Exchange rate issues relating to the acceding countries
Keynote speech by Tommaso Padoa-Schioppa,Member of the Executive Board of the European Central Bank,at the IMF Conference "Euro Adoption in the Accession Countries, Opportunities and Challenges",Prague, 2 February 2004.
I would like to express my gratitude to the IMF for organising what - judging by the papers that have been pre-circulated and by the attendance - promises to be a truly stimulating conference, and for inviting me to speak this morning. Even more importantly, as an ECB official and a European I am grateful to the IMF for the historic role that it has played in fostering and surveying the transition process of Central European economies. The good prospects with which they face the now very imminent EU membership owe a lot to the Fund.
The largest-ever enlargement of the European Union is less than three months away and the excitement of the countdown is palpable here in Prague, whose citizens are about to become citizens of the EU. Accession to the EU confirms and underscores the historical change and progress achieved over the past one-and-a-half decades, in particular in the central European and in the Baltic countries that had for so long lost democracy, economic freedom, end even their existence as nation-states.
Today we shall focus on the next steps in the economic side of this vast process, particularly in the field of monetary integration. As we all know EU membership and adoption of the euro are two different events, even if the former entails a commitment and a right to the latter and the latter presupposes the former. My remarks this morning will touch upon some of the elements that will be key to addressing the challenges and seizing the opportunities associated with the eventual integration of the new Member States into the euro area.
As you know, on 18 December 2003 the “Policy position of the Governing Council of the ECB on exchange rate issues relating to the acceding countries” was published. Our intent was to make our views publicly known and to help guide the process of monetary integration of the new Member States. I will draw, selectively, from the “Policy position”, which will serve as the backbone of my remarks today.
But before we turn towards the future, let me look briefly at the past. The recent ECB position is only the latest in a series of steps we have taken to provide guidance and orientation to the process of monetary integration of new EU members. The Eurosystem has been engaged in a comprehensive dialogue with the central banks of candidate countries well before the date and the countries of this enlargement were decided. The ECB has set up and entertained a very dense network of contacts at all levels since 1999. Policy positions on issues such as unilateral “euroisation” and the compatibility of currency board arrangements with ERM II participation were already firmly established and announced in November 2000.
More recently, since the signing of the Accession Treaty, almost ten months ago, the central bank governors of the acceding countries have been participating as observers in the meetings of the General Council of the ECB. This has intensified previous exchanges of views on monetary, economic and financial developments.
The interaction has been particularly strong at the technical level, where initiatives have been too numerous for me to go into detail here. Just to give you a flavour, let me mention two figures. First, in the last four years there have been more than 1000 central bank cooperation activities, by this meaning meetings, visits, or exchanges geared to spreading best-practice across the central banking community. Second, Eurosystem staff have spent in excess of 16,000 working days on these activities.
The ECB has also made continued efforts to communicate with the general public on the subject of accession. A number of articles in our Monthly Bulletin come to mind as a telling example. Another example is the publication of the ECB “Policy position” in all the official languages of the European Community - both current and prospective. Overall, I am confident that this crescendo of interaction and communication has laid the foundations for a smooth entry of the acceding central banks into the European System of Central Banks as of 1 May 2004.
Now, let me look to the future and ask what course should the new Member States follow towards ERM II and the adoption of the euro. When reflecting on this question, we can structure our thinking along three main blocks: first, the general principles that guide the whole process; second, considerations that refer especially to the ERM II phase; and, third, considerations that relate more specifically to the eventual adoption of the euro.
On general principles I can be brief because they have been laid down in the Treaty and in other key documents, such as the ERM II Resolution, which you all know very well. Some of these principles are as basic as recalling that, upon accession, the new Member States will be committed to striving towards the eventual adoption of the euro. It is nevertheless of the utmost importance that we keep such key principles in mind throughout our discussions today and tomorrow. This is because monetary integration does not take place in an institutional vacuum. The monetary integration of the new entrants will, on the contrary, take place in a very firmly defined institutional setting. Of these general principles, I would like to stress (i) the multilateral nature of the framework, (ii) the absence of a single trajectory towards the euro, (iii) the case-by-case approach and (iv) the principle of equal treatment.
First, the multilateral nature of the framework. The eventual adoption of the euro by a new Member of the EU is the end-point of a structured convergence process within a multilateral framework. This is the spirit of decision-making in the EU as a whole, with its procedures for the surveillance of economic policies and, specifically, the requirement to treat exchange rate policy as a matter of common interest. This also has implications for the design and communication of monetary integration strategies. The multilateral nature of the framework means that, at every stage of the process, decisions concerning one country or currency are collective decisions.
Second, the absence of a single trajectory towards the euro. No single path towards the euro can be identified and recommended to all acceding countries at all times. This key point is the natural consequence of the substantial differences that exist among countries, differences relating not only to the size and structure of the economies, but also to monetary and exchange rate regimes. The range of monetary and exchange rate regimes currently in place in the acceding countries extends from currency boards to free floating, with several countries conducting intermediate regimes such as pegs or managed floats. Let me stress that this variety of possible trajectories towards the euro applies not only to the five central European countries that are the focus of the paper prepared by the IMF for this seminar, but to all the new entrants. Indeed, it has also applied to the countries that are now in the EU and in the euro area.
Third, the case-by-case approach. It follows naturally from the differences I just referred to that the situations and strategies will be assessed on a country-by-country basis. This will also apply to the issuance of specific recommendations by the ECB. Depending on the circumstances of each case, the ECB may give such specific recommendations.
Last, but certainly not least, equal treatment. This principle, as in the past, will continue to apply during the entire process of monetary integration. So, while each country would be considered according to its specific merits (i.e., the case-by-case principle), comparable situations and cases will be treated in a comparable manner. Equal treatment has, of course, both a “cross-section” and a “time series” dimension.
Turning to ERM II, I would like to be explicit on the considerations that should guide the “use” of the mechanism. As you know, unlike the adoption of the euro, entry into ERM II is not subject to pre-established criteria. So in principle it can take place any time after accession. However, it is a matter of logic that, for the participation in the mechanism to be smooth (something we all desire), any major policy adjustments that may be still outstanding should be undertaken prior to entry into ERM II. This relates, for example, to deregulation of administered prices or major fiscal consolidation. Indeed, with regard to fiscal positions, the slippages that have occurred in certain countries, are causes of concern. One has to bear in mind that deficits are mainly structural and that expenditure pressures are expected to mount over the next few years, not least due to EU accession. Recent fiscal developments call for renewed efforts towards fiscal consolidation, where appropriate, and the need to follow a credible fiscal path.
The key challenge for acceding countries is how to advance, and indeed speed up, real convergence, while safeguarding and further improving the achievements in terms of nominal convergence. In fact, in a number of acceding countries inflation has come down considerably, the macroeconomic environment can be regarded as fairly sound, and financial sectors seem to be stable. At the same time, the gap with the EU in terms of per capita income is very wide. The new Member States have successfully implemented structural reforms that characterise the transition to well functioning market economies, but the catching up process has still a long way to go. The perspective of accession has been a powerful anchor for policy change and a formidable defence against contagion in the financial crises of the last decade, but the major ambition of reaching Western European standards in public infrastructure and living conditions has still to be met.
Thus, the fact that remarkable progress has been achieved thus far in a wide range of areas and policy fields should not mislead us into thinking that there will be no challenges ahead. Take the case of inflation. While very substantive headway has been made in many new Member States in reducing inflation to low or very low levels, upward pressures on prices will most probably re-emerge at some point. One cause of pressure, which we have already seen at work in some cases, stems from the further liberalisation or adjustment of administered prices. In addition, the harmonisation of indirect taxes and possibly food price increases in the context of EU accession are also expected to make the maintenance of low inflation a demanding task.
In this context, one should remember that the big gap in per capita income is usually accompanied by a gap in the level of prices and that the real convergence process, what we call the catching-up, usually entails a parallel narrowing of both these gaps. This is why it is important to analyse the underlying determinants of price dynamics. Some impulses may in fact result from the catching up process and can therefore be regarded as equilibrium phenomena –“physiological” inflation, if I may – while other less benign pressures, for example resulting from overly buoyant domestic demand growth or by a premature “catching up” of the wage level – i.e. “pathological” inflation – would require a different response. Rising inflation rates, in particular if they are not clearly associated with GDP-per-capita convergence, could make the economies vulnerable to increasing inflation expectations and wage-price spirals. This would seriously complicate the conduct of monetary policy and negatively affect growth.
The challenges to a sustainable growth and catching-up process are not limited to inflationary risks or to fiscal concerns. Also external positions have to be listed as a challenge. They have been remarkably robust so far, with imbalances apparently being largely attributable to high marginal returns on capital in the acceding countries. Nevertheless, risks to the sustainability of external positions may emerge if the convergence of relative price and wage levels with those of the EU proceeds too quickly. Similarly, large and possibly increasingly volatile capital flows could pose challenges to monetary and exchange rate policy frameworks.
To determine their optimal monetary integration strategy, new Member States will need to consider the extent to which the limitation of exchange rate flexibility may help to anchor expectations and also promote the pursuit of sound policies. As we put forward in the ECB Policy position, “while participation in ERM II per se does not ensure supportive and consistent macroeconomic and structural policies, it has the potential to act as a catalyst, enhancing the disciplinary effect of such policies.” Let me add that, for countries such as France, Belgium, Italy, or Spain, the exchange rate mechanism has certainly acted as such a catalyst for sound policies in the past.
Another key consideration when defining a monetary integration strategy is that the catching-up process may have an impact on the desired room for adjustment in the exchange rates of the new Member States. This may have a bearing on both the timing of entry and the desired duration of participation in ERM II.
In certain cases, structural reforms and progress in the catching-up of income levels could result in changes to the equilibrium real exchange rate, however difficult their measure may be. Of course, an appreciation of the real exchange rate could, in principle, be accomplished through domestic price changes alone. This may, however, be a very difficult path to follow. It may actually be much easier, and preferable, to plan a longer stay in ERM II to be able, if necessary, to realign the central rate. So, rather than focusing on the required minimum period of two years, the optimal duration of participation in ERM II could, and perhaps should, be looked at from the point of view of what is most helpful to accompany the real convergence process. It is so because, I repeat, real convergence is the main challenge. While the optimal duration may turn out to be two years for some new Member States, it could be longer for others.
Taking into account what I have just said, it might also be appropriate for some entrants to consider applying for ERM II membership only when further convergence has been achieved. For others, those that have implemented significant structural reforms and have shown the ability to advance convergence, entry into the mechanism can take place soon after accession – provided, of course, that there is agreement on the central rate. In my view, it would be unnecessarily restrictive to recommend that a country should enter ERM II only when it is confident that it would successfully meet the convergence criteria in two years’ time.
I know that some of you in this room consider that a prolonged stay in ERM II could entail significant risks. While our views are similar on most issues regarding the future monetary integration of the new Member States, this is an issue in which there are sometimes differences of opinion. For example, in the documentation prepared by the Fund staff for this conference one can precisely find such concern that a prolonged stay in ERM II could be risky. Let me say that every policy is “risky”. And in some cases, such a prolonged stay in ERM II could also entail significant benefits, resulting from the role of ERM II as a convergence adjuvant. It should not be forgotten that what distinguishes ERM II from the usual intermediate exchange rate regimes and makes it a unique framework is the fact that it entails a clearly marked, credible and dominant exit, namely entry into Monetary Union. If policy consistency of participating countries is ensured and fundamentals are solid, the risk of destabilising speculation against currencies of ERM II participants should not be overplayed. More generally, the view of markets as mainly acting in a destabilising manner is to my mind a biased one. I would also like to stress that, given the rules-based and multilateral nature of the framework, there can be no ex ante assurance regarding a limitation of the length of participation in the mechanism.
I mentioned earlier that, regarding the duration of participation in ERM II, the Treaty sets out the two year minimum prior to the adoption of the euro. Before the examination, a Member State must have respected the normal fluctuation margins provided for by the exchange rate mechanism without severe tensions for that minimum period.
Let me now touch upon the issue of the width of the fluctuation band. The ECB considers that the standard band of ± 15% is appropriate for Member States that are engaging in a convergence process. Multilaterally agreed narrow bands can only be considered at a very advanced stage of convergence, as was the case for Denmark when the band of ±2.25% was formally agreed in September 1998. As pointed out at the time, the agreement concerning the Danish krone was based on the high level of convergence achieved by Denmark in terms of the convergence criteria. This included the very high degree of exchange rate stability and the unchanged parity maintained by the krone within ERM I since 1987.
The importance of the narrow band is often overstated. One should not forget that among the twelve present countries in the euro area, only one, the Netherlands, had a formally agreed narrow fluctuation band prior to the adoption of the euro. This also further highlights that no single trajectory towards the euro need to be, or can be, identified. Of course, a Member State joining the ERM II may decide to make (or retain) a unilateral commitment to narrower exchange rate fluctuations. Given what I said earlier about the differences among countries, the merits of any such unilateral commitment would need to be considered in each case, taking into account specific circumstances and the multilateral nature of decision-making. ERM II is managed via collective decisions of the Member State concerned, the euro area countries, the ECB and the other Member States participating in the mechanism. This means that decisions concerning the width of the fluctuation band, as well as decisions regarding the central rates, have to be agreed among the parties involved in the mechanism.
Let me finally turn to the eventual adoption of the euro. On this, I will be brief. The eventual adoption of the euro by the new Member States will be a momentous occasion, with a profound impact on psychological and social attitudes.
The new entrants of next May are the first countries to join the EU after the euro has been launched. It is understandable that many may feel that “full” membership would not be achieved until euro notes and coins become their currency. This situation is different from that faced by the existing Member States. The principle of equal treatment, however, will continue to apply, as I stressed earlier, during the entire process of monetary integration. And two implications of this principle should be recalled.
First, for countries to adopt the euro, it is of the utmost importance that they fulfil the convergence criteria in a sustainable manner, as stated in the Maastricht Treaty. There will be no additional criteria but there will be no relaxation of the criteria either.
Second, the assessment of exchange rate stability against the euro will focus on the exchange rate being close to the central rate while also taking into account factors that may have led to an appreciation. This is in line with what was done in the past. In this regard, it is important not to confuse the issue of the width of the fluctuation band of a country participating in ERM II, which I talked about earlier, with the interpretation of the exchange rate stability criterion. In other words, the width of the fluctuation band within ERM II will not prejudice the assessment of the criterion of exchange rate stability.
I often hear calls for greater detail and precision about how compliance with the convergence criteria will be assessed. There is a great demand for being very specific in all respects already at this stage. Let me say that the Treaty and past practice so far provide useful guidance for future convergence assessments. But let me also say that the added precision would not only run counter to the institutional framework in place, but would also imply undue rigidity, leading to mechanistic assessments that would benefit no one. The reluctance to be more precise or to pre-empt the decision-making, which ultimately involves not only a quantitative but equally so a qualitative assessment, has to be seen in this light.
Ladies and gentlemen, it is time for me to conclude.
The basic interest of the euro area in the process of monetary integration is to ensure that the new Member States proceed towards the euro in a smooth manner and in line with Treaty provisions. A smooth participation in ERM II will require that the overall policies of participating Member States are consistent and, if necessary, that major policy adjustments take place prior to entry into the mechanism. The smooth monetary integration of the new Member States will also require that country-specific situations are taken into account when considering which trajectory towards ERM II and the adoption of the euro would best accompany the convergence process of each of the new Member States.
 Report by the (ECOFIN) Council to the European Council in Nice on the exchange rate aspects of enlargement, Brussels, 8.11.2000, Council of the European Union press release no. 13055/00.
 Protocol on the convergence criteria referred to in Article 121 of the Treaty establishing the European Community.
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