Transcript Contents of the course - Solvay Brussels School of

International Finance
Part 1
Fundamentals of
International Finance
Lecture n° 5
Money integration in the European Union
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European Monetary Union
 Introduction
European Union : case study for exchange rate co-operation
leading to a monetary union. Catalogue of lessons about
benefits and costs of a single currency, and of advantages and
disadvantages of different institutional structures.
History:
European Monetary System (EMS) started in 1979 with
relatively flexible target zones, becoming progressively more
rigid.
1987 - 1993 : rigid exchange rate fluctuation bands
1993 : large speculative attacks, causing a large threat on
the system. Introduction of Euro postponed of 2 years.
1999 : Euro as scriptural common currency
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2002 : Euro as fiduciary common currency
European Monetary Union
 The European Monetary System (EMS)
Main objective of EMS : promotion of monetary stability
within Europe.
Three immediate aims as established in 1979 :
Reduction of inflation in EU countries
Promotion of exchange rate stability to favor trade flows
and investments
Gradual convergence of economic policy, allowing for
more fixed exchange rates.
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European Monetary Union
 Three main features of the EMS :
 the European Currency Unit (ECU) : weighted average
of all EU currencies, weights depending on the size of each
country and its importance in intra-EU trade (DM, FRF,
Sterling).
the Exchange Rate Mechanism (ERM) : exchange rates
allowed to fluctuate up to 2.25% or 6% on either side of the
central rate.
the European Monetary Cooperation Fund (EMCF) :
provides credit for members to help in adjusting balance of
payments problems, at short-term (9 months) or mediumterm (2-5 years).
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European Monetary Union
 The achievements of the ERM :
Stability of the exchange rates
The cost of higher interest rates volatility (to reduce
pressure on FX rates) has been avoided thanks to the
capital controls in the ERM in the 1980’s.
Question of the benefits of exchange rates stability on the
intra-EU trade. Sekkat & Sapir (1990) find little evidence
of the effect of FX rate volatility on prices -> little impact
on commercial trade activities
Reduction of inflation
Argument : due to asymmetry effect in fixed FX rates
regime, deficit countries have to disinflate, whereas surplus
countries could avoid inflationary policies by sterilisation.
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European Monetary Union
 Reduction of inflation in EU - empirical evidence
Number of pieces of evidence which suggests that ERM has
worked asymmetrically.
Intervention within the system support the view that Germany
was the leader.
Inflation in initially higher inflation countries did converge on
German levels.
Idea of a reduced cost of disinflation (in terms of
unemployment), thanks to the credibility bonus brought by the
pegging of currencies to low inflation countries (Germany).
However, empirical evidence is mixed on this view. But high
costs in ERM countries might be due to the nature of the labour
markets (half way between high centralisation and high
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decentralisation).
European Monetary Union
 Five success factors for the stability of the ERM :
(1) Co-operation among ERM countries and the existence
of the various financing facilities.
ERM is part of a wider, institutionalized, cooperation framework among European countries.
(2) Clever operational features in the design of the
exchange bands :
Co-existence of narrow bands (2.25%) and wider
bands (6%), providing some flexibility for high
inflation countries, allowing them to gradually adapt
their economic policies.
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European Monetary Union
 Five success factors for the stability of the ERM :
(3) Luck.
Co-operation of policy goals among several ERM
governments, focusing on disinflation and willing to
accept the discipline implied by the system (in the
1980’s).
UK was not a member : DM was the only large
currency in the system.
Strength of the dollar in the 1980’s reduced the
pressure for appreciation on the DM.
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European Monetary Union
 Five success factors for the stability of the ERM :
(4) Existence of capital controls
Allow some monetary independence to the
countries, by preventing large capital flows if
interest rates differentials.
(5) Growing credibility of the exchange rate parities.
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European Monetary Union
 Crises of the ERM - Facts
September 1992 : speculative attacks leading to the departure of Italy
and the UK from the system. Peseta devalued by 5%. Ireland, Portugal
and Spain tightened their capital controls.
July 1993 : Several realignments of Ireland, Portugal and Spain.
Pressure on the FRF and bands extended to 15%.
 Crises of the ERM - Triggering Factors
Breakdown in the economic policy agreement. France wanted to focus
on growth and unemployment, Germany trying to absorb the shock of
the reunification. Recession on major industrialised countries.
Release of capital controls, according to the Delors plan to monetary
union, implying lesser flexibility on exchange bands (2.25% for all) and
no capital controls.
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European Monetary Union
 Economic and Monetary Union - plan
Delors report (1989), basis of the Maastricht Treaty :
Monetary union to be achieved by a gradualist and parallel
approach:
Parallel : economic convergence to achieve at the same time
as monetary union (the one needing the other)
Gradualist : economic integration is a slow process
Stage 1 : all countries join ERM with 2.25% fluctuation bands,
capital controls removed, single financial area.
Stage 1 began on July 1, 1990.
Maastricht Treaty signed in December 1991, setting a timetable for
the whole process.
Stage 1 was supposed to be completed by end of 1993, but the
exchange rate crises set back the process.
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European Monetary Union
Stage 2 : exchange rate commitment more stringent.
Realignments expected to be more infrequent. Creation of a
central European body in charge of the monetary policy.
Started in January 1994.
The European Monetary Institute (EMI) was created to coordinate monetary policy.
Stage 3 : irrevocable fixing of the exchanges rates,
replacement of the national currencies. Monetary policy fully
transferred to the European Central Bank.
From January 1997.
Adoption of the Euro of 11 members in January 1999,
Greece joined in 2001.
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European Monetary Union
 Stage 3 : Convergence criteria = Stability and Growth Pact
Inflation max 1.5% above the average of the 3 lowest inflation
countries.
Interest rates on LT government bonds max 2% above the
average of interest rates in the 3 lowest inflation countries.
Government deficit does not exceed 3% of the GDP.
Government debt to GDP ratio does not exceed 60%.
The exchange rate must have been fixed within its ERM
without a realignment for at least 2 years.
The statutes of the central banks should be compatible with
those of the ECB.
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The European Central Bank
 Stability and Growth Pact - some remarks
 Inflation target at 2%
Studies show that the high growth countries are the high
inflation countries (Greece, Ireland, Luxembourg, Spain)
Known as the “Balassa-Samuelson” effect
Different transmission mechanisms of monetary policy per
country , if different labour flexibility, or market organisation
2% nominal -> potential risk for deflationary pressure
 Deficit at 3% of GDP:
countries should run a surplus in good years
implies that government will fully wipe out debts in the long run
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European Monetary Union
 Benefits claimed from the EMU:
The European Commission estimated to gains to 10% of the EU
GNP. Benefits should come from :
1. Direct gains from the elimination of transaction costs
(0.5 - 1.0 of EU GDP)
2. Indirect gains from the elimination of transaction costs :
price transparency
3. Welfare gains from less uncertainty (in optimisation
function of firms)
4. Positive impact on trade and growth
5. Benefits of having an international currency:
• additional revenues for the central bank
• increased foreigners investments in domestic markets 15
European Monetary Union
 Costs claimed from the EMU:
Depends on several factors :
The extent to which the area in question suffers from
asymmetrical shocks (see Reichlin): newer and poorer
countries of the union could have more problems than the
others.
However, opinions are mixed regarding the likelihood of
occurrence of asymmetrical shocks in single currency zones.
Business cycles might also have adverse effects. Cycles are
the outcome of 3 factors : shocks - propagation mechanisms
- and policy response.
Shocks and cycles could both be costly for the EMU.
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European Monetary Union
 Fiscal policy and EMU
Fiscal autonomy is useful to individual countries if they are
affected by asymmetric shocks (since monetary policy is no
longer available).
However, the constraints on the public debt to GDP ratio limit
the fiscal autonomy of the EC members.
In a limited fiscal autonomy framework, the EU central budget
should play a greater role, to
equalise the effect on different regions (transfer fiscal
resources to badly affected regions)
provide an automatic stabilisation for regions suffering from
a temporary loss of income
spread the costs of an adverse shock over the entire area.
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European Monetary Union
 The transition to Euro
Eleven member states of the EU initiated the EMU, adopting the
Euro on Jan 4th 1999, replacing their national currencies on the
financial markets.
Countries are : Austria, Belgium, Finland, France, Germany,
Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, and
Greece 2 years later. UK, Sweden, and Denmark choose to keep
their national currencies.
The final fixed rates have been determined on Dec. 31, 1998.
The value of Euro against the $ slid steadily following its
introduction, from $1.19 in Jan 1999, to $0.87 in Feb 2002. Its
lowest was $0.825 in Nov. 2000.
The fiduciary introduction of the Euro started Jan 1st, 2002. Since
the spring 2002, the Euro gained in value against the $.
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Is enlargment favourable?
 Main criteria of benefits to join a Single Currency Area:
Openness of the economy to international trade with
members
Non asymmetric economic shocks to members
In case of shock : labour flexibility
 Characteristics of the new entrants (Check, Slovakia,
Estonia, Hungary, Poland, Romania, Lithuania, Latvia):
Trade in % of GDP at least equal to current members;
Asymmetric of shocks for most of them, and UK, not for
Hungary and Poland (De Grauwe, p. 94)
 Transition phase : should be as short as possible, due to
vulnerability of speculative attacks.
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The European Central Bank
 Possible models offered to the ECB:
The Anglo-French model : the objectives of the Central Bank
are,e.g. : price stability, stabilisation of business cycle,
maintenance of high employment, financial stability. Political
dependence of the central bank.
The German model : the primary of the Central Bank is price
stability, i.e., inflation control. Political independence of the
central bank.
 Maastricht Treaty : opted for the German model.
Possible reasons :
The come-back of the monetarist view
The political dominance of Germany, very focused on
inflation control.
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The European Central Bank
 Accountability the ECB:
Independent from the governments
Statutes fixed by the Maastricht treaty -> need a unanimous
vote to be modified
As independent than the Bundesband, less independent than
the Fed, and less accountable than both.
Decision body of the ECB : the Governing Council, made of
representative of national central banks (18 members)
 Decentralisation:
of the national needs and policy goals
could (does) lead to immobility on case of diverging
interests.
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Will Euro be an International Currency?
 Size matters :
Share of output and trade : US and EU (non-UK) similar
in size (25% output; 20% trade)
Outstanding equity and bonds : US twice as big as EU
(2.3 bios $ equity; 7 bios $ bonds in EU)
 Financial liberalisation matters :
to allow investors to hold liquid, diversified, freely
tradable portfolios.
 Financial stability matters :
not to confuse with price stability that, if excessive,
could lead to deflation.
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