1999 - A new European monetary system
Speech by Wim Duisenberg, President of the European Monetary Institute, at the conference "The euro and the European innovative industry" in Toulouse, France, on 17 October 1997
Stage Three of Monetary Union is little more than 14 months away. Preparations for this historic project are underway. As far as the EMI is concerned, the operational framework for the ESCB's monetary policy has been defined and specified; we have entered the stage of technical implementation.
EMU will contribute to the creation of a large zone of monetary stability in Europe. The euro, in particular, will be a strong and stable currency that will foster further economic and financial integration among member countries, thereby completing the internal market. It can be expected, nevertheless, that not all countries will initially participate in the euro area. Some may opt out; others might not yet be ready by 1 January 1999 as regards economic convergence. The question thus arises of how to avoid that the euro produces divisions within the European Union, between those that are in the euro area and those that are outside, with potential foreign exchange turbulences that endanger the internal market.
There are several ways to tackle this question. I would like, first, to remind that, except for the opt-out countries, the Treaty establishes a political commitment for all EU countries to join the euro area and to adopt policies consistent with this aim. This, by itself, will create a strong drive towards adopting sustainable economic policies that ensure stability and macroeconomic convergence. In this respect, the creation of the euro represents a catalyst, a force of attraction, that should foster stability also in the other EU countries.
Another aspect to keep in mind is that the Treaty foresees a number of explicit mechanisms for monitoring and co-ordinating Member States' economic policies such as, for instance, the annual broad guidelines for economic policies and the multilateral surveillance process which are required for member countries, independently from whether they are in the euro area or not. Such co-ordination aims at promoting convergence of policies and economic developments, thereby contributing to exchange rate stability. In this respect, the Treaty provision that exchange rates need to be treated by the Member States as a matter of common interest aims at avoiding that exchange rate developments create distortions within the EU.
To supplement these Treaty provisions, an exchange rate mechanism between the euro and the currencies of the other EU countries has been designed; it is ERM2.
ERM2 has been designed in close co-operation between the European Council, the Council of Ministers and the EMI. The EMI has contributed to this process in particular through its detailed report annexed to the conclusions of the European Council of Dublin in December 1996. On the basis of this document, the European Council adopted a Resolution on the ERM2 at its meeting in Amsterdam in June 1997. In parallel, the EMI has completed the Central Bank Agreement dealing with the operational aspects, which will be submitted for signature to the ECB and the non-euro area national central banks in 1998. The EMI is currently setting up the required technical infrastructure to ensure that the arrangement will be fully operational from 1 January 1999.
I would like to address with you today three main issues related to ERM2. First, what are its objectives and principles? Second, which are the main features? Third, what can be expected from ERM2 in terms of contributing to monetary and exchange rate stability and thus creating a favourable business environment within Europe?
1. Objectives and principles of the ERM2
Five main objectives and principles have guided the creation of ERM2.
First, as I already mentioned, Member States are required to treat their exchange rate policy as a matter of common interest. This is not only a Treaty requirement but a necessary condition with a view to avoiding that the single market is damaged by excessive exchange rate fluctuations.
Second, exchange rate stability is an important element of economic convergence. As you are well aware, the Treaty's convergence criteria include the observance of the normal ERM fluctuation margins without severe tensions for at least two years. In particular, a Member State is not allowed to devalue its currency's bilateral central rate against any other Member State's currency on its own initiative. Member States joining the euro area, including those entering at a later stage, have all to fulfil this condition.
Third, anchoring the exchange rate to a stable currency, as the euro will be, can be of help for non-euro Member States in their convergence efforts necessary to enter the euro area. It establishes a focal point for agents' expectations and may enhance the credibility of stability-oriented policies.
Fourth, exchange rate stability can be achieved only in the presence of continued convergence of economic fundamentals - in particular price stability - and sound fiscal and structural policies. Unless these conditions are met, there is no point - and it may even be counterproductive - to try to artificially stabilise exchange rates.
Fifth, ERM2 should ensure, as far as possible, continuity with the present exchange rate mechanism. At the same time, the arrangement must fully take account of the new economic and institutional environment in Stage Three. I would underline in this respect the ECB's and the non-euro area national central banks' statutory requirement to maintain price stability, which must be safeguarded.
A final point that needs to be mentioned is that participation in ERM2 will, as in the present ERM, be voluntary. Nevertheless, the Dublin and Amsterdam European Council conclusions have stated that a Member State with a derogation can be expected to join the mechanism.
2. Main features of ERM2
The main operational features of ERM 2 may be summarised under four points.
First, for each participating non-euro area currency, a central rate vis-à-vis the euro will be defined. Unlike the present ERM, there will no longer be a "parity grid". The new so-called "hub-and-spokes" approach puts the euro at the centre of the system. Around the euro central rates, a standard fluctuation band of +/- 15% will be established. This rather wide band reflects the good experience with the operation of the current ERM. It avoids offering "one-way bets" in periods of speculative pressure. It also allows temporary deviations from the central rates to accommodate minor asymmetric economic disturbances. The recent experience in the ERM has shown that central rates exert a strong magnetic force for exchange rates, thus contributing to avoiding misalignments. In practice, exchange rate fluctuations have, for most currencies, proved to be even more limited than in the former 2.25% narrow band of the ERM. This effect has been reinforced after the decision taken at the Mondorf Informal ECOFIN in mid-September to announce bilateral conversion rates in May 1998.
In summary, ERM2 is an asymmetric system, centred around the euro. There have been in the past many discussions concerning the asymmetric nature of the current exchange rate mechanism, and the desirability of this asymmetry. I think that there can be no doubt that ERM2 will have to be asymmetric, given the euro area's size and the stability-oriented policies that will be pursued in the euro area, in particular by the European System of Central Banks.
A second feature is that central rates and the standard wide band will be set by mutual agreement between all parties. These parties are the euro-area Finance Ministers, the ECB, and the Finance Ministers and central bank Governors of the non-euro area Member States participating in ERM2. The European Commission will, as today, be involved in the procedure. All parties to the agreement, including the ECB, will have the right to initiate a procedure for reconsidering central rates. This will ensure that any adjustment of central rates will be conducted in a timely fashion.
A third feature is that, as today, there will be automatic and unlimited foreign exchange intervention and financing when exchange rates reach the fluctuation margins. As a general principle, it is understood that intervention will have to be used to support - not replace - other policy measures, including appropriate fiscal and monetary policies. Furthermore, an explicit safeguard clause has been introduced, and this is new, by which both the ECB and the participating non-euro area NCBs are allowed to suspend intervention and financing if these were to impinge on their price stability objective. The central banks participating in the agreement will retain the possibility of co-ordinated intramarginal intervention, to be decided by mutual agreement in parallel with other appropriate policy responses.
Finally, there is the possibility to have closer links between non-euro area NCBs and the ECB. A non-euro area Member State that has reached an advanced degree of convergence with the euro area may request closer exchange rate co-operation. This may take various forms. It can entail participation in formal narrower bands, to be agreed upon in a procedure analogous to that for central rate decisions. Alternatively, informal arrangements can be made, for instance target ranges, which might not be made public.
3. How will ERM2 contribute to monetary and exchange rate stability in the EU?
I believe that the new arrangement is equipped with the necessary devices to contribute to exchange rate stability in Europe. Naturally, these features and instruments will have be used in an appropriate way. The existence of a system in itself is not a guarantee for stability. The experience of the last few years is nevertheless encouraging. There is now a common understanding on the way economic policies should be conducted in the ERM framework, with a view to fostering sustainable exchange rate stability. I would like to be more specific in this respect and examine with you how, I think, ERM 2 can be expected to foster stability.
I would distinguish four main aspects.
First, the ERM2 provides a framework to counter major competitive distortions within Europe. It will do so primarily by providing a policy co-operation mechanism through which monetary stability is fostered in countries not initially participating in the euro area. This forms an important pre-condition for stable exchange rates. On the other hand, ERM2 provides a way to initiate timely realignments of the central rates vis-à-vis the euro if prices and costs in the non-euro area countries still diverge with respect to the euro area. This ensures that major distortions do no longer build up, leading to misalignments. The experience of the so-called "hard ERM" between 1987 and 1992 by which nominal exchange rate stability was not accompanied in some cases with adequate convergence of prices and costs, is unlikely to be repeated. The brusque adjustment of exchange rates to compensate for the accumulated differences in inflation rates will be avoided as realignments will take place more promptly.
Looking at ERM experience since the widening of the fluctuation bands, it is evident that the authorities have been quite successful in avoiding misalignments. Building on this positive track record, ERM2 seems to be fully equipped with all the necessary devices to avoid excessive exchange rate fluctuations within the Union.
The second way in which ERM2 will contribute to a stable monetary environment within the EU is by limiting short-term exchange rate volatility. As I have already mentioned, the widening of the fluctuation bands has reduced the incentive for market participants to test the sustainability of the narrow margins. A two-way risk arises as exchange rates move away from central rates, thereby discouraging speculative attacks. The most recent experience is encouraging in this sense. In 1997, exchange rate volatility among ERM currencies has been the lowest since 1992.
The ERM2's flexibility also allows for closer - formal or informal - exchange rate links, where this is appropriate in the light of economic convergence and the policy strategy pursued by the respective country. All in all, ERM2 can be expected to reduce short-term exchange rate uncertainty. This will be to the benefit of European exporters and importers.
Third, participation in ERM2 implies the commitment to stability-oriented fiscal and monetary policies. It also implies a commitment to structural reforms with a view to facilitating the longer-term adjustment of the economy and entry into the euro area. This commitment to sound economic policies is further enhanced by the reinforced monitoring of convergence policies which will accompany the establishment of ERM2.
Let me elaborate a little on these procedures. From the start of Stage Three, all EU countries - both those participating and those not participating in the euro area - have to avoid excessive deficits. The Stability and Growth Pact will also apply to the non-euro area countries, except for a few provisions referring to sanctions. Equally, the reinforcement of the multilateral surveillance of budgetary positions and the co-ordination of economic policies fully involves both the euro area and the non-euro countries. Thus, all non-euro area countries have to submit convergence programmes. If a risk of slippage from the medium-term budgetary objective arises, an early-warning procedure is established.
Finally, by providing assistance and incentives for economic convergence, ERM2 is a way to support countries not initially participating in the euro area to join as soon as possible. Over time, the larger the euro area, the larger the area where the benefits of the single currency - such as the elimination of exchange transaction costs or the elimination of any residual exchange rate uncertainty - can be obtained.
Overall, ERM2 is equipped with the necessary instruments to ensure exchange rate stability and to avoid that the move to the euro creates tensions and segregation in the European Union.
I am fully aware that what I have been talking about until now may sound a bit theoretical. I do not want to shy away from the real question that you want to be tackled, which I believe is:
How can it be avoided that a country not entering the euro area from the start is "left out in the cold", to use the expression of an academic, with the consequence of severe exchange rate tensions, depreciation, competitive distortions that are a detriment not only to the country itself but also to the economies of the euro area?
I am fully aware that ERM2 provides only part of the answer. It represents a framework for monetary and foreign exchange policy co-operation; it does not ensure by itself that the right policies are in the end implemented, in particular in the countries outside the euro area. ERM2 is a necessary condition, it is not sufficient. But I believe that the creation of the euro will represent an additional impulse for further economic integration in Europe.
In other words, I believe that the euro need not be a factor of division of Europe but rather will have the potential of becomig an instrument for accelerating its integration./.