Efficiency gains

45. According to the Commission, implementing the common currency could lead to resource savings in the banking sector which would realize an annual gain of 0.2 percent of GDP for Sweden. This increase is comparable to the European Commission’s (1990) findings that lowering bid-ask spreads and reducing the costs of managing separate currencies would result in annual gains of 0.4 percent of GDP for the 12 members of the European Community in 1990. These calculations assume that the financial sector contracts by the amount of the reduction in foreign exchange business. However, it is possible that a single currency would result in new profit opportunities for banking. For example, Melitz (1996) argues in one of the Commission’s background papers that portfolio investors might substitute euro securities for securities issued outside the common currency area and generate higher profits for financial companies.

46. The Riksbank argues that the Commission’s estimates of the cost savings associated with the single currency are too low because they do not include the possibility that reducing foreign exchange transactions could boost foreign trade and investment for small- and medium-sized firms. In the Riksbank’s view, managing foreign exchange constitutes a sizeable obstacle for small firms to establish themselves on the export market, as they lack both the competence and the financial resources to manage foreign exchange and can seldom choose to delegate production to a subsidiary firm in a country with an advantageous exchange rate. Therefore, the introduction of the euro would allow small firms access to a much larger market and raise profits, employment and investment, which is vital for Sweden because future employment growth is expected to be concentrated in firms of this size owing to ongoing rationalization in large firms.

47. The Riksbank also notes that Swedish financial market participants expect that trading in the shares of major companies will gradually switch to the euro even if Sweden maintains its own currency because handling two currencies would be too costly. Therefore, even if Sweden decides to postpone EMU entry, renewals and new issues of financial market instruments might be denominated in euros and account for a growing proportion of securities trading. A scenario could develop in which financial markets and companies are active in the euro currency whereas the public sector continues to use the krona. According to the Riksbank, early entry into EMU would avoid the increased costs associated with conducting transactions in two currencies.

48. A payments system called TARGET is currently being set up to link all the national payments systems in preparation for the single currency regime. Although all national banks in the EU area will be entitled to join TARGET irrespective of participation in EMU, restrictions may be imposed on intra-day credits in euros for countries who are not initial participants of EMU. If these restrictions are implemented, the Riksbank notes that the flow of payments for non-EMU participants may be more erratic than for EMU participants.

Credibility gains

49. Cukierman (1996), in one of the Commission’s background papers, highlights Sweden’s credibility problem over the recent period in discussing the disciplinary benefits of a fixed exchange rate. He argues that Sweden’s credibility has been relatively low since the mid-1970s when repeated wage increases above those of partner countries reduced Sweden’s competitiveness and forced periodic devaluations of the krona (see Chart 1, Chapter IV), and that early entry into EMU would eliminate competitive devaluations and discipline Sweden into making structural adjustments in the domestic economy. To the extent that a commitment to build credibility domestically is more difficult than obtaining credibility by joining EMU, Cukierman argues that it is likely that mobilizing the political will needed to implement necessary fiscal and labor market reforms will be easier within EMU. The Riksbank is also skeptical that any reform of the Swedish labor market would have better conditions for its successful implementation if Sweden were to remain outside the monetary union; remaining outside EMU, in the Riksbank’s view, would make it harder for Sweden to implement reforms to improve the functioning of the labor market.

Lower nominal interest rates

50. Nominal long-term interest rates in Sweden have in recent years been significantly higher than equivalent interest rates in Germany and the majority of other EU countries. The difference has probably reflected expectations of a higher rate of inflation in Sweden on account of its poor inflation performance during the 1980s. Assuming that the low inflation resolve of the European Central Bank is as strong as that of the Bundesbank, the Commission agrees that long-term interest rates would likely be lower for the euro than for the Swedish krona, which would provide considerable fiscal savings for the Swedish government and strengthen the fiscal position over the medium term. The Commission, however, considers that the effects of lower nominal interest rates on the real economy are more uncertain because saving and investment decisions are determined by expected real interest rates. To the extent that the nominal interest rate premium between Sweden and the EMU countries reflects higher inflation expectations, expected real interest rates would not be any different in or out of the euro area.

Loss of the exchange rate as a shock absorber

52. One of the main arguments against joining a fixed exchange rate regime is that it eliminates the ability of the national authority to follow an independent monetary policy. Under the combination of fixed exchange rates and complete integration of financial markets, the domestic interest rate is tied to the foreign interest rate. Therefore, in the face of an adverse disturbance, monetary policy is powerless and adjustment must take place through fiscal policy and/or wages and prices. Under a flexible exchange rate regime, the country can respond to a negative disturbance through monetary expansion and a depreciation of the currency. The choice between a fixed and flexible exchange rate regime depends, therefore, on the nature of disturbances and on the economy’s responses to them.

53. A number of studies have focused on the nature of disturbances for various country groups within the EU area. The general consensus is that, although shocks to the Swedish economy are correlated with shocks to the EU aggregate, the correlation is considerably weaker than for a number of core countries. For example, Melitz (1996) finds that Sweden enters in eighth rank in a comparison of the magnitude of asymmetric shocks versus symmetric shocks (all of the core countries are above it in rank).¹³

54. The Commission argues that there is a risk that asymmetric disturbances will lead to large swings in Swedish output and employment. Moreover, temporary macroeconomic disturbances may give rise to very long-term effects on output and employment. Lower output and higher unemployment would also result in renewed government deficits requiring further cuts in public expenditure and tax increases which lower efficiency. Therefore, given the present state of the Swedish labor market, the Commission believes that Sweden would benefit from allowing the exchange rate to remain flexible and to cushion these asymmetric disturbances. However, it recognizes that, in the long run, unemployment is not affected by the decision to participate in a monetary union and therefore sees no reason why Sweden should not enter EMU at a later date.

55. The recommendation to postpone EMU entry is also made in Frankel and Rose’s (1996) background study of indicators which facilitate the absorption of shocks. One of the indicators which they focus on is the size of intra-EU trade. They argue that although exports are high in relation to GDP (at about 35 percent), Sweden’s trade with other members of the EU (at about 60 percent of total exports) is lower than the average among EU countries. They argue that under the assumption that the extent of EU trade is correlated with common shocks, the Swedish case for joining EMU is less clear cut than for the core countries. However, the authors also show that a closer trade linkage between two countries is strongly and consistently associated with more highly correlated economic activity between the two countries. Therefore, if Sweden’s accession to the EU in 1995 leads to an increase in the EU component of Sweden’s trade over time, the correlation of innovations to Swedish income and to the EU aggregate should rise accordingly and limit the need for exchange rate adjustment to moderate shocks.

56. The Riksbank, on the other hand, notes that it is necessary to distinguish between supply and demand shocks in evaluating the degree to which Sweden has suffered from asymmetric disturbances in the past. It argues, in particular, that the asymmetric shocks experienced by Sweden during the 1980s were the result of inappropriate domestic macroeconomic policies rather than negative external shocks, with uncompetitive wage bargains requiring adjustments of the nominal exchange rate to maintain competitiveness. Therefore, provided that Sweden adopted labor market and fiscal policies that were more conducive to maintaining competitiveness, the cost of losing the exchange rate as a shock absorber would be considerably smaller.

57. The Riksbank also stresses that it would be inappropriate to use monetary policy to cushion adverse asymmetric disturbances resulting from domestic policies because such actions would compromise the goal of price stability. In particular, the mere suspicion that the Riksbank might accommodate uncompetitive wage-cost increases (through a looser monetary policy) instead of counteracting them (through a tighter policy) could undermine the credibility of monetary policy built up over the past few years. In the Riksbank’s view, the decision to delay Sweden’s entry into EMU carries the risk of signaling a weaker resolve of containing inflation and could result in interest rate increases and a contraction of domestic demand.

Uncertainty about the EMU process

58. Some of the background studies prepared for the Commission consider as a factor the uncertainty regarding the creation of EMU, its composition, and the timing of its formation, as well as the level of commitment to price stability embodied in the Union’s institutions. Cukierman (1996) argues that the decision to join EMU should be postponed until these uncertainties are reduced to a reasonable level. De Grauwe (1996) argues that one of the major uncertainties regarding the creation of EMU is the nature of the costs and benefits of monetary union for Germany: while the loss of monetary hegemony in Europe can be considered a sunk cost for Germany, the benefit of EMU is a yearly (uncertain) return. Using options theory, he finds that this structure of costs and benefits creates the conditions in which waiting has a positive value for Germany. This raises the uncertainty about the timing of the formation of EMU.

Stringency of budgetary norms

59. As part of the convergence requirements for accession to EMU, budgetary norms have been set to limit potential spillover effects across countries from too large deficit and debt levels established by individual countries. For example, when a country issues too much debt to finance budget deficits, it raises the interest rate in the union, and increases the burden of government debt in the other member countries. In addition, the higher interest rates produced by the excessive debt issue of one member country lead to crowding out effects in the whole union. The Protocol on the Excessive Deficit Procedure (EDP) commits the member countries to avoid general government deficits above 3 percent of GDP and the Stability and Growth Pact penalizes members by as much as 0.5 percent of GDP for deficits exceeding this benchmark. Under the Stability and Growth Pact, the penalty would be waived if output had declined by 2 percent or more over the preceding 12 months. For an output decline of ¾-2 percent, the burden would be on the country to convince the Economic Council that the downturn was exceptional.

60. The Commission notes that one drawback of the budgetary norms set out in the Stability and Growth Pact is that they may hinder the effectiveness of automatic fiscal stabilizers. In particular, the cyclical sensitivity of the budget is very high in Sweden and, therefore, even a fairly mild recession could have significant effects on the budgetary position. The Commission, however, did not find such considerations very important for Sweden at the present time because it considers that the recent growth of government debt has severely constrained the use of fiscal policy to stabilize the economy.