Convergence and the role of the European Central Bank
Remarks by Alexandre Lamfalussy, President of the European Monetary Institute to the International Symposium "EMU - the euro's challenge to the dollar and the yen", Institute for International Monetary Affairs, Tokyo, 22 April 1997
These remarks will touch on the following topics: first, progress towards economic convergence in EU countries and related economic policies; second, the role of the European Central Bank in relation to monetary and foreign exchange policy, independence, financial supervision and management of TARGET; and, third, the possibility of the euro assuming the role of a key international currency.
1. Progress towards economic convergence
The dangers of a lack of convergence when countries enter EMU are self-evident. Notably, if fiscal positions are not initially under control, there may be repercussions on monetary policy from large deficits, and adverse spillovers across borders affecting the Monetary Union as a whole from lax fiscal policies in individual Member States. Similar arguments apply in respect of inflation. These difficulties are far from theoretical. With such a unique enterprise as EMU, we will have to live with the possibility of teething troubles during the crucial "running in" period, putting considerable strain on the strategy and the technical capabilities of the ECB. Such strain could become unbearable or, to put it less dramatically, could lead to a dangerously unbalanced policy mix if it were compounded by the consequences of initially weak budgetary positions in the member countries.
As regards current performance, important progress has been made in respect of the downward convergence of inflation and bond yields, and exchange rate stability has to date been broadly maintained. However, on the fiscal side, deficits in 1996 substantially overshot the benchmark laid down in the Treaty in most Member States, despite efforts at consolidation. Debt ratios have continued to rise in the aggregate, despite favourable trends in some Member States. In my view, the composition of consolidation continued to rely excessively on high revenue ratios and less than is desirable on expenditure restraint. Moreover, there were measures with a temporary effect, which cannot contribute to sustainable convergence. Given its central role, I shall henceforth focus on fiscal convergence.
As you know, the decision to select the countries will be made by the Heads of State or Government during the Spring of 1998. I do not know how they will interpret the convergence criteria. But I do know how I should like the advice by the EMI Council to be formulated.
In assessing the fiscal criteria, we should stick to both the spirit and the letter of the Treaty; and the Treaty says three things, not one. Firstly, it establishes the two reference values, the 3% deficit ceiling and the 60% debt ceiling. Secondly, it accepts deviations from these reference values on certain conditions which are described carefully, but are not quantified. Thirdly, it insists on the need to have sustainable positions - in fact, it even uses this expression twice: to cover all convergence criteria and, specifically, sustainability of budgetary positions. Consideration of the risks suggests two conclusions. First, deviations from the reference values should be granted sparingly by interpreting the words used by the Treaty in a carefully restrictive way; and, second, compliance with the reference values should be regarded as sufficient for eligibility only if the deficit and debt ratios observed for 1997 are genuinely sustainable. In short, in case of doubt when applying the second and third prescriptions of the Treaty, we should lean towards caution.
Concerning policy, the fiscal imbalances existing in the Union require the implementation of measures with lasting effects. Given distortions imposed by too high a level of fiscal levies, priority for adjustment will have to lie with the expenditure side of the budget, notably in non-productive expenditure. Fiscal consolidation can only lead to a lasting improvement in the growth potential of the Union if it is pursued with a long-term perspective, in a credible and determined manner. It is not sufficient that countries only aim to ensure that they comply with the Treaty reference values in the coming years. It is also necessary that they create sufficient room for manoeuvre to cope with adverse cyclical developments and that they implement measures for coping with new budgetary challenges such as the ageing of populations.
2. The role of the European Central Bank
Monetary policy: The Treaty provides unambiguous guidance that "the primary objective of the ESCB shall be to maintain price stability". However, in its pursuit of this objective, the ESCB, like all central banks, will face a complex transmission process from policy actions to price developments with long and variable lags. Thus, policy decisions must be both pre-emptive and forward-looking, taking into account all relevant information regarding the prospective evolution of prices and taking appropriate and timely action to ensure that the final objective is achieved. In addition, the need for credibility and consistency of the decision-making process over time will require the ESCB to establish a clear framework to guide use of its monetary policy instruments with a view to achieving its final target. Final decisions on strategy will be taken by the Governing Council of the ECB.
There are two potential candidate strategies, namely monetary targeting and direct inflation targeting. It can be argued that a particular strength of the monetary targeting strategy is that it clearly indicates the responsibility of the ESCB for developments which are both easily observable and under its more direct control. It also follows the strategy pursued by the central bank of the anchor country in the EMS. At the same time the long-term stability of money demand in the euro area is a crucial factor in determining the effectiveness of monetary targeting. Empirical studies provide some evidence that, for selected groups of EU countries, area-wide money demand currently has these desirable properties. On the other hand, these studies are subject to data and methodological limitations and may not be representative of the situation in Stage Three. With respect to an inflation targeting procedure, it is argued that it directly stresses the responsibility of the ESCB for achieving and maintaining price stability. Furthermore, policy actions under such a strategy can be consistently and directly linked to prospective price behaviour, which, if the strategy is credible, will affect public expectations in a favourable way. It should be noted, however, that to be successful, inflation targeting also requires stable relationships between various economic and financial indicators, on the one hand, and future inflation, on the other.
Overall, the similarities in the behaviour of central banks that pursue these two strategies are greater than the differences. Regardless of their choice of strategy, they all monitor a wide and similar set of economic and financial variables as indicators in the determination of the monetary policy stance.
For the implementation of its strategy, the ESCB will need to rely on a set of monetary policy instruments and procedures which will constitute its operational framework. This framework should enable the ESCB to control its operational target, normally a short-term interest rate, efficiently. It should allow signals of monetary policy intentions to be given with precision and differentiation. It should be capable of providing basic refinancing, absorbing liquidity and influencing the structural position of the banking system vis-à-vis the ESCB. It would also be desirable that the framework helps to control monetary aggregates, allows adequate information to be extracted from market developments and contributes to the smooth functioning of the payment system. It is envisaged that the ESCB will mainly use open market operations, but that it will also offer two standing facilities. In addition, preparations are being made for the ECB to impose minimum reserve requirements, if it chooses.
Foreign exchange policy: From the start of Stage Three, the ESCB will have the capacity to conduct foreign exchange intervention. The ESCB will conduct foreign exchange intervention by means of transactions on the foreign reserves transferred from the NCBs to the ECB (up to an amount equivalent to EURO 50 billion). The management of foreign assets which are not pooled will be subject to guidelines issued by the ECB. The decisions related to intervention will be taken by the ECB; the implementation of such decisions will be either centralised or decentralised within the ESCB.
The Treaty does not prescribe any specific exchange rate arrangement vis-à-vis non-EU currencies. In any event, the ESCB will have the technical capacity to conduct, if need be, intervention operations in order to counteract excessive or erratic exchange rate fluctuations of the euro against the major non-EU currencies.
On the other hand, as part of the future exchange rate policy co-operation between the euro area and other EU countries, a new exchange rate mechanism has already been agreed upon. In the context of this ERM II, intervention will be used as a supportive instrument, in conjunction with other policy measures, including appropriate fiscal and monetary policies conducive to economic convergence and exchange rate stability. The new mechanism will be based on central rates, defined vis-à-vis the euro for the participating non-euro area currencies; there will be no parity grid. A standard fluctuation band, which is expected to be 15%, will be established for these currencies around their central rates. Participating non-euro area Member States could establish, on a bilateral basis, fluctuation bands between their currencies and intervention arrangements aimed at limiting excessive bilateral exchange rate oscillations. Also, the exchange rate policy co-operation between non-euro area NCBs and the ECB could - in various forms - be strengthened further. Foreign exchange intervention and financing at the standard wide margins will, in principle, be automatic and unlimited. However, the ECB and the participating non-euro area NCBs will have the possibility of suspending intervention and financing if these were to impinge on their primary objective of maintaining price stability.
Independence: As noted, the Treaty states that "the primary objective of the ESCB shall be to maintain price stability". The European System of Central Banks (ESCB) will enjoy full independence to determine the appropriate level of interest rates in order to satisfy this requirement of the Treaty; "neither the ECB nor any national central bank shall seek or take instructions from Community institutions, governments of a Member State or any other body". Moreover, the members of the ECB's Executive Board and the Governors of the participating national central banks, who will together form the ECB Governing Council, will have long terms of office and will only be dismissible for serious misconduct or inability to perform their duties. These provisions imply that the concept of monetary stability will benefit from explicit legal protection.
Supervision: The Maastricht Treaty assigns practically no role to the ESCB in banking supervision, though the Statute of the ESCB explicitly states that it has the obligation to "promote the smooth operation of payment systems". It is true that the Statute also stipulates that "the ESCB shall contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system". This, however, tends to imply that other authorities are likely to be competent for the formulation of such policies. The safeguarding of financial stability is not explicitly mentioned as an objective of the ESCB, but I would expect the ESCB to play an important role in this "macro-prudential" area.
TARGET: To support the integration of the money market and thereby the singleness of the monetary policy, the EMI and the NCBs are developing an interbank funds transfer system, called TARGET, that will be able to process cross-border payments denominated in euro as smoothly as if they were domestic payments. It will interlink the domestic RTGS systems which NCBs have agreed to implement in their respective countries. Participation in the national RTGS systems will be determined by the NCBs. To avoid impediments to the efficient conduct of the single monetary policy, a certain degree of harmonisation of the features of the national RTGS systems within the euro area will be ensured in three respects: the provision of intraday liquidity, operating hours, and pricing policy. Focusing on the issue of liquidity, the value of payment orders being sent through TARGET may, for any participant at any given point in the course of the day, exceed the value of payment orders being received. To counter the ensuing liquidity shortfall which might delay settlement, intraday liquidity will be provided by NCBs, either by granting participants the right to make use of their reserve deposits with them or by providing them with intraday credit. At the end of the day, RTGS participants in the euro area that are eligible counterparties for monetary policy operations of the ESCB may draw on the marginal lending facility with their NCB in order to balance the position in their accounts.
3. The euro as an international reserve currency
The euro area is likely to be a global player. EMU will entail the creation of a major new global currency, which will join the dollar and the yen, reinforcing a tripolar system. Although this may take decades to occur (if past history is taken as a reliable guide), it could also occur much more rapidly than in the past given the nature of today's financial markets. The impact of this on reserve holding may be considered under several headings.
EMU could affect international use of the euro through, first, the creation of a large trading area with a single currency. This fact would favour greater use of the euro in the invoicing of trade, which in turn would tend to encourage use of the euro in financial transactions. Moreover, the size of the euro trading area would encourage third countries to stabilise their currencies vis-à-vis the euro, which may increase the demand for the euro as a reserve currency. However, these factors may take time to be felt and, in any case, cannot be expected to operate in a mechanical way as a critical mass would need to be reached before the established advantages of the dollar as an international currency can start to be eroded.
Second, there is the creation of a large and efficient financial market operating in euro. The introduction of a single currency should, in combination with the implementation of the single market, strengthen market forces and encourage regulatory developments leading toward the full integration of national financial markets in the euro area. To the extent that this would contribute to the efficiency, liquidity and range of financial services offered in the euro area's financial market, the euro would also become a more attractive currency for international investors and issuers, including central banks. Clearly, the size and efficiency of the euro financial market would be not only a determinant but also a result of the international role of the euro.
Third, EMU may alter the risk features of euro-denominated financial instruments. To the extent that the volatility of the euro's exchange rate may be lower than that of the former national currencies, euro assets and liabilities may be seen as less risky and, therefore, more attractive to international investors and borrowers, again including central banks. The same argument may apply to euro interest rates, to the extent that also these may be less influenced by country-specific shocks (although they will be more influenced by area-wide shocks). On the other hand, whether the euro would offer more or fewer opportunities for risk diversification is very difficult to predict, since it would depend on both the variances and the covariances of the returns on assets denominated in euro and in other currencies.