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KYIV NATIONAL TARAS SHEVCHENKO
UNIVERSITY
INSTITUTE OF INTERNATIONAL RELATIONS
Chugaiev O.
Monetary Policy of the European Union
Kyiv
2009
2
UDC 336.711: 336.748: 339.74
Approved by Scientific Board of Institute of International Relation of,
Kyiv National Taras Shevchenko University.
Minutes № 10, 27 May 2009.
Referees:
Rogach O., Doctor of Economics, Head of the Department of
International Finance, Institute of International Relations of Kyiv
National Taras Shevchenko University.
Kuznetsov O., PhD in Economics, Senior Researcher of Institute of
World Economy and International Relations of National Academy of
Sciences of Ukraine.
Chugaiev O. Monetary Policy of the European Union: Study
Manual. – Kyiv.: Kyiv National Taras Shevchenko University, Institute
of International Relations, 2009. – 90 p.
Chugaiev O. (2009): Monetary Policy of the European Union:
Study Manual. National Taras Shevchenko University, Institute of
International Relations, Kyiv.
The book is devoted to origins of the European Monetary Union, launch of
the euro currency and its consequences, enlargement of the EMU, structure and
functions of the European System of Central Banks, its monetary policy
instruments and procedures, recent exchange rate of the euro and the EU monetary
policy developments.
The book may be useful for instructors and students who major in
international economics, international finance, European studies; as well as for
researchers and public officers in related areas.
Chugaiev O., 2009
3
CONTENTS
List of Abbreviations………………………………………………...5
Introduction……………………………………………………….…6
Chapter 1. ORIGINS OF THE EUROPEAN MONETARY
UNION…………………………………………………………….…7
1.1. Early Stages of Monetary Cooperation………………….....7
1.2. Werner Plan………………………………………………...8
1.3. European Monetary System…………………………..……9
1.4. Towards the European Monetary Union. Stage 1………...10
1.5. Towards the European Monetary Union. Stage 2…….…..11
1.6. Towards the European Monetary Union. Stage 3………...13
1.7. Introduction of Cash Euro…………………………….…..14
Chapter 2. EFFECTS OF EURO INTRODUCTION……………18
2.1. Effects of Euro Introduction in 1999-2001…………….....18
2.2. Short-term Effects of Cash Euro Introduction ………...…19
2.3. Long-term Effects of Euro Introduction……………….….21
2.4. Enlargement of the Euro Area………………………….…24
2.5. Effects Outside the European Union…………………...…28
Chapter 3. EUROPEAN SYSTEM OF CENTRAL BANKS…....34
3.1. Legal Status and Financial Resources of the ESCB…........34
3.2. Objective and Principles………………………………..…37
3.3. Functions………………………………………………….39
3.4. Structure………………………………………………..…44
3.5. Interaction with Other Institutions……………………..…52
Chapter 4. MONETARY POLICY IMPLEMENTATION……. 58
4.1. Analytical Background…………………………………....58
4.2. Foreign Exchange Operations…………………………….59
4.3. Open Market Operations………………………………….61
4.4. Standing Facilities…………………………………..…… 64
4.5. Minimum Reserve Requirements…………….……….…..65
4.6. Procedural Aspects…………………………………….….66
4.7. Capital Controls……………………………………...……70
4
4.8. Transmission Mechanism of Monetary Policy………...….71
Chapter 5. EXCHANGE RATE AND MONETARY POLICY
DEVELOPMENTS UNDER THE EUROPEAN MONETARY
UNION………………………………………………………………76
5.1. Factors of the Exchange Rate of the Euro ....................…...76
5.2. Monetary Policy in 1999-2003…………………………….76
5.3. Monetary Policy in 2004 – early 2007……………………..81
5.4. Response to the Financial Instability in 2007-2009….....….84
References………………………………………...……………….....87
5
LIST OF ABBREVIATIONS
GDP Gross Domestic Product
EC European Community
ECB European Central Bank
ECOFIN Council Economic and Financial Affairs Council
ECU European Currency Unit
EEA European Economic Area
EEC European Economic Community
EMI European Monetary Institute
EMS European Monetary System
EMU Economic and Monetary Union, European
Monetary Union
ERM Exchange Rate Mechanism
ERM II Exchange Rate Mechanism II
ESCB European System of Central Banks
EU European Union
FXCG Foreign Exchange Contact Group
HICP Harmonized Index of Consumer Prices
IMF International Monetary Fund
MMCG Money Market Contact Group
NCBs National Central Banks
OECD Organization for Economic Co-operation and
Development
OMG Operations Managers Group
RTGS Real Time Gross Settlement
TARGET Trans-European Automated Real-time Gross
Settlement Express Transfer System
6
INTRODUCTION
The European Union has transformed into another economic
superpower owing to its significant share in the global economic
activities and since many policies have been delegated to the
supranational level by its Member Countries. Monetary policy is one of
these policies, though its supranational nature is largely limited to the
euro area countries. Policy decisions by the European Central Bank
affect the general economic developments virtually of all the countries
both through financial and trade links. The euro has become the second
most important currency in the world. The European Union has become
a leader in global integration processes.
The author describes different aspects of the EU monetary policy:
history, effects of single currency, institutional framework, operational
framework and procedures, transmission mechanism, recent policy
developments and factors affecting its implementation, with particular
emphasis on the single currency and monetary policy of the euro area.
The book was specially designed for teaching the EU Monetary
Policy course, but may assist professors in teaching some other courses,
such as International Finance, International Economics, International
Economic Organizations, International Economic Integration, Monetary
Systems of Foreign Countries, Exchange Rate Theory and Practice,
European Integration.
7
CHAPTER 1. ORIGINS OF THE EUROPEAN MONETARY
UNION
1.1. Early Stages of Monetary Cooperation
In 1950 the European Payments Union was established as a
component of the Organization for European Economic Co-operation
(the forerunner of the Organization for Economic Co-operation and
Development – OECD), providing a basis for currency convertibility in
Europe. It did this by establishing an automatic settlement mechanism
for net surpluses and deficits of its members, thereby aiding both
economic recovery and integration in Europe. Later on, established by
the Organization for European Economic Co-operation as a successor to
the European Payments Union, the European Monetary Agreement was
designed to foster general convertibility of European currencies and
multilateral trade. It continued the framework for monetary co-operation
set up by the European Payments Union. This agreement ended in 1972.
In 1951 six countries (Germany, Belgium, France, Italy,
Luxembourg and the Netherlands) signed the Treaty establishing the
European Coal and Steel Community which formed a basis for what was
to become the European Union. In 1957 the Rome Treaties were signed:
the Treaty establishing the European Economic Community (EEC) and
the Treaty establishing the European Atomic Energy Community. The
original Treaty of Rome establishing the European Economic
Community included only minor provisions for monetary co-operation
between Member States.
In 1962 the European Commission made its first proposal (Marjolin
Memorandum) for economic and monetary union. In 1964 the
Committee of Governors of the Central Banks of the Member States of
the European Economic Community was formed to institutionalize the
cooperation among EEC central banks. The Committee of Governors
complemented the Monetary Committee provided for by the EEC
Treaty. Initially the Committee of Governors had a very limited
mandate, but over the years it gradually became more important.
The Bretton Woods system, adopted by market economies,
guaranteed international monetary stability. Assuming that this stability
would remain the norm, there was no need to include additional
provisions on genuine monetary cooperation between EEC Member
States. But turbulence on markets in 1968 and 1969 led to the
8
devaluation of the French franc and the revaluation of the German mark.
This threatened the stability of the other currencies and the system of
common prices set up under the Common Agricultural Policy.
1.2. Werner Plan The Barre report of 1969 proposed a greater coordination of
economic policies and closer monetary cooperation. At the summit in
The Hague in December 1969, the Heads of State and Government
decided to set up Economic and Monetary Union (EMU) an official goal
of European integration. A group chaired by Pierre Werner, Prime
Minister of Luxembourg, was to draw up a report on how this goal
might be reached by 1980.
In 1970 the Werner group finished the report. It envisaged a three-
stage plan to achieve full economic and monetary union within ten
years. The ultimate goal was to achieve full liberalization of capital
movements, the irrevocable fixing of parities and introduction of single
currency.
In 1971 the EEC Member States gave their approval in principle to
the introduction of EMU in three stages:
- narrowing of currency fluctuation margins, broad guidelines for
economic policy at Community level, co-ordination of budgetary policy,
preparation of the Treaty changes to facilitate later stages of EMU.
- integration of financial markets and banking systems to create free
movement of capital, progressive elimination of exchange rate
fluctuations, closer co-ordination of short-term economic policies and
budgetary and fiscal measures.
- irrevocable fixing of exchange rates between participating national
currencies, convergence of economic policies, establishment of a
Community system of central banks.
But the collapse of the Bretton Woods system and the decision of
the US Government to float the dollar in August 1971 produced a wave
of instability which called into serious question the parities between the
European currencies. The EMU project was temporarily abandoned.
In the meantime in 1972 the Six created the "snake in the tunnel": a
mechanism for the managed floating of currencies within narrow
margins of fluctuation originally against the dollar. These margins were
set originally as +/-2.25%. For a while even two non-Community
currencies – the Swedish krona and Norwegian krone – were also part of
9
the system).However, the system came under pressure from the oil crisis
of the early 1970‟s when Member States‟ currencies fluctuated sharply,
with some countries leaving the system. By 1977 the snake was reduced
to a zone based around the German mark, with only few Member States
remaining.
Werner plan implementation resulted in limited monetary
integration:
- exchange rate (though rather flexible) pegging of national
currencies to each other;
- adjusting mechanisms of interventions at the foreign exchange
market;
- introduction of the EEC budget;
- creation of the mutual lending system;
- establishment of common institutions: European Investment Bank,
European Development Fund, European Monetary Co-operation Fund.
The latter was established in 1973 end was superseded by the European
Monetary Institute on 1 January 1994. The European Monetary Co-
operation Fund was to promote:
o proper functioning and progressive narrowing of the
fluctuation margins of the Community currencies;
o intervention on the exchange markets;
o settlements between central banks leading to a concerted
policy on reserves.
The reasons of only limited monetary integration were:
- development gap between the EEC member countries;
- difference in economic interests of Member States;
- external shocks such as global currency crisis, oil crisis, recession;
- lack of economic internationalization and psychological readiness.
1.3. European Monetary System
In 1979 the European Monetary System (EMS) was created. The
currencies of all the Member States, except the United Kingdom (it
participated for less than a year), took part in the exchange-rate
mechanism.
The core principle was the following: exchange rates were based on
central rates against the ECU, the European unit of account, which was a
weighted average of the participating currencies. A grid of bilateral rates
was calculated on the basis of these central rates expressed in ECU, so
10
that currency fluctuations had to be contained within a margin of
+/-2.25% either side of the bilateral rates (6% margin was applied to the
Italian lira).
The EMS consisted of three elements:
- currency basket (European Currency Unit or ECU);
- monetary stabilization mechanism (Exchange Rate Mechanism or
ERM);
- mechanism for financing monetary interventions (European
Monetary Co-operation Fund).
Achievements of the EMS included:
- growing exchange rate stability;
- establishment of common reserves.
Problems also existed:
- difference in level of development, inflation and interest rate
policies of Member States;
- difference in attitude towards the pace of integration;
- some countries had persistently large budget deficits which put a
disproportionate burden on monetary policy;
- ECU did not become the main currency in settlements within the
EEC.
In the financial markets, however, it gained some popularity as a
means of portfolio diversification and as hedging against currency risks.
The expansion of financial market activity in ECU was driven by a
growing volume of ECU-denominated debt instruments that were issued
by Community bodies and the public-sector authorities of some member
countries.
But with the adoption of the Single Market Programme in 1985, it
became increasingly clear that the potential of the internal market could
not be fully exploited as long as relatively high transaction costs due to
currency conversion and the exchange-rate fluctuations risks persisted.
1.4. Towards the European Monetary Union. Stage 1
In June 1988 a committee under the chairmanship of Jacques
Delors, the then President of the European Commission was set up to
study economic and monetary union. The other members of the
committee were the governors of the national central banks (NCBs) and
were closely involved in drawing up the proposals. In 1989 the
committee's report proposed the introduction of economic and monetary
11
union in three stages. It stressed the need for greater coordination of
economic policies, rules on the size and financing of national budget
deficits, and a new independent institution which would be responsible
for the monetary policy, the European Central Bank (ECB).
The first stage began on 1 July 1990. This was the date on which, in
principle, all restrictions on the movement of capital between Member
States were to be abolished. At this time, the Committee of Governors of
the central banks of the Member States of the European Economic
Community was given additional responsibilities.
The Council was to assess the progress made with regard to
economic and monetary convergence, while Member States were to
adopt appropriate measures to comply with certain prohibitions
(prohibition on restricting capital movements, prohibition on the
granting by central banks of overdraft facilities to public authorities and
public undertakings, prohibition on maintaining privileged access for the
latter to financial institutions). It provided for increased co-operation
between the central banks with relation to monetary policy, removal of
obstacles to financial integration, monitoring national economic policies,
co-ordination of budgetary policy.
During this stage the Treaty on European Union was signed in 1992
and entered into force in 1993. The Treaty provided for the Economic
and Monetary Union to be introduced by the end of the century in three
successive stages according to a precise timetable.
During the process of ratifying the Treaty, the speculation sparked
off by the negative result of the first Danish referendum (June 1992) and
the uncertainty surrounding the French referendum (September 1992)
resulted in speculative monetary turbulence. It forced the Italian and UK
authorities to withdraw their currencies from the European exchange-
rate mechanism. During the summer of 1993 currencies of France,
Belgium, Denmark, Spain, and Portugal also came under strong
pressure. As a result in August the fluctuation margins of the exchange-
rate mechanism were widened to 15%.
1.5. Towards the European Monetary Union. Stage 2
Transition to the second stage took place on 1 January 1994.
Member States were to make significant progress towards economic
policy convergence. The coordination of monetary policies was
institutionalized by the establishment of the European Monetary Institute
12
(EMI) in Frankfurt to strengthen cooperation between the NCBs and to
carry out the necessary preparations for the introduction of the single
currency. The Committee of Governors ceased to exist but was
effectively reconstituted as the Council (governing body) of the EMI.
During the second stage, Member States made their national law
compatible with the Treaty and with the Statute of the ESCB, with
special reference to independence of their NCBs. They were also to
make significant progress towards convergence of their economies,
since the move to the third stage was conditional on fulfillment of the
four convergence criteria laid down in the Treaty. The Commission
established annual reports on the state of convergence between Member
States.
In particular the so-called Maastricht convergence criteria included:
- exchange rate stability: severe tensions of devaluation should not
occur for at least two years with the respect to other currencies of
Member States, exchange rate fluctuations are to be within the
established margins under the Exchange Rate Mechanism;
- price stability: inflation no more than 1.5% higher than average
inflation in 3 countries with the lowest inflation;
- government finance stability: the general targets are budget deficit
no more than 3% GDP and public debt no more than 60% GDP (if a
country almost complies with this criterion and makes progress towards
complying with it, then it is not an obstacle to entering the monetary
union);
- interest rate (based on long-term government bonds) no more than
2% higher than average interest rate in 3 countries with the lowest
inflation.
In 1995 the EU leaders meeting at the Madrid European Council
decided to name the single currency the euro and set a date of 1 January
1999 for the final third stage of EMU creation. In December 1996 the
EMI presented to the European Council, and to the public, the design
series that had won the euro banknote design competition. In 1997 the
Amsterdam European Council adopted the Stability and Growth Pact,
designed to ensure budgetary discipline on the part of the Member States
after creation of the euro. A new Exchange Rate Mechanism (ERM II)
was also set up to provide stability between the euro and the national
currencies of the non-euro area Member States.
13
On 3 May 1998 the Heads of State and Government meeting in
Brussels decided that eleven Member States fulfilled the convergence
criteria and would take part in the euro in 1999, on the basis of
convergence reports prepared by the Commission and the ECB (despite
that only few of the countries really complied with the convergence
criteria). On 1 June 1998 The European Central Bank was created.
1.6. Towards the European Monetary Union. Stage 3
On 1 January 1999 conversion rates of the currencies of the
11 Member States initially participating in Monetary Union were
irrevocably fixed. The budgetary rules were to become binding. A single
monetary policy was introduced and entrusted to the European System
of Central Banks (ESCB), made up of the NCBs and the ECB, which
took over from the EMI.
The start of the third stage marked the effective beginning of
Economic and Monetary Union (EMU). During the 3 year transition
period the new currency euro was used on the financial markets in, for
example, electronic commerce and transactions between banks. During
1999-2001 people and businesses had the freedom to carry out
transactions in euro, but were under no obligation to do so.
During the negotiations the United Kingdom obtained an opt-out
exempting it from the third stage of EMU. In 2000 the Danes voted not
to adopt the euro in a national referendum on membership of the single
currency. So Denmark obtained clauses exempting it from several
provisions of the Treaty, including transition to the third stage of EMU.
In 2000 it was decided that Greece had fulfilled the convergence criteria
and joined the euro from January 2001. The rate for conversion of Greek
drachma to the euro was also announced. As for Sweden, in 2003 it
voted against joining the euro area.
Ten new Member States that joined the EU on 1 May 2004 (Czech
Republic, Estonia, Cyprus, Latvia, Lithuania, Hungary, Malta, Poland,
Slovenia and Slovakia) and on 1 January 2007 (Bulgaria and Romania)
were to adopt euro as a single currency as soon as they have fulfilled the
necessary conditions (and notably the Maastricht convergence criteria).
In 2007 Slovenia was the first to join euro among the new members. In
2008 Malta and Cyprus joined too, followed by Slovakia in 2009.
So in 2009 the euro area comprised 16 Member States of the
European Union (Belgium, Cyprus, Germany, Greece, Spain, France,
14
Ireland, Italy, Luxembourg, Malta, the Netherlands, Austria, Portugal,
Slovakia, Slovenia, and Finland). Certain parts of the euro area are
located outside the European continent, such as the four French overseas
departments (Guadeloupe, French Guyana, Martinique and Réunion), as
well as Madeira, the Canary Islands etc.
The euro area can be described by the following indicators:
Table 1.1.
Key real economy characteristics of the euro area, the United
States, and Japan, 2007.
Indicator Unit Euro area United
States
Japan
Population millions 320 302 128
GDP (share of world GDP) % 16 21 7
GDP per capita € thousands 28 39 29
Unemployment rate
(share of the labor force)
%
7.4
4.6
3.8
General government
Gross debt % of GDP 66 49 160
Expenditure % of GDP 46 34 34
Exports of goods and services % of GDP 22 12 18
Imports of goods and services % of GDP 21 17 17
Exports (share of world exports) % 30 8 5
Current account balance % of GDP 0.3 -5.3 4.8
Source: ECB (http://www.ecb.int/mopo/eaec/html/index.en.html).
Thus, we see that the euro area exceeds other world economic
centers in population, amount of government expenditure, public debt,
and foreign trade. If all the new members join the euro area, its total
GDP may grow by about 6% only.
1.7. Introduction of Cash Euro.
Prior to introduction of cash euro information campaign took place
focusing on: design of banknotes and coins, their denomination, security
features, and the changeover. The ECB spent €80 million on this
campaign. Each of the participating countries also took its own
communication activities.
15
Initially the ECB had intended not to disclose the design and
security features of the euro banknotes prior to September 2001, when
delivery of cash started. But since a lot of people had to be trained to use
it (shop assistants etc.), this training started in January 2001. In order to
meet the need of vulnerable people, sample banknotes with words “no
value” also were distributed to organizations for the blind starting from
March 2001.
Germany
32%
Greece
4%
Spain
13%
France
15%
Ireland
2%
Italy
16%
Luxembourg
0%
Netherlands
4%
Belgium
4%
Finland
2%Portugal
4%Austria
4%
Chart.1.1. Initial production volume of cash euro showing each
national central bank’s share (rounded-off to an integer).
Sources: ECB (2007) “How the Euro Became Our Money. A Short
History of the Euro Banknotes and Coins”.
The introduction of euro notes and coins at the beginning of 2002
was the largest-ever currency-changeover operation. More than
15 billion notes and 51 billion coins were produced and exchanged.
To ensure the smooth introduction of the euro, action was taken to
mobilize financial institutions, sales outlets, the police, transport firms
and, above all, the public in Europe, whose cooperation was essential.
16
The Commission, the different ministries involved, banks and trade
associations spent over half a billion euros on information campaigns for
the general public between 1996 and 2001.
As of September 2001 banks and sales outlets were frontloaded and
sub-frontloaded with the first notes and coins. The opportunity given to
sales outlets to be sub-frontloaded with small quantities so that their
payout-desk staff could receive training was not widely taken up. While
virtually all traders were sub-frontloaded in Ireland, the figure in Italy
was below 10%. Also in order to acquaint themselves with the new
coins, individuals were able to buy small kits containing coins from mid-
December.
But some problems took place. During the first ten days of January,
consumers flocked to their bank to withdraw euros or to exchange their
old national currency, causing queues to form. In the first few days
consumers tended to spend their national currencies before using the
euro. In order to give change, traders required a much larger cash float
since they were unable to give change using the legacy currency. Also
there were a large number of consumers using large-denomination notes
for their purchases. Longer queues were inevitable. But more than
7 thousand cash-transport vehicles operated at full stretch during that
time. So there were only isolated shortages of certain denominations of
notes and coins. Member States' central banks provided mutual
assistance when that was needed. For instance, France acquired
100 million 50 cent coins from Spain.
The legacy currencies swiftly disappeared from circulation as
traders and banks gave change in euros. 28 February 2002 was the latest
date for ending the legal tender status of national currencies during the
changeover period (Member States could arrange for earlier deadlines in
their national changeover plans). But the share of the euro in cash
payments averaged already 55% by the end of 4 January and 95% by
16 January.
As for introduction of cash euros after 2002, information campaigns
included public opinion polls, advertising, direct marketing. For
example, over 900,000 copies of different publications were distributed
by the Central Bank of Cyprus, and this was more than one copy per
Cypriot. The aim was to enable everyone in Cyprus to check their new
euro banknotes: every household received euro banknote „cards‟. They
showed the main security features of the €50 and €20 banknotes.
17
Discuss and answer the following questions.
1. Early stages of monetary cooperation between current European Union
Member States.
2. Incentives and obstacles to monetary integration between current European
Union Member States.
3. Achievements of Werner Plan implementation.
4. Achievements of European Monetary System implementation, and its
structural elements.
5. The role of institutions in European monetary integration.
6. Stages of EMU establishment.
7. Specifics of Maastricht convergence criteria and their implementation.
8. Sequence of countries joining the euro area.
9. Why some EU Member States have not joined the euro area.
10. Compare economy of the euro area and other world economic centers.
11. Organization of euro introduction. What were the difficulties in it?
12. If your country is to join the euro area, what steps must be taken?
18
CHAPTER 2. EFFECTS OF EURO INTRODUCTION
2.1. Effects of Euro Introduction in 1999-2001
Transactions. In 1999 settlements with public sector were converted
into euro. By 2000 35% of inter-bank settlements in Europe were done
in euro. Banks were recommended not to charge clients for converting
national currencies to euro. Fees for transactions in euro should have
been the same as in case of transactions in national currencies.
Pricing. As for pricing, it was not a problem for big companies that
already used many currencies. It was somewhat different in small
companies. But during transition period no company could completely
substitute national currencies with euros, since consumers used national
currencies.
Accounting. Some transnational companies like Siemens and Philips
started using euros in accounting already in 1999.
References in documents. Starting from 1999 all references to ECU
in legal documents changed to references to euro (with conversion rate
of 1:1). References to national currencies remained. Introduction of euro
has not led to any changes in contracts and was not a reason for
unilateral changes or annulment.
Economic Growth. After growing by an average of 3% during the
first two years of EMU, the euro-area economy slowed down in 2001.
But it was due to a number of other factors including increasing oil
prices, bursting of the speculative bubble on share markets and the event
of 11 September.
Labor market. The unemployment rate in the euro area fell to 8.3%
in 2001 because of structural reforms, wage restraint and economic
growth.
Exchange rate. Following its introduction on 1 January 1999, the
euro depreciated by more than 20% against the US dollar, but then
regained about 10%.
Current account balance. Depreciation of euro has placed the euro-
area economy in a strong position vis-à-vis its competitors and
positively contributed to rise in exports and GDP growth. The euro-
area's current-account balance continued to improve in 2001 to show a
small surplus.
Inflation. The inflation rose from 1.1% in 1999 to 2.5% in 2001 as a
19
result of the hike in oil prices and depreciation of the euro against the
US dollar.
Interest rates. After the launch of the euro, some countries suddenly
benefited from lower interest rates and easier access to more competitive
credit markets. It encouraged the purchase of durable and non-durable
goods, as well as housing.
2.2. Short-term Effects of Cash Euro Introduction
Prices. Although annual inflation rose from 2% to 2.7% between
December and January, this increase was mainly due to increases in
certain taxes, higher oil prices and higher prices for fruit and vegetables.
And the currency changeover accounted for only between 0% and
0.16% of the monthly price trend.
Actual and perceived inflation. According to consumer surveys, a
large proportion of the public (67-84%) felt that more often prices had
been rounded upwards during conversion to euro. Higher perceived
inflation can be explained in several ways.
1. Consumers tend to form their perception about inflation on the
basis of frequently bought goods and services (cafes, restaurants, repairs,
haircuts, newspapers, etc.), and these goods and services registered
unusually large price increases after the changeover.
2. So called “menu costs” are the costs of changing prices. It could
have led to an unusually high proportion of firms changing prices at the
turn of the year. Often such price adjustments involve upward rounding.
Security. Despite an unprecedented number of cash-transport
operations and the double number of notes and coins in circulation, the
number of incidents was below than usual.
Counterfeiting. Euro notes and coins are better protected against
counterfeiting than any of the old national currencies. The Commission
and the Member States have set up a network of institutions for the fight
against counterfeiting, with the participation of the ECB and Europol. So
in the first half of 2002 the ECB recorded only 7% of the number of
counterfeit notes recorded in the same period in 2001. The number of
counterfeit coins was negligible.
Preparation of small and medium-sized enterprises. At the time of
the changeover, 95% of small and medium-sized enterprises already
kept accounts in euros. Most of them did not face any problems in
20
switching to the euro. Some problems were encountered with IT
systems, the setting or display of prices and invoicing.
Conversion of vending and automatic teller machines machines.
Many vending-machine operators underestimated the speed at which the
new currency would replace the legacy currencies and faced decline in
turnover because some of the machines had not been converted. In some
countries cash amounts withdrawn from automatic teller machines
increased. This can be explained by the new banknote denominations
and rounding effects.
Total expenditures on remodeling all the systems and introduction
of euro were €500 billion.
Thinking in terms of the euro. Switching to the euro initially did not
change the purchasing behavior of 77% of the public. But many
consumers had difficulty in memorizing euro prices. Later situation
improved.
Dual display of prices. It helped people to adapt to the new currency
during the changeover period. But since it delayed the mental
conversion of the population to the euro, the Commission recommended
phasing out dual display by 30 June 2003 at the latest, including on bank
statements.
Perception of design. 92.6% of people said that they have no
difficulty with the different national sides. 92.8% found the various euro
notes easy to handle. Also the banknotes were designed with some
specific features that make it easier for people with disabilities and
weak-eyed people to use them.
Some discussion about the necessity to issue the low-value coins,
(especially the 1- and 2-cent coins), arose in some Member States. In
Finland the law required euro cash payments to be rounded to the
nearest five cents. Thus production and use of the 1- and 2-cent coins are
limited. At the same time the small coins played an important role in
helping to ensure that price conversion from national currency units was
done correctly.
General satisfaction. A large majority said they felt more European
thanks to the euro. Four out of five individuals felt that the changeover
to the euro was well or very well organized. Over two thirds of the
general public felt happy that the euro was their currency. Only in
Germany, Greece and Austria a higher proportion of people were
dissatisfied.
21
Collector's coins. The Member States have the right to mint euro-
denominated collector's coins. They are often made of precious metals,
have a nominal value and are legal tender (but only in the Member State
which issued them). By the end of 2002 80 euro-denominated collector's
coins with face values ranging from 25 cents to 400 euros had been
issued,.
Commemorative coins. Member States have retained the right to
issue euro-denominated commemorative coins, which are legal tender in
the whole euro area. Their technical properties, sizes and face values are
the same as those of euro coins, and their design may commemorate
some special national event. In order to avoid any possible confusion,
Member States have agreed not to issue commemorative coins during
the early years after the introduction of cash euro.
2.3. Long-term Effects of Euro Introduction
Cross-border trade and price transparency. The introduction of euro
notes and coins strengthened the integration of markets in the European
Union by eliminating exchange-rate risk, reducing transaction costs, and
abolishing a psychological barrier to cross-border trade through price
transparency.
Since the changeover to the euro, 12% of European consumers are
more interested in buying goods in another EU country. 32% of
businesses in the EU indicate that they are more interested in selling
their goods abroad. It was estimated that euro has boosted intra-euro
area trade by 5% to 15%. In total, exports and imports of goods within
the euro area rose from about 27% of GDP in 1999 to around 32% in
2006. But still there has been no trade diversion vis-à-vis the rest of the
world: use of the euro has so far boosted imports from non-euro area
countries almost as much as it has boosted imports from euro area
partners. From 1999 to 2006 extra-euro area exports and imports of
goods rose to 33% of euro area GDP, from about 24%.
Let us look back at the factors boosting cross-border trade. As for
trade between the euro area countries, zero exchange-rate volatility
reduces uncertainties for both importers and exporters.
Elimination of the various transaction costs was equivalent to 1%
GDP. For example, these were the costs resulting from:
- foreign exchange operations themselves;
22
- hedging operations intended to protect companies from adverse
exchange rate movements;
- cross-border payments in foreign currencies, which are typically
more expensive and slower than domestic operations;
- management of several currency accounts, which complicates
currency management and internal accounting systems.
As for price transparency, consumers and businesses can compare
prices of goods and services more easily when they are expressed in the
same currency. Easier price comparisons foster competition. Consumers
and traders can buy from the cheapest seller, and thus can avoid buying
from companies trying to charge a higher price.
Competition hence leads to lower prices. For several years the
average annual increase in the Harmonized Index of Consumer Prices
since the introduction of the euro has been just slightly above 2%, which
is a significant achievement under substantial adverse price shocks
during this period. The difference in inflation rates in the euro area
countries has decreased substantially since 1999 to a level much lower
than that of the previous decade, and is now similar to the inflation
observed in the United States.
Investment potential and financial markets. The euro has increased
investment potential in the euro area. It has eliminated the exchange-rate
risk for operations within the area and has fostered competition within
this integrated market. Also financing conditions for firms have
improved thanks to the faster integration of financial markets. A large
single market with a single currency means investors can do business
throughout the euro area with minimal disruption and can also take
advantage of a more stable economic environment. Intra-euro area FDI
stocks have grown considerably, doubling from 14% of euro area GDP
in 1999 to around 28% in 2006.
Before the introduction of the euro, financial markets were, as a
rule, national in character. Creation of a common regulatory framework
and the changeover to the euro fostered their integration.
1. The euro area‟s inter-bank money market is fully integrated.
2. The euro-denominated bond market is well integrated. Greater
liquidity has been reflected in higher issuance volumes of bonds.
3. The euro area equity market is increasingly viewed as a single
market. Demand for cross-border equity investment in euros has risen.
Also mergers and acquisitions in financial sector increased.
23
Changes in investment and consumption behavior took place. Savers
benefit from a wider and more diversified offer of investment and saving
opportunities. Investors are increasingly moving towards sector-based
investments, instead of purely country-based investments. Investors can
spread their risks more easily, and have an appetite for riskier ventures.
Consumption does not need to follow movements in regional output,
because consumers can borrow abroad, as well as because their financial
wealth is less dependent on local conditions thanks to an internationally
well diversified portfolio allocation.
Recent research by London Economics estimated the benefits of the
integration of EU bond and equity markets to be around 1 percentage
point of additional GDP growth over a ten-year period.
Euro has probably contributed to the financial opening of the euro
area too. On the assets side, stocks of euro area assets held abroad
increased from less than 87% of GDP in 1999 to over 124% in 2005.
Stocks of euro area liabilities side increased from 92% to 137% of GDP.
Effects for individuals. Citizens can travel more easily within the
euro area without the need of changing currencies after crossing a
border. Traveling outside the euro area is also easier since the euro is
widely accepted as an international currency in many tourist destinations
outside the euro area.
As for labor indicators, euro as a single currency increases price
transparency and facilitates comparisons that may lead to "wage
imitation". Unemployment rate in the euro area has reached low levels
not seen for 25 years (7.3% in September 2007).
Independence of monetary policy and shocks. Once the euro has
been adopted, adjustments to economic problems, external shocks and
changes in competitive positions need to be made other than via set
short-term interest rates changes and exchange rate policy carried out
individually by countries.
Exchange rate can be an absorber to some shocks, but exchange rate
fluctuations are often an independent source of shocks rather than a
solution. It is therefore not obvious that abandoning an independent
monetary policy is worse in terms of macroeconomic stability. Moreover
there are limits to the scope for national monetary policy under free
capital movements. Thus other adjustment mechanisms should be used.
Owing to the size of the euro area economy and the fact that the
majority of its trade takes place within this area (50-75% depending on
24
the country concerned), the euro area can withstand external economic
shocks or fluctuations in the external exchange rate vis-à-vis other major
currencies than the previous national currencies.
There is an interesting study about the United States. The US capital
markets smooth out 39% of shocks to gross state product (equivalent to
country‟s GDP in the EU). The credit channel smoothes out 23% of such
shocks, and the federal budget smoothes out 13%. 25% of the shock is
not smoothed out. Thus, according to this study, financial markets and
financial institutions absorb 62% of idiosyncratic shocks in the United
States. This effect is much larger than that of the federal budget. By
analogy with it financial market-based risk-sharing will become
increasingly important over the coming years in euro-area.
Other effects. The euro is one of the main factors in speeding up
integration. It acts as a stimulus to further integration by showing that
common action by Member States can bring benefits to all participants.
Owing to a single currency and an Economic and Monetary Union
strengthens Europe has become more important in international fora and
organizations like the International Monetary Fund, World Bank, and
Organization for Economic Co-operation and Development.
As a world currency, the euro is often used as an international
investment and reserve currency, which increases demand for it. The
euro is also becoming a major transaction currency, enabling a
significant proportion of European exports and imports to be invoiced in
euros.
2.4. Enlargement of the Euro Area
All EU Member States, apart from Denmark and the United
Kingdom, are committed to strive to fulfill the convergence criteria as
soon as possible and adopt the euro thereafter.
Old Member States. Under Protocols annexed to the EC Treaty,
Denmark and the United Kingdom have been exempted from
participation in Stage Three of EMU. However, both Member States
have retained the right to “opt in” at a later stage, if they fulfill the
conditions necessary for the adoption of the euro. The Danish kroner
joined the ERM II on 1 January 1999 with narrow fluctuation margins
(±2.25%) vis-à-vis the euro. The UK practices independent floating.
In Denmark, businesses accept cash payments in euros and 13%
practice dual pricing. In Sweden many shops, hotels and restaurants
25
accept euro cash payments, especially near the border with Finland. The
Swedish town of Haparanda has adopted the euro as the currency of
payment. In the United Kingdom, especially in London and tourist areas,
the euro is sometimes accepted for payments and dual pricing is
practiced occasionally.
New Member States. The new Member States (like Sweden) are to
take over the Community acquis and are required to participate in EMU.
At the beginning, they may benefit from the Treaty derogation until they
satisfy the convergence criteria. The conditions necessary for the
adoption of the single currency are high degree of economic and legal
convergence.
Economic convergence criteria include participation in ERM II for
two years, price stability, public finance stability, and interest rate
targets, as we have mentioned before. The requirement of legal
convergence obliges each Member State to adapt national legislation to
ensure the independence of the respective national central bank,
integrating it into the European System of Central Banks etc. (including
provisions on the issue of banknotes and coins, holding and management
of foreign reserves and exchange rate policy).
The EC Treaty also requires the Commission and the EMI (now the
ECB) to take into account several other factors: integration of markets,
development of the balance of payments, unit labor costs and other price
indices.
Originally target dates which Member States had set themselves for
the adoption of the euro were:
- Estonia, Lithuania and Slovenia: 1 January 2007;
- Cyprus, Latvia and Malta: no later than 1 January 2008;
- Slovakia: 1 January 2009;
- Czech Republic and Hungary: 2010.
But delays in several cases have happened.
The table below shows how far the new Member States met the
Maastricht criteria in 2008. These criteria measure „nominal
convergence‟, which actually reflects underlying „real convergence‟ –
the convergence of competitiveness, workforce skills, financial sector
integration, industry structures, and a range of other socio-economic
factors. A euro-area member must have a sufficient degree of real
convergence to be able to withstand economic shocks.
26
Table 2.1.
Observance of the convergence criteria in the new Member States,
May 2008.
What is
measured
Price Stability Sound Public
Finance
Sustainable
Public
Finance
Durability of
Convergence
How it is
measured
Consumer Price
Inflation Rate
Government
balance as % of
GDP
Government
debt as % of
GDP
Long-term
interest rates
Convergence
criteria
definition
<1.5% more than
the 3 lowest
inflation Member
States
No less than
-3%
No more
than 60%
<2% more than
the 3 lowest
inflation Member
States
Actual
convergence
criteria
3.2 -3.0 60.0 6.5
Bulgaria 9.4 3.2 14.1 4.7
Estonia 8.3 0.4 3.4 …
Latvia 12.3 -1.1 10.0 5.4
Lithuania 7.4 -1.7 17.0 4.6
Poland 3.2 -2.5 44.5 5.7
Romania 5.9 -2.9 13.6 7.1
Slovakia 2.2 -2.0 29.2 4.5
Czech Republic 4.4 -1.4 28.1 4.5
Hungary 7.5 -4.0 66.5 6.9
Source: Kramp P., Thamsborg S. (2008) “Real Convergence in the New
EU Member States”. Danmarks Nationbanks Monetary Review, vol.
XLVII, No.3, pp.77-88.
The new Member States faced the following main problems.
1. Although the new Member States had successfully reduced
inflation nearly to the euro-area average, their economies were growing
more rapidly than the rest of the EU. Fast economic growth is desirable
but it can produce inflationary pressures.
2. Originally several new Member States did not meet the 3% target
on the government deficit. Thus the new Member States should find a
balance between investment and prudence to sustain investor
confidence. These challenges are even more acute if we take into
account the challenge of an ageing population which will very soon start
to weigh on public finances.
27
Three Member States (Estonia, Lithuania and Slovenia) joined
ERM-II with standard fluctuation margins (±15%) vis-à-vis the euro on
28 June 2004. Moreover Estonia and Lithuania unilaterally maintained a
euro-based currency board. Latvia joined the ERM-II on 2 May 2005,
but it maintained the exchange rate of the lats within a 1% fluctuation
band around its central rate vis-à-vis the euro. Slovakia joined ERM II in
November 2005.
Unilateral exchange rate regimes have been practiced also:
- euro-based currency board: Bulgaria.
- unilateral shadowing of ERM II (peg to the euro with ±15%
fluctuation bands): Hungary.
- managed floating with the euro as reference currency: Czech
Republic, Romania.
Poland practices independent floating.
At least once every two years, or at the request of a Member State
with a derogation, the European Commission and the ECB report on the
progress made in the fulfillment by the Member States of the
"Maastricht" convergence criteria. The Treaty moreover requires an
examination of the compatibility of the country's national legislation,
including the statutes of its national central bank, with the relevant
provisions of the Treaty.
In accordance with the EC Treaty, the Council decides, on a
proposal from the Commission, and after consulting the European
Parliament, which Member States fulfills the necessary conditions for
adopting the euro and fixes the date on which they will join the euro
area. The Council, after consulting the ECB, adopts the conversion rate
at which the euro shall be substituted for the currency of the Member
State concerned. On the date of adoption of the euro, the conversion rate
becomes effective, the national currency ceases to exist and
responsibility for monetary policy is transferred to the ECB. The
national authorities are in charge of the co-ordination of all preparatory
work for the introduction of the euro in their country.
Surveys showed that a small majority of citizens in the new EU
Member States (53%) believed that adopting the euro would have
positive consequences for their countries. Fewer people felt happy about
the prospect of a future changeover (48%).
On opinion of advocates of joining the euro area, the advantages of
the euro will have a greater catalytic effect on growth, but only for an
28
economy that is well prepared:
- the prospect of accession brought much foreign direct investment,
mostly from the EU. The euro can help sustain these flows.
- integration into the euro area can boost foreign trade also by
bringing the stability and credibility to local exporters.
- the EMU and the euro will lower the cost of borrowing for
investments.
But sometimes participation in the monetary union is viewed by
skeptics in terms of a loss of sovereignty.
At present shops, hotels and restaurants in most of the countries
already accept euros. In tourist areas prices are often displayed in euros.
The use of the euro is most widespread in Bulgaria (as well as in a
candidate country Turkey), where it can be considered a parallel
currency, together with the U.S. dollar. Evidence from a selected group
of eleven countries in the region of central, eastern and south-eastern
Europe shows that the share of euro-denominated – or euro-indexed –
deposits increased steadily from 60% of total foreign currency deposits
in 2003 to 72% in 2006, while the share of euro-denominated loans went
up from 64% of total foreign currency loans in 2003 to almost 80% in
2006.
In particular this is owing to increasing presence of foreign banks,
mainly from the euro area. The other factors include geographical
proximity of the EU, and thus, trade, financial, migration and tourism
links; institutional anchor of the EU and EMU membership, and role of
the euro as an external anchor in countries‟ exchange rate policies.
2.5. Effects Outside the European Union
The US dollar is still the leading international currency, but the euro
is the world's second most important currency. This is owing to the size
of the euro-area economy and to its stability, which reflects sound
economic fundamentals.
Euro as a legal tender or parallel currency. Europe. Monaco, the
Vatican City and San Marino adopted the euro as their national
currency. The Community has concluded agreements with them
authorizing them to issue a certain quantity of euro coins. However, they
are not authorized to issue euro notes. In Andorra the euro is circulating
as the means of payment in place of the French franc and the Spanish
peseta, as the country does not have a national currency. The euro is
29
being used as the domestic currency in Kosovo and Montenegro,
without any official agreements, following the precedent set by the
German mark which had previously been the de facto currency in these
territories. In many countries, especially in the Balkans and Eastern
Europe, the euro and US dollar are commonly used for transactions.
Africa. The Portuguese islands of Madeira and Azores, and the
Spanish Canary Islands are part of the euro area. Also the euro is
important for transactions in countries, where the domestic currency is
linked bilaterally to the euro by a fixed exchange rate regime.
America. The entire American continent is strongly US-dollar-
oriented and the launch of euro cash has had only a limited effect there.
In the French overseas departments and territories (French Guiana,
Guadeloupe, Martinique, etc.) the euro is the official currency. Saint-
Pierre-et-Miquelon is a French overseas territorial community not
forming part of the EU which previously used the French franc and now
use the euro by means of an agreement with the Union. In the
Dominican Republic, Cuba and Surinam payments in euros are possible,
especially in tourist areas.
Asia and Oceania. In the Middle East the euro is not important.
Only in Israel the use of the euro is more or less common. In the rest of
Asia the introduction of the euro has had a more significant impact. In
Thailand, South Korea and Laos the euro is widely accepted in shops,
restaurants and hotels. But the US dollar is still predominant in
international transactions. In Oceania the euro is not yet accepted as a
means of payment, with the exception of the French territories in the
region. French overseas department of Réunion in the Indian Ocean is a
part of the euro area, while Mayotte has the same status as Saint-Pierre-
et-Miquelon.
Anchor currency. Over fifty countries have tied their currencies to
the euro, including within managed exchange-rate arrangements or a
currency board. They are located mainly in Europe and Africa, with the
main incentives being commercial and financial links and the EU
accession process.
Unilateral exchange rate regimes include:
- Euro-based currency boards: Bosnia Herzegovina.
- Managed floating with the euro as reference currency: Croatia,
FYR Macedonia, Serbia.
30
- Peg arrangements based on currency baskets involving the euro:
Seychelles, Russia, Botswana, Morocco, Vanuatu, Jordan, Tunisia, and
Libya. (In Russia, the weight of the euro in the Central Bank of the
Russian Federation‟s operational basket for daily exchange rate
management increased to 45% in February 2007).
Bilateral exchange rate agreements. Several countries and territories
operate exchange rate regimes with pegging to the euro according to
agreements with the Community or one of its members, namely:
- the CFP franc area (Change Franc Pacifique) - France‟s overseas
territories in the Pacific (French Polynesia, New Caledonia and Wallis
and Futuna Islands), the area was previously linked to the French franc
via a fixed parity;
- the CFA franc area, which consists of two monetary unions: the
WAEMU (West African Economic and Monetary Union), with Benin,
Burkina Faso, Guinea-Bissau, Ivory Coast, Mali, Niger, Senegal and
Togo being the member countries, and the CAEMC (Central African
Economic and Monetary Community), consisting of Cameroon, Central
African Republic, Chad, Congo, Equatorial Guinea, Gabon.
Both the CFA franc area and the Comoros islands previously
enjoyed currency agreements with the French franc, while Cape Verde
had an agreement with Portugal. The EU agreed that France and
Portugal could maintain these agreements in the form of a peg with the
euro, but that the signatories would continue to retain sole responsibility
for their implementation.
Foreign reserves. The euro is used as a store of value and is the
second most important reserve currency held by central banks. The share
of the euro in global foreign exchange reserves has risen from 18% in
1999 to over 25% in 2007 (and to 29% in developing countries). It
largely reflects positive valuation effects for the euro. In comparison, the
US dollar accounts for around 65%, and the pound sterling for around
4.5% of global currency reserves.
However, the currency composition of foreign exchange reserves is
not so transparent, because amount of foreign assets held by countries
which do not disclose the currency composition of their reserve assets
has increased. Moreover, foreign assets have been increasingly
accumulated outside central banks in “sovereign wealth funds”
(estimated as 1.7 trillion dollars compared to 5 trillion dollars
31
accumulated as traditional foreign exchange reserves). Most of the funds
do not disclose details on their currency composition.
The role of the euro has increased most in countries located near the
euro area and in countries with an institutional link to the EU. The
choice of the currency composition of foreign exchange reserves is
closely linked to anchor currency considerations. The share of euro in
disclosed foreign reserves more than 50% is in the U.S., the UK,
Canada, several new Member States etc.
As far as the role of the euro as an intervention currency is
concerned, several central banks in EU neighboring countries continued
to intervene in foreign exchange markets by using the euro as the
intervention currency. In particular, this applies to some non-euro area
EU Member States and the EU candidate countries. Public statements by
the Bank of Russia suggest that there have also been interventions in the
rouble/euro market, although less than in the rouble/US dollar market.
Cash. In December 2001 26 central banks and financial institutions
outside the euro area had frontloaded a total of some 4 billion euros in
order to ensure that euro notes would be available in the first days of
January. Later it was estimated that 15% of the overall value of euro
banknotes in circulation were held outside the euro area (compared to
60% of cash dollars outside the U.S.). But the figure is not accurate.
Trade. Before the introduction of euro notes and coins in 2002, the
share of the euro in the invoicing of international transactions was
estimated to be between 15% and 17% of the total. Use of the euro in
international trade is also expanding, and pricing goods and
commodities in euro (such as oil and metals for example) will become
more attractive over time.
The euro-area Member States also benefit, as trading in euro
becomes more widespread. In the first quarter of 2006, in most euro-area
countries where data was available the average share of the euro in euro-
area exports of goods to countries outside the EU was around 50% in
terms of value (the US dollar was used in around 44% of the
transactions), while in imports of goods the euro's share was around
35%. The share of exports invoiced/settled in euro in exports of Ukraine
rose from 4% in 2002 to 7% in 2005, while the share of such import –
from 11 to 18%.
Financial Markets. The euro is an attractive currency for the
international financial markets because of the size of the euro-area
32
economy, its openness to international trade, its commitment to prudent
economic management, and the clear price stability mission of the ECB.
Debt Securities. The euro has become the second most important
financing currency. In 2003 30% of debt securities in foreign currencies
were issued in euros, while before introduction of euro the total share of
debt securities in the respective national currencies was only 20%. At
the end of 2006, the share of euro-denominated debt in international debt
markets was 31.4%, while the US dollar comprised 44.1%. But recent
decline by around 2.5 percentage points was most pronounced in the
market for long-term securities, mainly as the indirect effect of a large
increase in the issuance of bonds and notes denominated in US dollars.
As for issuance of short-term international debt securities at the end of
2006 the share of euro denominated securities was higher (34.4%
compared to 40.5% denominated in dollars).
Loans and deposits. In December 2006, 36.3% euro-area bank
lending to non-bank institutions outside the euro area was denominated
in euro (while 44.8% – in the US dollars). There is growing role of
emerging countries neighboring the euro area in attracting euro-
denominated loans. In the fourth quarter of 2006, according to the
narrow measure, i.e. cross-border transactions denominated in a
currency which is neither the home currency of the borrower nor that of
the lender, the euro share was equal to around 17% in the international
loan markets and 18% in the international deposit markets.
Forex. At the beginning of 2007 euro accounted for 37% (of 200%)
of conversion operations (it is a smaller portion than the share of former
national currencies of euro area due to decrease in mutual conversion
operations), compared to a share of 86.5% for the US dollar, 16.5% for
the Japanese yen and 15% for the pound sterling.
Discuss and answer the following questions.
1. Specifics of developments in the economy of the euro area in 1999-2001,
and the role of euro during this period.
2. Immediate effects of introduction of cash euro for the EU.
3. The problem of higher perceived inflation.
4. Trade-related effects of euro introduction.
5. Investment-related effects of euro introduction.
6. Discuss benefits and drawbacks of independent monetary policy.
33
7. Describe effects of supposed joining the euro area by your country.
8. Procedures and perspectives for enlargement of the Euro Area.
9. Compare current indicators of European countries in terms of satisfying
Maastricht convergence criteria.
10. Discuss effects of possible use of the euro as a parallel / anchor / foreign
reserve currency in your country.
34
CHAPTER 3. EUROPEAN SYSTEM OF CENTRAL BANKS
3.1. Legal Status and Financial Resources of the ESCB
General information. The European System of Central Banks
(ESCB) is composed of the ECB and of the NCBs of all 27 Member
States. The main documents regulating it are the Treaty Establishing
European Community and the Protocol (No 18) on the Statute of the
European System of Central Banks and of the European Central Bank
annexed to the EC Treaty (1992) (Statute).
The ECB has legal personality and is located in Frankfurt, while
NCBs are located in Member States. However only 16 the Member
States have adopted the euro. The 16 countries collectively make up the
„euro area‟ and their central banks, together with the ECB, make up
what is called the „Eurosystem‟ (do not take it for the ESCB). The NCBs
of the non-participating EU Member States are also members of the
ESCB but have a special status. They are responsible for their respective
national monetary policies and are thus excluded from taking part in the
core activities of the Eurosystem, in particular the conduct of the single
monetary policy.
The ECB decides how the ESCB is represented. The ECB and,
subject to its approval, the NCBs may participate in international
monetary institutions.
Privileges and immunities. The ECB enjoys in the territories of the
Member States several privileges and immunities. The European Central
Bank is exempt from taxation to certain extent. Governors of NCBs and
members of the Executive Board of the ECB have:
- a minimum term of office for NCB governors of five years;
- a non-renewable term of office of eight years for members of the
Executive Board of the ECB;
- a removal of the Members of the Executive Board from office only
in the event of incapacity or serious misconduct.
Auditing and Justice. The accounts of the ECB and NCBs are
audited by independent external auditors recommended by the
Governing Council (one of the decision-making bodies of the ECB) and
approved by the Council.
The Court of Justice may review the legality of acts of the ECB,
other than recommendations and opinions. The Court of Justice has
35
jurisdiction, under the same conditions, in actions or proceedings
brought by the ECB in the areas falling within the latter's field of
competence and in actions or proceedings brought against the latter (the
same is relevant for the NCBs).
Specific provisions for certain countries. The National Bank of
Denmark preserves the right to carry out its existing tasks concerning
those parts of the Kingdom of Denmark which are not part of the
Community. The UK is not a subject to applicability of certain articles
related to monetary policy.
Capital. The NCBs are the only holders of the capital of the ECB.
Each national central bank has a share in capital as a weighted average
of:
- 50 % of the share of the respective Member State in the population
of the Community;
- 50 % of the share of the respective Member State in the gross
domestic product.
The weightings is adjusted every five years. Adjusted for the shares
of the non-euro area NCBs the capital also serves as a yardstick for the
distribution of the following financial rights and obligations among euro
area NCBs:
- contributions to the ECB‟s foreign reserve assets;
- allocation of euro banknotes in circulation among the NCBs and
the allocation of monetary income (intra-Eurosystem income sharing is
limited to monetary income; all other income earned by NCBs remains
with the NCB which earned it; monetary income consists mainly of
seigniorage income);
- appropriation of the annual financial results of the ECB;
- weighting of voting rights in the Governing Council.
The non-euro area NCBs are not required to pay up their
subscriptions. Instead, they have to make contributions to cover the
operational costs incurred by the ECB related to tasks performed for the
non-euro area NCBs. These contributions were set at 7% of the amount
which would be payable if these countries were to participate in EMU.
Foreign reserves. The financial resources of the ECB consist mainly
of its own funds, its foreign reserve assets and its claims on the NCBs
resulting from the ECB‟s share in the issue of euro banknotes.
36
Table 3.1.
Structure of the ECB capital by owner, from 1 May 2004
NCB of what country Share in the ECB capital,
%
Belgium 2.6
Germany 21.1
Greece 1.9
Spain 7.8
France 14.9
Ireland 0.9
Italy 13.1
Luxembourg 0.2
Netherlands 4.0
Austria 2.1
Portugal 1.8
Finland 1.3
Subtotal for euro area NCBs 71.5
Czech Republic 1.5
Denmark 1.6
Estonia 0.2
Cyprus 0.1
Latvia 0.3
Lithuania 0.4
Hungary 1.4
Malta 0.1
Poland 5.1
Slovenia 0.3
Slovakia 0.7
Sweden 2.4
The United Kingdom 14.4
Subtotal for non-euro area NCBs 28.5
Total 100.0
Source: Scheller H. (2006), “The European Central Bank. History, Role
and Functions”, Second revised edition. ECB.
37
Originally the Eurosystem NCBs transferred foreign reserve assets
to the ECB totalling some €40 billion (85% in foreign currency holdings
and 15% in gold). In exchange, the NCBs have received interest-bearing
claims on the ECB, denominated in euro. Further calls of foreign reserve
assets beyond may be effected. The ECB also may hold and manage the
IMF reserve positions and SDRs. The Eurosystem NCBs are involved in
the management of the ECB‟s foreign reserves: they act as agents for the
ECB, in accordance with portfolio management guidelines set by the
ECB. The remaining Eurosystem foreign reserve assets are owned and
managed by the NCBs, but such operations above a certain limit are
subject to approval by the ECB.
The foreign reserve assets and the related liabilities are a source of
sizeable exchange rate and interest rate risks. Such risks materialized,
for example, in 2000, 2003 and 2004: in 2000, the ECB recorded high
profits from intervention sales of US dollars and Japanese yen; in both
2003 and 2004, however, it suffered sizeable losses when the US dollar
weakened sharply against the euro. For example, a depreciation of the
US dollar against the euro by only 100 basis points reduces the ECB‟s
net profit by some €300 million, which almost equals the total
administrative expenses of the ECB for 2005.
3.2. Objective and Principles
Primary objective. Primary objective of the ESCB is to maintain
price stability. Supporting the general economic policies in the
Community (high level of employment, sustainable and non-inflationary
growth) is a lower priority objective. The ECB typically should avoid
generating excessive fluctuations in output and employment. But it does
not require the ECB to coordinate its policy ex ante with the economic
policies in the Community.
Price stability helps to achieve high levels of economic activity and
employment by the following channels.
1. Improving the transparency of the price mechanism. Under price
stability people can recognize changes in relative prices better. It allows
them to make better consumption and investment decisions.
2. Reducing inflation risk premia in interest rates. It increases
incentives to invest.
3. Avoiding unproductive activities to hedge against the negative
impact of inflation or deflation.
38
4. Reducing distortion effect of inflation or deflation on economic
behavior of tax and social security systems.
5. Preventing an arbitrary redistribution of wealth and income as a
result of unexpected inflation or deflation.
The ECB‟s Governing Council has defined price stability as a year-
on-year increase in the Harmonised Index of Consumer Prices (HICP)
for the euro area of below 2%. So both deflation and high inflation are
inconsistent with price stability. Price stability is to be maintained over
the medium term and in the euro area as a whole. Price stability is
achieved by controlling the money supply and by monitoring price
trends.
Principles and basic tasks. The ESCB is to act in accordance with
the principle of an open market economy with free competition, favoring
an efficient allocation of resources, stable prices, sound public finances
and monetary conditions and a sustainable balance of payments. In
addition, the operational framework follows several guiding principles.
1. Operational efficiency in terns of precise and fast effect of
monetary policy.
2. Equal treatment and harmonization. Credit institutions must be
treated equally irrespective of their size and location in the euro area.
The harmonization of rules and procedures helps to provide identical
conditions to all credit institutions in the euro area in transactions with
the Eurosystem.
3. Decentralized implementation. NCBs carry out most the
operational activities, which are coordinated by the ECB. The ECB itself
carries out few operations.
4. Simplicity and transparency – to ensure that the intentions behind
monetary policy operations are correctly understood.
5. Continuity – to avoid major changes in instruments and
procedures.
6. Safety – to keep the Eurosystem‟s financial and operational risks
to a minimum.
7. Cost efficiency – to keep low the operational costs to both the
Eurosystem and its counterparties.
The basic tasks to be carried out through the ESCB are:
- to define and implement the monetary policy of the Community;
- to conduct foreign-exchange operations;
39
- to hold and manage the official foreign reserves of the Member
States;
- to promote the smooth operation of payment systems.
Prohibited activities. The ECB and the NCBs cannot:
- provide overdraft facilities or purchase directly debt instruments of
public authorities, public undertakings (except credit institutions) etc.;
- seek or take instructions from Community institutions or bodies,
from a government of a Member State or from any other body (the ECB
works in complete independence).
3.3. Functions
Legislative functions. There are three intra-Eurosystem types of
legal acts, namely:
1. ECB guidelines. They are internal to the Eurosystem and only
addressed to the euro area NCBs. Guidelines are adopted usually by the
Governing Council.
2. ECB instructions. The ECB instructions are adopted by the
Executive Board (another decision-making body of the ECB) to ensure
implementation of monetary policy decisions and guidelines by giving
specific and detailed instructions to the NCBs of the euro area.
3. Internal decisions. They address internal organizational or
administrative matters.
The ECB may also adopt legal acts that have a direct effect on third
parties other than the NCBs of the Eurosystem. These instruments are
ECB Regulations and ECB Decisions.
ECB regulations have general application to an unlimited number of
entities and cases. Their direct applicability means that ECB Regulations
do not need to be transposed into national law. The ECB Regulations are
adopted by the Governing Council usually.
ECB decisions are binding in their entirety on the addressees and
take effect on notification to them. They may be addressed to any legal
or natural person, including the euro area member countries. ECB
Decisions may be adopted by the Governing Council or by the
Executive Board.
The ECB shares with the European Commission the right to initiate
the adoption of secondary Community legislation complementary to, or
amending, the Statute of the ESCB.
40
Consulting. The Community legislative bodies are required to
consult the ECB on any proposed Community act that falls within its
field of competence. As part of its advisory activities, the ECB may
adopt non-binding legal acts: recommendations and opinions within its
field of competence. In particular, the ECB should be consulted in case
of:
- institutional changes in the monetary area;
- before taking safeguard measures with regard to third countries,
where movements of capital to or from third countries cause, or threaten
to cause, serious difficulties for the operation of economic and monetary
union;
- on any proposed Community act in its fields of competence;
- by national authorities regarding any draft legislative provision in
its fields of competence with certain limitations.
The President of the ECB is to be invited to participate in Council
meetings when the Council is discussing matters relating to the
objectives and tasks of the ESCB.
Financial activities and monetary policy. The ECB has the exclusive
right to authorize the issue of banknotes within the Community. The
ECB and the NCBs may issue such notes. The ECB issues 8% of the
total value of banknotes issued by the Eurosystem. In practice, the
ECB‟s banknotes are put into circulation by the NCBs, thereby incurring
matching liabilities vis-à-vis the ECB. These liabilities carry interest at
the main refinancing rate of the ECB. The other 92% of the euro
banknotes are issued by the NCBs in proportion to their respective
shares in the capital key of the ECB. The difference between each
NCB‟s share of total banknotes in circulation and the amount of
banknotes it has actually put into circulation is established each month
and recorded as an interestbearing intra-Eurosystem claim or liability. A
NCB which puts more banknotes into circulation than its share in the
capital key incurs an interest bearing liability vis-à-vis the rest of the
Eurosystem and vice versa.
The ECB and the NCBs may:
- operate in the financial markets by buying and selling outright
(spot and forward) or under repurchase agreement and by lending or
borrowing claims and marketable instruments, whether in Community or
in non-Community currencies, as well as precious metals;
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- conduct credit operations with credit institutions and other market
participants, with lending being based on adequate collateral.
In order to conduct their operations, the ECB and NCBs may open
accounts for credit institutions, public entities and other market
participants and accept assets as collateral. The ECB may require credit
institutions established in Member States to hold minimum reserve on
accounts with the ECB and NCBs. The ECB and NCBs may also act as
fiscal agents for public authorities.
External operations. The ECB and NCBs may:
- establish relations with central banks and financial institutions in
other countries and international organizations;
- acquire and sell foreign exchange assets and precious metals;
- hold and manage the assets;
- conduct all types of banking transactions in relations with third
countries and international organizations.
In 2005, in response to the continuously increasing use of the euro
as an international reserve currency, the Eurosystem launched a common
framework for the provision of a comprehensive set of reserve
management services in euro to official foreign customers (central
banks, monetary authorities and government agencies located outside
the euro area, and international organizations).
The individual Eurosystem central banks that act as single access
points (currently the Deutsche Bundesbank, the Banco de España, the
Banque de France, the Banca d‟Italia, the Banque centrale du
Luxembourg and De Nederlandsche Bank), are known as “Eurosystem
service providers” and offer the complete set of reserve management
services. These services range from the provision of custody accounts
and related custodian and settlement services to cash and investment
services.
Payment systems. The ECB and NCBs may provide facilities, and
the ECB may make regulations, to ensure efficient and sound clearing
and payment systems within the Community and with other countries.
In particular, in 1999 the Eurosystem has introduced TARGET
(Trans-European Automated Real-time Gross Settlement Express
Transfer System) to process large-value payments in euro in real time
throughout the euro area. It comprises and interlinks several national
RTGS systems and the ECB payment mechanism (EPM). TARGET
42
must be used for all payments directly resulting from or made in
connection with:
- the Eurosystem‟s monetary policy operations;
- the settlement of the euro leg of foreign exchange operations
involving the Eurosystem;
- the settlement operations of large-value systems handling euro
transfers.
For other payments, such as interbank and commercial payments in
euro, market participants are free to use TARGET or another payment
system. In 2005 89% of the total turnover of large-value payments in
euro were carried out via TARGET. At the end of 2004, there were more
than 10,000 participants. However, in view of increasing financial
integration within the euro area development of a new enhanced system
(TARGET2) was initiated in October 2002 to start operations in 2007.
The Eurosystem also acts as settlement agent for payment systems
that it does not operate itself. E.g., the ECB is the settlement agent for
the EURO1 system operated by the Euro Banking Association (EBA).
Some NCBs are settlement agents for privately operated retail payment
systems and securities settlement systems. They offer neutral and open
networks in which banks can participate, irrespective of the size of their
business.
The ECB provides account facilities for the Continuous Linked
Settlement (CLS) system based in the U.S. and is the overseer for the
euro which is the second most important currency in the CLS system,
while the US Federal Reserve is the main overseer of the system.
The ECB is the overseer of European wide large-value payment
systems (including TARGET), while the NCBs oversee the respective
domestic systems. As far as the oversight of securities clearing and
settlement systems is concerned, the powers of the Eurosystem are less
explicit and exclusive.
Financial supervision. The Eurosystem contributes to the conduct of
financial supervision. According to the principle of home country
control, the supervision of a credit institution is the responsibility of the
competent authorities of the Member State where it was licensed. In
some countries, the respective NCB is entrusted with banking
supervision. In other Member States, separate bodies perform banking
supervision, but cooperate with the respective central bank. Back in the
43
1970s fora for multilateral cooperation in the field of banking
supervision were created at the European level.
The ECB‟s contribution to the smooth conduct of policies pursued
by the competent authorities relating to the prudential supervision of
credit institutions and the stability of the financial system consists of:
- promoting cooperation among central banks and supervisory
authorities;
- performing its advisory function;
- cooperating with other relevant fora operating in Europe.
The ECB is entrusted with the task of monitoring compliance with
prohibition the central banks from providing overdraft facilities or any
other type of credit facility to governments and Community institutions
or bodies, and from purchasing debt instruments directly from them; an
exception to this is the UK government‟s “ways and means” facility
with the Bank of England. The ECB also monitors the EU central banks‟
secondary market purchases of debt instruments issued by both the
domestic public sector and the public sector of other EU Member States.
The ECB may impose fines or periodic penalty payments on
undertakings for failure to comply with obligations under its regulations
and decisions.
Reporting. The ECB is to address an annual report on the activities
of the ESCB and on the monetary policy of both the previous and
current year to the European Parliament, the Council and the
Commission, and also to the European Council. Also the ECB is to draw
up and publish reports on the activities of the ESCB at least quarterly. A
consolidated financial statement of the ESCB is to be published each
week.
The ECB actually exceeds these statutory obligations by producing
a Monthly Bulletin and by publishing Working Papers and other
publications on its website. However, unlike the US Federal Reserve
System, the Bank of England and the Bank of Japan, the ECB does not
publish the minutes of the meetings of its main policy-making body, nor
does it publish details of how the members of the Governing Council
voted. The publication of individual voting behavior could lead to
pressure and speculation about the motives behind the decisions of the
individual members of the Governing Council.
At least once every two years, or at the request of a Member State
with a derogation, the Commission and the ECB are to report to the
44
Council on the progress made in the fulfillment by the Member States of
their obligations regarding the achievement of economic and monetary
union.
Research. The goal of economic research at the ECB is to provide a
strong conceptual and empirical basis for policy-making and to better
communicate policy to the markets and the public. The research
activities include:
- macroeconomic modeling of the euro area;
- financial support for young and bright European economists;
- organizing regular seminars, conferences, and workshops (e.g., in
2006, the ECB co-organized fourteen conferences on a broad range of
topics, such as the theory and practice of monetary policy, wage and
labor costs, financial integration and stability, financial systems and
economic growth, payment and settlement issues, financial globalization
and integration, financial statistics, and national accounts);
- disseminating research through the Working Paper Series;
- contributing to research networks and centers: the network on
Capital Markets and Financial Integration in Europe, the Euro Area
Business Cycle Network, and the Centre for Economic Policy Research.
Statistics. The ECB is primarily or jointly responsible for euro area
monetary, financial institutions and financial markets statistics, external
statistics (including the balance of payments), financial accounts and the
development of quarterly non-financial accounts for institutional sectors
(households, corporations and government).
For this purpose the ECB is assisted by the NCBs and is required to
cooperate with the Community institutions or bodies and with the
competent authorities of the Member States or third countries and with
international organizations. The ECB cooperates most closely with the
Eurostat.
3.4. Structure
Decision-making bodies. Composition. The ESCB is governed by
the decision-making bodies of the ECB: the Governing Council and the
Executive Board. Additionally there is the General Council.
The Governing Council of the ECB comprises the members of the
Executive Board of the ECB and the Governors of the NCBs of the euro
area. The Executive Board comprises the President, the Vice-President
and four other members. The President, the Vice-President and the other
45
members of the Executive Board are appointed from among persons of
recognized standing and professional experience in monetary or banking
matters by common accord of the governments of the Member States at
the level of Heads of State or Government, on a recommendation from
the Council, after it has consulted the European Parliament and the
Governing Council of the ECB. Their term of office is eight years and is
not renewable. Members of the governing bodies and the staff of the
ECB and the NCBs are required, even after resignation, not to disclose
information covered by the obligation of professional secrecy.
Decision-making bodies of the ECB
Executive board Governing council General Council
President
Vice-President
President
Vice-President
President
Vice-President
4 other members of
the Executive board
4 other members of
the Executive board
Governors of
the NCBs of all EU
Member States
Governors of the Euro
Area NCBs
Chart. 3.1. Decision-making bodies of the ECB.
Source: ECB (2004), “The Monetary Policy of the ECB”.
Governing Council. The Governing Council is the European Central
Bank's highest decision-making body. It is chaired by the President of
the ECB. The President of the Council and a Member of the
Commission may attend meetings of the Governing Council, but without
the right to vote.
The Governing Council formulates the monetary policy of the
Community including decisions relating to intermediate monetary
objectives, key interest rates and the supply of reserves in the ESCB, and
establishes the necessary guidelines for their implementation. It also:
- has the exclusive right to authorize the issue of banknotes within
the Community;
46
- may bring an action before the Court of Justice;
- establishes the rules to standardize the accounting and reporting of
NCB operations;
- decides on the allocation of financial resources to the ECB and the
appropriation of its financial results, and adopting the rules governing
the allocation of monetary income among the euro area NCBs;
- adopts the Annual Report and Annual Accounts of the ECB, etc.
The Governing Council meets at least 10 times a year, currently
meets twice a month, usually on the first and third Thursday of each
month. Monetary policy issues are normally discussed at the first
meeting of the month only.
As for voting, 2/3 quorum and simple majority rules are used. For
some decisions (on certain financial matters) weighting of votes
according to the national central banks' shares is used. Financial matters
requiring weighted voting are: the paying-up and increases in the ECB‟s
capital, revisions of the ECB‟s key for capital subscription, transfers of
foreign reserve assets to the ECB, the allocation of NCBs‟ monetary
income and the allocation of the ECB‟s net profits and losses.
Unanimous voting may also be required in some cases. The President of
the EU Council and a member of the European Commission may attend
the meetings, although only the members of the Governing Council have
the right to vote. For certain procedures members of the Governing
Council may cast their vote by means of teleconferencing.
It was decided, that when the euro area has more than 15 member
countries, the number of NCB governors holding a voting right would be
restricted to 15. Thus, the six members of the Executive Board maintain
permanent voting rights, whereas the NCB governors exercise voting
rights on the basis of a pre-established rotation system. NCB governors
are allocated to different groups according to a ranking of the size of
their respective countries‟ economies. The country ranking is based on a
composite indicator consisting of two components:
- the share of the country in the aggregate GDP at market prices;
- the share of the country in the total assets of the aggregated
balance sheet of the monetary financial institutions (TABS-MFI).
The weights of the two components are 5/6 for GDP and 1/6 for
TABS-MFI. The first group consists of five governors from the euro
area countries with the highest positions in the country ranking. The
second group includes the remaining governors. The rotation system will
47
be based on three groups, when the euro area is enlarged to 22 member
countries.
Executive board. The Executive Board is responsible for the current
activities of the ECB and implements monetary policy. In order to do
this, the Executive Board gives the necessary instructions to national
central banks. In addition the Executive Board may have certain powers
delegated to it by the Governing Council. For example, the Executive
Board decides once a week on the allotment of liquidity to the banking
sector via the main refinancing operations. The Executive Board is also
responsible for organizing the internal structure of the ECB. Usually it
acts by a simple majority of the votes cast. In the event of a tie, the
President has the casting vote.
President. Specific responsibilities of the ECB President are:
- chair of all three decision-making bodies of the ECB;
- casting vote in the Governing Council and on the Executive Board;
- external representation of the ECB;
- presentation of the ECB‟s Annual Report to the European
Parliament and the EU Council;
- possibility to attend sessions of the ECOFIN Council and the
Eurogroup.
The General Council. The General Council performs the tasks taken
over from the EMI and will exist as long as some EU Member States
have not adopted the euro. It comprises the ECB‟s President and the
Vice-President and the governors of the NCBs of all 27 EU Member
States. The General Council contributes to the ECB's advisory and
coordination work and assists in preparing for the future enlargement of
the euro zone, collecting statistical information, drawing up reports on
the ECB activities, monitors the functioning of ERM II, etc. It has no
responsibility for monetary policy decisions in the euro area. The
General Council usually meets once every three months. Meetings may
also be held by teleconference.
Staff. The ECB employs staff originating from all EU Member
States. In 2005 the 12 euro area NCBs had almost 49,000 employees,
with the ECB having 1,300 staff members. Even if we assume that
around 50% of NCB staff are involved in non-Eurosystem activities, the
ECB‟s share in the staff working for the Eurosystem is less than 5%.
The linguistic plurality of the EU requires that the ECB
communicate in many languages in order to reach the widest possible
48
audience. For the internal workings of the ECB and intra-ESCB
relations, only one language – English – is used.
Business Areas. The ECB is divided into 17 business areas. Each
business area is headed by a senior manager (Director General or
Director) who reports to a member of the Executive Board. The business
areas include:
Administration (Directorate General): Office Services
Premises
Security
- Internal Finance (Directorate): Accounting and Procurement
Financial Reporting and Policy
Banknotes (Directorate): Banknote Issue
Banknote Printing
Communications (Directorate): Official Publications and Library
Press and Information
Protocol and Conferences
Counsel to the Executive Board
ECB Permanent Representation in Washington D.C.
Economics (Directorate General): Fiscal Policies
- Directorate Economic Developments: Euro Area Macroeconomic Developments
EU Countries
External Developments
- Directorate Monetary Policy: Capital Markets and Financial Structure
Monetary Policy Stance
Monetary Policy Strategy
Financial Stability and Supervision (Directorate): Financial Stability
Financial Supervision
Human Resources, Budget and Organization (Directorate General): Budget and Projects
Recruitment and Compensation
Organizational Planning
HR Policies and Staff Relations
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Risk Management
Information Systems (Directorate General): IT Management Functions
IT Operations and Support
- Directorate IT Projects
Internal Audit (Directorate): Audit Missions
Audit Services
International and European Relations (Directorate General): EU Institutions and Fora
EU Neighboring Regions
International Policy Analysis and Emerging Economies
Legal Services (Directorate General): Lawyer-Linguists
Legal Advice
Market Operations (Directorate General): Back Office
Front Office
Investment
Market Operations Analysis
Market Operations Systems
Payment Systems and Market Infrastructure (Directorate General): Market Infrastructure
Oversight
TARGET
Research (Directorate General): Econometric Modeling
Financial Research
Monetary Policy Research
Secretariat and Language Services (Directorate General): Language Services
Secretariat
Statistics (Directorate General): Euro Area Accounts and Economic Statistics
External Statistics
Monetary, Financial Institutions and Markets Statistics
Statistical Information Management and User Services
Statistics Development and Coordination
Several internal ECB committees have been established to facilitate
the performance of cross-departmental functions. They consist of
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members from the ECB and the NCBs of the Eurosystem , as well as
from other competent bodies, such as national supervisory authorities in
the case of the Banking Supervision Committee. The Committees are
(their composition may be changed):
Accounting and Monetary Income Committee (AMICO) advises
on all intra-Eurosystem issues related to accounting, financial reporting
and the allocation of monetary income;
Banking Supervision Committee is in the field of the prudential
supervision of credit institutions and the stability of the financial system;
Banknote Committee promotes intra-Eurosystem cooperation in
the production, issue and post-issue handling of euro banknotes;
External Communications Committee (ECCO) assists the ECB in
its communication policy, particularly on issues related to multilingual
publications;
Information Technology Committee (ITC) assists in the
development, implementation and maintenance of IT networks and
communications infrastructure which support the joint operational
systems;
Internal Auditors Committee (IAC) develops common standards
for auditing Eurosystem operations and audits joint projects and
operational systems at the Eurosystem/ESCB level;
International Relations Committee (IRC) assists the ECB in
performing its statutory tasks related to international cooperation and
acts as a forum for exchanging views on matters of common interest in
this field;
Market Operations Committee (MOC) assists the Eurosystem in
carrying out monetary policy operations and foreign exchange
transactions, managing the ECB‟s foreign reserves and the operation of
ERM II;
Monetary Policy Committee (MPC) advises mainly on strategic
and longer-term issues relating to the formulation of the monetary and
exchange rate policy and is responsible for the regular Eurosystem staff
projections of macroeconomic developments in the euro area;
Payment and Settlement Systems Committee (PSSC) advises on
the operation and maintenance of the TARGET, general payment
systems policy and oversight issues, and issues of interest for central
banks in the field of securities clearing and settlement;
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Statistics Committee (STC) advises on the design and the
compilation of statistical information collected by the ECB and NCBs;
Legal Committee (LEGCO) provides advice on all legal issues
related to the ECB‟s statutory tasks;
Management Committee advises and assists the Executive Board
on issues related to the management of the ECB, its strategic planning
and the annual budget process;
Human Resources Conference was also established to promote
the cooperation in the field of human resources management.
National Central banks. The NCBs act in accordance with the
guidelines and instructions of the ECB. NCBs are independent and may
under no circumstances seek or take instructions from Community
institutions and bodies, governments of Member States or any other
bodies. The NCBs are largely responsible for collecting national
statistical data and for issuing and handling euro banknotes in their
respective countries. The NCBs can be assigned other functions that are
not related to monetary policy functions: some NCBs are involved in
banking supervision and/or act as the government‟s principal banker.
The NCBs also perform functions outside the scope of the Statute,
unless the Governing Council decides it to be incompatible with the
objectives and tasks of the Eurosystem.
Common operational systems. The ECB and the NCBs have
established a number of common operational systems to make it easier
to carry out decentralized operations. As for the Eurosystem, the
following common operational systems are used.
Systems for tender operations and bilateral market intervention,
which ensure the secure and speedy transmission of instructions for
carrying out decentralized monetary policy operations.
The system for the exchange of non-statistical data, which serves
as the communication channel for the NCBs‟ and the ECB‟s daily
balance sheet data, reported to the ECB‟s liquidity management function
and used for the daily money market analysis.
The common front office system, used for recording and
processing of transactions with the ECB‟s foreign reserve assets carried
out by NCBs, and by the ECB with its own funds, and for monitoring
positions, limits, risks and performance.
The Currency Information System, which monitors the NCBs‟
banknote stocks in order to identify potential shortages and surplus
52
stocks of euro banknotes at the Eurosystem‟s different access points. It
enables correcting imbalances by transporting surplus stocks of
banknotes from one country to compensate for potential shortages in
another.
Other common operational systems include the NCBs of the non-
euro area Member States:
The TARGET system.
CebaMail, which is a closed electronic mail system for the secure
exchange of information among the EU NCBs.
The Teleconference System, which is a closed and secure system
for holding teleconferences among the ESCB members at governor and
expert levels.
The Counterfeit Monitoring System, which enables centralized
information about the details of counterfeit euro banknotes in the EU to
be shared securely with all authorized parties.
The Exchange of Statistical Data System, which ensures the
secure and speedy transmission of statistical data in common format
within the ESCB.
The MFI Statistics and Monetary Database, which is the
centralized register of the monetary financial institutions that make up
the reporting population for money and banking statistics. Among them
are the credit institutions, which are subject to minimum reserve
requirements. The database also lists the assets which are eligible to be
used as collateral in the Eurosystem‟s intraday credit and monetary
policy operations.
3.5. Interaction with Other Institutions
Other EU bodies. European Parliament. The interaction between
the ECB and the European Parliament is mainly related to the fulfillment
of the ECB‟s mandate and tasks. The European Parliament is important
in terms of accountability of the ECB for monetary policy and related
tasks.
EU Council. The ECB shares responsibility with the EU Council for
exchange rate matters and the international representation of the euro
area. Also the ECB is involved in non-binding dialogue with the Council
on economic policy cooperation at the euro area level. Though officially
there is only one EU Council, it meets in various compositions,
depending on the subject under consideration. The EMU matters fall
53
within the sphere of the Economic and Financial Affairs Council
(ECOFIN Council). The ECB President is invited to participate in the
ECOFIN Council meetings, if matters related to the objectives and tasks
of the ESCB are considered. The ECB has reporting obligations towards
the ECOFIN Council as well. The ECB has also been involved in the
activities of specific bodies, such as the Financial Services Committee or
the Committee of Wise Men on the Regulation of European Securities
Markets. Upon a recommendation by the European Commission or the
ECB the EU Council, acting by qualified majority, has the right to
formulate general orientations for exchange rate policies. These
orientations should not contradict the ECB‟s primary objective of price
stability.
Eurogroup. In the euro area foreign exchange policy is ultimately
decided by the Eurogroup and the ECB. The Treaty does not provide for
a body that brings together the finance ministers of euro area member
countries to discuss issues of common concern relating to the euro area
and the single currency. But the Luxembourg European Council of
December 1997 decided to establish the “Eurogroup”: an informal body
composed of the finance ministers of euro area countries and the
Commissioner for Economic and Monetary Affairs. The ECB may be
invited to participate in Eurogroup meetings. The Eurogroup focuses on
the overall functioning of the euro area economy, budgetary
developments in euro area member countries, and stimulating structural
reform, the euro exchange rate developments, and the external
perception of the euro area.
There is a strong interaction with the Eurogroup, with a view to
achieve a common position with the other main partners, in particular
the United States and Japan. But some finance ministers may make
public statements about exchange rate issues before Eurogroup
meetings, often in order to influence the meeting. This weakens the
negotiating position of the euro area, and the most likely effect on
financial markets is the opposite of that intended.
European Commission. The Commissioner for Economic and
Monetary Affairs attends the respective meetings of the ECOFIN
Council, the Eurogroup, and the ECB‟s Governing Council. Eurostat and
the ECB cooperate closely in the area of statistics, both bilaterally and
within the relevant statistical committees of the Community, in
particular the Committee on Monetary, Financial and Balance of
54
Payments Statistics. The ECB is also involved in a number of
specialized working groups and regulatory committees. Such bodies deal
with financial market integration (the “Giovannini Group”), prudential
supervision and financial stability (the European Banking Committee
and the Committee of European Banking Supervisors) and many other
issues.
Economic and Financial Committee. The Economic and Financial
Committee (EFC) was established to assist the ECOFIN Council with
analyses and advice on economic and financial questions. By
participating in the EFC activities the ECB has become involved in
discussions on the Broad Economic Policy Guidelines, the surveillance
of fiscal policies on the basis of Member States‟ annual Stability and
Convergence Programmes and the preparation of European positions on
international issues.
Economic Policy Committee. The Economic Policy Committee
(EPC) was established in 1974 and consists of two representatives and
two alternates from each of the Member States, the Commission and the
ECB. It is involved in preparing the Eurogroup and ECOFIN Council
meetings, but focuses particularly on structural reforms. The ECB
participates in its work as well.
Discussion groups involving private agents. Foreign Exchange
Contact Group (FXCG). The FXCG is a forum for discussing industry
developments and structural trends which are important for the foreign
exchange market developments. The FXCG is chaired by the Director
General of the ECB Directorate General for Market Operations, and his
Deputy acts as the ECB Member of the group. The FXCG consists of
around 20 Members with leading functions in financial institutions that
play important role in foreign exchange. Besides Members, other
participants include representatives from the euro area NCBs.
Money Market Contact Group (MMCG). The MMCG discusses
issues related to the euro money market, including short-term and
structural developments. The MMCG is chaired by the Director General
of the ECB Directorate General for Market Operations with his Deputy
acting as the ECB member of the group. The MMCG has around 20
members representing different commercial banks from all over Europe.
Besides Members, other participants include, representatives from the
euro area NCBs.
55
Operations Managers Group (OMG). The OMG was established as
a sub-group of both the ECB FXCG and MMCG. It is used by
settlement experts in the financial market community to maintain regular
contact with the Eurosystem and with each other on operational matters
of common interest. The OMG is also a forum for responding to crisis
situations in financial markets affecting euro area participants. The
OMG is chaired by a representative from one of the member banks.
Rotation every 2 years is applied. The group has about 20 members
representing different commercial banks from all over Europe as well as
the euro area NCBs.
International organizations. The ECB is involved it international
cooperation in the following ways.
1. When the subject of international cooperation concerns the single
monetary policy, the ECB is the sole institution entitled to represent
policy positions of the European Community.
2. As for the euro exchange rate, the ECB shares responsibility with
the EU Council (ECOFIN) and the Eurogroup.
3. In the area of payment systems, the ECB and the NCBs may
formulate positions on issues related to the Eurosystem‟s responsibility
for promoting the smooth and efficient operation of payment and
settlement systems.
4. In statistical matters, the ECB is required by the Statute to
cooperate with international organizations.
5. In the area of prudential supervision and financial stability, both
the ECB and the national authorities that have competence in this field
may take part in international meetings and formulate their positions.
The ECB has established relations with the International Monetary
Fund (IMF) and the Organisation for Economic Co-operation and
Development.
IMF. On 21 December 1998 the IMF Executive Board decided to
grant observer status to the ECB. This solution avoided the need to
amend the IMF‟s Articles of Agreement, which restrict membership to
countries. Also the Commissioner for Economic and Monetary Affairs
participates in the annual and spring meetings of the Bretton Woods
institutions on behalf of the European Commission.
Informal fora for finance ministers and central bank governors. G7
finance ministers and central bank governors. Their meetings are mainly
concerned with economic and financial developments and prospects in
56
their respective countries, exchange rate issues and the global economy.
Both the President of the ECB and the President of the Eurogroup
participate in those parts of the meetings that deal with macroeconomic
surveillance and exchange rate issues. The three central bank governors
of the euro area G7 countries (France, Germany and Italy) do not
participate in this part of the meetings. However, they continue to take
part when the G7 discusses other issues, e.g. the international financial
architecture and debt initiatives for poor countries.
G10 finance ministers and central bank governors. It dates back to
the creation of the General Arrangements to Borrow (GAB), which were
established in 1962 to complement the IMF‟s ordinary resources. In
recent years the G10 focused mainly on preventing and managing
international financial crises. The President of the ECB participates as
an observer in the annual meetings of the G10, which are organized
alongside the IMF‟s annual meeting. The G10 central bank governors
have established several permanent committees and ad hoc Working
Parties. Four permanent committees are of particular relevance for the
ECB.
1. The ECB has observer status at the meetings of the Basel
Committee on Banking Supervision.
2. The Committee on Payment and Settlement Systems has been
chaired by a member of the ECB‟s Executive Board since June 2000.
3. The ECB is also a member of the Committee on the Global
Financial System. The activities of the CGFS are designed to identify
and assess potential sources of instability in the global financial
environment, to further understanding of the functioning of financial
markets and to promote their efficiency and stability.
4. The ECB is a member of the Markets Committee, which brings
together senior central bank representatives to regularly review
developments in the financial, and especially foreign exchange markets.
G20 finance ministers and central bank governors. The Group of 20
is an informal forum set up in 1999 to involve key emerging market
countries. The members of the Group of 20 are the finance ministers and
central bank governors of Argentina, Australia, Brazil, Canada, China,
France, Germany, India, Indonesia, Italy, Japan, Korea, Mexico, Russia,
Saudi Arabia, South Africa, Turkey, the United Kingdom and the United
States. Another member is the European Community, represented by the
President of the EU Council and the President of the ECB. The
57
managing director of the IMF and the President of the World Bank, as
well as the chairpersons of the International Monetary and Financial
Committee and Development Committee of the IMF and World Bank,
also participate in the talks as ex officio members.
Financial Stability Forum. In February 1999 the G7 finance
ministers and central bank governors decided to set up a Financial
Stability Forum (FSF) with the following objectives:
- to assess vulnerabilities of the international financial system;
- to identify activities for promoting international financial stability
through enhanced information exchange and international cooperation in
financial supervision and surveillance.
A member of the ECB‟s Executive Board has attended FSF
meetings as a regular member as the Chairman of the BIS Committee on
Payment and Settlement Systems.
Bank for International Settlements (BIS). The ECB takes part in all
BIS-based cooperation activities, including statistical work. Since 2000,
the ECB has also been a shareholder of the BIS with voting and
representation rights at its Annual General Meeting. Within this forum
key international economic, monetary and financial issues are discussed
(e.g. economic trends in advanced and emerging market economies,
potential threats to global financial stability and longer-term monetary
and financial developments).
Discuss and answer the following questions.
1. Legal status of the European System of Central Banks.
2. Capital and Foreign Exchange Reserves of the ECB.
3. Reasons why price stability is the primary objective of the European Central
Bank.
4. Tasks and principles of the European Central Bank.
5. Decision-making bodies of the European Central Bank.
6. Other structural units of the European Central Bank. Role of the national
central banks.
7. Interaction of the ECB with other institutions.
8. Asses perspectives for evolution of the ESCB role and decision making
process within it.
9. Compare the ESCB and the U.S. Federal Reserve System.
58
CHAPTER 4. MONETARY POLICY IMPLEMENTATION
4.1. Analytical Background
In implementing monetary policy the ECB has the following
strategy:
- firm anchoring inflation expectations;
- being forward-looking and considering lags in the monetary policy
transmission process;
- focusing on the medium term, thus, some short-term volatility in
inflation is unavoidable;
- taking into account all relevant information and using several
approaches and models in order to understand the factors driving
economic developments.
The ECB's approach to analyzing information relevant for assessing
the risks to price stability is based on two analytical perspectives or "two
pillars": economic analysis and monetary analysis in order to cross-
check and combine different time perspectives and analytical
approaches.
The economic analysis considers current economic and financial
developments from the perspective of the interplay between supply and
demand in the goods, services and factor markets. The economic
analysis assesses both short and medium-term factors of price
developments:
- overall output developments,
- demand and labor market conditions,
- price and cost indicators,
- fiscal policy,
- exchange rates and balance of payments developments,
- asset prices and financial yields.
The economic analysis also deals with shocks hitting the euro area
economy, their effects on cost and pricing behavior. The
macroeconomic projections are made by means of a number of
analytical and empirical models.
Monthly Bulletin provides a detailed analysis of all relevant
economic developments, necessary for making decisions on monetary
policy. The ECB also carries out several other related surveys: Bank
lending survey, Survey of professional forecasters.
59
The monetary analysis focuses on a longer-term horizon. It analyses
developments in money and its components with the respect to the long-
run link between money and prices. The monetary analysis uses growing
number of econometric models of monetary and credit aggregates
developed by both academics and economists at public institutions. To
signal its commitment to monetary analysis the ECB has announced a
reference value for the growth of the broad monetary aggregate M3.
4.2. Foreign Exchange Operations
At its meeting in Luxembourg on 13 December 1997, the European
Council stressed that the exchange rate of the euro should be the
outcome of both economic developments and economic policies, rather
than an independent objective. That is why, general orientations for the
exchange rate policy of the euro area should only be drawn up under
exceptional conditions.
Exchange rate policy consists of four steps:
Step 1: Assessing exchange rate markets and developments,
considering the underlying fundamentals. The ECB takes into account
exchange rates with the respect to the currencies of all relevant trading
partners (without focusing on a single exchange rate only, i.e. the euro-
dollar rate) because it is the effective exchange rate which matters in
assessing the impact of exchange rate developments on trade and the
balance of payments. E.g. the US dollar only has 24% of the weight for
the calculation of the effective rate of the euro, while the other main
currencies considered are the pound (21%), the yen (10%), the Renminbi
and the Swiss franc (7%). The Asian currencies in total count for about
25%, which is bigger than the US dollar.
Step 2: Discussing market developments with the other major
partners and assessing the configuration of different exchange rate
developments and policies. For this purpose, the G7, the IMF and
bilateral discussions are involved.
As for the G7, the euro area is represented by the President of the
Eurogroup and the President of the ECB. Their deputies often meet with
the US Deputy Secretary of the Treasury and Japan‟s Deputy Finance
Minister, and other relevant partners.
Within IMF discussions the representatives of euro area countries on
the Executive Board of the IMF are bound by a common position on the
60
euro exchange rate issues, agreed in Europe by the ECB and the
Eurogroup. The Article IV Consultation of the IMF on the euro area
envisages regular missions and discussions with the ECB, the European
Commission, and the Eurogroup. When non-euro exchange rate
developments and policy are considered the euro area countries are not
bound by a common position, and the euro area does not speak with one
voice in the IMF.
Step 3: Making public statements on the situation of the foreign
exchange markets and on exchange rate policies. Verbal interventions
are practiced in the context of the G7 and involve contribution by the
Eurogroup and ECB representatives.
Step 4: Intervening in the foreign exchange markets. Intervention
operations are made with the foreign reserves held by the ECB only.
They may be conducted in the currencies either of countries outside the
European Union or the ERM II participants.
Intervention in non-EU currencies. Due to the absence of both
institutional arrangements and an exchange rate target of the ECB,
intervention on the foreign exchange market vis-à-vis non-EU currencies
only occurred twice in the first five years of Monetary Union, in
particular in the autumn of 2000 after a significant decline of the euro
since 1998. Thus, on 22 September 2000, the ECB, together with the
monetary authorities of the United States, Japan, the United Kingdom
and Canada, initiated concerted intervention in the foreign exchange
markets; the ECB intervened again in early November 2000.
Intervention under the ERM II. Central bank interventions are
automatic and unlimited in case a currency approaches the fluctuation
band margins. The ECB and the relevant NCBs could suspend automatic
intervention if the primary objective of price stability is threatened. Thus
the ERM II participants may initiate procedure aimed at reconsidering
central rates.
Management of foreign exchange reserves. The ECB‟s foreign
reserves are mainly held and managed to serve as a means of
intervention by the ECB if it is necessary. At the end of 2005, they
amounted to €41.5 billion. Both foreign currency reserves and gold
holdings declined in terms of volume, due to the ECB‟s intervention
sales in 2000 and some sales of gold in 2005 and 2006 within the
Central Bank Gold Agreement. But it was offset by the higher market
value of the ECB‟s gold holdings. The ECB may make further calls of
61
foreign reserve assets. The ECB would only do this to compensate
depletion reserves and not to increase its reserve holdings.
The ECB‟s foreign reserves. The ECB‟s manages its foreign
reserves primarily in order to maximize their value. Specific principles
include the currency distribution, the trade-off between interest rate risk
and return, the credit risk and liquidity requirements. Some portfolio
management functions, such as risk management and accounting, are
performed by the ECB itself. But most of the functions are decentralized
across the Eurosystem, and are delegated to the euro area NCBs. The
NCBs may carry out foreign reserves management operations on behalf
of the ECB or manage their own reserves. Those NCBs that take up an
ECB foreign reserve management mandate are eligible for a mandate
corresponding to either a US dollar sub-portfolio or a Japanese yen sub-
portfolio. The Deutsche Bundesbank and the Banque de France are
eligible for both mandates. The ECB‟s gold reserves are not actively
managed.
The NCBs‟ foreign reserves. The foreign reserves held by the NCBs
declined steadily between 1999 and 2005; at the end of 2005, they
amounted to around €279 billion, of which €111 billion was in foreign
exchange assets and €168 billion in gold, SDRs or IMF reserve
positions. The foreign reserves of the NCBs no longer serve foreign
exchange policy purposes, but they may be subject to further calls on
reserves by the ECB. Foreign exchange operations above certain limits
carried out by the NCBs with their foreign reserves are subject to prior
approval by the ECB. NCBs‟ investment operations in foreign financial
markets are not subject to prior approval.
4.3. Open Market Operations
The operational framework of the Eurosystem consists of the
following operations:
- open market operations;
- standing facilities;
- minimum reserve requirements for credit institutions.
Types of open market operations.
1. Main refinancing operations are the most important open market
operations. They are regular liquidity-providing reverse transactions
with a frequency and maturity of one week. They provide a lot of
liquidity to the banking system, influence interest rates considerably,
62
and signal the stance of monetary policy. The operations are executed in
a decentralized manner by the NCBs under standard tender procedure.
Table 4.1.
Pic.4.1. Eurosystem monetary policy operations
Monetary
policy
operations
Liquidity
providing
transactions
Liquidity
absorbing
transactions
Maturity Frequency Procedure
Open market operations
Main
refinancing
operations
Reverse
transactions
- 1 week Weekly Standard
tenders
Longer-term
refinancing
operations
Reverse
transactions
- 3 months Monthly Standard
tenders
Fine-tuning
operations
Reverse
transactions,
foreign
exchange
swaps
Reverse
transactions,
collection of
fixed term
deposits, foreign
exchange swaps
Non-
standardized
Non-regular Quick
tenders,
bilateral
procedure
Outright
purchases
Outright
purchases
- Non-regular Bilateral
procedure
Structural
operations
Reverse
transactions
Issuance of debt
certificates
Standardized,
non-
standardized
Regular,
non-regular
Standard
tenders
Outright
purchases
Outright
purchases
- Non-regular Bilateral
procedure
Standing facilities
Marginal
lending
facility
Reverse
transactions
- Overnight Access at the discretion
of counterparties
Deposit
facility
- Deposits Overnight Access at the discretion
of counterparties
Source: Scheller H. (2006), “The European Central Bank. History, Role
and Functions”, Second revised edition, ECB.
2. Longer-term refinancing operations are liquidity-providing
reverse transactions with a monthly frequency and a maturity of three
months. These operations represent only a small part of the global
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refinancing volume. The Eurosystem normally does not send signals to
the market by such operations and hence acts as a rate taker. All
counterparties fulfilling general eligibility criteria may participate. They
are executed in by the NCB too under standard tender procedure.
3. Fine-tuning operations can be executed on an ad hoc basis to
manage the liquidity situation in the market and to steer interest rates.
They may be both liquidity-providing or liquidity-absorbing and aim to
smooth the effects on interest rates caused by unexpected liquidity
fluctuations. Such operations are usually executed as reverse
transactions, and less frequently as outright transactions, foreign
exchange swaps or collection of fixed-term deposits. Fine-tuning
operations are normally executed in by the NCB through quick tenders
or bilateral procedures. For operational reasons, only a limited number
of selected counterparties may participate in fine-tuning operations.
4. Structural operations can be carried out as reverse transactions,
outright transactions or issuance of debt certificates. They may be both
liquidity-providing or liquidity-absorbing. These operations when the
ECB wishes to adjust the structural position of the Eurosystem vis-à-vis
the financial sector. Structural operations in the form of reverse
transactions and issuance of debt instruments are executed by the NCBs
under standard tender procedure. Structural operations in the form of
outright transactions are executed through bilateral procedures.
Instruments. Five types of instruments are used for open market
operations.
1. Reverse transactions are carried out with use of eligible assets
provided by counterparties. The NCBs may execute reverse transactions
either in the form of repurchase agreements (i.e. the ownership of the
asset is transferred to the creditor, while the parties agree to reverse the
transaction through a retransfer of the asset to the debtor in future) or as
collateralized loans (i.e. an enforceable security interest is provided over
the assets; assuming fulfillment of the debt obligation, the ownership of
the asset is retained by the debtor). The difference between the purchase
price and the repurchase price in a repurchase agreement is equivalent to
the interest over the maturity of the operation.
2. Outright purchases are executed only for structural and fine-
tuning purposes. An outright transaction means full transfer of
ownership from the seller to the buyer without any connected reverse
transfer of ownership. They are executed through bilateral procedures.
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No restrictions are placed a priori on the range of counterparties to
outright transactions. Only marketable assets are used as underlying
assets in outright transactions.
3. Debt certificates of the ECB may be issued to adjust the structural
position of the Eurosystem vis-à-vis the financial sector by creating or
enlarging a liquidity shortage in the market. They are issued under
standard tenders at a discount with maturity of less than 12 months.
4. Foreign exchange swaps for monetary policy purposes mean
simultaneous spot and forward transactions in euro against a foreign
currency. The Eurosystem and the counterparties agree on the swap
points for the transaction, which are the difference between the
exchange rate of the forward transaction and the exchange rate of the
spot transaction.
5. Remunerated fixed-term deposits are placed with the NCB in the
Member State in which the counterparty is established. It is used for
fine-tuning purposes only in order to absorb liquidity in the market. The
NCB provides no collateral for the deposits. Quick tender procedure is
used normally, but the Eurosystem may apply bilateral procedures as
well.
4.4. Standing Facilities
Standing facilities (marginal lending facility and deposit facility)
provide and absorb overnight liquidity, signal the general monetary
policy stance too, and set minimum and maximum overnight market
interest rates. Standing facilities are administered by the NCBs and are
available to eligible counterparties on their own initiative.
Marginal lending facility. Counterparties can use it to obtain
overnight liquidity from the NCBs against eligible assets. The interest
rate on these overnight loans is usually substantially higher than the
corresponding market rate (actually it equals to minimum bid rate on the
main refinancing operations +1%). That‟s why, credit institutions only
use this facility to obtain funds as a last resort at a predetermined interest
rate.
Liquidity is provided either in the form of overnight repurchase
agreements or as overnight collateralized loans. Access to the marginal
lending facility is granted only on days when the relevant national real-
time gross settlement system and the relevant securities settlement
system(s) are operational. There is no limit to the amount of funds that
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can be advanced under the marginal lending facility. The maturity of
credit is overnight.
A counterparty may use marginal lending facility either by sending
request to the NCB in the Member State in which the counterparty is
established or automatically for the amount of counterparties‟ intraday
debit positions on their settlement account with the NCB at the end of
each business day.
Deposit facility. Counterparties can use the deposit facility to make
overnight deposits with the NCBs. The interest rate on the deposit
facility actually sets the minimum overnight market interest rate
(actually it equals to the minimum bid rate on the main refinancing
operations -1%). Counterparties only place overnight deposits with the
Eurosystem if they cannot use their funds in any other way.
No collateral is provided by the Eurosystem. Access to the marginal
lending facility is granted only on days when the relevant national real-
time gross settlement system and the relevant securities settlement
system(s) are operational. A counterparty may use deposit facility by
sending request to the NCB in the Member State in which the
counterparty is established. There is no limit to the amount a
counterparty may deposit under the facility. The maturity of deposits is
overnight.
The Governing Council decides on the interest rate changes under
the standing facilities together with interest rate for main refinancing
operations to signal the general monetary policy stance (the three
interest rates are called the key interest rates). These decisions are
normally made at its first meeting of the month and become effective
only from the beginning of the new reserve maintenance period.
By setting the interest rates on the standing facilities, the ECB
determines the corridor within which the overnight money market rate
can fluctuate. The incentive for banks to use the standing facilities is
significantly reduced by the rates applied to them. Therefore, the
average daily use of the standing facilities is usually below 1 billion
euro.
4.5. Minimum Reserve Requirements
The ECB requires credit institutions established in Member States to
hold minimum reserves with the NCBs. This implies that branches in the
euro area of entities with no registered office in the euro area are also
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subject to the Eurosystem‟s minimum reserve system. However,
branches located outside the euro area of credit institutions established
in the euro area are not subject to this system.
The minimum reserve requirements aim to stabilize money market
interest rates, create structural shortage of liquidity, and contribute to the
control of monetary expansion. Compliance with the reserve
requirement is determined on the basis of the institutions' average daily
reserve holdings over a maintenance period of about one month. The
required reserve holdings are remunerated at a level corresponding to the
average interest rate over the maintenance period of the main
refinancing operations of the Eurosystem. Reserve holdings exceeding
the required reserves are not remunerated.
The amount of required reserves to be held by each institution is
determined by its reserve base multiplied by a reserve ratio. The ECB is
entitled to include liabilities resulting from the acceptance of funds
together with liabilities resulting from off-balance-sheet items in the
reserve base of institutions. Only deposits and debt securities issued are
actually included in the reserve base. Liabilities vis-à-vis other
institutions included in the list of institutions subject to the Eurosystem‟s
minimum reserve system and liabilities vis-à-vis the ECB and the NCBs
are not included in the reserve base. The ECB applies a zero reserve
ratio on deposits with an agreed maturity of over two years, deposits
redeemable at notice of over two years, repos and debt securities with an
agreed maturity of over two years.
Each institution must hold its minimum reserves on one or more
reserve accounts with the NCB in the Member State in which it is
established. If an institution has establishments in more than one
Member State, it is required to hold minimum reserves with the NCB of
each Member State in which it has an establishment, taking into account
its reserve base in the corresponding Member State. Institutions may use
their settlement accounts with the NCBs as reserve accounts.
4.6. Procedural Aspects
Counterparties. The Eurosystem‟s monetary policy framework
involves broad range of counterparties. Institutions subject to minimum
reserve requirements may access the standing facilities and participate in
open market operations based on standard tenders. But counterparties
must be financially sound. Usually they should be subject to at least one
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form of harmonized EU/EEA (European Economic Area) supervision by
national authorities. The Eurosystem may select a limited number of
counterparties to participate in fine-tuning operations. For outright
transactions, no restrictions are placed a priori on the range of
counterparties.
For foreign exchange swaps conducted for monetary policy
purposes, active players in the foreign exchange market able to conduct
large-volume foreign exchange operations are used. In order to be able
to intervene efficiently in different geographical locations and time
zones, the Eurosystem can use counterparties in any international
financial center. However, in practice, most counterparties tend to be
located in the euro area.
Sanctions. The ECB imposes sanctions on institutions which do not
comply with obligations according the ECB Regulations and Decisions
on minimum reserves. In addition, in the case of serious infringements
of the minimum reserve requirements or infringement of tender rules or
on the grounds of prudence, the Eurosystem may suspend
counterparties‟ participation in open market operations.
Eligible assets. All Eurosystem liquidity-providing monetary policy
operations and intraday credit are based on adequate collateral. The ECB
establishes, maintains and publishes a list of eligible marketable assets.
The single framework for eligible collateral covers marketable and non-
marketable assets that fulfill uniform euro area-wide eligibility criteria
specified by the Eurosystem.
The eligibility criteria are the following. It must be a debt
instrument having:
- a fixed, unconditional principal amount;
- a coupon that cannot result in a negative cash flow;
- the coupon should be a zero coupon, a fixed rate coupon or a
floating rate coupon linked to an interest rate reference.
The coupon may be linked to a change in the issuer‟s rating.
Inflation-indexed bonds are also eligible. Debt instruments may not
afford rights to the principal and/or the interest that are subordinated to
the rights of holders of other debt instruments of the same issuer. The
debt instrument must be denominated in euro.
The debt instrument must meet the high credit standards specified in
the Eurosystem credit assessment framework rules, which relies on
different credit assessment sources. High credit standards are defined in
68
terms of a “single A” credit assessment (equivalent to a minimum long-
term rating of “A-” by Fitch or Standard & Poor‟s, or “A3” by
Moody‟s).
Normally the requirement is that the debt instrument must be
deposited/registered (issued) in the EEA with a central bank or with a
central securities depository which complies with the ECB minimum
standards. The issuer must be established in the EEA or in one of the
non-EEA G10 countries. Debt certificates issued by the ECB and all
debt certificates issued by the NCBs of the Eurosystem prior to the date
of adoption of the euro in their respective Member State are eligible.
International or supranational institutions are eligible issuers/guarantors
irrespective of their place of establishment.
It was decided that only two types of non-marketable assets should
be eligible as collateral: credit claims and non-marketable retail
mortgage-backed debt instruments. Undrawn credit lines, current
account overdrafts and letters of credit are not eligible. Nonmarketable
assets are not used as collateral by the Eurosystem for outright
transactions.
A counterparty may not submit as collateral any asset issued or
guaranteed by itself or in general by any other entity with which it has
close links. Other eligibility criteria are also applied.
Tenders and other procedures. Tender procedures include the
following steps.
1. Tender announcement (through public wire services or directly to
individual counterparties if necessary).
2. Preparation and submission of bids by counterparties.
3. Compilation of bids by the Eurosystem.
4. Tender allotment and announcement of tender results.
5. Certification of individual allotment results.
6. Settlement of the transactions.
All counterparties fulfilling the general eligibility criteria may take
part in standard tenders. For standard tenders, the certification of the
allotment result happens maximum 24 hours after the tender
announcement. The main and the longer-term refinancing operations are
executed according to an indicative calendar published by the
Eurosystem. Main refinancing operations are usually carried out on each
Tuesday, while longer-term refinancing operations are normally
executed on last Wednesday of each month.
69
Quick tenders are executed within a time frame of 90 minutes. A
limited number of counterparties may participate in quick tenders. The
Eurosystem normally announces quick tenders publicly in advance, but
may decide not to do this under exceptional circumstances. In a quick
tender, the selected counterparties are contacted directly by the NCBs.
Bilateral procedures mean conducting transactions without using
tender procedures. They include operations executed through stock
exchanges or market agents, or operations where counterparties are
contacted directly by the Eurosystem. Usually the Eurosystem does not
announce bilateral operations publicly in advance, and may decide not to
announce their results publicly as well.
Tenders are also classified as fixed rate (volume) or variable rate
(interest) tenders. In case of a fixed rate tender, the ECB specifies the
interest rate in advance and participating counterparties bid the amount
of money they want to transact at the specified interest rate. In case of a
variable rate tender, counterparties bid both the amounts of money and
the interest rates themselves. In fixed rate foreign exchange swap
tenders, the ECB fixes the swap points and the counterparties offer the
amount of currency they wish to sell (and buy back) or buy (and sell
back). In variable rate foreign exchange swap tenders, the counterparties
bid both the amount of the currency kept fixed and the swap point
quotation.
The ECB may impose a maximum bid limit in order to prevent
disproportionately large bids. In case of fixed rate tenders, if the
aggregate amount bid exceeds the total amount of liquidity to be
allotted, the submitted bids are usually satisfied proportionally.
In case of variable rate tenders the rules are different. In the
allotment of liquidity-providing variable rate tenders bids are listed in
descending order of offered interest rates. Bids with the highest interest
rate levels are satisfied first and subsequently bids with successively
lower interest rates are accepted until the total liquidity to be allotted is
exhausted. In case of liquidity-absorbing variable rate tenders (for the
issuance of debt certificates or the collection of fixed-term deposits),
bids are listed in ascending order of offered interest rates (or descending
order of offered prices for debt certificates). Bids with the lowest interest
rate (or highest price respectively) are satisfied first.
In case of liquidity-providing variable rate foreign exchange swap
tenders, bids are listed in ascending order of swap point quotations. The
70
bids with the lowest swap point quotations are satisfied first. In the
allotment of liquidity-absorbing variable rate foreign exchange swap
tenders, bids are listed in descending order of offered swap point
quotations. The bids with the highest swap point quotations are satisfied
first.
For variable rate tenders, either single rate or multiple rate auction
procedures are used. In a single rate auction (Dutch auction), the
marginal interest rate/price/swap point (i.e. that at which the total
allotment is exhausted) is deemed the allotment interest rate/price/swap
point applied for all satisfied bids. In a multiple rate auction (American
auction), the allotment interest rate/price/swap point is different for each
counterparty and is equal to the interest rate/price/swap point offered by
the counterparty.
Settlement procedures. Money transactions relating to the standing
facilities or open market operations are settled on the counterparties‟
accounts with the NCBs (or on the accounts of settlement banks
participating in the TARGET system).
Money transactions are settled only after (or at the moment of) the
final transfer of the assets underlying the operation. Open market
operations based on standard tenders are normally settled on the first day
following the trade day on which all relevant national real-time gross
settlement systems and all relevant securities settlement systems are
open. The Eurosystem aims to settle open market operations based on
quick tenders and bilateral procedures during (foreign exchange swaps
may be settled during either the trade day or subsequent two days).
4.7. Capital Controls
As from 1 January 1994, which corresponds to the start of the
second stage of economic and monetary union, new arrangements for
capital movements were introduced:
- full freedom of capital movements and payments, both between
Member States and between Member States and third countries;
- possibility of maintaining certain existing restrictions vis-à-vis
third countries;
- in certain fields Member States can maintain information,
prudential supervision and taxation requirements without capital
movements being hindered;
71
- possibility of taking safeguard measures if movements of capital to
or from third countries cause serious difficulties for the operation of
economic and monetary union;
- possibility of measures on movements of capital to or from third
countries for security or foreign policy reasons.
Parallel measures have also been introduced to ensure the greatest
possible consistency between Community policies.
1. Economic actors and consumers: such measures aim to ensure
high degree of consumer protection and apply to banks, firms, and
consumers;
2. Tax matters: despite taxation is largely the responsibility of the
Member States, some tax provisions must be observed at Community
level by economic actors and consumers;
3. Fraud: such measures aim to ensure in particular that the financial
system is not used for money-laundering purposes;
4. Enlargement: after enlargement of the EU the Union and the new
Member States negotiated transitional periods for the purchase of
property;
5. Fight against terrorism: the Community planned to introduce
restrictions on the free movement of capital and the possibility of
freezing assets to prevent the funding of terrorist acts.
4.8. Transmission Mechanism of Monetary Policy
Transmission mechanism of monetary policy is the process through
which monetary policy decisions affect the economy in general and the
price level in particular. The transmission mechanism is characterized by
long, variable and uncertain time lags. Thus, it is difficult to predict the
precise effect of monetary policy actions on the economy and price
level.
Theoretical background. The central bank provides funds to the
banking system and charges interest. The change in the official interest
rates affects directly money-market interest rates and, indirectly, lending
and deposit rates, which are set by banks to their customers.
Expectations of future official interest-rate changes influence medium
and long-term interest rates.
If a central bank has a high degree of credibility, economic agents
do not have to increase their prices for fear of higher inflation or reduce
them for fear of deflation.
72
Chart. 4.1. Transmission mechanism of monetary policy
Source: ECB (2004), “The Monetary Policy of the ECB”.
Financing conditions in the economy and market expectations
influenced by monetary policy affect asset prices (e.g. stock market
prices) and the exchange rate.
Interest rates fluctuations influence saving and investment behavior
of households and firms. Normally higher interest rates make it less
attractive to borrow in order to finance consumption or investment.
Expectations Bank and market
interest rates
Official interest rates
Money,
credit
Asset
prices
Exchange
rate
Wage and
price-setting
Supply and demand in
goods and labor
markets
Domestic
prices
Import
prices
Price developments
Shocks
outside the
control of
the central
bank
Changes in
global
economy
Changes in
fiscal policy
Changes in
commodity
prices
73
Consumption and investment are also influenced by movements in
asset prices due to wealth effect and effect on the value of collateral. For
example, if equity prices increase, households possessing equities
become wealthier and may increase their consumption. Conversely,
when equity prices fall, households may reduce consumption. As for the
collateral value effect, higher asset prices mean that a borrower may get
a bigger loan for the same collateral, which price has risen.
Higher interest rates increase the risk of borrowers being unable to
pay back their loans. Considering such risk, banks may decrease amount
of money that they are ready to lend.
Changes in consumption and investment affect domestic demand for
goods and services relative to domestic supply. When demand exceeds
supply, prices increase, and vice versa. Changes in aggregate demand
may result in changes of prices in labor and intermediate product
markets.
Changes in the exchange rate affect inflation in three ways:
1. Exchange rate developments directly influence the domestic price
of imported goods. In case of exchange rate appreciation, the price of
imported goods tends to decrease, thus, reducing inflation.
2. If these imports are used as inputs into the production process,
lower prices for inputs may result in lower prices for final goods.
3. Appreciation of national currency makes domestically produced
goods less competitive on the world market, while competitiveness on
the domestic market does not change. Producers tend to sell more on the
domestic market. It reduces overall demand pressure in the economy and
decrease inflationary pressures.
The importance of these exchange rate effects depend on how open
the economy is to international trade.
Empirical evidence. A number of studies by both academics and the
Eurosystem staff try to find empirical evidence about how transmission
mechanism of monetary policy works, in particular in the euro area.
The table below shows the results of estimating the effects of
changes in short-term interest rates on prices and economic growth
based on three different econometric models of the euro area. It shows
the responses of the levels of GDP and prices to a transitory
1 percentage point increase in the central bank interest rate, which is
then maintained at the higher level for two years. The effect is a
temporary decrease in output, which peaks about two years after the
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interest rate increase and reverts back to the baseline level thereafter.
But prices adjust gradually to a permanently lower level.
Table 4.2.
The effect of change in the central bank interest rate on real
GDP and prices, %.
Real GDP Consumer prices
Year 1 Year 2 Year 3 Year 4 Year 1 Year 2 Year 3 Year 4
Model 1 -0.34 -0.71 -0.71 -0.63 -0.15 -0.30 -0.38 -0.49
Model 2 -0.22 -0.38 -0.31 -0.14 -0.09 -0.21 -0.31 -0.40
Model 3 -0.34 -0.47 -0.37 -0.28 -0.06 -0.10 -0.19 -0.31
Source: ECB (2004), “The Monetary Policy of the ECB”.
The common conclusion is that monetary policy is neutral in the
long run. Its effect on output is temporary and its effect on prices is
permanent. But the magnitude and the timing of these responses may
differ across models. Also the larger euro appreciates owing to the
change in interest rates, the faster and larger the decline in inflation take
place.
Asymmetric transmission of monetary policy. The problem of
asymmetric transmission means that countries with higher inflation rate
will have lower real interest rates because in a monetary union nominal
interest rates are harmonized across countries. If higher inflation rate is
driven by overheating of the domestic economy, then the associated
lower real interest rate may have a pro-cyclical effect and foster de-
coupling from the rest of the union.
However the pro-cyclical effect arising from the common interest
rate can be at least in part compensated by the anti-cyclical effect
produced by the rigidity of the nominal exchange rate. Thus, countries
with higher inflation face loss of competitiveness with respect to the rest
of the union. Another channel is growing trend towards portfolio
diversification that fosters cross-country risk sharing.
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Discuss and answer the following questions.
1. Analytical background of the monetary policy.
2. Components of foreign exchange operations of the Eurosystem.
3. Compare importance and specific features of different types of open market
operations, standing facilities, and minimum reserve requirements.
4. Eligibility criteria for counterparties and assets used for monetary policy
operations.
5. Tender and settlement procedures.
6. Compare specific features of monetary policy instruments and methods used
in the Eurosystem and by central banks of other countries.
7. Theoretical background and empirical evidence for monetary policy
transmission mechanism in the euro area.
8. What are the determinants of prices?
9. Analyze the influence of interest rate changes on economic growth in the
euro area.
10. Analyze correlation of the key interest rates and deposit and lending interest
rates in different countries of the euro area.
11. Show examples of link between changes in interest rates and asset prices in
the euro area.
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CHAPTER 5. EXCHANGE RATE AND MONETARY POLICY
DEVELOPMENTS UNDER THE EUROPEAN MONETARY
UNION
5.1. Factors of the Exchange Rate of the Euro
The main factors of the euro to dollar exchange rate are:
1. ECB policy aiming at reaching inflation below 2% and 4,5%
reference value for M3 aggregate growth.
2. Interest rates:
- refinancing rates set by the ECB and the difference (differential)
between them and the respective rates used by the Federal Reserve
System.
- 3-month eurodeposit rate for euro (for deposits denominated in
euro located outside countries where the currency is used as the legal
tender) and the difference between it and the respective eurodeposit rates
for other curencies.
3. Spread for long-term government bonds (mainly between yield of
German and American bonds).
4. Economic fundamentals, such as: GDP, consumer and other price
indices, industrial output, unemployment, government budget deficit of
the main euro area countries or the euro area as a whole. E.g. the
influence of oil prices is shown below (there is obvious link between the
euro/ECU exchange rate and the oil prices in 1998-2000, but we do not
observe the link in 2001-2003).
5. Cross rate effects of the euro to euro to yen or other currencies
exchange rates.
6. Three-month eurofutures, which reflect market expectations for
there-month eurodeposits
7. Political factors, including any instability in main euro area or
neighboring countries.
5.2. Monetary Policy in 1999-2003
In early 1999:
- HICP inflation was below 1%;
- in low-inflation environment, downside risks to economic growth
emerged as a consequence of weaker external demand stemming from
77
the Asian crisis of late 1997 and the drop in confidence that followed the
financial market turmoil after the Russian crisis of the summer of 1998;
Chart 5.1. The euro exchange rate and oil price development.
Source: ECB (2004), “The Monetary Policy of the ECB”.
- thus, it became increasingly clear that risks to price stability over
the medium term were decreasing, however, the following indicators
were seen as pointing in the opposite direction;
- consumer confidence remained relatively high;
- oil prices started to rise as from mid-February;
- the euro depreciated slightly in effective terms in the first few
months of the year;
- over the same period loans to the private sector were growing at an
annual rate of around 10%;
- the M3 growth was also clearly above the ECB‟s reference value.
78
Chart 5.2. The euro exchange rate developments.
Source: ECB. Statistical Data Warehouse.
(http://sdw.ecb.europa.eu/browse.do?node=2018794).
79
Nevertheless, monetary developments were not seen as implying
upward risks to price stability at that time. In reaction to this, the
Governing Council decided in April 1999 to reduce the fixed rate on the
main refinancing operations to 2.5%.
Later, between the summer of 1999 and late 2000:
- inflationary pressures gradually mounted under strong economic
growth;
- rising oil prices increased import price pressures;
- the euro exchange rate continued to weaken;
- the monetary growth remained high;
- as a consequence, annual HICP inflation in the euro area grew up
gradually over this period, reaching levels above 2%, which is the upper
bound of the ECB‟s definition of price stability.
Therefore the Governing Council gradually increased its key interest
rates by a total of 225 basis points from November 1999 to October
2000. By late 2000 these decisions set the minimum bid rate on the main
refinancing operations as 4.75%, and the rates on the deposit and
marginal lending facilities as 3.75% and 5.75% respectively.
The depreciation of the euro was considered at the level of the G7
on 22 September 2000, at the initiative of the ECB. The reaction took
form of a concerted intervention in the foreign exchange markets by the
ECB and the monetary authorities of the United States, Japan, the
United Kingdom and Canada. The ECB itself intervened again in early
November. After these interventions the downward trend of the
exchange rate of the euro came to an end in late 2000.
Subsequently in 2001:
- inflationary pressures were gradually abating;
- the main factors reducing inflationary pressures were lower
economic growth and a stronger euro exchange rate;
- already by late 2000 the global economy was showing indications
of weakness (the first signs of a slowdown took place in the United
States);
- strong decline in stock market prices and a worsening of the
situation in Japan increased uncertainty about global growth prospects;
- in the euro area some signs of a slowdown in economic growth
emerged in early 2001;
80
- the M3 growth continued to decline in early 2001 due to the
increase in the key ECB interest rates since November 1999, the growth
of loans to the private sector also moderated at the beginning of 2001;
- the terrorist attacks on the United States on 11 September 2001
reinforced the downward trend in economic activity.
In the first months of 2002:
- the downward risks to economic growth related to the terrorist
attacks of 11 September decreased, a moderate recovery of economic
growth was recorded in the euro area in early 2002, but the economic
recovery appeared to be weaker than expected;
- increase in geopolitical tensions in the Middle East resulted in
rising oil prices;
- there were increasing concerns about the reliability of the financial
accounting information of corporations;
- these concerns and weaker than expected corporate earnings data
resulted in high volatility of equity prices;
- downward revisions to expectations for economic growth in the
euro area took place;
- nevertheless, the HICP inflation remained above 2% in 2002 due
to the effect of adverse weather conditions on food prices, rising oil
prices, and small upward impact on prices from the euro cash
changeover;
- monetary growth continued to be strong in 2002 and early 2003,
because investors preferred short-term liquid and less risky financial
assets under high volatility in financial markets;
- but the subdued economic activity was seen as a factor that would
limit the potential upward risks to price stability, because wage growth
pressure would not materialize;
- appreciation of the exchange rate of the euro in the spring of 2002
helped to reduce inflationary pressures.
Under these conditions, the Governing Council gradually reduced
the key ECB interest rates by 275 basis points between May 2001 and
June 2003. The minimum bid rate on the main refinancing operations
reached 2% in June 2003 (the rates on the marginal lending facility and
deposit facility were lowered to 3% and 1%, respectively). In particular,
following an extraordinary meeting held by teleconference on 17
September 2001 (soon after the September 11 event), the Governing
Council reduced the key ECB interest rates by 50 basis points, together
81
with the US Federal Reserve System and other central banks around the
world.
Thus, in its early years, the single monetary policy had to be
conducted in an environment full of different shocks affecting price
developments. These shocks, in particular, included the tripling of oil
prices between early 1999 and mid-2000, a significant depreciation of
the exchange rate of the euro over this period, and increases in food
prices resulting from a series of livestock epidemics in 2001.
5.3. Monetary Policy in 2004 – early 2007
During 2003-2006 only few monetary policy changes took place.
In 2004 and the beginning of 2005:
- economic growth in the euro area moderated in the second half of
2004 and the first half of 2005 because of rising oil prices, a temporary
slowdown in world trade, and the lagged effects of the past appreciation
of the euro (but in the second half of 2005, economic growth in the euro
area strengthened again as a result of global demand growth, growth in
corporate earnings, and very favorable financing conditions under low
interest rates);
- despite large increases in commodity and energy prices, domestic
inflationary pressures remained low owing to relatively moderate
economic growth and wage developments;
- the inflationary pressures were also limited by lower prices on
imports owing to the appreciation of the euro;
- but the actual inflation remained somewhat elevated in 2005 (the
HICP inflation stood at 2.2%), mainly owing to large increases in energy
prices and some rises in administered prices and indirect taxes.
Against this background, the minimum bid rate on the Eurosystem‟s
main refinancing operations remained unchanged at the historically low
level of 2% for most of the year.
But by the end of 2005 the situation had changed:
- inflation projections were progressively revised upwards during
the year;
- the rise in oil prices would continue for longer than initially
anticipated;
- following its strong appreciation during the last three months of
2004, the euro declined in the first half of 2005, especially against the
82
US dollar and several Asian currencies which were formally or de facto
pegged to the US dollar;
- by the end of 2005 the euro had stabilized, its nominal effective
exchange rate was about 6% lower than at the beginning of the year;
- the depreciation of the euro was due to increasing signs of an
improvement in economic activity in both the United States and Japan;
- in the United States, news suggesting better economic activity
coincided with signs of rising inflationary pressures;
- it switched the market‟s attention from the problem of the U.S.
current account deficit towards expectations of higher interest rates in
the United States, thereby supporting the US currency;
- another reason for the euro depreciation was the fact, that in 2005
the current account of the euro area recorded a deficit of €29.0 billion
(or 0.4% of GDP), down from a surplus of €43.5 billion in 2004 (0.6%
of GDP);
- as for the financial account, the euro area experienced net outflows
of €13 billion in combined direct and portfolio investment in 2005,
compared with net inflows of €24 billion in 2004.
As a result, the Governing Council decided in December 2005 to
increase the key ECB interest rates by 25 basis points. The minimum bid
rate on the main refinancing operations reached 2.25%. The decision
was made mainly due to indications of upside inflation risks, while the
actual inflation remained well contained.
In 2006 and the beginning of 2007:
- the upward trend of the euro nominal effective exchange rate
started in the fourth quarter of 2005 and intensified in 2006, by the end
of the year the nominal effective exchange rate was about 5% stronger
than at the beginning of January;
- this was partially because the overall economic developments were
becoming more favorable in the euro area in comparison with possible
slowdown in the US;
- increasing US current account deficit supported the euro against
the US dollar too;
- as for the financial account, the euro area experienced net inflows
of €109.2 billion in combined direct and portfolio investment in 2006
after outflows in 2005;
- but the real GDP growth was above potential resulting in
heightened inflation pressures;
83
- the unemployment rate dropped to historically low levels, thus
increasing wage growth pressure;
- there were renewed oil price increases and the possibility of
additional upward adjustments in administered prices and indirect taxes
(the average price (in euros) of a barrel of Brent crude oil increased by
20% in 2006 after increase of 45% in 2005);
- the annual M3 growth reached 11% in March 2007, the highest
level since the introduction of the euro, that was the reaction to generally
low interest rates, solid economic expansion and strong property market
developments.
To address the upside risks to price stability, the Governing Council
has adjusted the key interest rates gradually in eight steps since the end
of 2005. As a result, the minimum bid rate for the main refinancing
operations rose from 2.00% in December 2005 to 4.00% in June 2007.
As for the particular monetary policy components, in 2006 the
amounts allotted within main refinancing operations ranged from €280
billion to €338 billion. The liquidity provided through main refinancing
operations represented, on average, 73% of the overall net liquidity
supplied by the Eurosystem through monetary policy operations.
In total, eleven fine-tuning operations were carried out in 2006, five
of them liquidity-providing (17 January, 7 February, 11 April, 10
October and 12 December) and six liquidity-absorbing (7 March, 9 May,
14 June, 11 July, 8 August and 5 September).
On average, longer-term refinancing operations represented 27% of
the total net liquidity provided through open market operations in 2006.
The allotment volume in each operation was increased from €30 billion
to €40 billion in January 2006 and to €50 billion in January 2007.
In 2006 the average daily recourse to the marginal lending facility
amounted to €126 million, while the average daily recourse to the
deposit facility amounted to €171 million. The low recourse to the
standing facilities in 2006 as well as in the previous years reflects the
high efficiency of the interbank market.
On average, the reserve requirements stood at €163.7 billion, the
excess reserves amounted to €0.7 billion.
In 2006 the average amount of eligible marketable collateral
increased by 6% compared with 2005, to a total of €8.8 trillion. General
government debt accounted for 52% of the total, with the remainder
taking the form of credit institution covered or uncovered bonds (29%),
84
corporate bonds (9%), asset-backed securities (6%), and other bonds,
such as those issued by supranational organizations (4%). The average
value of marketable assets deposited by counterparties as collateral
against the Eurosystem credit operations stood at €930 billion in 2006
(€866 billion in 2005).
In 2006 as well as in 2005 the ECB did not carry out any
interventions in the foreign exchange market for policy reasons. It
undertook foreign exchange transactions only for investment. The ECB
did not undertake any foreign exchange operations in the non-euro area
currencies participating in the ERM II.
5.4. Response to the Financial Instability in 2007-2009
Between the end of June and early August 2007, it became clear that
there is a demand for additional liquidity from a number of European
financial institutions suffering from the crisis in the US sub-prime
market. The interest rate in the overnight money market in the euro area
increased to 70 basis points above its normal level.
In the middle of 2007 the Governing Council still considered the
prevalence of the upside risks to price stability. But facing the tensions
in the financial market, the ECB undertook a special liquidity providing
fine tuning operation on 9 August in order to lend € 94.8 billion in one
day. The ECB used a fixed rate tender procedure at 4.0% and with pre-
announced full allotment. The reason for choosing such a procedure was
that the ECB was not able to estimate the liquidity needs of the banking
sector. Also the fixed-rate tender procedure would reduce the risk of
skewed bid rates. As a result, the overnight rates decreased.
The ECB used more liquidity providing fine-tuning operations and
increased amount of liquidity provided with main refinancing
operations, but trough a variable rate in order to avoid an excessive
provision of liquidity. The ECB also undertook two supplementary
longer-term refinancing operations (with a maturity of three months), on
27 August and 12 September to lend €115 billion. On 8 November, the
ECB decided to roll-over those longer-term refinancing operations. As a
result, the weight of the 3-month refinancing operations relative to
1-week operations increased. Both liquidity-providing and liquidity-
absorbing (like in December 2007) fine-tuning operations took place at
different time in order to counter both temporary lack and excess of
liquidity.
85
Meantime, the euro appreciated in nominal effective terms during
three months by the end of December 2007, especially in November.
Despite this the 12-month cumulated current account of the euro area
showed a surplus of around 0.3% of GDP in October 2007, compared
with a deficit of 0.3% of GDP a year earlier.
There was a sharp appreciation in the euro against the dollar owing
to a change in direction of the US monetary policy stance, growing
concerns about poor performance of the U.S. economy and credit
market. In December 2007 the real effective exchange rate of the euro
was 7% above its average level in 2006. Since the end of September
2007 most currencies participating in ERM II have remained stable and
have continued to trade at, or close to, their respective central rates. As
for the pound sterling, the euro appreciated by 7.4% against it between
the end of September 2007 and 9 January 2008. The strengthening of the
euro intensified in November and December owing to growing market
expectations of further interest rate cuts in the United Kingdom. Over
the same period, the euro appreciated by slightly over 9% vis-à-vis the
Romanian leu, while it depreciated by 5.6% against the Czech koruna
and by 4.8% against the Polish zloty.
In early 2008:
- the ECB forecasted that the HICP inflation would range between
2.6% and 3.2% in 2008, and between 1.5% and 2.7% in 2009;
- the upward pressure on prices was caused by wage growth
concerns, further rises in oil and agricultural prices, expectations about
possibly bigger increases in administered prices and indirect taxes;
- money and credit had continued to grow vigorously, in particular
due to the financial market turmoil and specific transactions associated
with the restructuring of certain banking groups;
- the growth of household borrowing has moderated as a result of
higher interest rates since December 2005, but the growth of loans to
non-financial corporations was still rather robust (at the end of 2007
bank loans to the euro area non-financial corporations was 14.4% higher
than a year earlier);
- despite moderating the GDP continued to grow, but there was
increasing uncertainty because of the turmoil in financial markets and
weakening of the global demand.
86
Thus, the ECB decided to leave the key ECB interest rates
unchanged: the minimum bid rate for main refinancing operations: 4%,
marginal lending facility rate: 5%, and deposit facility rate: 3%.
On 27 March 2008 the ECB decided to undertake supplementary
longer-term refinancing operations with a maturity of six months with a
preset amount of €25 billion as well as further supplementary
longer-term refinancing operations with a three month maturity with
preset amounts of €50 billion each. Also in March the ECB decided in
conjunction with the Federal Reserve to the Eurosystem counterparties
offer with US dollar funding (as it did earlier in December 2007 and in
January 2008) with a maturity of 28 days and for an amount of up to $15
billion.
During the reserve maintenance period from 13 February 2008 till
11 March the average reserve requirements were almost €205 billion
with remuneration rate 4.1% and penalty rate for deficiencies 7.5%.
Meanwhile the euro appreciated against the dollar to more than
1.5 dollars/euro (in March-July). But Starting from August the euro
depreciated to less than 1.3 dollars/euro in November and (after a short
reversal of the trend in December) in February 2009. But as the financial
crisis exacerbated and deflationary pressure could materialize, the ECB
lowered gradually the interest rate for main refinancing operations
starting from October to 2% by the end of January 2009. Further
reduction was made on 11 March 2009 to 1.5%.
Discuss and answer the following questions.
1. Factors of the euro exchange rate.
2. Use statistical analysis to estimate how economic indicators affect the
exchange rate of the euro.
3. Monetary policy during the first years of the EMU existence (1999-2003).
4. Monetary policy during 2004-early 2007.
5. Exchange rate developments and monetary policy under financial instability
(2007-2009).
6. Estimate further exchange rate and monetary policy developments in the
euro area in short-term and long-term period.
7. Use statistical analysis to estimate how changes in the exchange rate of the
euro affect economic indicators of the world, euro area or a particular
country.
87
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90
Oleksii A. Chugaiev
Monetary Policy of the European Union
Підписано до друку 05.06.2009
Наклад 100 прим.
4,3 друк.арк.
Відділ оперативної поліграфії
Інституту міжнародних відносин
Київського національного університету імені Тараса Шевченка
Тел. 483-11-25
