Exchange-rate policy prior to EMU membership

DISCLAIMER: All opinions in this column reflect the views of the author(s), not of EURACTIV Media network.

For the acceding countries the prospect of eventual membership in the European Monetary Union (EMU) already raises some important monetary-policy questions: when exactly should they join EMU, and what exchange-rate strategies should they adopt in the intervening period? Time is particularly tight for those that want to join EMU as quickly as possible.

For the ten countries currently scheduled to accede to the European Union (EU) on May 1, 2004 – referred to here as the EU-10 1 – the prospect of eventual membership in the European Economic and Monetary Union (EMU) already raises some important monetary-policy questions: when exactly should they join EMU, and what exchangerate strategy should they adopt in the intervening period? Time is particularly tight for those that want to join EMU as quickly as possible. In this article we analyse basic problems of EMU membership, and then look at the demands on exchange-rate policy during the remaining time until EMU accession.

EU-10 will become “member states with a derogation”

Participation in EMU is a must for the EU-10. In signing up to the accession treaty they accepted the goal of monetary union as part of the acquis communautaire. In order to become members of EMU, countries have to fulfil the convergence criteria. The only alternative would be to remain outside as Sweden has done, i.e. by not participating in the exchange-rate mechanism, with the result that the exchangerate criterion is not met.2 The EU-10 will be treated as ” countries with a derogation” until they fulfil the convergence criteria and join EMU. Most of the EU-10 countries are pressing for rapid acceptance as members of EMU. There has at times even been talk of euroisation, i.e. unilaterally adopting the euro as the country’s own currency – in Estonia, for example.

Rapid adoption of the euro offers great advantages…

The desire to join EMU as quickly as possible is understandable as participation will bring considerable advantages for the EU-10:

  • All of the EU-10 countries – with the exception of Poland – have relatively small, open economies that are heavily dependent on foreign trade.
  • On average, almost 60% of their foreign trade is with the euro area.
  • It is therefore to their advantage to eliminate the currency risk in trade with the euro area and reduce transaction costs.
  • They will also gain from being domestic players in the large, liquid EMU capital market. Interest rates for creditworthy borrowers will be low, particularly for government debt.
  • Finally, submission to the discipline of the monetary union will strengthen the credibility of the economic and fiscal policies of the EU-10.

… coupled with economic-policy risks

The risks of over-hasty adoption of the euro should not be overlooked, though. Members of EMU surrender their sovereignty in monetary and exchange-rate policy to a supranational authority, the European Central Bank (ECB). They have little influence on ECB policy even though the governors of their own central banks can participate in decisionmaking in the ECB’s Governing Council.

  • The ECB sets the monetary policy for the euro area, with price stability as its primary objective; the encouragement of economic growth is not on the ECB’s list of goals.
  • The policy of the ECB does not always suit all countries, as it is necessarily geared to the euro area as a whole. For example: Spain and the Netherlands would have preferred monetary policy to be tighter in 1999/2000, and Germany could have done with lower interest rates for some time now.
  • EMU members retain national control over major elements of economic and fiscal policy, e.g. the level and structure of taxes and state spending. But each has to observe the 3%-of-GDP ceiling for its budget deficit. Even though the surveillance and sanctions procedure is to be altered4, the EU is sticking to the stability and growth pact. This means that members which exceed the 3% limit court the risk of political embarrassment, economic policy stipulations and ultimately of being fined.
  • Being subject to the monetary, exchange-rate and fiscal-policy discipline of EMU can thus lead to severe constraints, depending on the development of the economy. In ext reme cases growth and the catch-up process may be jeopardised, at least temporarily.

The EU-10 must therefore be quite clear on the fact that adoption of the euro radically alters the economic and fiscal-policy environment. Once a country relinquishes sovereignty over large areas of macroeconomic process steering, microeconomic structural policy immediately becomes much more important as an instrument to encourage growth. Experience with the present members of EMU gives no reason for optimism here, though: expectations that the intensified competition in the euro area would lead almost automatically to much greater efforts in supply-side policy have been disappointed, at least to date.

No relaxation of convergence test

The new EU members will have to meet the convergence criteria, just like the initial members of EMU and later Greece. The point of the convergence examination is to have a country prove to itself and to the EMU partners that it really is fit to participate in monetary union, i.e. that it can sustainably ensure price stability, limit its government debt, and manage without altering the exchange rate. The image of the euro as a stable currency is also at stake.

Demands to water down the convergence criteria, for instance, or shorten the examination period should hence be rejected. The period is two years for the exchange-rate criterion and one year for the other conditions (see box on p. 14). Two years is in fact a pretty short time in which to establish whether a country can really manage with absolutely fixed exchange rates. Of the initial EMU members, though, Italy and Finland did not participate in the ERM I (Exchange Rate Mechanism) for a full 24 months before the convergence test, but only for 15 and 16 months, respectively. Prior to that their currencies had floated more or less freely. If, contrary to expectations, the United Kingdom were to decide in the near future to join EMU, it would no doubt also insist on a much shorter test period in the ERM II. It would then be quite understandable if the EU-10 demanded equal treatment. From the economic point of view, a country such as Estonia, which has operated a currency board successfully, is in a special position; Estonia has had an absolutely fixed exchange rate (initially against the D-mark and since 1999 against the euro) for over ten years. It has already proved it can live with a fixed exchange rate. However, countries should appreciate that the EU does not want to permit any exceptions.

A scenario for rapid adoption of the euro

EU-10 countries that want to join EMU as quickly as possible must, of course, aim to take the convergence test at the earliest possible date. For this, they will need to enter the ERM II as soon as they join the EU. A time scenario based on the wording of the convergence criteria could look as follows:

  • May 1, 2004: accession to the EU.
  • Simultaneously, membership in the ERM II. Test period for the exchange-rate criterion from May 1, 2004 to April 30, 2006.
  • Second half of 2006: convergence test by the ECB and the European Commission and decision on acceptance into EMU by the Economic and Financial Affairs Council (ECOFIN) on the basis of a proposal of the European Commission and after consultation with the European Parliament and after a discussion in the European Council in the composition of the heads of states and governments. The examination of the budget and of government debt would probably be based on the data for 2005, or otherwise the latest available figures.
  • January 1, 2007: adoption of the euro as national currency. The central bank governor of each new EMU country becomes a member of the Governing Council, the main decision-making body, of the ECB. It has not yet been decided whether euro banknotes and coins will be introduced immediately, or whether there will be an introductory phase in which the euro serves only as book money.

The main argument in favour of the very long, three-year transitional phase after EMU started – namely that this length of time was needed for printing the notes and minting the coins – is irrelevant in this case. So there is much to be said for a start with a bang, i.e. for the immediate, full introduction of the euro.

Increasingly realistic attitude towards EMU membership

In the past, almost all EU-10 countries wanted to join EMU as soon as possible. Over time, this has given way to a more considered stance. Most of the countries are reticent with official statements on the matter. But in the Czech Republic, for example, 2009 is now being cited as entry date; previously, there had been talk, of joining quickly. The reason for this change of heart is that the countries have to weigh up nominal and real convergence. Nominal convergence means the harmonisation of a candidate’s inflation rate, interest rates, exchange rate and budget deficit with those of the EMU members, i.e. the sustainable fulfilment of the convergence criteria. Real convergence refers to the desired process of catching up through economic growth and higher per capita income, which ultimately means convergence in terms of prosperity. It is generally agreed that, in the long run, price stability and fiscal discipline create the best conditions for sustained, robust economic growth. But the situation is problematic, especially if a country is registering a high budget deficit and/or severe inflation. In such a case, efforts to satisfy the convergence criteria as quickly as possible may lead to a sizeable loss of growth for a time. In addition, it must be feared that the pursuit of a rigorous policy in order to fulfil the criteria will produce temporary, but not ” sustainable”, results; in other words, problems will erupt sooner or later, with a structural budget deficit, for instance.

A look at the present performance in respect of the convergence indicators shows that the criteria still present considerable difficulty for a number of the EU-10 countries. This goes particularly for inflation and their budget deficits. The three largest of the EU-10 – Poland, Hungary and the Czech Republic – are troubled with high budget deficits, which rose considerably further in 20025 (see the table on EMU convergence, p. 26). The Czech deficit would have been much higher still in 2002 without the abundant proceeds from privatisations. The budget balance gave no grounds for concern in the smaller states, with the exception of Lithuania, in 2002. On inflation, no less than four of the eight prospective members from Central and Eastern Europe exceeded the reference value of 3.0%, the highest rates being registered in Slovenia (7.5%) and Hungary (5.3%). General government debt was well below the reference level of 60% in all the acceding countries. Hungary is closest to this threshold, but with a ratio of 50%. It is still difficult to assess the countries’ performance in the convergence of long-term interest rates, especially since the capital markets of the EU-10 are not very highly developed. It remains to be seen whether long-term (ten-year) government bonds will even exist in all countries at the time of the convergence test. If not, a comparable market rate must be used. At this stage the countries cannot really be assessed on the remaining criterion, the stability of the exchange rate, as they cannot yet be members of the ERM II. In the table on page 26 we have taken each currency’s average rate against the euro in the last three years as the “central rate” and measured the fluctuations against this. The fluctuations are naturally still large – except in the countries with a currency board anchored on the euro. All in all, it seems rather improbable that the EU-10 will eventually join EMU all at the same time in another “big bang”, similar to the EU enlargement.

Present exchange-rate regimes vary greatly

At present, the EU-10 have very different exchange -rate arrangements. This corroborates Jeffrey Frankel’s view that no single currency regime is right for all countries at all times.6 The exchange-rate strategies of the Central and Eastern European countries (CEECs) differed greatly throughout the transition phase of more than ten years, and they still differ today. Over time, they have also changed in the individual countries, in some cases very considerably.

In a way, the exchange-rate policies of the EU-10 can also be seen as backing for Stanley Fischer’s hypothesis that “corner solutions” – the two poles of a range extending from freely floating exchange rates at one extreme to monetary union or the adoption of a foreign currency (e.g. through dollarisation) at the other – are the most viable exchangerate regimes in the present-day world of high capital mobility.

At any rate, the currency boards have proved very stable. At the start of the transition phase some countries, such as the Czech Republic and Poland, had fixed exchange rates, with sliding depreciation at times. The fixed rates were specifically employed as an instrument of disinflation during the early stages of transition, and in this they were relatively successful. But they proved to be unstable. The Czech Republic and Poland combined the changeover from an exchange-rate peg to much more flexible rates with the switch to inflation targeting in monetary policy. Hungary, on the other hand, has kept to its policy of a fixed exchange rate, initially with sliding devaluation at a pre-announced rate. For some time now, Hungary has pursued a strategy similar to ERM II: it has set a fixed rate against the euro with a fluctuation margin of 15% on either side. In recent months the forint has repeatedly come under strong upward pressure.

The euro has, in one way or the other, increasingly become established as anchor or reference currency in the monetary regimes of the EU-10. Apart from Poland, Latvia is the only country that does not orient its currency to the euro. The clearest link is naturally in the currency-board countries: Estonia (since 1992), Lithuania (since 2001) and Bulgaria (since 1997). The orientation, or use of the euro as reference currency, is less evident in the countries with managed floating.  

The role of exchange-rate policy in the run-up to EMU entry

Countries that want to enter EMU at the earliest possible date must prepare now to be able to pass the convergence test, which could take place in mid-2006. The biggest questions arise in exchange-rate policy, because the countries’ discretionary freedom is greatest here. The period until they join EMU can be divided into four phases, with the constraints on exchange-rate policy tightening from phase to phase:

1. Prior to becoming members of the EU, the countries are entirely free in their exchange-rate strategy. The ECB recommends “an increasing degree of orientation towards the euro”, though.
2. Once a country joins the EU, its exchange-rate policy is regarded as a matter of common interest. There are no indications, though, as to what this means in practice. But EU members do have to coordinate their economic and fiscal policies with the community in the ECOFIN Council. They also have to submit annual convergence programmes. Restrictions on capital movements are, in principle, no longer permitted.
3. The EU expects the acceding countries to join the ERM II, i.e. to agree an exchange-rate arrangement between the euro and their currency (see box next page). This phase will last at least two years. The ERM II is neither a waiting-room nor a straitjacket, but an instrument for gaining the confidence of the markets and proving that a country can live with a more or less fixed exchange rate. The fluctuation band of 15% on either side of the central rate still allows considerable flexibility – which can be necessary in order to absorb the effect of fluctuations in international capital flows.
4. T he fourth, and final, phase is the adoption of the euro, i.e. the discontinuation of the national currency and thus of the national exchange rate.

From today’s perspective, the first question that arises is what exchange-rate strategy a country should pursue until it joins the ERM II. This is not independent of the country’s designs for its exchange-rate policy in the ERM II. It has a degree of discretionary freedom here, too, especially with regard to the width of the fluctuation band. Enormously important is the central rate at which the country aims to enter the ERM II, and hence the conversion rate at which it ultimately wants to join EMU. If a new EU member wants to be received quickly into EMU, it will be well advised to accept an under- rather than overvalued rate at which to enter the ERM II. For it is crucial to avoid a devaluation within the two-year test period, as that would fail the country on the exchange-rate criterion. That a marked devaluation on ERM II entry would create inflation risks and thus threaten the country’s fulfilment of the price-stability criterion is another matter. There is an obvious conflict of goals here.

The choice of the right starting rate for the ERM II is of vital consequence for another reason, too: the agreed central rate will, as a rule, be identical or close to the later conversion rate to the euro. For the first members of EMU, the conversion rates to the euro were fixed on the basis of their bilateral central rates in the ERM. Shortly before the decision on participation in EMU, however, Ireland and later Greece revalued their currencies slightly in order to avert inflation risks and to join EMU at a realistic exchange rate.

An overvalued conversion rate – a rate that does not match the country’s competitiveness – can greatly hamper trade, and thus growth. Portugal’s experience can serve as a warning. The country may have entered EMU at an overvalued rate, and it has had to pay a high price in the form of weak exports, low growth and a persistently high current account deficit. The weakness of growth was a major reason why Portugal already breached the European stability and growth pact in 2001 with a budget deficit equivalent to 4.1% of GDP. As everyone knows, the EU then launched proceedings against the country for an excessive budget deficit.

An appropriate exchange-rate policy should be adopted well before entry into the ERM II in order to ensure that any rise in inflation due to a “devaluation shock” can still be overcome before the convergence test. That would imply managed floating to steer the currency towards the “right” rate for entry into the ERM II. This applies especially to the countries with relatively flexible exchange rates, such as Poland and the Czech Republic. The big question naturally is: what level should a country steer towards? There are no known methods of determining an exact “equilibrium rate”. The question is, too: what role should market forces or, alternatively, the authorities play in the process? In other words, how strongly should the currency be steered in managed floating, for instance, towards a certain rate? It is important to remember that the ERM II central rate is fixed jointly by the acceding country on the one hand and the ECOFIN Council and the ECB on the other.

The EU-10 countries are free to chart their path to ERM II membership at their own discretion. The ECB does not want to dictate a strategy. “No common path should be prescribed to all 12 accession countries with regard to their exchange rate policies prior to accession, the inclusion of their currencies in ERM II or the later adoption of the euro […]. A plurality of approaches should be feasible without compromising equality of treatment”, the ECB stated in a press release following the Helsinki Seminar with the central bank governors of the CEECs.8 It also indicated, though, that an increasing degree of orientation towards the euro would be in line with further econo mic and financial integration with the euro area.

Questions relating to exchange-rate strategy will also arise during the period in the ERM II. In principle, the system provides considerable scope owing to the large bandwidth of 15% on either side of the central rate. If the full band is used, there is little difference from managed floating. Many fear there is potential for high exchange-rate volatility not only before entry into the ERM II, but also within the mechanism. They give several reasons for these expectations or fears:

  • The complete liberalisation of capital movements is new for the acceding countries; the consequences are hardly predictable.
  • Many of the acceding countries have large current account deficits.
  • It is unlikely that funds raised through privatisations will help to finance the current account deficits to the same extent as in the past.

Some economists therefore criticise the ERM II as a typical intermediate exchange-rate regime, a system somewhere between the two poles of “rigidly fixed rates” and “freely floating rates”. They say that such a system necessarily displays high volatility and instability. These dangers cannot be denied. The critics overlook, though, that unlike other intermediate solutions the ERM II offers a clear exit: entry into monetary union. It must also be pointed out that, contrary to many predictions from the academic and financial-market communities, the old ERM I worked very well after the bands were widened in 1993 from +/- 2 ¼% and +/- 6% to +/- 15% for all participants following the withdrawal of Italy and the United Kingdom from the exchange rate mechanism of the European Monetary System on September 15, 1992. The essential factors are probably that credible central rates be fixed, and that economic and fiscal policy in the individual acceding country provide for stable macroeconomic development.

If the full bandwidth of the ERM II is used, the system resembles floating. But completely different approaches can also be taken: e.g. a narrow band, similar to that applied by Denmark (+/- 2 ¼%). It is even possible that, in the ERM II, countries will be able to continue the currency board they have already had for years. The ECB will judge this on a case-by-case basis.10 It would indeed seem silly for Estonia, which has successfully pegged its currency for over 10 years, first to the Dmark and then to the euro, to loosen the link with the euro after it joins the EU. All things considered, it seems likely that the EU-10 will continue to operate widely differing exchange-rate policy after they become members of the EU and the ERM II. Preliminary decisions will have to be taken soon, especially in the countries with flexible exchange rates, such as Poland and the Czech Republic.

For more DB Research Analysis see

Deutsche Bank Research website.  

Subscribe to our newsletters