VI Institutional Arrangements for Entering ERM2 and Adopting the Euro

International Monetary Fund
Published Date:
April 2005
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Members of the EU are obliged to treat economic policy as a matter of common interest and to participate in the multilateral coordination and surveillance procedures for macroeconomic policies. This includes submitting to the excessive deficit reporting procedure under the Stability and Growth Pact (SGP) and preparing Convergence Programs (successors to Pre-Accession Economic Programs).52 EU members are also expected to avoid excessive exchange rate fluctuations, competitive devaluations, and exchange rates that are inconsistent with economic fundamentals. EU accession itself, however, has no immediate implications for countries’ choice of exchange rate regime.

The Path Toward Euro Adoption

Upon accession, EU members become members of EMU, with a derogation from adopting the euro as their national currency. The path from EU accession to euro adoption consists of several steps—participation in ERM2, meeting the Maastricht criteria, and final conversion. Countries may decide, on the basis of their national interests, how quickly to attempt to take the preparatory steps (indefinite delay is an option), but they are bound to take them prior to adopting the euro. Under the “principle of equal treatment,” new members of the EU aiming to adopt the euro should neither be confronted with additional hurdles nor allowed to adopt the euro on looser terms than earlier entrants. While economic and monetary union is one of the negotiated chapters of the acquis communautaire, EU membership carries no formal obligations on the timing of joining ERM2, of meeting the convergence requirements set out in the Maastricht Treaty, or of adopting the euro.

In order to adopt the euro, EU members must satisfy the nominal convergence criteria specified in the Maastricht Treaty. These criteria, intended as a test of sustainable convergence, are (1) an average rate of consumer price inflation, observed over a one-year period, not exceeding by more than 1½ percentage points the average rate of inflation in the three “best-performing Member States in terms of price stability”; (2) the year-average nominal interest rate on a 10-year benchmark government security no more than 2 percentage points above the average in the same three countries; (3) participation in ERM2 for at least two years while the currency trades without severe tensions within the “normal fluctuation margins” of ERM2 and without a devaluation of the central parity; and (4) a fiscal deficit that is not excessive. A deficit is excessive if at the general government level it exceeds 3 percent of GDP (unless this ratio has been falling substantially and continually and is close to the reference value, or the excess over the reference value is exceptional and temporary) or public debt exceeds 60 percent of GDP (unless this ratio is dropping and approaching the reference value at a satisfactory rate).

EMU members with a derogation from adopting the euro may request at any time an assessment of their progress in fulfilling the requirements for the single currency. In any event, assessments are required of all EMU members with a derogation (even if not a member of ERM2) at least once every two years.53 The EC and the ECB prepare separate, parallel Convergence Reports as inputs to a decision by the ECOFIN Council (Council of Economics and Finance Ministers of the European Union) on whether the country has fulfilled the necessary conditions.54 A qualified majority is needed to overturn the derogation on monetary union. While both the EC and the ECB are guided by the treaty definitions of the convergence criteria, they have discretion in interpreting and applying them: potentially, one could find compliance while the other does not. Decisions are made by the ECOFIN Council.

After satisfying the Maastricht criteria and agreeing on the final irrevocable exchange rate at which its currency will be converted, a country relinquishes its own currency for the euro. Euro-area members are required to abide by the SGP. They are also required to present annual Stability Programs that cover the current and at least the three following years. The ECOFIN Council, on a recommendation from the EC, delivers an opinion on each program and may ask member states to strengthen it.

ERM2: Rules and Questions

After accession, countries may request to join ERM2.55 No explicit preconditions exist for joining ERM2. Its purpose is to guide market expectations and to test the appropriateness of the central parity. The central parity is decided by agreement between the member state, the euro-area member states, the ECB, and other member states participating in the mechanism.56 The central parity may be realigned to head off speculative pressures: all parties have the right to initiate the realignment procedure.57 ERM2 is compatible with a range of monetary and exchange rate frameworks. The ECB identifies the only incompatibilities as fully floating exchange rates, pegs to currencies other than the euro, crawling pegs, and unilateral “euroization.” Establishing narrower fluctuation bands within ERM2 is permitted.58 Compatibility of currency board arrangements with participation in ERM2 is assessed on a case-by-case basis.59

The discretion afforded the ECB and EC in interpreting the fulfillment of the Maastricht exchange rate criterion and the previous participants’ experiences in ERM and ERM2 have resulted in considerable debate about what the criterion requires.

First, how much exchange rate variability will be consistent with the exchange rate stability criterion? Past interpretations by the EC and ECB suggest that containing currency fluctuations within ±2¼ percent of the central parity (the standard against which existing euro-area members were judged) or at least maintaining a bias in favor of strength rather than weakness relative to this band would almost certainly be judged consistent with the criterion. However a close reading of precedents and of recent official statements suggests that exceeding ±2¼ percent around parity would not automatically indicate severe tensions. Rather, assessment would take into account three elements: (1) the duration and amplitude of the deviation; (2) the nature and extent of any policy response; and (3) whether the pressure was on the upside or downside of parity. A recent ECOFIN Council statement affirms that “assessment of the exchange rate stability criterion against the euro will focus on the exchange rate being close to the central rate while taking into account factors that may have led to an appreciation, in line with what was done in the past.”60 In effect, ERM2 members are likely to face an asymmetric standard for exchange rate stability, with considerable scope for exchange rates on the strong side of parity (albeit well within the top of the ERM2 band) and some scope for brief deviations below parity if these are judged to stem from events beyond the control of the authorities.

Second, will a two-year stay in ERM2 be mandatory? The experiences of Italy and Finland together with statements by the EC and ECB suggest some scope for flexibility.61 According to the EC, exchange rate stability during a period of nonparticipation before entering ERM2 can be taken into account.62 On the other hand, there is no expectation that participation in ERM2 will be limited to two years. This is reflected in a statement by an ECB official that it is “premature and probably impossible at this stage to try to assess the appropriate length of ERM2 participation from an economic perspective, beyond the minimum compulsory statutory requirement of a two-year ERM2 membership. This would depend on the actual progress made by the countries concerned in real and nominal convergence combined with the possible need to use the exchange rate as a tool.”63

Third, would ECB intervention be a major source of support for currencies at the lower end of the ERM2 band? It appears unlikely. In principle, intervention support by the ECB is automatic and unlimited at the lower end of the ERM2 band. At this point, countries would have access to the very short-term financing facilities (VSTFF), provided that the intervention does not threaten the ECB’s primary objective of price stability and the country concerned has appropriate interest rate and fiscal policy responses.64 In practice, direct ECB or ECB-financed intervention may be limited: participants would be expected to adjust interest rates and/or intervene on their own account well before exchange rates challenged the margins, and parity adjustments would be considered if challenges persisted. Also, the initial maturity for VSTFF operations is three months, and extensions are subject to restrictions—one automatic extension for three months is provided but only up to preassigned country-specific limits. On a case-by-case basis, ERM2 participants may request formal agreement on a fluctuation band narrower than the standard one and backed in principle by ECB intervention financing. Such ECB financing of intramarginal intervention, however, is subject to two restrictions: as with intervention at the normal ERM2 margins, participants are expected to make “appropriate” use of their own reserves before relying on financing from the ECB; but also, access limits to the VSTFF for intramarginal intervention are subject to ceilings even for the first operation. Examples of ceilings range from (previously) €300 million for the Bank of Greece to €3.5 billion for the Bank of England.65

Fourth, while EU accession requires full liberalization of capital accounts, is the use of capital controls precluded in ERM2? The safeguard clause of the Maastricht treaty allows countries to introduce temporary restrictions on capital movements in the case of serious balance of payments difficulties. These restrictions can be introduced overnight but must subsequently be sanctioned by the ECOFIN Council. The conditions under which capital restrictions might be permitted, if at all, have not been tested.

The SGP requires countries to aim for a medium-term budgetary position close to balance or in surplus. Euro-area members are subject to sanctions if excessive deficits (above 3 percent of GDP) persist.

Denmark and the United Kingdom have a special status whereby Convergence Reports are prepared only upon request.

In addition to the four criteria, convergence reports consider current account developments and prospects, trends in ULCs, and the compatibility of national legislation with the Statutes of the European System of Central Banks and the articles of the relevant EU treaties as regards the objectives and independence of national central banks.

ERM2 replaced ERM in January 1999. It is similar to its predecessor post-August 1993, when the ERM band for exchange rate fluctuations around parity was widened from ±2¼ percent to ±15 percent. But it differs in a few important respects: (1) fluctuation bands are defined relative to the euro; (2) the ECB has the right to suspend intervention if price stability is in jeopardy; and (3) needed realignments are expected to take place in a timely manner. Only Denmark and Greece have participated in ERM2. Greece has since adopted the euro; Denmark maintains ±2¼ percent fluctuation margins around its central parity.

EC (2000), Annex D.

Finland joined ERM on October 14, 1996, and Italy rejoined on November 25, 1996. The decisions that they could adopt the euro were taken on May 2, 1998—less than two years after they joined ERM. Actual euro adoption, however, occurred more than two years after ERM entry.

EC (2000), Annex D.

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