From the EMI to the ESCB: Achievements and challenges

Speech delivered by Dr. W. F. Duisenberg,President of the European Monetary Instituteat a luncheon organised in conjunction withthe Luxembourg Bankers' Association and the International Bankers Clubin Luxembourg on 12 September 1997

It is a great pleasure to be here today to speak to you about the progress that has been made in respect of the transition to Stage Three of European Economic and Monetary Union (EMU) and some of the challenges that lie ahead.

The European Monetary Institute (EMI), established under the Maastricht Treaty, has been assigned an important role in the transition to Monetary Union. Located in Frankfurt, it came into being on 1 January 1994, its members being the central banks of the EU Member States. The three main tasks of the EMI are to further strengthen co-operation among the national central banks and the co-ordination of national monetary policies with the aim of ensuring price stability; to provide advice to the EU Council regarding the achievement of a high degree of sustainable convergence by Member States adopting the single currency; and to undertake the necessary technical preparations required for EMU. The European Central Bank (ECB) will be established by the appointment of its President and other members of the Executive Board after the decision is taken on which countries will participate initially in Monetary Union, and will, in conjunction with the national central banks (NCBs), form the European System of Central Banks (ESCB), which will take on responsibility for monetary policy within the euro area from the beginning of 1999. By then, the EMI will have been liquidated.

In considering the achievements and challenges on the way to Monetary Union I should like to focus my remarks on two issues which are at the forefront of the tasks of the EMI; first, and very briefly, the progress and challenges with respect to convergence. Second, the state of preparations for the introduction of the single currency.

PROGRESS TOWARDS CONVERGENCE

In the area of convergence, a key challenge facing the European Union is the selection of the countries which will be deemed eligible to participate in Monetary Union from 1 January 1999.

As you are no doubt aware, the Treaty provides that no Member State can enter EMU unless the Heads of State or Government conclude that it fulfils the necessary conditions to do so in terms of attaining a high degree of sustainable convergence as indicated by price stability, the sustainability of fiscal positions, exchange rate stability and the convergence of long-term interest rates. In this context, let me say that I do not intend - and I am sure you would not expect me - to discuss the probability of individual Member States participating in EMU from the outset. The EMI will give its views on this subject in due course as, under the Maastricht Treaty, it is required to provide a report on convergence to the EU Council in the spring of next year. I am, however, happy to discuss the current situation in relation to the convergence criteria. In short, there has been a considerable measure of achievement in some areas, notably in the progress towards price stability, while some challenges still remain, particularly in the fiscal area.

With regard to inflation, Member States have made remarkable progress in recent years. As measured by both the national Consumer Price Indices (CPIs) and the recently introduced Harmonised Index of Consumer Prices (HICP), the weighted average annual rate of inflation in the EU currently stands at 1.7%. Not only has such a subdued rate of price increases not been achieved for decades, but there are also few signs of incipient price pressures. Furthermore, differences in inflation rates among Member States have declined substantially: almost all Member States currently have HICP inflation rates of around 2% or less.

Reflecting the pattern of economic convergence in actual and expected inflation, and credible monetary policies, intra-EU exchange rate stability has been broadly maintained during the first half of 1997, while long-term interest rates are low and long-term interest rate differentials have narrowed.

The fiscal situation is less bright. Most countries exceeded the reference values of the Treaty in 1996 and had yet to ensure sustainable consolidation. In May, the ECOFIN Council sent recommendations to correct excessive deficits to all Member States with the exception of Denmark, Ireland, Luxembourg, the Netherlands and Finland. This points to the crucial need to ensure sustainable convergence in the fiscal field. Notably, it is quite evident that sustainable consolidation cannot be achieved by one-off and accounting measures. Looking ahead to the medium term, it is necessary to address the issue of the future liabilities of social security systems in the context of an ageing population. In the absence of appropriate reforms, sizable increases in contributions, or even substantial increases in government indebtedness, would appear to be in prospect. This is of particular importance as fiscal discipline is essential not only at the time of entering EMU but also thereafter.

I would acknowledge that the fiscal stance has generally been tightened. The government deficit for the EU as a whole is forecast, according to the European Commission, the IMF and the OECD, to decline from 4.4% of GDP in 1996 to around 2.9-3.0% in 1997. For the EU as a whole, the debt ratio was estimated to have risen further in 1996, to 73.2%, but is generally projected to fall slightly in 1997. Needless to say, the projections have yet to be confirmed by outcomes.

Besides fulfilment of the convergence criteria, there are also a number of other significant challenges in the economic environment; in particular, there is a clear and insistent need for structural adjustment, notably in labour markets. The Union does not have a good record in terms of job creation. Unemployment in most Member States, though showing signs of stabilising, remains high, and the situation in labour markets is forecast to remain highly unsatisfactory. A wide range of institutional rigidities account for the weak employment performance, and it will be a major challenge to tackle them in a decisive manner. Of course, continued cost moderation is also required. I welcome the importance that has been attached to the issue of labour markets by the Council, in particular the Resolution on growth and employment passed at Amsterdam in June this year and the initiative for an extraordinary meeting of the European Council this autumn under the Luxembourg Presidency.

PREPARATIONS FOR THE CONDUCT OF THE SINGLE MONETARY POLICY

From the issue of economic convergence, let me now turn to the technical preparations for the conduct of a single monetary policy. The EMI is responsible for preparing the operational framework that will enable the ESCB to perform its tasks in Stage Three: preparatory work that is progressing according to schedule. The conceptual phase has been completed for all the main issues of relevance and the main challenge now is for the EMI (working closely with the NCBs) to ensure that the options which have been selected are designed in full detail, and that they are prepared and tested in due time. The framework, as prepared by the EMI, will be submitted to the ECB for decision after its establishment in 1998.

Let me mention a number of the areas where the EMI is involved in preparations. I shall try, in particular, to provide you with a guide to the progress that has been made more recently. The EMI continues to focus on a wide range of issues, such as monetary policy strategies, the instruments and procedures necessary for conducting a single monetary policy, foreign exchange issues, the integration of national payment systems through TARGET, the issuance of euro banknotes, statistical issues relating to the conduct of a common monetary policy, the rules for operations of NCBs within the framework of the ESCB, and the structure and functions of the ECB/ESCB.

First, let me remind you that the EMI published an assessment of alternative monetary policy strategies in February this year. The Treaty provides unambiguous guidance as to the ultimate objective: "the primary objective of the ESCB shall be to maintain price stability". However, in pursuing 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 directed at price stability 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 the use of its monetary policy instruments with a view to achieving its final objective.

The document to which I am referring ("The single monetary policy in Stage Three: elements of the monetary policy strategy of the ESCB") identified two potential candidate 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. Regardless of their choice of strategy, they all monitor a wide and similar set of economic and financial variables as indicators in determining the monetary policy stance.

The ESCB will face two particular challenges from the outset when implementing a monetary policy strategy for Stage Three. First, the ESCB will have no track record of its own and must, therefore, attach the utmost importance to establishing and maintaining a high degree of credibility. Second, the transition to Stage Three will constitute a major shift in regime, which will imply initial uncertainty concerning economic and financial conditions and developments in the euro area as well as the future relationships between major macroeconomic variables. It will not be easy for the Governing Council of the ECB to draw firm conclusions from the observation of indicators.

Moreover, while the stance of the single monetary policy of the ESCB can only be set to ensure that it will be appropriate for the euro area as a whole, it will nevertheless be important for the ESCB to be fully aware of any differential impact of its policies across Member States due to remaining structural differences across countries, not least because inflation in an individual Member State may spill over into the euro area as a whole.

In order to implement its monetary policy strategy, the ESCB will need to rely on a set of monetary policy instruments and procedures - its operational framework. The EMI Council has defined a set of monetary policy instruments that will be made available to the ESCB. In January of this year the EMI published a report entitled "The single monetary policy in Stage Three: specification of the operational framework". The aim of the report was to provide information to the public on the operational aspects of the ESCB's monetary policy, including the main features of the instruments, procedures and supporting functions which were being prepared by the EMI.

Briefly, it is envisaged 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 a broad range of counterparties will have access to ESCB operations. Preparations have also been made for an infrastructure that will allow the ESCB, if it so chooses, to impose minimum reserve requirements. The ECB will decide in 1998 whether to do so. Required reserves could be used mainly to stabilise money market interest rates and to create or enlarge a structural liquidity shortage. The EMI has seen a need to study further the extension of the relevant article of the ESCB/ECB Statute to allow the ECB to subject a broader range of financial institutions than credit institutions alone to reserve requirements.

The EMI plans to publish a further report in the near future on the subject of monetary policy instruments and procedures, the so-called "General documentation", which updates the operational framework, taking account of the progress made in the specification of the ESCB's monetary policy instruments and procedures over the past few months. This new report is intended particularly to provide financial institutions with the information they need to prepare themselves to participate in ESCB monetary policy operations in Stage Three. In this respect, the report sets out the criteria to be fulfilled by financial institutions to be eligible counterparties in ESCB monetary policy operations. It then presents the features of the different types of open market operations which might be conducted by the ESCB (the main refinancing operations, the longer-term refinancing operations, fine-tuning operations and structural operations) and those of the ESCB's two standing facilities. The report will contain a detailed description of the procedures related to the various types of operations and, furthermore, it will specify the eligibility criteria and risk control measures to be applied to assets underlying the ESCB's liquidity-providing operations. It will also present the features of the ESCB's minimum reserves system as prepared by the EMI. Of course, the final decision on the operational framework will be taken by the Governing Council of the ECB after its establishment. The Governing Council, consisting of the Executive Board of the ECB together with the Governors of each of the participating Member States' central banks, may choose not to use all the options made available in the General documentation, or may decide to amend certain features.

Next week the EMI also plans to publish a provisional list of Monetary Financial Institutions (MFIs), primarily for the use of reporting institutions and compilers of statistics, in support of its aim to produce a homogeneous monetary sector and reporting population for the production of properly articulated money and banking statistics in Stage Three. This report will cover credit institutions but not Money Market Funds (MMFs). Work is under way to identify Money Market Funds in the EU for inclusion in an Addendum to the present provisional list, which it is planned to make available later in the year.

Another important aspect of the EMI's work relates to legal convergence, i.e. the adaptation of national legislation including the statutes of the NCBs, with a view to Stage Three. Member States are obliged, in accordance with the Maastricht Treaty, to eliminate incompatibilities between national legislation and the Treaty and ESCB/ECB Statute. The EMI has considered this earlier in both its 1995 and 1996 Annual Reports, distinguishing between central bank independence, the integration of NCBs in the ESCB and legislation other than the statutes of the NCBs. Recent work has built on these earlier reports.

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. The EMI has finalised the first stage of its preparatory work on the future monetary and exchange rate relationships between the euro area and other EU countries. The outline of a new mechanism (ERM II) was approved in Amsterdam in June of this year and 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 does not rule out forms of closer exchange rate co-operation between non-euro area NCBs and the ECB agreed on a case-by-case basis, such as narrower fluctuation bands.

The integration of payment systems is an essential element of the technical preparations for Stage Three, in order to facilitate the implementation of the ESCB's monetary policy, and to provide sound and efficient mechanisms to settle same-day cross-border payments under any circumstances. In March 1995 the EMI Council agreed to establish the TARGET system; the TARGET Report was released in May 1995 and a first progress report in August 1996, providing additional information. Further work in this field has focused on elaborating the organisational aspects of TARGET, the technical implementation of the system and legal issues. For instance, in February this year the EMI Council endorsed the decision to choose S.W.I.F.T. as the Interlinking network provider and a contract was finalised in June. Testing of NCB links with the EMI's test centre has begun. An ECB Payment Mechanism (EPM) is also being prepared. It has been decided that the ECB will have a direct link to the Interlinking, in the same way as the NCBs. The EMI will be publishing a second progress report shortly, covering detailed issues such as the harmonisation of the operating time of domestic RTGS systems linked to TARGET, pricing policy and the provision of intraday liquidity to non-euro area NCBs. It is proposed that there should only be two common days when TARGET is closed: Christmas Day and New Year's Day. On other days the TARGET system will remain open, but individual NCBs will have the flexibility to close on national or regional holidays. The Interlinking system will remain open as long as at least two national RTGS systems are open. Normal TARGET operating hours will be from 7 a.m. to 6 p.m. "ECB time" (that is, the time on the clocks at the ECB), although some flexibility could be left to NCBs to open earlier for domestic reasons. On the issue of pricing, it has been agreed by the EMI Council that a common transaction fee for cross-border TARGET transfers should be charged, based on the principle of full cost recovery (subject to confirmation from the Commission that this would not create competitive distortions). The EMI is intending to publish a price range, but the exact fees will be decided by the Governing Council of the ECB. There has also been progress with respect to options for preventing intraday credit, if provided to non-euro area NCBs, from spilling over into overnight credit. One of the options is for an earlier cut-off time for these NCBs connected to TARGET. It has been decided that if this option were to be chosen, the earlier closing time would only need to apply to the use of intraday credit in euro (which means in effect a liquidity deadline), rather than to the processing of payments.

During the first half of this year, the EMI opened a dialogue with EU-wide banking and financial associations on issues concerning their preparation for the changeover to the euro. In March, the EMI and the representatives of the banking community agreed a list of priorities for preparatory work to be accomplished during the year. At the request of the banking industry, the EMI supported the private sector's preparations by defining common standards for the computation of interest rates in the money market, the method of quotation of the exchange rate of the foreign currencies against the euro and the definition of euro area-wide business days. The EMI invited the banking and financial community to take a lead in harmonizing other market conventions.

This lead ten EU-wide banking associations and two International Central Securities Depositories (ICSDs) to submit to the EMI a "joint statement on market conventions for the euro". This statement 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 statement proposes that, after the start of Stage Three, newly issued instruments in the euro financial markets should reflect minimum standards of harmonisation. The EMI has welcomed and supported the initiative taken by the associations of the banking and financial industry, which reflects a broad consensus among market participants on common conventions for the euro financial markets, and is of the view that implementation of these conventions will enhance the integration of, and greater transparency in, the euro financial markets.

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. Originally, the EMI Council was of the opinion that it should not interfere in what is essentially a matter for the private sector. However, the market has indicated to the EMI its difficulties in calculating this reference rate itself and, given the need to ensure the continuity of contracts, the Council has reconsidered and has agreed to assist in the calculation of this rate, although it will not take responsibility for its publication.

Finally, let me come to the topic of the ESCB itself. The main issues outstanding as regards the degree of centralisation and decentralisation of operations within the ESCB have now been agreed upon. One significant challenge confronting the EMI and the NCBs in the coming months will be to determine the functions and the structure of the ECB. Significant thought has been given to these issues within the EMI, and the EMI Council has given serious consideration to staffing requirements. I regard it likely that just under 500 staff members will be required initially; the current staff at the EMI numbers less than 350. Given the lead times needed to recruit suitably qualified staff, this process will begin in the near future. Further consideration is being given to institutional issues, in particular the form of co-operation between the ECB and the NCBs. Although there are some specific responsibilities assigned to the different bodies within the ESCB, there will also need to be close co-operation between them. The experience to date with sub-committees and working groups of central bank experts meeting under the auspices of the EMI suggests that this could form a useful basis for such co-operation in Stage Three.

CONCLUSION

To conclude, EU Member States have made considerable progress in terms of economic convergence, although challenges remain in terms of structural reforms, notably in the area of fiscal policy and labour and product markets. Considerable progress has also been made by the EMI in terms of the necessary preparations for the introduction of the single currency on schedule on 1 January 1999. The greatest challenge that lies ahead is to establish and maintain a zone of price stability within the euro area after the start of Stage Three, in fulfilment of the clear mandate given to the ECB in the Maastricht Treaty. Personally, I am convinced that the application of the convergence criteria, 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 powerful institution, safeguarding the value of the new currency./.