EMU and the International Monetary System

Comments on Berrigan and Carré

Thomas Krueger, Paul Masson, and Bart Turtelboom
Published Date:
September 1997
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György Szapáry

I agree with Berrigan and Carré that the creation of EMU is a major international development, which will affect not only the member states of the monetary union but also their trading partners. The Berrigan-Carré paper rightly examines the impact of EMU on those countries that have particularly close economic and financial links with the EU, namely, Central and EU, African sub-Saharan countries, and Mediterranean countries. I will discuss the impact of the establishment of a single European currency only on the first group of countries, since that is the one I am most familiar with.

Preparing for the advent of the euro is important for the CEECs from several points of view. First, those members of the EU that are likely to be the first to participate in the monetary union (the “core” countries) are the major trading partners of the CEECs. For example, the most commonly assumed core countries—Germany, France, Austria and the Benelux countries—account for about 50 percent of the exports and imports of the Czech Republic, Hungary, and Poland. If more countries were to join the EMU in the first wave, that share would of course be even greater. Second, the economies of most CEECs are by now highly integrated into those of the EU: their trade is practically liberalized and the remaining restrictions on capital flows hardly constitute a serious constraint on the flow of capital, legal or otherwise. This means that changes in the monetary and exchange rate policies of EMU will have an immediate impact on their economies. Third, even though the CEECs have made great progress in developing market institutions and policy instruments, in adopting EU-conforming legislation, and in upgrading technologies in the financial sector, there is still much to be done in these areas. Since they are in an earlier stage of development, they have an opportunity to leapfrog. Hence, they have to follow closely the institutional and legal developments leading up to the creation of EMU. Finally, the CEECs have concluded agreements with the EU recognizing the aim of membership in the EU. The establishment of EMU will fundamentally change the “acquis communautaire” to which the acceding CEECs are expected to adapt.

Exchange Rate Policy

The most important question is whether the advent of EMU will mean that the CEECs will face more or less global exchange rate stability. This question can be divided into two subquestions: will the euro be more or less stable than the deutsche mark vis-à-vis the currencies of nonparticipating EU members; and will the euro be more or less stable than the deutsche mark vis-à-vis the dollar and the yen?

To answer the first question, one could argue that there should be more stability since the principle has been laid down that the exchange rates between the euro and the nonparticipating EU countries (the “outs”) are of common interest. This will mean in practice that the ECB and the interested national central banks of the outs will coordinate their intervention policies to maintain the currencies of the outs within a certain limit around a central rate within the framework of ERM II. However, it was also made clear that the interventions should not jeopardize the commitment of the ECB to its primary anti-inflationary goal, which has an implication of asymmetry with respect to intervention obligations. An asymmetric system can imply a higher burden for the outs and can be less persuasive for market players. On the other hand, in a more symmetric scenario the credibility of the commitment of the ECB toward price stability could be weakened: although the exchange rates between the euro and the currencies of the outs could be more stable, inflationary pressures could emerge within the euro region itself as a consequence of unlimited support for weaker currencies. It is hard to predict at this early stage what the outcome will be. It would seem to me that the objective of the outs, or at least of most of them, will be to join the EMU, that is, they will want to achieve convergence in fundamentals. This should result in increased exchange rate stability.

There is, however, another argument put forward by Gros,1 which brings me to the second question. Since the trade of the core countries with the rest of the world is much larger than that with the outs, Gros argues that for the ECB the dollar and yen exchange rates will be more important than the exchange rates of the outs. The ECB will therefore be more inclined to react to developments in the euro-dollar rate then be concerned with the exchange rates of the outs.

It is not my task to second-guess the intentions of the future ECB. From the point of view of the acceding countries, EMU will certainly mean some degree of increased exchange rate stability because the core countries, which, as said, represent a major share in the acceding countries' trade, will have eliminated the exchange rate fluctuations between them, however small these fluctuations have become by now. This will reduce the price level changes transmitted to CEECs due to exchange rate changes beyond their control. More important, it will have eliminated the individual exchange rate risks vis-à-vis this group of countries, replacing them with a single exchange rate risk vis-a-vis the euro. In parallel, transaction costs will be reduced in relation to these countries. Also, as already mentioned, it is reasonable to assume that the euro exchange rate against the currencies of the outs will move toward greater stability as convergence takes place. We can also expect the euro to become more important in currency baskets and the acceding countries increasingly to formulate their external policies by reference to the euro zone.

As to the value of the euro against the dollar and the yen, the big question is to what extent the current strength of the deutsche mark might be diluted by the establishment of the EMU. Strict adherence to the Maastricht criteria will lessen that risk, as will the large size of the euro financial market. Nevertheless, the question is raised of how the establishment of the euro will affect portfolio choices. If the euro is perceived to be stronger than the deutsche mark, a shift into the euro from other currencies will take place. The opposite will happen if the euro is perceived to be weaker than the deutsche mark. Acceding countries that hold most of their reserves in deutsche mark or dollars will be confronted with this problem, as will of course the other countries.

If there is a large portfolio shift out of the dollar and toward the euro, the latter will appreciate, confronting the CEECs with the question of whether they could afford to let their currencies appreciate along with the euro. The Balassa-Samuelson effect means that over time the currencies of catchup countries such as the CEECs will appreciate. Nevertheless, since these countries need to restructure their output and absorb a large amount of reform-induced unemployment, while some countries, such as Hungary, have also a relatively high level of external debt, great care has to be taken to maintain competitiveness. I therefore agree with Berrigan and Carré that there is a strong economic case against the premature adoption of a fixed exchange rate regime by the CEECs.

A point can be raised here concerning relative risk perceptions. With the establishment of EMU, participating countries and their financial institutions, backed as they will be by a strong central bank, are likely to be judged less risky than others by the markets. As a consequence, the perceived relative riskiness of the outs, including the CEECs, might increase, leading to higher interest rate spreads between the “ins” and the others, even if nothing happened in these other countries to warrant such increase. To some extent this has already taken place, as there is evidence that the most likely first-round participants in the EMU enjoy by now more favorable spreads than the others. This will provide a powerful incentive for the outsiders to join.

Alternative Monetary Policy Strategies

The possible monetary policy strategies of the ECB have been outlined in the EMI's January 1997 report.2 However, the strategy to be adopted is still debated. One view is that the ECB should operate along the principles of the Bundesbank and adopt an intermediate monetary target. The main merit of such a strategy according to its proponents would be continuity with the German monetary policy, inheriting its reputation as a successful practice. On the other hand, many argue that monetary targets based on Europe-wide demand for money are too unreliable to serve as a rule for monetary policy action. To be useful, monetary targeting needs a predictable and stable relationship between money growth and inflation. Critics of monetary targeting point out that in some countries, notably in the United States and the United Kingdom, such targeting resulted in excessive interest rate volatility because it prevented the flexible adjustment of the money growth target to the changing demand for money. As a result, monetary targeting has been abandoned in these countries.

The other alternative is direct inflation targeting. Those favoring this approach argue that it would be more understandable and would make the ECB more accountable to the general public. Also, inflation targeting would allow for more flexibility when the demand for money changes and could thus lessen the volatility of interest rates. But it could also be harder for market participants to judge how the ECB assesses the inflationary pressures arising from actual monetary developments and how and when it will react to them. While this regime would leave a greater degree of flexibility and discretion to the ECB, it would create greater uncertainty for market participants about the monetary authorities' reactions. This is true in principle, but steps such as the publication of Federal Reserve Bank's Open Market Committee minutes in the United States and of the minutes of the meetings between the Chancellor and the Governor of the Bank of England can reduce that uncertainty.

The EMI's report acknowledges the ongoing debate by stating that it is not necessary to determine the precise details of the ECB's strategy at this stage. However, the different strategies can result in a slightly different monetary and financial environment for the outs and the CEECs, to which they must adapt. Theoretical considerations would suggest that a strict monetary targeting can result in higher volatility of interest rates, whereas inflation targeting could alleviate this problem. But in the real world, the dividing lines are not so clearly drawn. As is pointed out by Lamfalussy,3 there is room for compromise between intermediate monetary and direct inflation targeting, and they need not be strictly exclusive strategies. Inflation targeting does not exclude monitoring monetary targets; it simply means that the authorities do not interpret them in a mechanistic way, disregarding other useful indicators of inflation. On the other hand, it is known that intermediate monetary targeting has not prevented the Bundesbank from using this tool flexibly in its pursuit of price stability. Indeed, there no longer seems to be a very predictable demand for money in Germany. This probably reflects both the impact of reunification and the growing use of the deutsche mark in other countries. In fact, some works have suggested that the demand for money in the EMS as a whole has been more stable than the demand for money in Germany. Nevertheless, money targeting might be difficult at the beginning within EMU because there will be no experience how the demand for money behaves in the new setting of the euro.

Looking at the transition economies like Hungary, the demand for money is even more unstable and more difficult to predict than in the other, more developed countries. There are several reasons for this. The breakup of large firms as a result of privatization and the emergence of hundreds of thousands of new enterprises have led to an increase in the transaction demand for money of the enterprise sector. The informal economy is relatively large in Hungary—due in part to the high tax burden—which normally increases the demand for cash, but it is unclear how the informal economy will react to the easing of the tax burden now being implemented. Financial innovation, improvements in the payment system, the liberalization of the money and financial markets, and the traditional demand for foreign currency have all affected the demand for money in such ways that it is hard to assess their combined impact. All this means that strict monetary targeting does not seem to be a workable solution in the immediate future in the transforming economies. Over time, however, as the transition is being completed, the behavioral relationships should normalize in the transforming economies and there are no reasons to believe that the demand for money would be more difficult to predict in these countries than in the EMU.

The monetary and exchange rate policy of the ECB will be concerned with the economic performance of the whole EMU rather than with that of the individual member countries. Therefore, monetary and exchange rate policy will not be available to deal with asymmetric shocks, such as a supply or a wage shock, affecting only an individual member or affecting individual members in different ways. This will leave fiscal policy as the only effective tool to respond to such shocks. Since there are limits to the flexibility of fiscal policy to respond to shocks in the short term, there could be greater fluctuations in the output of individual member countries if such shocks were to take place, affecting not only the economy of the monetary union but also the economies of the CEECs. Whether the fluctuations in output caused by asymmetric shocks will be greater in the new setting will depend in part on how the automatic stabilizers can work within the fiscal deficit constraint adopted within the framework of the stability pact. This raises the issue of the differences in the structures of government budgets in the individual member countries. Somewhat surprisingly, this issue has received insufficient attention in the ongoing discussions on convergence as the attention has focused on the permissible size of the overall fiscal deficit. However, the sustainability of this deficit in the long term and the budget's ability to respond to shocks depend on the structure of budget receipts (taxes) and expenditures. Therefore, some degree of harmonization in this area seems to be unavoidable in the long run for the monetary union to work efficiently. An important issue in this respect is the reform of the pension systems, since the unfunded pension obligations faced by the individual countries in the medium term are quite different.

Choice of Monetary Policy Instruments

The EMI Council has defined a set of monetary policy instruments that will be available to the ECB. The principal tool of monetary policy will be repurchase transactions. In addition, there will be two standing facilities: a marginal overnight lending facility and an overnight deposit facility. The interest rates on these facilities will define the corridor within which money market rates will fluctuate.

Repo facilities have been used in Hungary for some time and are the principal monetary policy tool. The National Bank of Hungary uses repos and reverse repos, and the respective interest rates provide a corridor for interbank money market rates as in the proposal described above. Thus, Hungary has already in place the main policy instruments proposed for the ECB. The same is true for several other acceding countries, such as the Czech Republic and Poland. The ECB will also be able to resort to outright transactions, swaps, and the issuance of debt certificates. These instruments are available to the Hungarian National Bank and to the central banks of several CEECs as well.

An infrastructure that will allow the ECB to impose reserve requirements will be established. However, views differ on the role to be played by reserve requirements within the EMU. Current practices still differ considerably within the EU, although there has been some tendency toward harmonization in recent years. Despite considerable reduction in their level, required reserves continue to play an important role in German monetary policy. Compulsory reserves make German banks more dependent on central bank money than banks in countries where there are no reserve requirements. This helps the Bundesbank to stabilize the demand for central bank money and makes it easier to follow intermediate quantitative monetary targets. Since these reserve requirements have to be met on an average basis over a period, they play a buffer role as well, helping to stabilize short-term interest rates. Also, short-term interest rate actions by the Bundesbank do not transmit themselves as rapidly to the longer segments of the yield curve, making longer-term interest-rates less volatile.

By contrast, several countries have abandoned reserve requirements as a monetary policy tool, most notably the United Kingdom. Banks in the United Kingdom are therefore less dependent on central bank money, rendering direct monetary targeting more difficult. Nor do required reserves play a buffer role as in Germany. This is one explanation of why short-term interest rates can be more volatile in the United Kingdom and why changes in short-term rates are transmitted faster to the longer maturities of the capital markets. Required reserves represent an implicit tax on banks. In a world where global competition dictates regulation, the ECB could well be forced to adopt a nonreserves strategy for common monetary policy.

The reserve requirement policy eventually adopted by the ECB will affect the acceding countries in a number of ways. If the above reading of the German and the British practices is correct, adoption of one or another alternative will imply different monetary policy strategies, which might result in money and capital markets with different volatility properties. Even if the ECB generalizes the current German practice, acceding CEECs must prepare themselves to reduce considerably reserve requirements. Currently, the reserve requirement is 12 percent in Hungary and even higher in some of the other CEECs. The announced policy of the Hungarian monetary authorities is to gradually reduce the rate of compulsory reserves to a level in line with EU standards, but this shall be done in a manner that will not jeopardize the anti-inflationary goals of the monetary authorities. In other words, the reduction will have to be gradual.

Payment System

The EMI has made considerable progress in its preparatory work toward establishing a Europe-wide payment system called TARGET (Trans-European automated real-time gross settlement express transfer). The system will be built on the basis of the existing national real time gross settlement (RTGS) systems, with an interlink network connecting the national central banks and using a version of the SWIFT language. Although the outs will not be part of the TARGET, they will be connected to the system. CEECs are in the early stages of developing their national payments system, which provides an opportunity for them to leapfrog, introducing right at the outset the systems that are compatible with and best suited for TARGET.

RTGS systems involve intraday borrowing and lending. A corollary of these transactions is the extensive use of high-quality collateral to cover against the risk of nonpayment. This requirement can pose some difficulties for countries that are at an early stage of securitization and development of their securities markets. It can turn out that these countries do not have enough papers of the necessary quality to meet the needs of the payment system. The development of the securities markets and the building up of confidence in them takes time. This is another good reason why CEECs should make it a top priority to develop their capital markets.

Accession to the EU

Meeting the Maastricht criteria is not a condition for joining the EU. However, the establishment of EMU will change the acquis communautaires to which the acceding countries are expected to adapt. Of particular importance to the acceding countries is the question of what they will have to do to join the EU, that is, what obligations will they have to undertake during the accession negotiations as a sign that they are willing and able to take on the acquis communautaires in the area of the EMU. These obligations will crystallize progressively and will become more precise once EMU has been established and working for some time. This is why representatives of the CEECs have to keep close pace with the proposals, studies, and evolution of thinking about the future of EMU in order to best prepare themselves for the entry into the EU and eventually the EMU as well.

What If…

It is my sincere hope that EMU will be established as scheduled on January 1, 1999. This is not only in the interest of the current member states of the EU, but also in the interest of the CEECs. Nevertheless, policymakers in the CEECs must be prepared to deal with the consequences of developments that are beyond their control. Hence, we must ask ourselves the not-to-be-asked question of what would happen if the start of Stage III were postponed. Such postponement could take place if performance deviated significantly from the Maastricht criteria in one or two of the most important core countries. Two scenarios are possible.

If there were an “orderly” decision to postpone, announcing a new date along with strong measures to achieve the Maastricht criteria, markets would be likely to perceive the postponement as credible. In this case, I think that there would be no abrupt changes in the exchange and capital markets. In fact, such credible delay could increase the chances of more countries joining EMU from the start, which could actually stabilize the markets and reduce interest rate spreads. On the other hand, if there were a “disorderly” delay accompanied by rancor and mutual recrimination, the markets could react strongly. In such a case, I am afraid that there would be greater exchange rate volatility with a flight to the deutsche mark, and a widening of spreads would also take place. This would complicate the task of policymakers everywhere, but especially in the CEECs, where the mechanisms of adjustment to sudden shifts in external conditions are less sophisticated and the room for maneuver to adjust is narrower.


Mr. Eichengreen enquired about the suggestion in the Berrigan-Carré paper that the relationship between European currencies and the French franc on the one hand and the CFA currencies on the other could remain unchanged after EMU. In particular, who would assume the role played by the Bank of France and the related French government role in Stage III?

Mr. Carré noted that the Bank of France played a very small role in the current arrangement. It was the French treasury that had the major role, and that would continue in the future if the French treasury was still willing and if the African members of the zone agreed. In his opinion, the relationship between the French and the CFA zone was not a monetary arrangement.

Mr. Goos noted that while he largely agreed with Mr. Carré's statement, it was not only up to the French authorities and the CFA countries to decide on the future arrangement, but rather a matter to be decided by the Community. The provisions for exchange rate relationships clearly stipulated that whatever happened vis-à-vis third countries had to be agreed upon by the respective Community institutions. That was not to imply that the Community already had a position on that issue, which had yet to be discussed.

Mr. Dairi recalled that, in his paper, Mr. Carré had indicated that Mediterranean countries did not wish to join the EU. He considered that too hasty an assessment. He understood that Turkey, for one, was very much eager to join, and Morocco had requested full EU membership a few years ago. So the question was really whether the EU was ready to bring those countries into full-fledged membership.

He wondered whether, given that most of the free trade agreements being signed under the European initiative were in fact looking at greater Integration of the whole Mediterranean region with Europe and the flow of foreign investment to the Mediterranean countries, it would not make sense for the Mediterranean region to seek stronger ties with Europe, at least in terms of exchange rate arrangements. Would that not move the Mediterranean countries to peg their currencies to, for example, the euro, in order to promote foreign investment from Europe?

Daniel Gros, EMU: The Ins and the Outs (Brussels: Centre for European Policy Studies, 1996).

European Monetary Institute, The Single Monetary Policy in Stage Three: Specification of the Operational Framework (Frankfurt: EMI, January 1997).

Alexandre Lamfalussy, “Monetary and Exchange Hate Policy Co-operation Between the Euro Area and Other EU Countries,” oral report to the informal ECOFIN Council in Verona, April 12–13, 1996.

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