Where do we stand in the EMU process?

Keynote address by Dr. W. F. Duisenberg, President of the EMI, at the National Conference of the Confederation of British Industry, Birmingham, 10 November 1997

In addressing you on the issue of where we are in the EMU process, I shall consider progress in respect of economic convergence, foreign exchange policy, the changeover to the euro and preparatory work for the single monetary policy in Stage Three. I shall conclude with observations on the conduct of monetary policy by the ESCB in Stage Three.

1 Ensuring sustainable convergence

The key outstanding economic challenge in the EMU process is undoubtedly the selection, in the Spring of next year, of countries deemed eligible to take part in EMU as of 1 January 1999. The EMI stresses the importance of countries achieving a high degree of sustainable convergence.

One of the untercertainties in the selection of the Euro-area countries has recently been removed. The UK will not participate in EMU from the outset. On the one hand, I think it is unfortunate that such an important country as the United Kingdom will not be among the founding fathers of the euro. On the other hand, it is welcome that one of the main uncertainties surrounding the EMU-process no longer exists. It is also welcome that the UK-Government is in favour of EMU in principle.

The UK debate on EMU very often focuses on psychological and political aspects such as the so-called transfer of sovereignty to the ESCB. Important as these issues may be, the statement of the Chancellor rightly makes clear that EMU needs also to be assessed on economic grounds.

In this respect, it is essential that UK economic policies remain aimed at further convergence. I note with satisfaction that the Chancellor has stated that he will ensure that UK fiscal rules and the plan for deficit reduction continue to be consistent with the terms of the Stability pact and that he has underlined his commitment to avoid an excessive deficit. His intention to lower the inflation target, if international conditions permit, is important. It may foster convergence of UK-inflation on the lower inflation levels in many other EU countries. I would like to recall that the core of EMU is the irrevocable fixing of exchange rates. A single monetary policy, a single currency and a common Central Bank are impossible without it. Reflecting this, Article 109j of the Treaty requires exchange rate stability as an entry criterion for EMU; the related Protocol requires a country to respect the normal fluctuation margins of the ERM for at least two years without severe tensions and, particularly devaluations of bilateral central rates. For countries with a derogation, the Treaty emphasises that exchange rates are a matter of "common interest".

As regards current performance in the EU in relation to convergence, progress has been made in respect of the downward convergence of inflation, which illustrates the determination of the national central banks across the entire Union to pursue price stability as the objective of monetary policy. In no less than fourteen countries, inflation, observed over a period of 12 months was below the reference value calculated according to the Treaty on the basis of harmonised figures recently published for July 1997. This was against the background of a historically low inflation rate for the Union as a whole of below 2%. There has also been considerable progress in bond yield convergence and - with some exceptions - exchange rate stability has, over the last couple of years, been broadly maintained throughout the EU.

However, on the fiscal side, the sustainability of public finances in EU countries remains an issue. The latest official data show that in 1996 many EU countries were above the reference values for public deficits and debt ratios laid down in the convergence criteria. Reflecting this situation, the EMI's report entitled "Progress towards convergence 1996" concluded that "most countries had not yet achieved a situation which, in a broader view, might be judged as sustainable in the medium term". For 1997, the recent autumn forecasts from bodies such as the Commission and the IMF suggest that most countries are expected to meet the "headline" reference values for public finances in respect of public deficits, and to have a declining debt ratio although the projections are still to be confirmed by outcomes. To assess the soundness and durability of the correction of public finances which will be shown by the final data for 1997 available in early 1998, the EMI will, inter alia, take careful note of the potential impact of temporary or "one-off" measures adopted by various countries in order to comply with the convergence criteria on deficits and debt in 1997. Sustainability will be examined from both a backward and forward looking perspective. Our final view will be expressed in the Convergence Report to be produced under Article 109(j) and published (together with a similar report produced by the European Commission) in the spring of 1998.

Convergence is not only required in macroeconomic terms, but also in legal terms. The achievement of central bank independence is an important precondition in order to qualify for participation in EMU. This obligation of legal convergence does not require the full harmonisation of central banks' statutes. It does, however, imply that national legislation and the statutes of central banks will need to be adjusted before the ESCB is established in order to eliminate incompatibilities with the Treaty in respect of features such as institutional, personal, functional and financial independence. The EMI has developed a list of the remaining incompatibilities which could serve as guidance for national legislators. Considerable progress has been made by Member States in adapting the statutes of their respective central banks in order to comply with the requirements arising from the Treaty and the Statute of the ESCB/ECB. The statutes of some central banks, require further adaptation, in particular with a view to their legal integration into the ESCB. An updated report on legal convergence has just been issued.

2 Exchange rate issues

Speaking here among industrialists, I need hardly stress the importance of exchange rate stability to trade and international investment. One of the main benefits of EMU is after all the elimination of exchange rate volatility, notably the risk of medium-term deviations of exchange rates from fundamentals which have often been observed historically - not least in this country. In discussing progress towards EMU, I should like to focus on two issues linked to foreign exchange policy which should be helpful in this regard.

First, I welcome the recent political decision by the ECOFIN meeting, on a recommendation by the EMI, to pre-announce the bilateral conversion rates applicable to the currencies of participants in Monetary Union at the time of their selection. This should reduce the risk of exchange rate instability in the so-called interim period prior to the irrevocable fixing of the euro exchange rates against the euro-area currencies which is set to take place on 1 January 1999. The so-called "pre pre-announcement" was well received by market participants and seen as a sign of commitment to the EMU process. It will in my view also have to be complemented by strengthened cooperation in the conduct of monetary policies. This is essential not only for a stable development in the interim period but also because monetary conditions at the beginning of Stage Three depend on the stance of monetary policy prior to its commencement.

Second, given that not all Member States are likely to participate from the start of Stage Three, the exchange rate relationship between the euro area and the non-euro area EU countries will be of great importance.

Following preparatory work by the EMI, the European Council adopted a resolution on the new mechanism (ERM II) in Amsterdam in June of this year, and a draft Central Bank Agreement to be signed by the Executive Board of the ECB and the NCBs concerned has been almost finalised. ERM II includes the following features: It will be based on central rates, defined vis-à-vis the euro for non-euro area currencies. A standard fluctuation band will be established for these currencies around their central rates. The margins of the standard fluctuation band will be relatively wide: +/-15%. Central rates and the standard wide band will be set by mutual agreement between the ECB, the Ministers of the euro area Member States and Ministers and Governors of the central banks of the non-euro area Member States. The ECB will have the right to initiate a realignment and the possibility of suspending intervention and financing if these were to threaten the pursuit of price stability. The ERM II allows for forms of closer exchange rate co-operation between non-euro area NCBs and the ECB agreed on a case-by-case basis.

3 The changeover and preparations in the private sector

Following the agreement on the EMI's plan for the changeover to the euro at the 1995 Madrid summit, the ESCB will conduct its monetary policy operations in euro as of 1 January 1999 and Monetary Union Member States will issue all new debt in euro. Most Monetary Union Member States also envisage redenominating their outstanding debt in euro from the start of Stage Three. A broad timetable for the rest of the changeover has been finalised. The preparations for the changeover to the euro have gained considerable momentum over the past twelve months. National changeover scenarios have been defined in most EU countries. Meanwhile, the legal framework for the changeover process has been substantiated in two Council Regulations which will form the lex monetae of the Community. Most importantly, the lex monetae will ensure the continuity of contracts denominated in euro or in the former national currencies, which will be treated as if they were in euro. One element still to be agreed is the common date of introduction of the euro banknotes and coins.In line with subsidiarity, the practical arrangements for the changeover will have to be made by the EU Member States. "Fine-tuning" at the Community level is deemed to be neither possible nor desirable. I note that a standing committee has been set up to co-ordinate preparations in the United Kingdom.

As industrialists, you will certainly be aware of the need to prepare for the implications of the changeover to the euro. It is evident that in parallel with the public preparations, there has been an increasing amount of investment by the private sector in the adaptation of systems and procedures across the entire Union, notably by banks, other financial institutions and large non-financial companies. But we should not be complacent; in many area, there remains a great deal of work to be done.

Banks are acting collectively. Recently, eight EU-wide banking associations and two International Central Securities Depositories (ICSDs) submitted a "joint statement on market conventions for the euro" to the EMI. Their statement - subsequently supported by several other banking associations - is a non-binding catalogue of market standards which are proposed by the signatory associations to issuers of financial instruments and other market participants for inclusion in new wholesale financial products after the start of EMU. The EMI has welcomed and supported the initiative. In discussions with the EMI, representatives of some EU-wide banking associations have also stressed that they would favour the ESCB participating in a neutral manner in the calculation of an overnight reference rate to be used in the context of derivatives contracts for the euro area. The EMI Council has agreed to assist in the calculation of this rate, although it will not take responsibility for its specification or publication.

4 Technical preparations for the single monetary policy

The EMI is responsible for preparing the framework that will enable the ESCB to perform its monetary policy tasks in Stage Three. Given the lead times involved, progress was essential at an early stage in the preparation of a set of monetary policy instruments and procedures - the operational framework of the ESCB, which will be necessary to control interest rates. Preparations are on track. As required by the Treaty, in January of this year the EMI published a report entitled "The single monetary policy in Stage Three: Specification of the operational framework". The report confirmed that the ESCB will mainly use open market operations, in most cases employing reverse transactions, but that it will also offer two standing facilities (a marginal lending facility and a deposit facility), and that a broad range of counterparties will have access to ESCB operations. Preparations have also been made for an infrastructure that will allow the ECB, if it so chooses, to impose minimum reserve requirements. The EMI has just published a further report on the subject of monetary policy instruments and procedures, the so-called "General documentation", which updates the operational framework, taking account of recent progress made in its specification. The main aim of this report is to provide financial institutions with the information they will need to prepare for participation in ESCB monetary policy operations in Stage Three.

While the Treaty provides unambiguous guidance as to the ultimate objective of the ESCB, namely price stability, it does not specify the monetary strategy to be adopted. In this context, early decisions were less crucial, since the adoption of a strategy requires relatively less preparation and does not require action from others to implement it. Nevertheless, as a basis for the ECB Council's later decision, the EMI published an assessment of alternative monetary policy strategies in February of this year, entitled "The single monetary policy in Stage Three: Elements of the monetary policy strategy of the ESCB". It identified two potential strategies, namely monetary targeting and direct inflation targeting. Overall, it concluded that the similarities in the behaviour of those central banks that pursue these two strategies are greater than the differences; they all monitor a wide and similar set of economic and financial variables as indicators in determining the monetary policy stance.

Preparation of the infrastructure needed to pursue either strategy has also advanced. For example, the estimation of econometric forecasting models is under way and research on a number of topics linked to the analysis and monitoring of the conjunctural situation in Stage Three is ongoing. Moreover, work has been under way for some time on the statistical infrastructure for EMU. In this respect, the EMI has recently issued a provisional list of Monetary Financial Institutions (MFIs) - primarily intended for use by reporting institutions and compilers of statistics -, in support of its aim to produce a homogeneous reporting population for the production of properly articulated money and banking statistics in Stage Three. A future Addendum will cover Money Market Funds.

In order to ensure that a single interest rate obtains across the euro area, it is essential that payment systems be fully integrated. In early 1995 the EMI Council agreed to establish the TARGET system of linked real-time gross settlement (RTGS) systems; since then, besides specifying the system in two reports, we have focused on elaborating the organisational aspects of TARGET, the technical implementation of the system and the associated legal issues. The EMI has just published a further progress report, covering detailed issues such as the harmonisation of the operating time of domestic RTGS systems linked to TARGET and pricing policy, as well as providing further information regarding the provision of intraday liquidity to non-euro area NCBs.

Technical preparations also include forging an agreement on the organisation of the ESCB itself and how it operates. The main issues outstanding as regards the degree of centralisation and decentralisation of operations within the ESCB have been resolved. However, one significant challenge in the coming months will be to determine the functions and the structure of the ECB. In this context, I consider it likely that around 500 staff members will be required initially. Further consideration is now being given to institutional issues, in particular the form which co-operation between the ECB and the NCBs will take.

5 The outlook for monetary policy in Stage Three

Finally, I should like to turn to a few more general considerations concerning the task of the ESCB in Stage Three. As you know, the core task of a central bank is to safeguard the purchasing power of money or, to put it differently, to create a zone of monetary stability. The concept of monetary stability comprises in any case the requirement that money has a stable internal value - that there is price stability. When foreign countries also adhere to price stability, this creates favourable conditions for the currency to have a stable external value of the currency, in other words, exchange rate stability.

A growing number of central banks throughout the world have been given the legal mandate to ensure price stability. As I have already observed, such a mandate also applies in the case of the European System of Central Banks (ESCB). Following a definition which has been advocated by my colleagues Paul Volcker and Alan Greenspan, price stability obtains when the public no longer takes account of actual or prospective inflation in its decision-making. A rate of consumer price inflation not exceeding 2% is probably consistent with this definition. Some European central banks have indeed set themselves quantitative monetary or inflation targets that reflect this benchmark for price stability.

How does exchange rate stability fit in? For several EU countries it has proved highly beneficial in past decades to aim for a stable external value of the currency against the strongest and most credible EU currencies as the key to achieving price stability. In contrast, some central banks of other, usually larger, EU countries have preferred to focus their monetary policy directly on the achievement of price stability and thereby also to lay the foundations for a stable exchange rate. While this has allowed them to set official interest rates in line with domestic price requirements, these were nonetheless influenced by the interaction between exchange rate developments and inflation. As experience has shown, the success of either form of monetary policy orientation depends crucially on the support of economic policies directed at sound public finances, responsible wage behaviour and efficient markets.

In Stage Three of EMU, the ESCB will carry out its mandate of ensuring price stability in a somewhat different economic environment, comparable to the situation of the Federal Reserve in the United States. The euro area will be a large internal market with strong trade relations among its partners stimulated by the existence of a single currency. As a natural consequence, trade flows with the rest of the world will be relatively small. This will allow the ESCB to focus primarily on "domestic" inflationary risks and to consider fluctuations in the euro exchange rate only to the extent that these significantly affect "domestic" prices. This also explains why any so-called orientations that might be formulated by the ECOFIN Council in the field of exchange rate policy for the euro area will have to be limited to exceptional circumstances. As stated in the Treaty, such general orientations shall be without prejudice to the primary objective of the ESCB to maintain price stability.

Some would argue that focusing on price stability as the primary goal of monetary policy means that the ESCB will no longer be concerned about output and employment growth. I believe this view to be wrong. Rather, stable prices are a condition for sound growth and the sustainable creation of employment. A stable price and financial environment also enhances the capacity of monetary policy to react appropriately to cyclical weakness in the economy. A central bank's long-term commitment to price stability does not mean that monetary policy will ignore the short-term impact of economic events and developments in the business cycle. When price stability is established and the credibility of the central bank in respect of its efforts to safeguard that goal is not in doubt, monetary policy can effectively play a role in stabilising the business cycle, if price pressures are least at the low point in the business cycle.

Conclusions

To conclude, the main challenge still remaining in the EMU process is to ensure that the countries entering Stage Three of EMU are fully qualified to do so. Progress towards price and exchange rate stability as well as bond yield convergence is promising but fiscal consolidation remains a key issue; the analyses of the EMI and the Commission of the degree of convergence due early next year, will show the extent to which countries' undoubted efforts are considered to have resulted in sustainable positions. Meanwhile, foreign exchange policies vis-à-vis countries not initially participating in the euro area have been agreed in ERM II and the recent decision to pre-announce bilateral conversion rates should help to avoid instability in the interim period. Banking associations have put forward catalogues of market standards, while individual institutions are undertaking their own technical preparations.

The overall preparations for the operating framework for monetary policy in Stage Three are well on track, as is the accompanying infrastructure. The monetary strategy options have been set out in detail for decision by the Governing Council of the ECB, and the accompanying infrastructure will be prepared so that we may start mimicking the procedures for the preparation of day-to-day policymaking during the second half of 1998. On balance, provided the choice of the Member States adopting the euro is credible, the institutional arrangements for the ESCB and the preparations that have been made to date will ensure that the euro will be a stable currency and that the ESCB will be a strong institution, safeguarding the value of the new currency./.