concerns about German prospects must surely be worrying for the whole of the eurozone.
69. However, a major threat still hangs over the euro in the form of the successful challenge launched by France and Germany against a strict interpretation of the Stability and Growth Pact. The Pact was established to ensure fiscal responsibility amongst member countries by limiting their budget deficit to a maximum 3% under normal circumstances. The rules of the pact laid down that that if countries ran budget deficits above this level they would be obliged to take remedial action or face fines.
70. Though the basic premise of the pact was sound enough, the recent slow economic growth has revealed problems with the mechanism, which punishes countries when they were already in trouble, obliging them to raise taxes or cut spending when slow growth pushed their budgets into deficit. Having resisted such counter-cyclical medicine strongly, France and Germany gravely wounded the Stability and Growth Pact in November 2003, as they persuaded the finance ministers of the eurozone not to impose fines on them, despite heading for their third consecutive year of excessive budget deficits. In a compromise solution, they promised to cut their budgets in 2004 and 2005 (by 0.6% and 0.5% for Germany, 0.77% and 0.6% for France) in order to return to the 3% limit by 2006. However, they still maintain a ‘get out of jail free’ clause, and will not have to make these cuts if growth turns out to be unexpectedly low.
71. Having called for stronger action against budget violators, the European Commission was left angry and embarrassed by the actions of France and Germany, and has declared its intention to initiate a court case before the EU’s European Court of Justice, saying that the decision by the finance ministers has no legal basis. The European Central Bank is also unhappy with the weakening of the pact.
72. This decision by the finance ministers was not, however, unanimous, with Spain, Finland, Netherlands and Belgium all disapproving. These smaller countries are furious that - having taken tough and unpopular budget decisions themselves - the larger EMU players have been able to ignore the rules with impunity. No doubt this was a major factor leading to the collapse of the EU Summit in Brussels in December 2003 meant to agree on a new EU constitution, in that it poisoned the atmosphere amid a feeling that France and Germany obeyed different rules than the rest. Such divisions are a particular problem following the May 2004 enlargement of the Union. Grzegorz Kolodko, former Polish finance minister, put it: “There is a real problem now that, when you come up with plans to cut your deficit, people turn around and say:’ That is not what’s happening in Western Europe.’”12 Such political disunity is likely to harm the euro’s long term credibility, and the ECB has warned that fiscal indiscipline may eventually mean higher inflation and long-term interest rates.
73. In April 2004, the European Commission published forecasts for budget deficits in 2004 and 2005 indicating that no less than half the EMU membership – Germany, France, Italy, Greece, the Netherlands and Portugal – would go beyond the 3% budget deficit limit in 2004, with only Germany foreseen to come beneath it in 2005. The Commission also forecast budget deficits of 5% in 2004 and 4.2% in 2005 for the group of the ten new EU members (see Appendix 2). Even the United Kingdom in 2003 registered a budget deficit in breach of the Stability and Growth Pact - 3.2% - but this was forecast to be reduced to 2.8% in 2004. (The United Kingdom is bound by the Pact despite its not being an EMU member. However, the country is not subject to threat of sanctions).
74. Some see any ‘death’ of the pact as a blessing in disguise and an opportunity for reform. Robert Lind of ABN Amro may have expressed a widely held when he claimed: “The stability pact needed to be killed off. It should have been done years ago and it is only a shame that it has taken so long to get here. Europe needs self-sustaining domestic demand growth and, if it is not going to get that from lower ECB interest rates, the French and German governments have every right to resist a pro-cyclical fiscal policy”13. The system has been clearly shown to have been flawed, being originally set up to bring countries with a serious debt problem, (i.e. over 100% of GDP as was the case with Greece and Italy for example), under control, rather than to impose excessively restrictive, counter-cyclical constraints on countries with a basically healthy fiscal position.
75. The problem Europe is left with is that the finance ministers have killed off the pact without putting anything in its place, risking a budgetary free-for-all which could harm long term prospects for the single currency. The system clearly in the Rapporteur’s view needs reforming, even though he is aware that some members of the Economic Committee feel that no changing of the Pact should be undertaken just to please the ‘sinners’. Proposals for reform include:
-
excluding expenditure on infrastructure investment, research and even defence from the budget deficit calculation;
-
including in the Pact a ‘lasting economic stagnation’ as an added reason for exemption from the Pact’s provisions;
-
considering a below average inflation in a given EMU country as a mitigating factor for it to go beyond the budget deficit limit;
-
focussing less on the budget deficit and more on other factors such as the overall indebtedness of a country and its longer-term economic prospects (such as, for instance, an ageing population) and;
-
concentrating more on having governments save more in ‘fat’ years of strong growth, for use in ‘lean’ years (sometimes termed ‘symmetry’).
76. The most generally favoured combination of reforms seems to build on elements of the Golden Rule in use in the UK, (which distinguishes between general spending and investment, and aims to keep the budget balanced over the economic cycle)
77. If thoughtful reforms are instituted, the credibility of the single currency could be restored. Britain and the other non-EMU countries may also then be more willing to sign up for the single currency, further increasing credibility. Mid-term guidelines should therefore be established, with the intension of reforming the pact officially once budgets have, supposedly, been brought back under control in 2005.
78. Inflation is currently low in Euroland, possibly even lower than the 2 per cent set as a maximum for policy-setting interest rate reductions by the ECB, and at any rate well on the way to below that figure, unless the high oil prices observed more recently (up beyond $40 per barrel in May 2004) pushes inflation back up again. There is, however, considerable monetary tension between EMU members with comparatively high inflation, such as Ireland, and those with very low inflation or indeed deflationary pressure, such as Germany. Inflationary concerns raised after the physical introduction of the single currency in 2002 due to the reported practice of the ‘rounding up’ of prices by retailers seem to have abated, but inflation has not disappeared. Indeed, at the beginning of 2003 it stood at a stubborn approximate 2% (that is, the same as the ECB policy-setting interest rate, meaning a zero real interest rate for depositors). With the euro’s considerable firming of the euro vis-�-vis the dollar in the course of 2003 and the first half of 2004, inflation can be expected to come down to below 2% in the course of 2004. At least there seems no immediate risk of inflation’s opposite, namely deflation.
79. The economies of the ten new EU members have on average grown faster in recent times than has the eurozone, causing their currencies to appreciaterelative to the euro, if one accepts those few which have pegged their currencies to the euro. The higher growth rates among the new members when compared to many countries in the eurozone imply that the former have the choice of either accepting a resulting appreciation of their currencies vis-�-vis the euro and thereby enjoy lower inflation; or maintaining a fixed exchange rate to the euro and risk suffering higher inflation. If the former action is chosen, this might make eventual entry into the EMU more problematic, in that the national currency may be ‘locked’ to the euro at too high a level, to the detriment of exports. However a somewhat weakening US dollar had by May 2004 allowed the euro to recover to around € 1.20. This has led to some appreciation of the euro also vis-�-vis the currencies of the new EU members, relieving some of the above concerns for the time being.
80. The new EU members will have to exercise fiscal restraint in an economic environment which is still not fully recovered. They will also have to engage in considerable public investment in order to comply with the ‘acquis communautaire’. This will make it more challenging for them to meet the Maastricht EMU criterion of a limited budget deficit, in spite of the considerable cash inflow from EU funds, which are already reaching them and which will increase even more once they have become members.
81. Other areas of reform are the reduction of subsidies and state aids, pensions, and adjusting the public sector and further developing the financial sector. Other challenges include the pursuit of nominal as well as real convergence with the EU area in order to meet the requirements of EMU entry on a sustainable basis and enhance economic cohesion.
82. Other challenges are, however, raised by the current turnaround in the euro’s fortunes, as EMU area exports are also facing challenges in the face of the currency’s appreciation to new highs. Evidence suggests this is already affecting the results of some companies, such as in the automotive sector.
83. In conclusion, after its surprisingly smooth introduction, the euro is now facing further challenges following its worrisome weakening in the 1999-2002 period. The Stability and Growth pact is looking increasingly restrictive, with its rules challenged so blatantly by some of the larger member states as to potentially undermine confidence in the currency itself and to render relations with their smaller EMU partners more difficult. The strength of the euro is caused more by the weakness of the US dollar (due to that country’s huge current account deficit and to some extent also by its growing budget deficit) than by Euroland growth as such, which is still weak. Meanwhile, the appreciation risks dampening exports just when these are needed to underpin a Euroland economic recovery. The new EU members are to be commended for the work they are doing to prepare for the adoption of the single currency, but the ‘locking’ process risks being long and delicate.
84. It is difficult to argue that the decision by the three EU members still outside the EMU is irrational. Reform of the EMU system is needed, notably in the direction of greater flexibility. This would allow countries to pursue much needed structural reform at home and to work more closely together to counter future strain on the currency. Everybody has an interest in a eurozone of strong and lasting growth. It would be a sign of soundness of the project and the best way to get the entire EU membership to join. It would also be the best way to establish a counterweight to the almighty dollar, a development in which the United States also should also have an intrinsic interest.
Appendix 1
European Central Bank
POLICY POSITION OF THE GOVERNING COUNCIL OF THE EUROPEAN CENTRAL BANK ON EXCHANGE RATE ISSUES RELATING TO THE ACCEDING COUNTRIES
I. GENERAL PRINCIPLES
Upon accession to the European Union, new Member States are required to treat their exchange rate policy as a matter of common interest and to pursue price stability as the primary objective of monetary policy. Moreover, economic policies will become subject to a number of multilateral surveillance procedures within the EU policy framework. However, beyond these obligations, which are laid down in the Treaty establishing the European Community (the Treaty), the choice of the monetary and exchange rate strategy after EU accession is, in the first instance, a responsibility and prerogative of the Member State concerned.
The ten new Member States will all join the European Union as Member States with a derogation. This means that, while not yet adopting the euro, they will be committed to striving towards the eventual adoption of the euro upon fulfilment of the convergence criteria laid down in the Treaty. The Treaty foresees that: i) at some point following accession, new Member States will join the Exchange Rate Mechanism II (ERM II); and, ii) when they are deemed to have fulfilled the Maastricht convergence criteria, they will adopt the euro.
Any unilateral adoption of the single currency by means of “euroisation” outside the Treaty framework would run counter to the economic reasoning underlying Economic and Monetary Union, which foresees the eventual adoption of the euro as the end-point of a structured convergence process within a multilateral framework. Unilateral “euroisation” cannot therefore be a way of circumventing the stages foreseen by the Treaty for the adoption of the euro.1
As the acceding countries differ greatly in their economic structure, exchange rate and monetary regimes, and the degree of nominal and real convergence already achieved, no single path towards ERM II and the adoption of the euro can be identified and recommended. It should be noted that there has been no such single path for the current euro area members either. Therefore, country situations and strategies will be assessed on a case-by-case basis throughout the process leading to the adoption of the euro. In this context, the Governing Council of the ECB may give specific recommendations to individual countries. As in the past, the principle of equal treatment will continue to apply during the entire process of monetary integration.
II. EXCHANGE RATE MECHANISM II
The Resolution of the European Council of 16 June 1997 (the Resolution)2 established ERM II in order to link the currencies of EU Member States outside the euro area to the euro. ERM II replaced the European Monetary System that had been created in 1979. Within the framework of ERM II, exchange rate stability is explicitly subordinated to the primary objective of price stability for all participating currencies.
ERM II has two roles, as set out in the Resolution. One is to act as an arrangement for managing exchange rates between the currencies of Member States participating in the mechanism and the euro, and the other is to play a role in the convergence criteria for joining the euro. The first of these roles builds on two key provisions of the Resolution, namely that “lasting convergence of economic fundamentals is a prerequisite for sustainable exchange-rate stability,” while at the same time underlining that “the exchange-rate mechanism will help to ensure that Member States outside the euro-area participating in the mechanism orient their policies to stability, foster convergence and thereby help them in their efforts to adopt the euro.”3 These provisions illustrate how the mechanism is designed to deal with the complex relationship between economic fundamentals and exchange rate stability. The second role of ERM II is provided for in Article 121 of the Treaty and the corresponding Protocol on the convergence criteria, which is annexed to the Treaty. Hence, ERM II acts as a testing phase for both the central rate and the sustainability of convergence in general.
Main features
ERM II is a multilateral arrangement of fixed, but adjustable, exchange rates with a central rate and a standard fluctuation band of �15%. The economic policies of participating Member States should be consistent with the preservation of the central rate and, thus, avoid misalignments. Interventions at the margin will in principle be automatic and unlimited, unless they conflict with the primary objective of price stability in the MemberState or the euro area. Very short-term financing can be made available to support such interventions.
ERM II is based on a multilateral agreement between the MemberState concerned, the euro area member countries, the ECB and other MemberStates participating in the mechanism. In this context, decisions concerning central rates and, possibly, narrower fluctuation bands are taken by mutual agreement of the participating members, including the ECB. All participating members in the mechanism, including the ECB, have the right to initiate a confidential procedure aimed at reconsidering central rates. Such realignments may be necessary, for example, if equilibrium exchange rates evolve over time, as shown by the past experience of current Member States.
ERM II can accommodate features of a number of the exchange rate strategies currently used by the acceding countries. Incompatibilities with ERM II are the cases of free floating (or managed floats without a mutually agreed central rate), crawling pegs, and pegs against anchors other than the euro.4 With regard to currency boards, the ECB does not consider them to be a substitute for participation in ERM II, implying that countries operating a currency board will be required to participate in ERM II for at least two years before the convergence assessment that is made before a country can finally adopt the euro. However, countries that operate a euro-based currency board deemed to be sustainable might not be required to go through a double regime shift, i.e. floating the currency within ERM II only to re-peg it to the euro at a later stage. Such countries may therefore participate in ERM II with a currency board as a unilateral commitment, enhancing the discipline within ERM II. However, the ECB has stressed that such an arrangement will be assessed on a case-by-case basis and that a common accord on the central parity against the euro will have to be reached.
As foreseen in the Resolution, formally agreed fluctuation bands narrower than the standard one may be set at the request of the non-euro area MemberState concerned. Such decisions will be taken on a case-by-case basis and would be deemed exceptional – as they were in the past – taking into account that the standard band is appropriate for Member States that are engaging in a convergence process. Multilaterally agreed narrow bands can only be considered at a very advanced stage of convergence, as in the case of Denmark.5
Entry into the mechanism
Participation in ERM II is voluntary for Member States outside the euro area. However, as membership of ERM II is a precondition for the eventual adoption of the euro, new Member States are expected to join the mechanism at some stage. ERM II membership can take place any time after EU accession. While the procedure for joining ERM II may be initiated at any time by the MemberState concerned and is not linked to specific calendar dates, the main features, notably the central rate and the width of the fluctuation band, have to be agreed among all parties involved in the mechanism.
Entry into ERM II is not subject to a set of pre-established criteria, and there are no preconditions to be fulfilled to join the mechanism. To ensure a smooth participation in ERM II, however, it would be necessary that major policy adjustments – for example with regard to price liberalisation and fiscal policy – are undertaken prior to participation in the mechanism and that a credible fiscal consolidation path is being followed. Moreover, as with any exchange rate regime, participation in ERM II is only one element of the overall policy framework and hence should not be regarded in isolation. It must be compatible with other elements of this overall policy framework, in particular with the monetary, fiscal and structural policies.
The central rate chosen should reflect the best possible assessment of the equilibrium exchange rate at the time of entry into the mechanism. This assessment should be based on a broad range of economic indicators and developments while also taking account of the market rate. The outcome of such an assessment cannot be predetermined by any of the parties to the agreement.
Decisions on central rates are taken by mutual agreement of the various parties to ERM II. Consequently, unilateral announcements about the intended central rates are not in line with the multilateral nature of the arrangement and should be avoided. In any case, they would in no way prejudice the ultimate choice of the central rate.
Realignments of the central rates should be made in a timely fashion. In that regard, the ERM II Resolution stipulates that all parties may initiate a procedure aimed at reconsidering central rates. Such realignments may be necessary, for example, if equilibrium exchange rates evolve over time, as shown by the past experience of current Member States. Such developments are likely to be all the more relevant in an environment of real convergence, in the case of significant changes in external competitiveness, or in the presence of inconsistent macroeconomic policies.
Length of participation
The Treaty sets out the minimum period of participation in ERM II prior to the adoption of the euro.6 A protocol attached to the Treaty elaborates on the criterion for participating in the exchange rate mechanism, stipulating that a MemberState must have respected the normal fluctuation margins provided for by the exchange rate mechanism without severe tensions for at least the last two years before the examination. In particular, the MemberState must not have devalued its currency’s central rate against the euro on its own initiative within this period.7 A minimum stay of two years in the mechanism prior to the convergence assessment leading to final adoption of the euro is therefore expected.
Beyond the minimum period of ERM II membership of two years prior to the convergence assessment, there are no restrictions on the length of stay in ERM II for new Member States. Although all new Member States are ultimately expected to join the euro area, no timetable is foreseen and there can be no ex ante assurance regarding a limitation of the length of participation in the mechanism. Therefore, the length of participation in ERM II should be assessed in terms of what is most helpful to accompany the convergence process, rather than in terms of the required minimum period of two years.
There should be no presumption that the initial central rate will be the ultimate conversion rate for euro adoption. This derives not only from the fact that realignments may be necessary, but also from the relevant institutional provisions: the decisions on central rates and on conversion rates are distinct, they are taken at different periods in time, and are made through different decision-making processes.
Key considerations regarding membership
The decisions regarding the timing of entry and duration of participation in ERM II should be based on the extent to which participation in the mechanism enhances the prospects of achieving a lasting convergence of economic fundamentals. The overall goal of this process should be to foster macroeconomic stability in the new Member States, thereby providing the best possible contribution to sustainable growth and real convergence. New Member States should also consider the extent to which the limitation of exchange rate flexibility may help anchor expectations and promote the pursuit of sound macroeconomic and structural policies, thus fostering real and nominal convergence. While participation in ERM II per se does not ensure supportive and consistent macroeconomic and structural policies, it has the potential to act as a catalyst, enhancing the disciplinary effect of such policies.
To determine their optimal strategy regarding ERM II and later euro adoption, new Member States will have to consider the specific circumstances of their country, including their overall monetary integration strategy, monetary and exchange rate policy framework and fiscal position. In addition, they will need to consider to what extent the transition process and progress in the catching-up of real incomes could have a bearing on the desired degree of adjustability of their exchange rates. Given the risks implied by premature rigidity of the exchange rate, it might be appropriate for some new Member States to only consider applying for ERM II membership after a further degree of convergence has been achieved. This is particularly advisable when an early rigidity of the exchange rate could precipitate disorderly realignments with potentially disruptive economic consequences, including for the credibility of the mechanism as a whole. For other new Member States that have implemented significant structural reforms and have shown the ability to advance convergence through sound economic policies and an exchange rate regime that is in principle compatible with ERM II, entry into the mechanism can take place soon after accession, provided that there is mutual agreement on the central parity.
In certain cases, new Member States may consider it desirable to envisage a longer stay in ERM II while further convergence takes place. In addition, further progress towards sustainable convergence of economic fundamentals, structural reforms and progress in the catching-up of income levels could result in changes to the equilibrium real exchange rate that may be more difficult to accomplish through domestic price changes alone. In such a scenario, it would be necessary to remain in ERM II for a longer period and to realign the central rate, if necessary, before locking in the exchange rate permanently and adopting the euro.
III. THE ADOPTION OF THE EURO
All new Member States are expected to adopt the euro in due course once they are deemed to have fulfilled the conditions set by the Treaty. Such conditions include an assessment of the sustainability of the degree of nominal convergence achieved. Under Article 121(1) of the Treaty, this assessment will also consider the situation and development of the balance of payments on current account and the development of unit labour costs and other price indices. As in the past, the assessment will be made on a case-by-case basis and will need to take into account the specific situation of each individual country.
The assessment should be based on the principle of equal treatment with the current Member States. Therefore, no additional criteria for the adoption of the euro by the new Member States will be introduced, while at the same time there will be no relaxation of the criteria laid out in the Treaty, including the criteria concerning the sustainability of nominal convergence. With regard to exchange rate stability, the criterion refers to participation in ERM II for a period of at least two years prior to the convergence assessment without severe tensions, in particular without devaluing against the euro. The assessment of exchange rate stability against the euro will focus on the exchange rate being close to the central rate while also taking into account factors that may have led to an appreciation, which is in line with what was done in the past. In this respect, the width of the fluctuation band within ERM II shall not prejudice the assessment of the exchange rate stability criterion. Moreover, the issue of absence of “severe tensions” is generally addressed: i) by examining the degree of deviation of exchange rates from the ERM II central rates against the euro; ii) by using indicators such as short-term interest rate differentials vis-�-vis the euro area and their evolution; and iii) by considering the role played by foreign exchange interventions.
Footnotes:
1 Report by the (ECOFIN) Council to the European Council in Nice on the exchange rate aspects of enlargement, Brussels, 8.11.2000, Council of the European Union press release no. 13055/00.
2 Resolution of the European Council on the establishment of an exchange-rate mechanism in the third stage of economic and monetary union, Amsterdam, 16 June 1997 (OJ C 236, 2.8.1997, pp. 5-6). As foreseen in the Resolution, the operating procedures of ERM II were set out in the Agreement of 1 September 1998 between the European Central Bank and the national central banks of the Member States outside the euro area laying down the operating procedures for an exchange rate mechanism in Stage Three of Economic and Monetary Union (OJ C 345, 13.11.1998, pp. 6-12).
3 Paragraphs 1.1 and 1.3 of the Resolution respectively.
4 Report by the (ECOFIN) Council to the European Council in Nice on the exchange rate aspects of enlargement, Brussels, 8.11.2000, Council of the European Union press release no. 13055/00.
5 Denmark participates in ERM II with multilaterally agreed bands of �2.25%.
6 See the third indent of Article 121(1). The fourth indent of Article 121(1), which states the interest rate criterion, also refers to participation in ERM II as follows: “the durability of convergence achieved by the MemberState and of its participation in the exchange-rate mechanism of the European Monetary System being reflected in the long-term interest-rate levels”.
7 Protocol on the convergence criteria referred to in Article 121 of the Treaty establishing the European Community.
Appendix 2
|
Estimates and forecasts for the European Union (Sample)3
|
|
|
|
GDP1 |
|
Unemployment rate (%) |
Inflation (%)2 |
National budget balance |
||||
|
|
2003 |
2004 |
2005 |
2004 |
2005 |
2004 |
2005 |
2003 |
2004 |
2005 |
|
|
|
|
|
|
|
|
|
|
|
|
|
Eurozone |
0.4 |
1.7 |
2.3 |
8.8 |
8.6 |
1.8 |
1.6 |
-2.7 |
-2.7 |
-2.6 |
|
EU – 15 |
0.8 |
2.0 |
2.4 |
8.1 |
7.9 |
1.8 |
1.7 |
-2.6 |
-2.6 |
-2.4 |
|
Germany |
-0.1 |
1.5 |
1.8 |
9.1 |
8.8 |
1.3 |
1.1 |
-3.9 |
-3.6 |
-2.8 |
|
France |
0.2 |
1.7 |
2.4 |
9.6 |
9.4 |
1.9 |
1.5 |
-4.1 |
-3.7 |
-3.6 |
|
Italy |
0.3 |
1.2 |
2.1 |
8.6 |
8.5 |
2.2 |
1.9 |
-2.4 |
-3.2 |
-4.0 |
|
Greece |
4.2 |
4.0 |
3.3 |
8.4 |
8.0 |
3.4 |
3.5 |
-3.0 |
-3.2 |
-2.85 |
|
Great Britain |
2.2 |
3.0 |
2.8 |
5.0 |
5.0 |
1.6 |
1.9 |
-3.2 |
-2.8 |
-2.6 |
|
The Netherlands |
-0.8 |
1.0 |
1.6 |
5.3 |
6.0 |
1.4 |
0.7 |
-3.2 |
-3.5 |
-3.3 |
|
Austria |
0.7 |
1.8 |
2.5 |
4.5 |
4.3 |
1.4 |
1.3 |
-1.1 |
-1.1 |
-1.9 |
|
Portugal |
-1.3 |
0.8 |
2.2 |
6.8 |
6.7 |
2.0 |
2.2 |
-2.8 |
-3.4 |
-3.8 |
|
Accession countries |
3.6 |
4.0 |
4.2 |
14.1 |
13.8 |
3.8 |
3.3 |
-5.7 |
-5.0 |
-4.2 |
|
EU – 25 |
0.9 |
2.1 |
2.5 |
9.0 |
8.8 |
1.8 |
1.8 |
-2.7 |
-2.7 |
-2.5 |
|
|
|
|
|
|
|
|
|
|
|
|
|
||||||||||
Reporting committee: Committee on Economic Affairs and Development.
Reference to committee: Order No 481 (1992)
Draft resolution adopted by the Committee on 28 April 2004.
Members of the committee: Mr Kirilov (Chairman), Mrs Burbiene, Mrs Pericleous Papadopoulos, Mr Figel (Vice-chairpersons), Mr A�ikg�z, Mr Adam, Mr Agramunt, Mr Anacoreta Correia, Mr Andov, Mr Arnau, Mr Assis Miranda, Mr Ates, Mr van Baalen, Mr Berceanu, Mr Bilalov(Alternate: Mr Eltsov), Mr Braun, Mr Brunhart, Mr Budin, Mr �avusoglu, Mr Cosarciuc, Mr Crema, Mr Dimic, Mr Djupedal (Alternate: Mr Monsen), Ms Griffiths, Mr Grignon, Mr Gunnarsson, Mr Gusenbauer, Ms Hakl, Mr Haupert, Mr H�gmark, Mr Jonas, Mr Kacin, Mr Kalanovic, Mr Karapetyan, Mr Klympush, Mr Korobeynikov, Mr Kraus, Mr Kristovskis, Mr Lachnit, Mr Le Guen (Alternate: M. Hunault), Mr Leibrecht, Mr Makhachev (Alternate: Mrs Piroshnikova), Mr Masseret, Mr Melcak, Mr Mikkelsen, Ms Milicevic, Mr Mimica, Mr Nikolopoulos, Mr �hman, Mr O’Keeffe, Mr Opmann, Mrs Patarkalishvili, Mrs Pintat Rossell, Mr Podgorski, Mr Popa, Mr Puche, Mr Pullicino Orlando (Alternate: Mr Arrigo), Mr Ramoudt, Mr Ramponi (Alternate: Mr Rigoni), Mr Rattini, Mr Reimann, Mr Rivolta, Lord Russell-Johnston, Mr Rybak, Mr Sasi, Mr Schreiner, Mr Severin, Mr Seyidov, Mr Slutsky, Ms Smith (Alternate: Mr Marshall), Mr Sofiyeva (Alternate: Mr Mollazade), Mr Stefanov, Mr Tepshi, Mr Timmermans (Alternate: Mr Kox), Mr Todorovic, Mrs Vadai (Alternate: Mr Szalay), Mr Versnick, Mr Vrettos, Mr Walter, Mr Wielowieyski, Mr Wikinski, Mrs Zapfl-Helbling, Mr Zhevago.
N.B. The names of those members present at the meeting are printed in italics
Head of Secretariat: Mr Torbi�rn
Co-Secretaries to the committee: M. Bertozzi, Ms Ramanauskaite; Ms Kopa�i-Di Michele
1 Poll of 200 firms taken by private equity house Gresham
2 Estimated in a recent report sponsored by the Britain in Europe campaign
3 Analysis on the economic impact of the ‘no’ vote taken from a research issued by West LB
4 Sweden does not have such an ‘opt out’ clause since it joined the EU after the Maastricht Treaty was negotiated but made its membership at the current stage contingent upon a victory for the yes side in the referendum.
5 Jalcova Zuzana. “European Monetary Union”, Action Commission for an Enlarged Euro-Atlantic Community.
6 See for example, D. Begg, B. Eichengreen, L. Halpern, J. von Hagen and C. Wyplosz in “Sustainable Regimes of Capital Movements
7 F�lsz Attila. “The monetary framework after accession – a political economy analysis of ERM2”, European Integration online Papers (EIoP), Vol. 7 N� 2, 31 March 2003.
8 “Not so easy to join”, The Economist, 22 May 2003 and “Inelastic bands”, The Economist, 12 June 2003.
9 See ECB Press Release of 20 December 2002 at website www.ecb.int
10 One example is in the Pyrenees region. French locals are increasingly shopping across the border in Spain as the use of the same money makes it much easier to compare prices. Industry has also as benefited from the easier cost comparisons, and the industrialised area of northern Spain has gained from that trend, and now boasts 3,000 foreign companies on its soil. Between 1999, when the euro officially came into being, and 2001, Spanish Catalonia experienced a substantial increase in trade with other European countries, with imports up 20% and exports 30%. Other factors also contribute, such as Spain's lower production costs, but the euro is clearly providing a beneficial backdrop.
11 OECD real GDP growth forecasts for the Euro area are 0.5% in 2003, 1.8% in 2004 and 2.5% in 2005. The 2004 figure has been revised down from an earlier 2.4% and is now less than half the 4.2% growth forecast for the US economy in 2004. For the EU, growth is forecast at 0.7% in 2003, 1.9% in 2004 and 2.5% in2005. For Germany, the corresponding forecasts are 0%, 1.4% and 2.3%.
12 As quoted in the ‘Financial Times’ November 27th 2003.