Exchange rate policies in the accession process
Speech by Eugenio Domingo Solans, Member of the Governing Council and of the Executive Board of the European Central Bank, delivered at the conference on "Alternative Exchange Rate Regimes in the Globalised World" marking the 10th anniversary of the Currency Board in Estonia, Tallinn, 11 June 2002.
It is a pleasure for me to be in Tallinn today to celebrate with you the 10th anniversary of the establishment of the currency board arrangement in Estonia. I would like to take this opportunity to congratulate the policy-makers in Estonia, and at the Bank of Estonia in particular, for their sound and successful management of the Estonian economy.
Maintaining the currency board without any severe strain for a period as long as 10 years is a major achievement, in particular if one takes into account the difficult circumstances in which the country has found itself over the last decade. These circumstances included not only the banking crisis of the early 1990s and the Russian crisis of 1998, but also the transition process from a centrally planned economy towards a market economy. Nevertheless, the arrangement itself was never fundamentally questioned as it was underpinned by a fast and vigorous move towards deregulation, liberalisation and the restructuring of the economy to achieve more flexible labour and product markets. As a consequence, Estonia made considerable progress in its fight against inflation, and the arrangement has proved conducive to strong and sustainable growth in recent years.
The success of Estonia's currency board certainly makes the country a valuable case study for our conference today on "alternative exchange rate regimes in a globalised world". However, I would like to take this opportunity to share with you some thoughts about monetary and exchange rate policies not only in Estonia but in accession countries in general. These policies are an important element in the pursuit of real and nominal convergence insofar as they provide an anchor for inflation expectations, safeguarding external competitiveness and thereby strengthening the economic environment for growth. At the same time, monetary policy and exchange rate strategies have become more difficult to conduct over the past decade due to highly mobile international capital and increasingly integrated economies. One distinctive feature of accession countries compared with other emerging market economies is that they can rely on the well-established institutional and policy framework of the acquis communautaire and anchor their strategies with a clear endpoint, the ultimate goal being the adoption of the euro.
Before I speak in greater detail about the main challenges that accession countries will have to cope with in the coming years, let me first briefly talk about the past. To better understand the future challenges, it might be useful to look at the experience that accession countries have acquired so far with regard to monetary and exchange rate policies.
Exchange rate policy in the past
Let me start with the following remark: in my view, in general terms monetary and exchange rate policies have been managed in a rather successful manner in the accession countries because they have contributed to macroeconomic stability and thereby laid the ground for sustainable growth. This is not only true for Estonia, but for many other accession countries as well. Most of them have set and adjusted their monetary and exchange rate policies in line with the overall economic policy frameworks and economic conditions prevailing in their respective countries. At the beginning of the transition process, most accession countries opted for a fixed exchange rate regime since an external anchor was regarded as the most effective strategy for combating high inflation. Once the immediate threats of inflation running out of control had been averted, a number of accession countries experienced regime shifts, mainly from fixed pegs towards more flexible regimes. This resulted in a broad diversity of exchange rate regimes. At first glance, the current diversity could seem somewhat surprising considering that the accession countries all had similar starting points and all share the same endpoint of integration, namely the adoption of the euro. However, while all accession countries have been progressing in terms of real and nominal convergence, the pace of such positive developments has varied from one country to the next. In view of these contrasting developments over time, the exchange rate proved to be a valuable policy tool when used in a proactive manner. In contrast to the experience of other emerging market economies, most of the shifts – although not all – were not a reaction to currency crises but the result of forward-looking policy management. In this context, the institutional framework for EU integration also facilitated and guided the adjustment of exchange rate policies in those accession countries that had to shift regimes.
Despite the diversity in regimes, the role of the euro – or its European legacy currencies – as the main reference currency has increased substantially over the past decade. The euro is now the main, if not the sole, reference currency in most accession countries. This increase in importance materialised either through regime shifts to pegs to the euro or through shifts towards managed floating regimes where the euro became the predominant reference currency. Overall, these shifts have been in line with the rising trade and financial integration of accession countries with the euro area. Recently, some shifts have been driven by institutional requirements in view of the ultimate objective of adopting the euro. Indeed, accession countries have already started to prepare for the exchange rate mechanism (ERM II) where the euro is the sole reference currency. The most recent example has been Lithuania, which recently re-pegged its currency board from the U.S. dollar to the euro.
The challenges ahead
Let me now turn to the challenges that accession countries are likely to face in the coming years. From an ECB point of view, there are four main challenges on the accession countries' road to the euro: they need to make further progress in bringing down inflation; they need to pursue real and nominal convergence in parallel; they need to implement sound monetary policies and exchange rate strategies, taking account of increasing capital flows and the aim of maintaining competitiveness; and finally they need to further develop the financial sector and its functioning. In addition to these four economic policy challenges, there is the important issue of central bank independence that needs to be implemented and fully respected. While each of these challenges would justify a speech in its own right, I would like to touch upon some of them from the point of view of the impact they could have on monetary and exchange rate strategies in the accession countries.
First, there is the desirability to pursue real and nominal convergence in parallel. By fostering real convergence through structural reforms that enhance the growth potential and increase goods and labour market flexibility, accession countries can indeed support the nominal convergence process, mainly by ensuring a gradual decline in inflation. Likewise, by further advancing nominal convergence and anchoring inflation expectations, accession countries can support non-inflationary growth and thereby ensure real convergence. Even though different income levels are in principle compatible with the eventual participation of accession countries in EMU, advancing real convergence with the euro area is desirable in order to foster economic cohesion within EMU and to help minimise the risks of asymmetric shocks. If, as a result of structural convergence, real shocks were to become more symmetric with the euro area, this would then reduce the need for nominal exchange rate adjustments and would therefore enhance countries' ability to withstand pressures in a monetary union. A final argument in favour of pursuing real and nominal convergence in parallel is that an excessive degree of real divergence could make the sustainability and durability of nominal convergence extremely difficult, both being conditions to be complied with in order to qualify for joining EMU, as is established in the Maastricht Treaty, Article 109 J (1) and in Article 1 of its Protocol no. 6.
The second challenge I would like to touch upon is the expected increase in more volatile capital flows to accession countries. Such an increase is likely as a result of the full liberalisation of capital accounts upon accession – as part of the acquis communautaire –, the further development of the financial sector, and market participants' expectations for interest rate convergence. Large capital inflows can have a bearing on macroeconomic stability. By putting upward pressure on the currency, large capital inflows can pose risks to a country's external competitiveness if this appreciation is not matched by increased productivity.
Finally, I would like to briefly refer to the difficulties of finding the appropriate policy mix in an environment characterised by continuous structural changes and the need for further disinflation. In view of strong pressures for government spending during the process of catching-up in income levels, further efforts in fiscal consolidation seem justified. In fact, in some accession countries the current fiscal policy stance might not be sustainable over the medium term or may conflict with other policy objectives, in particular the continued fight against inflation. In this case, an expansionary fiscal policy might call for a more restrictive monetary policy than would otherwise have been warranted. As recently experienced, this could lead to political problems that could even result in threats to central bank independence. Let me just state at this point that the ECB is closely following the issue of central bank independence and we remain concerned about some recent developments.
The path towards the euro
Let me now turn to the path towards the euro and the benefits for accession countries of having such an explicit roadmap for monetary integration. As I already mentioned, the institutional framework for EU integration and the clearly defined endpoint of accession are of crucial importance for accession countries in guiding their exchange rate policies. In the coming years, accession countries will continue to follow the various steps defined by this framework, namely EU accession, ERM II membership and eventually the adoption of the euro. Each of these steps has different implications for the exchange rate strategies in accession countries. Upon EU accession, accession countries will join EMU with the status of "countries with a derogation". As such, they will be expected to treat their exchange rate policy as a "matter of common interest" and to join the ERM II mechanism for a minimum of two years before adopting the euro.
As I have already indicated, accession countries have already started to bring their exchange rate regimes in line with the ERM II requirements. Crawling pegs, free floats and pegs to anchors other than the euro are not compatible with ERM II. With regard to currency boards, the countries would not necessarily have to go through a double regime shift but could in principle maintain their existing arrangements. Following an agreement with the ECB, based on an assessment of the appropriateness of the regime in terms of convergence with the euro area, countries would be able to participate in ERM II. However, a currency board cannot be regarded as a substitute for participation in ERM II, but would constitute a unilateral decision augmenting the relevant countries' obligations under ERM II while not implying additional commitments for the ECB.
In this context, I would also like to stress that unilateral "euroisation" – a proposal made in particular by a number of academics – is not considered to be an appropriate policy option for accession countries in the ongoing integration process. Adopting the euro unilaterally as legal tender would be inconsistent with the rationale of EMU, which envisages the eventual adoption of the euro as the endpoint of a convergence process within a multilateral framework. Moreover, unilateral "euroisation" may not be a suitable policy option even from the accession country's viewpoint. In this respect, I would point to the example of Estonia, where a couple of years ago the government discussed whether Estonia should "euroise" or not. As we all know, Estonia decided to maintain the currency board arrangement and to follow the prescribed integration path. This decision has indeed served Estonia well, as interest rates in Estonia are now close to those in the euro area. For countries with flexible exchange rate regimes, too, the benefits of "euroisation" could be outweighed by the costs, not least because "euroisation" would deprive countries of the possibility of autonomous monetary policy and the use of the exchange rate as an adjustment tool during the convergence process.
Allow me now to also briefly reflect on the benefits of the ERM II framework. Doubts are sometimes expressed as to the usefulness of requiring the accession countries to first join the ERM II mechanism before adopting the euro. Let me take this opportunity to explain why the ECB regards ERM II as a meaningful policy framework within which accession economies can prepare for monetary union and make progress towards real and nominal convergence. I recently addressed a group of Latin American Central Bankers in Madrid in a seminar jointly organised by the Banco de España and the ECB. I conveyed to them the idea that ERM was a key factor for the success of European monetary integration. ERM avoided excessive exchange rate volatility and, of course, competitive devaluations and, at the same time, it acted as a good shock absorber. In the process towards what I like to call the functional culmination of European monetary integration, ERM struck a right balance between commitment and flexibility. Mutatis mutandis, the same arguments could now be applied in the process towards the geographical completion of European monetary integration, i.e., the incorporation into it of the accession countries.
As the decision on the central rate is based on a multilateral agreement, whereby the ECB is fully committed, the ERM II mechanism can be expected to help anchor inflation expectations. Given that accession countries are small and open economies and that the capital accounts should be fully liberalised by the time of EU accession, accession countries cannot disregard exchange rate developments. Thus, large exchange rate fluctuations should be avoided, as they would hamper progress in disinflation and sustainable growth. ERM II is expected to contribute to achieving this target. At the same time, the ERM II mechanism will provide accession countries with a degree of flexibility provided by its broad fluctuation band of ± 15% and the possibility of adjusting the central rate. The flexibility inherent in the ERM II mechanism should be instrumental in accommodating the reforms necessary to complete the process of economic restructuring and real income convergence. It seems premature and probably impossible at this stage to try to assess the appropriate length of ERM II participation from an economic perspective, beyond the minimum compulsory statutory requirement of a two-year ERM II membership. This would depend on the actual progress made by the countries concerned in real and nominal convergence combined with the possible need to use the exchange rate as an adjustment tool. This could prove particularly important in view of the ongoing catching-up process and the countries' exposure to competition from the single market in an environment of full capital mobility.
Ladies and gentlemen, I will now make a few concluding remarks. The ultimate goal of entry into the euro area is an ambitious one that will confront the accession countries with substantial challenges for which they have to prepare themselves thoroughly. Nevertheless, given the impressive success of macroeconomic policies in the past, I am confident that accession countries will be able to rise to meet all future challenges.
The coming years will be crucial to ensure the smooth integration of the accession countries' central banks in the European System of Central Banks and, subsequently, the Eurosystem. In this respect, the ECB together with the national central banks of the euro area have already begun an intense policy dialogue with the central banks of the accession countries. The co-operation activities with the central banks of the accession countries are well under way and the ECB stands ready to further intensify its dialogue.
Thank you for your attention.