Transcript European Monetary Union

European
Economic and Monetary
Union
Sander Winckel
Adviser EIF
Ministry of Finance SR
Sofia, October 20-21, 2006
Content



Economic theory
History of Economic and Monetary Union
EU new Member States
Models of Economic Integration




Preferential trade agreements ( Lome)
Free Trade Area (EFTA)
Harmonisation of external tariffs plus free trade
area (EEC)
Common Market: market integration plus factor
mobility (capital and labor). This stage may
include monetary union to ensure complete
factor mobility (EU)
Monetary union - definition


In economics, a monetary union is a situation
where several countries have agreed to share a
single currency among them.
The European Economic and Monetary
Union (EMU) exists between 12 of the 25
member states of the European Union which
have adopted the euro as their single currency
and who co-ordinate their economic policies.
Theory of Optimal Currency Areas
(OCA)
Robert Mundell – 1961 (Nobel Prize 1999):



Size of OCA dependent on degree of integration of economy
(highly integrated economy less susceptible to asymmetric
shocks), preferences regarding inflation and unemployment,
different labor market institutions, growth rates, balances of
trade, fiscal systems etc. (economic policy coordination)
Asymmetric shock: recession which only affects some members
of a group of trading countries
Country needs separate currency if the economic costs of an
asymmetric shock, through changes in wages and prices, factor
mobility or government budget, would be higher than those of
altering the exchange rate
Optimal Currency Areas (cont.)





Therefore, an independent monetary policy with exchange rate
flexibility is the most efficient way to deal with asymmetric
shocks
But …. asymmetric shocks sometimes occur only in one region
or in a specific sector in one or more countries
Flexible exchange rate regime less efficient in open and/or small
economies
And …. theory is static (e.g. exchange rate changes can be
effected in short term, other changes take much longer)
Thus … more dynamic (and contrarian) theory in follow-up
paper:
‘Uncommon Arguments for Common
Currencies’ and ‘A plan for a European
Currency’ (Mundell, 1970)






Common currency can reduce impact of asymmetric shocks by
better reserve pooling and portfolio diversification:
Negative effects on currency are shared with currency partners
Impact on economy of whole currency area will be less,
therefore less risk premium needed on capital market
instruments denominated in that currency
Macro-economic shocks weakened by capital movements
Single currency reduces speculation (as in 1960s)
EU economies are highly integrated (e.g. intra-EU trade >90%
of all members’ trade)
Costs and benefits of
Monetary Union
Costs:
 Increasing loss of national sovereignty
 Loss of control over monetary policy (instruments: interest rate,
exchange rate, open market ops, discount window, reserve
requirements)
Benefits:
 Lower transaction costs between member states
 More efficient market – less price inequality
 Greater economic certainty
 Lower interest rates
 Seignorage
 Less speculation and currency risk
 Sharing of macro-economic shocks
Exchange rate system after WW II





Bretton Woods fixed exchange rates – since
1945
Currencies pegged to fixed USD/gold rate
Currency had to remain within upper and lower
bands
At shock reserves had to be sold
US expansionary fiscal policy from 1965
(Vietnam) caused inflation and stress to the
system
Exchange rate system after WW II –
cont.





1967: devaluation UK pound
Increased speculative activities in money markets
1971: first US dollar devaluation
1973: second US dollar devaluation
1973: Bretton Woods system abolished
Economic and monetary integration
in Europe





1950: European Payments Union
1951: European Coal and Steel Community
(ECSC)
1957: Treaty of Rome – European Economic
Community: 6 members
1958: European Monetary Agreement
1970: Werner Report
Werner Report


1969: Following Bretton Woods System
instability and impact of Optimal Currency
Areas theory of Prof. Mundell, a High Level
group, chaired by Prime Minister Werner of
Luxembourg, was set up during the The Hague
summit
Werner Report proposed a three-stage plan to
create an economic and monetary union (EMU)
within 10 years
Werner Report – cont.
1) Reduction of fluctuation margins between Member
states currencies, broad guidelines for economic policy,
coordination of budgetary policy, preparation of Treaty
changes to facilitate later stages of EMU
2) Integration of financial markets and banking systems to
create free movement of capital, gradual elimination of
exchange rate fluctuations, closer coordination of short
term economic policies and budgetary and fiscal
measures
Werner Report – cont.
3) Irrevocable fixing of exchange rates between
participating national currencies, convergence of
economic policies, establishment of a
Community system of central banks

1971: collapse Bretton Woods system –
temporary abandonment of EMU project
European economic and monetary
integration after Bretton Woods - 1


1972: Snake in the tunnel: fluctuations between
member currencies were narrowed (“snake”) in
relation to fluctuations towards the US dollar
(“tunnel”)
1970s oil crisis put system under heavy pressure;
sharp fluctuations, some leaving system; 1977:
only 5 Members remained in a zone based
around the German mark.
European economic and monetary
integration after Bretton Woods - 2
1973: new Member States: UK, Ireland,
Denmark
 1979: European Monetary System, consisting of:
1) currency basket (ECU)
2) monetary stabilisation mechanism (Exchange
Rate Mechanism ERM)
3) mechanism for financing monetary
interventions (European Monetary Cooperation
Fund)

European economic and monetary
integration in the 1980s




1981: Greece joins EEC
1986: Spain and Portugal join EEC
1986: Single European Act (Delors Commission):
creation of single market; free movement of goods,
services, persons, capital (‘four freedoms’)
1989: Study on EMU (Delors Report) – completing the
single market: introduction of EMU in three stages;
using existing institutional framework (unlike Werner
Plan) and creating European system of Central Banks
European economic and monetary
integration – Delors report



Stage 1: increased cooperation between central banks in
the field of monetary policy, removal of obstacles to
financial integration, monitoring of national economic
policies, coordination of budgetary policy
Stage 2: Preparations for final EMU phase,
establishment of ESCB, gradual transfer of monetary
policy to European institutions, narrowing of margins
of fluctuation within exchange rate mechanism
Stage 3: fixing exchange rates between currencies and
replacement by single European currency, transfer of
responsibility for monetary policy to ESCB
European economic and monetary
integration – 1990s



1992: ERM under pressure: speculative attacks on GBP
and ITL; ESP and PTE devaluation
1992: Maastricht Intergovernmental Conference
establishing new Treaty on European Union, including
the acceptance of the Economic and Monetary Union
(EMU)
Economic convergence criteria concerning inflation
rate, public finances (relating to deficits and debt),
exchange rate stability and long-term interest rates
(“Maastricht criteria”)
Economic and Monetary Union



1990 - Stage 1: elimination of exchanges controls and
most restrictions on capital movements, better
coordination of economic policies and intensification
of central bank coordination among Member States;
setting of criteria for entry into stage 3
1994 - Stage 2: closer policy coordination, devising
multi-annual programs to reduce inflation and budget
deficits, creation of European Monetary Institute
1998 – Stage 3: fixing of exchange rates, establishment
of European Central Bank
Maastricht Criteria





Inflation rate: average inflation rate not more than 1.5
% from average of best three EU member states
Budget deficit: at or below 3 % of GDP, with tendency
to 0 % or surplus in the medium term
Public debt: not exceeding 60 % of GDP
Currency stability: respect for normal fluctuation
margins of ERM without severe tensions for at least
two years without devaluation
Interest rate convergence: average nominal long-term
interest rate not more than 2 % above that of best
three EU member states
European economic and monetary
integration – 1990s – cont.





1993: ERM fluctuation bands widened to +/- 15% after UK
pound and Italian lira had left the mechanism and Spanish
peseta, Portuguese escudo, Irish punt and French franc came
under speculative attack
1994: launch of European Monetary Institute, forerunner of
ECB
1995: Austria, Finland and Sweden become members of EU
1997: Stability and Growth Pact (SGP) adopted and ERM II set
up to provide stability between euro and non-euro EU currencies
1998: decision on Euro members – 11 fulfilling convergence
criteria. Greece and Sweden not fulfilling criteria; opt-outs: UK
and Denmark
Stability and Growth Pact (1997)
To keep budgetary discipline in EMU:
 Political commitment to implement budget surveillance
process (peer pressure)
 Elements to prevent budget deficits> 3%: preparation
according to specific format and submission of stability
and convergence programs to Council; early warning
mechanism
 Dissuasive elements requiring Member States to take
corrective actions if 3% value is breached, including
sanctions (excessive deficit procedure)
Exchange Rate Mechanism II




Participating currencies have 15% fluctuation bands
around the central Euro rate
Denmark (participant since beginning of the system in
1999) has narrower fluctuation band of 2.25%
Formal requirement of two year participation before
country can request to join Euro
Intended to orient policies towards stability, foster
convergence and thereby helps them to prepare for
Euro adoption
The institutions of the
Economic and Monetary Union



European Central Bank and European System of
Central Banks: The primary independent economic
institutions of the EMU. Their goal is maintenance of
price stability
The Council of Economic and Finance ministers
(Ecofin, Council): consists of all the Economic and
Finance ministers of the EU Member States
Euro-12 committee: meeting of the Ministers of
Economy and Finance of the Euro-zone countries only
European economic and monetary
integration – from 1998 until now







1998: creation of European Central Bank (ECB)
1998: conversion rates fixed
1999: birth of Euro – with 3 year transition period
between creation of the Euro and introduction of
notes and coins
2000: Greece allowed to join Euro
2002: Euro becomes official currency in 12 member
states
2004: 10 new states enter EU, including obligation to
join EMU (no opt-out possibility)
2005: Stability and Growth Pact adjusted
Stability and Growth Pact –
adjustments 2005





Medium-term budgetary objective of close to balance
or in surplus: more room for new CE Member States
with low debt and high growth potential
Member states to cut deficit and debt in good times
EC: warnings to countries failing to consolidate in
upswings
Debt must fall at sustainable pace towards 60% of
GDP
Assisting rather than punishing countries that break 3%
limit, but sanctions remain as last resort
Stability and Growth Pact –
adjustments 2005 – cont.
But …. new ‘get-out’ clauses if budget deficit > 3%:
 Severe economic downturn – negative economic
growth (old: -2%)
 Small and temporary breaches because of relevant
factors, such as: development aid, EU policy goals (e.g.
R&D), cost of European (i.e. German) unification
 Countries carrying out pension reforms: small breaches
allowed
 Time between deficit surpassing 3% and start of
sanctions now minimum 5 years or even longer in times
of low growth
Fiscal surveillance:
Broad Economic Policy Guidelines




Guidance on macro- and microeconomic policies in Member
States
2005-2008: Integrated Guidelines – combination with
Employment Guidelines; links with Lisbon Strategy
Macro guidelines include: economic stability, efficient allocation
of resources, coherence between macro- and structural policies
and contribution to dynamic and well-functioning EMU
Micro guidelines include: deepening internal market, create
more attractive business environment, in particular for SMEs,
stimulate R&D, ICT, industrial base (Lisbon Strategy – criticism:
Europe should not concentrate on peer mechanism to reduce productivity gap
but increase working hours)
Criteria for Euro membership





High degree price stability
Sustainability of public finances
Normal fluctuation margins in ERM for
minimum 2 years
Durability of convergence as reflected in long
term interest rate levels
……translated in ‘Maastricht’- criteria:
Maastricht Criteria





Inflation rate: average inflation rate not more than 1.5 % from
average of best three EU member states (over a period of one
year before the examination) (Lithuania–2006)
Budget deficit: at or below 3 % of GDP, with tendency to 0 %
or surplus in the medium term (there should be no excessive
deficit)
Public debt: not exceeding 60 % of GDP
Currency stability: respect for normal fluctuation margins of
ERM without severe tensions for at least two years without
devaluation (in particular the Member State shall not have
devalued on its own initiative)
Interest rate convergence: average nominal long-term interest
rate not more than 2 % above that of best three EU member
states in terms of price stability (on the basis of long term
government bonds or comparable securities)
Progress towards Maastricht criteria
in 2006
Country
Interest rate
(average)
Inflation rate
(average)
Government
budget balance
Government
debt
Reference value
5.53
(July ’06)
2.8
(July ’06)
<-3
<60
Cyprus
4.20
2.2
-2.1
69.1
Czech Republic
3.64
2.3
-3.2
31.5
Estonia
4.02
4.4
1.4
3.6
Hungary
6.73
2.9
-6.7
59.9
Latvia
3.77
7.0
-1.0
11.3
Lithuania
3.79
3.2
-0.6
18.9
Malta
4.35
3.1
-2.9
74.0
Poland
5.07
1.3
-3.0
45.5
Slovakia
3.93
3.9
-2.9
33.1
Slovenia
3.74
2.6
-1.9
29.9
Pros and cons of early joining Euro
- examples
Pro:
 Stimulus for trade and foreign investment (greater certainty)
 Stimulus for reigning in public spending
 Volatile capital flows can heavily influence exchange rate (e.g.
Hungary, Czech Republic, Poland, Slovakia)
Con:
 Transitional restructuring unfinished (e.g. high government
deficit in Hungary)
 Rapid productivity growth (e.g. Baltics) and high inward
investment are offset via appreciation or inflation; fixing of
exchange rates will close off former route
 Exogenously induced inflation limits room for endogenous
inflation (Slovakia)
Euro entry preparations–current
situation







Denmark participates since start of ERM-II (1.1.99)
Estonia, Lithuania joined ERM-II on June 27, 2004, but high inflation makes
some obstacles to adopt Euro before 2010. Slovenia has already fulfilled all
Maastricht criteria and EMU entry is approved from January 2007 by relevant
European institutions
Cyprus, Latvia and Malta joined ERM-II on May 2, 2005, Cyprus and Malta
plan to join the Eurozone in 2008 (and to start using Euro notes and coins as
from January 1, 2009), while Latvia will have to wait until 2010 because of
high inflation.
Slovakia joined ERM-II on November 28, 2005, plans to join the Eurozone in
2008 and to start using Euro notes and coins as from January 1, 2009.
The Czech Republic envisaged to adopt the Euro in 2010, but delay has
already been admitted by the prime minister and CNB governor, so ERM-II
participation is only foreseen as from 2008
Hungary could realistically join ERM II between 2007 and 2009 aiming to
adopt Euro between 2011 and 2013.
Poland could be prepared for EMU entry in 3 years, but in line with market
expectation based also on reactions of rating agencies it is not very probable
before 2012.
Adopting Euro –
economic requirements





Ability to deal with asymmetric shocks:
Synchronisation of business cycles with Euro area
Stabilising role of fiscal policy (budgetary room in case
of unforeseen shocks)
Wage and price flexibility (in the absence of the former,
competition in product markets)
Appropriate level of competitiveness (wage growth
consistent with productivity)
Convergence Program 2005-2010
Slovakia (Nov 2005)
Inflation
Government budget
(excl. - costs of 2nd pillar - incl.)
Government
debt
2003
8.4
- 3.8
- 3.8
43.1
2004
7.5
- 3.2
- 3.2
42.6
2005
2.9
- 4.1
-4.9
33.7
2006
3.6
- 2.9
-4.3
35.5
2007
2.0
- 1.6
-3.0
35.2
2008
2.0
- 1.3
-2.7
36.2
2009
2.4
- 0.3
-1.8
35.5
2010
2.6
+0.6
-0.9
34.0
Latest estimates
Slovakia
Inflation
(June 2006)
Government budget
(excl. - costs of 2nd pillar - incl.)
Government
debt
2005
2,7
- 2.9
-3.6
34.5
2006
4,5
- 2.2
-3.5
33.1
2007
2,5
- 1.8
-3.0
31.9
2008
2,0
- 1.2
-2.5
31.2
2009
2,4
- 0.7
-2.0
30.1
Comparison Convergence Program 2005-2010
(Nov 2005) with Draft 2007-2009 Budget (August 2006)
Draft 2007-2009 Budget
Government budget
(excl-costs 2nd pillar-incl.)
Government
debt
Convergence Program 2005-2010
Government budget
(excl.-costs 2nd pillar- incl.)
Government
debt
2005
-2.9
-3.6
34.5
- 4.1
-4.9
33.7
2006
-2.9
-4.2
33.1
- 2.9
-4.3
35.5
2007
-1.8
-3.0
31.9
- 1.6
-3.0
35.2
2008
-1.2
-2.5
31.2
- 1.3
-2.7
36.2
2009
-0.7
-2.0
30.1
- 0.3
-1.8
35.5
2010
-
-
-
+0.6
-0.9
34.0
Slovakia: convergence – cont.





Interest rates safely settled below threshold value (3.9% in SR vs
reference 5.3% on average in July 2006)
Pension reform, health reform, public administration/ finance
reform - necessary to achieve long-term stability
Thanks to higher economic growth (6.0% SR vs 1.4% EU15 in
2005), real convergence also under way: GDP per capita (PPP;
2005) 50.0%; labour productivity per capita (2005) 57.7%,
relative price level (2004) 52.8% - necessary to achieve long-term
stability
But unemployment still problem: 15.5% in 2007; 14.7% in 200810 (ESA95)
And inflation rising in 2006 due to higher energy prices
Thank you