1 Part 1 Fundamentals of International Finance - Lecture n° 5 Money integration in the European Union International Finance

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Part 1Fundamentals of

International Finance -

Lecture n° 5Money integration in the European Union

International Finance

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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 bands1993 : large speculative attacks, causing a large threat on

the system. Introduction of Euro postponed of 2 years.1999 : Euro as scriptural common currency2002 : Euro as fiduciary common currency

European Monetary Union

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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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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 medium-term (2-5 years).


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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 inflationArgument : 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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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 decentralisation).

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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, co-operation 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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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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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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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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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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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 co-ordinate 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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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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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


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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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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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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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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 viewThe political dominance of Germany, very focused

on inflation control.

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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.

Documents

1 Part 1 Fundamentals of International Finance - Lecture n° 5 Money integration in the European Union International Finance