Abstract
THE COUNCIL OF MINISTERS of the European Economic Community (EEC) took several important decisions on February 8 and 9, 1971 relating to the establishment of an economic and monetary union. Inter alia, the Council reaffirmed that a monetary union would imply complete elimination of the margins of exchange rate fluctuation between the currencies of member countries and reiterated the agreement previously reached not to widen existing margins between the currencies of the members of the EEC. It also invited the five EEC central banks to initiate the process of progressively narrowing the present margins of fluctuation between their currencies. Although the agreement subsequently reached by the central banks could not be put into effect, the EEC countries remain committed to achieving monetary unification and thus to narrowing and eventually eliminating margins of exchange rate fluctuation between their currencies.
I. Introduction
THE COUNCIL OF MINISTERS of the European Economic Community (EEC) took several important decisions on February 8 and 9, 1971 relating to the establishment of an economic and monetary union. Inter alia, the Council reaffirmed that a monetary union would imply complete elimination of the margins of exchange rate fluctuation between the currencies of member countries and reiterated the agreement previously reached not to widen existing margins between the currencies of the members of the EEC. It also invited the five EEC central banks to initiate the process of progressively narrowing the present margins of fluctuation between their currencies. Although the agreement subsequently reached by the central banks could not be put into effect, the EEC countries remain committed to achieving monetary unification and thus to narrowing and eventually eliminating margins of exchange rate fluctuation between their currencies.
The purpose of the present paper is to discuss the operation of a system of narrower margins, as originally proposed, and its implications for exchange rate flexibility, interest rate policy, and movements of official reserves.
II. Background
At a meeting in The Hague on December 1 and 2, 1969, the Heads of State and of Government of the member countries of the EEC agreed to expedite the process of economic integration within the Community and gave instructions that a plan be prepared detailing the stages leading to the creation of an economic and monetary union. The subsequent proposals for a narrowing of the margins of fluctuation between the currencies of the EEC countries arose from this request.
As early as 1962, the EEC Commission had warned that greater cooperation among member countries would be necessary to avoid parity changes that could jeopardize the common agricultural policy and the Common Market itself. The currency crises of 1968 gave a new force to these fears and, in February 1969, the Commission sent to the Council of Ministers recommendations on the coordination of the members’ short-term and medium-term economic policies and on the establishment of machinery for short-term and medium-term financial assistance to members in balance of payments difficulties. In February 1970 a system of short-term financial assistance went into effect under which the Community’s central banks agreed to make available the equivalent of up to $2 billion for balance of payments support. Each member can automatically obtain the equivalent of its quota and, upon approval by the central banks’ Governors, up to an additional $1 billion.
On March 6, 1970 the EEC Council entrusted the task of drafting the plan requested at The Hague summit meeting to a group headed by Mr. Pierre Werner, Prime Minister of Luxembourg. On October 8, 1970 this group submitted to the Council and to the Commission a report on the step-by-step establishment of the Community’s Economic and Monetary Union (the “Werner Report”). The proposals made in the Report regarding the exchange rate policy to be pursued in the first stage of the integration process (January 1971–December 1973) are as follows:
… from the beginning of the first stage, the central banks, acting in concert and on an experimental basis, should keep exchange rate fluctuations between Community currencies de facto within bands narrower than those resulting from application of the dollar margins at the time the system is introduced. This could be achieved by concerted action in respect of the dollar.
At the end of this experimental period the narrowing of the margins could be officially announced.
The concerted action in respect of the dollar could be supplemented by intervention in Community currencies, first at the outer limits and later at points within the margins. But this intervention should be such that any credit facilities which it may generate in the course of the first stage should not exceed those provided for under the short-term monetary support system.
Further reductions of intra-Community margins could then be decided on.
In elaborating its proposals, the Werner Group drew on a report by a subcommittee of central bank experts, chaired by Baron H. Ansiaux.
Following the submission of the Werner Report, the Commission proposed to the Council, on October 29, 1970, (1) a draft resolution concerning the progressive establishment of an economic and monetary union and a program of action for the first stage (1971–73) and (2) two preliminary decisions concerning coordination of short-term economic policies and cooperation between the EEC central banks. The relevant part of the draft resolution, for the purposes of this paper, reads as follows:
In order progressively to attain a single exchange system for the whole Community, the Council invites the Central Banks of the member countries, on an experimental basis and from the beginning of the first stage, to limit the fluctuations in the exchange rates of their currencies to narrower margins than those resulting from the application of the margins in force for the dollar, this objective to be achieved by concerted action in relation to the dollar.
The Council is agreed that in view of the circumstances and the results noted in the harmonization of economic policies, it will be possible to take new measures which will consist in the passage from a de facto to a de jure régime, in interventions using Community currencies and in successive reductions in the margins of fluctuation between these currencies. The Committee of Governors of the Central Banks will report twice a year to the Council and the Commission on the progress of the concerted action of the Central Banks on the exchange market and on the advisability of adopting new measures in this field.
On February 8 and 9, 1971 the Council adopted the Commission’s proposed resolution and decisions and agreed that the initial three-year phase would begin retroactive to January 1, 1971. It also agreed on a system of medium-term financial assistance under which $2 billion would be made available for balance of payments support to member countries, in addition to the short-term balance of payments support, beginning on January 1, 1972. Subsequently, the central banks agreed that, starting on June 15, 1971, the exchange rate fluctuations of their respective currencies against one another would not exceed 1.2 per cent on either side of par. Implementation of the agreement was postponed, however, after Germany and the Netherlands allowed their currencies to float.
III. Operation of a System of Narrower Intra-EEC Margins
Prior to the events of May and August 1971, countries party to the European Monetary Agreement (EMA) had generally agreed to maintain exchange rate margins of up to a maximum of about 0.75 per cent on either side of their par value with the U. S. dollar, the intervention currency. Thus, the exchange rate for each EEC currency was allowed to fluctuate against the dollar within a band having a range of 1.5 per cent. As a result, the cross rates of EEC currencies could fluctuate by up to 1.5 per cent on either side of parity, and fluctuations between EEC currencies thus had a maximum possible range of 3 per cent.1
It would have been possible to achieve a relative narrowing of margins between the EEC currencies, compared with those that existed vis-à-vis the dollar, by retaining existing intra-Community margins but widening the margins against the dollar. The proposals of the Werner Group were, however, that there should be an absolute narrowing of the existing intra-EEC margins. Ultimately, once the process of monetary integration had been completed, these margins would be eliminated.
An absolute narrowing of the margins of exchange rate fluctuation between EEC currencies could have been achieved by a simple agreement that each EEC country would limit the range of exchange rate fluctuation of its currency against the dollar to one half the desired band of intra-EEC exchange rate fluctuation. Such a solution, however, would have reduced exchange rate flexibility vis-à-vis the dollar, and this was considered undesirable.
The essential feature of the system that was selected was that the exchange rate margins between EEC currencies could be narrowed without, at the same time, narrowing the EEC margins vis-à-vis the dollar over a period of time. This was achieved by narrowing the band within which EEC currencies would be allowed to fluctuate against the dollar but permitting this band to move within the limits of ±0.75 per cent. The mid-point of the band, the “Community level” for the dollar, would have been determined by agreement between the EEC central banks.
The mechanics are best illustrated by an example. Let us assume that there is agreement that intra-EEC margins are to be reduced from ±1.50 per cent of parity (expressed in each other’s currency) to, say, ±1.00 per cent. This, in itself, means that, at any point in time, the permissible band of fluctuation of EEC rates against the dollar would be reduced to 1.00 per cent (from the 1.50 per cent allowed by the EMA). But, over a period, the EEC exchange rates could fluctuate by the full 0.75 per cent on either side of parity with the dollar if there is agreement to move the Community level for the dollar. This level may be set anywhere within ±0.25 per cent of the existing par values (Chart 1), but, to permit EEC exchange rates to make use of the full extent of the ±0.75 per cent margins against the dollar, it would have to be moved from +0.25 per cent to −0.25 per cent of par, or vice versa.
Band of Fluctuation for EEC Currencies Against the U. S. Dollar1
Citation: IMF Staff Papers 1971, 003; 10.5089/9781451969276.024.A006
1 Assuming a narrowing of intra-EEC margins to ± 1 per cent, while margins against the dollar remain at ±0.75 per cent.Band of Fluctuation for EEC Currencies Against the U. S. Dollar1
Citation: IMF Staff Papers 1971, 003; 10.5089/9781451969276.024.A006
1 Assuming a narrowing of intra-EEC margins to ± 1 per cent, while margins against the dollar remain at ±0.75 per cent.Band of Fluctuation for EEC Currencies Against the U. S. Dollar1
Citation: IMF Staff Papers 1971, 003; 10.5089/9781451969276.024.A006
1 Assuming a narrowing of intra-EEC margins to ± 1 per cent, while margins against the dollar remain at ±0.75 per cent.An obvious implication of such a system is that one, or more, of the EEC countries may not be able to use its full allowable margin of fluctuation against the dollar. If, for example, one currency is at the floor in relation to the dollar, i.e., 0.75 per cent below par, no other EEC currency can go up to its potential ceiling against the dollar without violating the new arrangement. Assuming a reduction of intra-EEC margins to ±1.00 per cent, the potential appreciation is limited to 0.25 per cent above par instead of 0.75 per cent (see the Appendix). Although the EEC as a whole would retain the same degree of exchange rate flexibility over a period as its member countries enjoyed under the EMA arrangements, each individual EEC country would lose some part of its exchange rate flexibility vis-à-vis the United States, EEC members, and third countries.
A second obvious point is that the Community level for the dollar would not be determined wholly by market forces, and agreement on the appropriate level may not always be a simple matter. Presumably this question could be more difficult in an enlarged Community. Countries with a balance of payments surplus may prefer to see the Community level at its upper limit (point B on Chart 1) in order to check their possible accumulation of foreign reserves. Countries with a deficit, on the other hand, would be likely to favor the lower end of the range (point D) in order to reduce possible losses of reserves. It may be that countries with a deficit, by virtue of their known difficulties and possibly limited reserves, would be in a strong position to argue that the Community level for the dollar be set toward the lower end of the range or, if this were not done, to request financial assistance from other EEC countries. The Ansiaux Report suggests that, in deciding on the Community level for the dollar, account should be taken of (1) the degree of accumulation or loss of reserves experienced by members wishing to change the Community level and (2) the magnitude and direction of the combined balance of payments position of the EEC vis-à-vis the rest of the world. The central banks’ system of short-term financial assistance would—according to the Werner Report—be activated to finance the countries experiencing temporary deficits as a result of the fixing of a Community level for the dollar higher than that compatible with their balance of payments position. At a later stage, the Community level for the dollar would be allowed to reflect the balance of payments position (and policy) of the EEC as a whole, while intra-EEC deficits would be financed automatically by mutual credits.
It is likely that, in seeking to maintain their exchange rates within the new specified limits, EEC central banks would have continued their practice of intervening in dollars. The possibility of intervening also in Community currencies was raised in the Werner and Ansiaux Reports. The Ansiaux Report observed that interventions in Community currencies could, in principle, take place either at the outer limits of the EEC band or within the band. Intervening in EEC currencies at the outer limits of the band appears to raise no practical difficulty; once the Community level for the dollar has been agreed upon, intervention rates for EEC currencies are determined automatically. On the other hand, interventions within the band would require central banks to inform each other continuously of their intervention policies, and this might prove a cumbersome procedure.2
Intervention in EEC currencies is not essential for the successful operation of a system of narrower bands. However, in the view of some, such intervention would have the advantage of leading to a diversification of reserves and thus to a reduction of the share of dollars in the total gross reserves of the EEC members.3 The actual amount of reserves that each member would hold in EEC currencies would depend on the frequency of intra-EEC clearings and on the magnitude of mutual assistance.
The Ansiaux Report also mentions two other possible techniques of intervention:
(1) The exchange rates of the EEC currencies could be expressed in terms of one of them, which would then be designated as the EEC intervention currency. The other EEC central banks would intervene on the market to keep the exchange rates of their currencies within the agreed band in relation to the intervention currency, and their interventions would be only in that currency. The central bank of the intervention currency would intervene in dollars on its market to maintain the EEC dollar rates within the agreed band. Such a system would lead to a movement en bloc of all EEC currencies vis-à-vis the dollar, but it could give the impression that one EEC currency was being given a predominant role and might, therefore, be subject to criticism.
(2) Alternatively, one could envisage the creation of a unit of account against which all EEC currencies would fluctuate and that would be allowed to fluctuate against the dollar. This is mentioned as a possibility for a more advanced stage in the integration process.
The implications of the proposal to narrow the EEC band can be considered against the background of exchange rate developments up to the second quarter of 1971 (Chart 2). In recent years all EEC countries have made full use of the permitted exchange rate flexibility. Two points are worth noting: (1) some currencies have moved from one end of the band to the other in short periods of time, e.g., the deutsche mark at the end of 1969 and the beginning of 1970; and (2) the EEC currencies have shown no tendency to move together as a group against the dollar. Between January 1968 and June 1970, at least two EEC currencies were at opposite extremes at some time during 11 of the 30 months.
Spot Exchange Rates—EEC Currencies Against the U.S. Dollar, 1966–71
Citation: IMF Staff Papers 1971, 003; 10.5089/9781451969276.024.A006
Source: Board of Governors of the Federal Reserve System, Selected Interest & Exchange Rates for Major Countries & the U.S.* Devaluation of the French franc from 4.94 to 5.55 for $1.00.** Deutsche mark rate not supported by the Bundesbank.*** Revaluation of the deutsche mark from 25.00 to 27.32 in U. S. cents.Spot Exchange Rates—EEC Currencies Against the U.S. Dollar, 1966–71
Citation: IMF Staff Papers 1971, 003; 10.5089/9781451969276.024.A006
Source: Board of Governors of the Federal Reserve System, Selected Interest & Exchange Rates for Major Countries & the U.S.* Devaluation of the French franc from 4.94 to 5.55 for $1.00.** Deutsche mark rate not supported by the Bundesbank.*** Revaluation of the deutsche mark from 25.00 to 27.32 in U. S. cents.Spot Exchange Rates—EEC Currencies Against the U.S. Dollar, 1966–71
Citation: IMF Staff Papers 1971, 003; 10.5089/9781451969276.024.A006
Source: Board of Governors of the Federal Reserve System, Selected Interest & Exchange Rates for Major Countries & the U.S.* Devaluation of the French franc from 4.94 to 5.55 for $1.00.** Deutsche mark rate not supported by the Bundesbank.*** Revaluation of the deutsche mark from 25.00 to 27.32 in U. S. cents.IV. Implications of the Proposal for Interest Rate Policy
A narrowing of intra-EEC margins implies, under certain conditions, a loss of autonomy in interest rate policy for individual EEC countries. The EEC as a whole, however, could retain vis-à-vis the rest of the world a greater degree of autonomy.
In theory, the scope for independent interest rate policy by one country depends, inter alia, on the degree to which interest rate differentials with foreign countries may be offset by exchange rate variations and/or premiums (or discounts) on its forward exchange rate. It is usually assumed that there is no sizable response to an interest rate differential unless the differential is larger than the premium to be paid for hedging in the forward exchange market against the exchange risk.
The EMA system of fixed rates implies that spot exchange rates for EEC currencies may fluctuate by a maximum of 1.5 per cent vis-à-vis the dollar and by a maximum of 3 per cent vis-à-vis other EEC currencies. In the absence of speculation regarding parity changes, the permitted fluctuations of the spot rate limit the size of premiums (or discounts) for forward rates and, therefore, the interest rate differentials that can arise before interest arbitrage begins.4 For a country whose currency is at the lower or upper intervention points, interest rates on three-month money may in theory diverge by as much as 6 per cent (on an annual basis) from those prevailing in the United States, and by 12 per cent from those prevailing in another country whose currency is at the opposite end of the band, without necessarily leading to flows of capital.
A reduction of intra-EEC margins to ± 1 per cent would reduce this maximum interest rate differential between two EEC countries from 12 per cent to 8 per cent.5 With respect to the dollar area6 (and, by extension, to the rest of the world), the situation is slightly more complicated: while for any EEC currency the forward rate expressed in another EEC currency cannot differ from the spot rate by more than 2 per cent, the maximum differential between its spot and forward rates expressed in dollars will depend on the position of the EEC band. The following example illustrates the movements of spot and forward exchange rates under a system of intra-EEC margins narrowed to ±1 per cent and the implications for interest rate policy.
Assume that at time t1 the spot rate for the Belgian franc is at its ceiling against the dollar (point E on Chart 1) and that the spot rate for the Italian lira is at its lowest level consistent with the maintenance of a ±1 per cent EEC band (point G). Then, on the assumption that the EEC band will be shifted to its lowest level (t3 on Chart 1), the maximum three-month forward discount on the Belgian franc becomes 1.5 per cent (point L). The corresponding interest rate differential is 6 per cent, i.e., Belgian interest rates can be up to 6 per cent above U. S. rates. The forward rate for the lira, however, cannot show a premium of more than 0.5 per cent (point B). A higher premium would mean that the forward rate for the lira is more than 1 per cent above the forward rate for the Belgian franc,7 which is inconsistent with the fact that spot rates can show only a 1 per cent divergence; it would also be inconsistent with the assumed expectation in the foreign exchange market of a downward shift of the intra-EEC band, which would allow a maximum depreciation of the Belgian franc. The forward premium of 0.5 per cent would permit Italy to keep its interest rate on three-month money no more than 2 per cent below the U. S. level.
If, however, there is no expectation of a movement of the EEC band, the maximum discount on the Belgian franc in the forward market is only 1 per cent in terms of the dollar (point G), and the maximum premium on the lira is also 1 per cent (point E). Belgium can keep its interest rate on three-month money 4 per cent above the U. S. level, and Italy 4 per cent below. Thus, the maximum interest differential between two EEC countries with margins reduced to ±1 per cent is 8 per cent per annum on three-month money; between any EEC country and the dollar area the differential is reduced to 4 per cent if no change is expected in the position of the EEC band relative to the dollar; if, on the other hand, a change is expected, the interest differential may be as large as 6 per cent or as small as 2 per cent.
As intra-EEC margins are progressively reduced, the same considerations remain valid. For example, a reduction of intra-EEC margins to ±0.25 per cent would allow a maximum interest rate differential between two EEC countries of 2 per cent on three-month money (annual basis). Vis-à-vis the United States, however, one country’s interest rate could be 1 per cent above the U. S. rate and the other 1 per cent below, or one 6 per cent above and the other 5 per cent above, or still 6 per cent and 5 per cent below, depending on expectations regarding future movements of the intra-EEC band and its initial position.
Once fluctuations between the currencies of EEC countries are no longer permitted in spot, and hence in forward, rates, there will be no room for other than marginal interest rate differentials between these countries. However, the maximum differential between EEC and U. S. interest rates will remain 6 per cent (as long as margins of ±0.75 per cent are maintained vis-à-vis the dollar and the EEC band is allowed to move to the full extent permitted). Monetary policy would then be of limited use as an instrument of stabilization in individual member countries unless they are all in the same economic situation and agree on similar monetary measures.8 Vis-à-vis the rest of the world, the EEC would be no more restricted in its interest rate policy than any individual member under the EMA system of fixed rates.
The examples discussed above are illustrations only. The figures quoted are extremes and are unlikely to occur under normal circumstances;9 they overestimate the degree of autonomy that EEC countries had in interest rate policy. A fair conclusion would seem to be that until margins are reduced significantly there would not, in practice, be any great loss of interest rate autonomy for member countries of the EEC compared with the position under fixed rates. With fixed rates their autonomy was already limited, owing to the degree of integration of financial markets and the fact that capital movements did take place without cover in response to interest rate differentials.
Selected Countries: Short-Term Interest Rates, 1965–70
Citation: IMF Staff Papers 1971, 003; 10.5089/9781451969276.024.A006
Source: Organization for Economic Cooperation and Development, Financial Statistics.1 Three-month certificates of deposit or time deposits; monthly averages.2 Three-month treasury bills; monthly averages.3 Day-to-day loans against private bills; end of period.Selected Countries: Short-Term Interest Rates, 1965–70
Citation: IMF Staff Papers 1971, 003; 10.5089/9781451969276.024.A006
Source: Organization for Economic Cooperation and Development, Financial Statistics.1 Three-month certificates of deposit or time deposits; monthly averages.2 Three-month treasury bills; monthly averages.3 Day-to-day loans against private bills; end of period.Selected Countries: Short-Term Interest Rates, 1965–70
Citation: IMF Staff Papers 1971, 003; 10.5089/9781451969276.024.A006
Source: Organization for Economic Cooperation and Development, Financial Statistics.1 Three-month certificates of deposit or time deposits; monthly averages.2 Three-month treasury bills; monthly averages.3 Day-to-day loans against private bills; end of period.Two additional points should be made: (1) as long as changes in the parities of EEC currencies remain possible, forward exchange rates may exceed the limits set by the intervention points and allow greater scope for interest rate differentials; and (2) if, on the other hand, parity changes are not expected, or are ruled out by agreement, the narrowing of margins can be expected to encourage uncovered movements of funds and thereby to increase the responsiveness of capital movements to interest rate differentials.
V. Implications for Movements of Official Reserves
An argument often used in favor of wider margins is that they would encourage equilibrating capital movements with a resulting reduction in movements of official reserves. If confidence in the parity exists, speculators are attracted by the potential for recovery in the rate when a currency reaches its lower intervention point, and the larger the potential gain, the larger the likely inflow. The resulting capital flow has a stabilizing effect and economizes official reserves that might have been expended to support the exchange rate. A narrowing of margins would reduce the potential exchange rate recovery and thus affect the volume of stabilizing short-term capital flows. Furthermore, if confidence in the parity were to be eroded, a narrowing of margins would reduce the risks of losses for those who were speculating upon a change in the parity. In such circumstances a narrowing of margins may, therefore, increase speculative movements of funds and, thus, losses of reserves.
However, under the proposed arrangements, the Community level for the dollar could be moved so as to allow one EEC currency to move from its lowest possible level to its highest possible level in terms of dollars. This uncertainty about the Community level of the dollar means that for speculators in non-EEC countries potential gains or losses from EEC exchange rate movements would be much the same as under the situation prevailing before May-August 1971.10
On the other hand, the narrowing of the EEC band would reduce the potential gain or loss to a speculator in an EEC country from a recovery in the rate of another EEC currency. Intra-EEC equilibrating capital movements might, therefore, be checked by the narrowing of the band.
On this basis, and leaving aside capital movements generated by a crisis of confidence in parities, one could assume that an EEC country with a weak currency might tend to “lose” reserves as a result of a narrowing of the band, even if the Community level for the dollar enabled that country to maintain its exchange rate at the potential floor against the dollar. In addition, when confidence in the existing parity is eroded, disequilibrating capital movements might be intensified, not only for the reasons just mentioned but also because an EEC country might be forced by the others to accept a movement of the band that would involve, e.g., an appreciation of its currency in the face of a balance of payments deficit and speculative attacks against the existing parity. This would happen when the currency was already at the bottom of the EEC band and a decision was reached to move the band upward.
On the whole, an EEC country might lose reserves because of the narrowing of the band: (1) if the Community level for the dollar does not allow its currency to be at its lowest potential level against the dollar; (2) if its currency is at its lowest potential level against the dollar but the speculative capital inflow remains below what it would have been without a narrowing of the band; and (3) if the country wants to pursue (for domestic reasons) an autonomous interest rate policy that entails large outflows of capital. With respect to (3), although an autonomous interest rate can no longer be used for domestic stabilization purposes, it does, nonetheless, become a more powerful instrument of balance of payments adjustment (to the extent that the narrowing of the EEC margins results in a greater responsiveness of capital movements to interest rate differentials).
To help member countries to face fluctuations in reserves that could result, inter alia, from the narrowing of the EEC band, the EEC countries have set up systems of short-term and medium-term assistance (see Section II). The amount of assistance available is sizable, but only part of the short-term assistance is available “automatically.”
VI. Significance of the Proposals
The proposal to narrow the EEC band for exchange rate movements involved self-imposed limitations in exchange rate flexibility at a time when calls for greater flexibility in the international monetary system were being heard with increasing strength and frequency. These limitations implied a reduction in autonomy for interest and, consequently, monetary policy and a relatively greater need for the participants to hold reserves.
It is therefore important to restate the purpose of the proposal: it was to be viewed as a first and transitory step toward the goal of monetary union, i.e., toward “the full and irreversible convertibility of members’ currencies, the elimination of exchange rate fluctuations within the union, and irrevocably fixed par values.” A question that was raised within the Ansiaux Committee, however, was whether this step was essential and whether it needed to be taken at such an early stage of the integration process. Some of the doubts expressed are reported below.
With fixed exchange rates and relative freedom of capital movements, it remains possible, as long as the EEC countries’ price levels can develop in different directions, that existing parities will come under pressure and a narrowing of margins would make the defense of these parities more difficult. Also, until more progress has been made toward economic integration and harmonization of policies, conflicts of interest may arise in the determination of the Community level for the dollar. The latter would depend partly on the results of a consultation process. Even if the resulting average level of the EEC currencies’ exchange rates against the dollar were to be the same as it would have been without a narrowing of margins, the position of individual EEC countries might be different, and they might experience balance of payments difficulties until such time as a fully automatic system of payments compensation among the ECC members has been introduced.
The representatives of one of the five central banks on the Ansiaux Committee thought it preferable to wait until the harmonization of the member countries’ policies had progressed sufficiently to abolish exchange rate margins.11 They doubted whether a narrowing of margins would by itself lead to harmonization of economic policies. While cooperation among central banks would increase, monetary policy would become less capable of offsetting inadequate coordination of other policies, particularly fiscal policy.
The majority of the Ansiaux Committee was, nevertheless, of the opinion that a progressive reduction of margins was preferable to their complete elimination without any transition period. A complete once-for-all removal of the spread between currencies would be too drastic a step: it assumes a high degree of harmonization of policies and institutional arrangements for a joint management of foreign exchange markets, possibly through a central authority similar to the Federal Reserve Board. They did not dispute, however, the contention that a narrowing of intra-EEC margins could create potential difficulties if the harmonization of economic policies was insufficient. Indeed, the Communiqué of The Hague Meeting had acknowledged this possibility when it stated that “the development of monetary cooperation should be based on the harmonization of economic policies.”
The advantages of establishing an EEC monetary bloc taking a common position vis-à-vis the rest of the world was also emphasized by some of the supporters of narrower intra-EEC margins. From this point of view, the proposal discussed here would have had the benefit of forcing, to some extent, the EEC members to reach a common policy regarding international monetary problems, if only because of their need to select the level of the EEC band relative to the dollar.
VII. Conclusion
The practical effect of a narrowing of the margins of exchange rate fluctuation between the EEC currencies would have been to circumscribe exchange rate movements in terms of the dollar—the intervention currency—within a narrower band than the one of ± 0.75 per cent on either side of par prevailing at the time. The narrower band would, however, have been free to move within the wider band of fluctuation against the dollar. Movements of the EEC band would have resulted from a joint decision of the five EEC central banks. A progressive narrowing of margins could eventually lead to their elimination and result, for all practical purposes, in a single currency, which would be allowed to fluctuate against the dollar to the extent permitted by the rules of the International Monetary Fund and the European Monetary Agreement.
One must distinguish the implications of the proposal for individual EEC countries from those for the EEC as a whole. For the individual member countries a narrowing of margins implies some loss in exchange rate flexibility, which, in turn, means some reduction in autonomy for interest rate and, consequently, monetary policy and a greater liability to fluctuations in official reserves. The EEC as a whole, however, would have retained the same degree of exchange rate flexibility that its member countries had at the time of the agreement; this can be seen most clearly in the final stage when margins would be completely eliminated and all currencies free to move en bloc within the permissible band vis-à-vis the dollar. Movements of the EEC currencies within this band, however, would have implied an agreement by all member countries, although in the final stages the decision would probably be taken by a Community institution, such as a common central bank.
Although the agreement reached between the EEC central banks on a narrowing of margins could not be implemented, some of the reasons behind it have not disappeared. In particular, if the EEC is to achieve monetary unification, fluctuations of the member countries’ currencies against one another will eventually have to be eliminated. This is reflected in various EEC proposals for dealing with the problems arising out of the events of May-August 1971, such as a widening of margins against non-EEC currencies while retaining 0.75 per cent margins within the EEC, or a “joint float” by the EEC currencies. This last proposal was enacted by the Benelux countries among themselves: on August 23 the Netherlands Bank and the National Bank of Belgium agreed to support each other’s currency so as to keep them within margins of 1.50 per cent on either side of parity (expressed in the other country’s currency), while the two currencies would float jointly vis-à-vis the rest of the world. By contrast, the narrowing of margins agreed upon by the EEC central banks early in 1971 would have been a more modest step toward a monetary union but it would also have minimized potential difficulties.
APPENDIX
The following example will illustrate the operation of narrower margins (±1 per cent) between EEC currencies. Let us assume that the Italian lira has weakened relative to the dollar to the floor of its permissible margins of fluctuation, i.e., to U. S. cent 0.1588. Should the Belgian franc be strong, it will not be able to appreciate to the ceiling of its band vis-à-vis the dollar, i.e., U.S. cents 2.015, because this would imply a cross rate between the Belgian franc and the lira of BF 1 = Lit 12.69 (2.015 ÷ 0.1588), which is outside the agreed EEC band. The most the Belgian franc can appreciate is to U. S. cents 2.005 (Table 1).
Dollar Exchange Rates and Cross Rates for the Belgian Franc and the Italian Lira with Narrower Intra-EEC Margins
A = potential ceiling and floor resulting from ±0.75 per cent margins against the dollar. B = permissible ceiling (and floor) rates consistent with ±1 per cent intra-EEC margins, in the event that one EEC currency is at the floor (or ceiling) of its band of fluctuation with the U.S. dollar.
Dollar Exchange Rates and Cross Rates for the Belgian Franc and the Italian Lira with Narrower Intra-EEC Margins
| Belgian Franc | Italian Lira | ||||
|---|---|---|---|---|---|
| In U.S. cents | In Italian lire | In U.S. cents | In Belgian francs | ||
| Parity | 2.00 | 12.50 | 0.16 | 0.08 | |
| Ceiling 1 | |||||
| A | 2.0150 | 12.6875 | 0.1612 | 0.0812 | |
| B | 2.0050 | 12.6250 | 0.1604 | 0.0808 | |
| Floor 1 | |||||
| A | 1.9850 | 12.3125 | 0.1588 | 0.7880 | |
| B | 1.9950 | 12.3750 | 0.1596 | 0.7920 | |
A = potential ceiling and floor resulting from ±0.75 per cent margins against the dollar. B = permissible ceiling (and floor) rates consistent with ±1 per cent intra-EEC margins, in the event that one EEC currency is at the floor (or ceiling) of its band of fluctuation with the U.S. dollar.
Dollar Exchange Rates and Cross Rates for the Belgian Franc and the Italian Lira with Narrower Intra-EEC Margins
| Belgian Franc | Italian Lira | ||||
|---|---|---|---|---|---|
| In U.S. cents | In Italian lire | In U.S. cents | In Belgian francs | ||
| Parity | 2.00 | 12.50 | 0.16 | 0.08 | |
| Ceiling 1 | |||||
| A | 2.0150 | 12.6875 | 0.1612 | 0.0812 | |
| B | 2.0050 | 12.6250 | 0.1604 | 0.0808 | |
| Floor 1 | |||||
| A | 1.9850 | 12.3125 | 0.1588 | 0.7880 | |
| B | 1.9950 | 12.3750 | 0.1596 | 0.7920 | |
A = potential ceiling and floor resulting from ±0.75 per cent margins against the dollar. B = permissible ceiling (and floor) rates consistent with ±1 per cent intra-EEC margins, in the event that one EEC currency is at the floor (or ceiling) of its band of fluctuation with the U.S. dollar.
Conséquences possibles des propositions visant à réduire les marges de fluctuation des taux de change entre monnaies de la CEE
Résumé
Dans cette étude, les auteurs examinent le fonctionnement d’un système de marges plus étroites comme celui qui avait été convenu par les banques centrales de la Communauté Economique Européenne (CEE) et qui devait entrer en vigueur le 15 juin 1971 mais dont l’application a été ajournée, ainsi que ce qu’un tel système implique pour la flexibilité des taux de change, la politique des taux d’intérêt et les variations des réserves officielles. La caractéristique fondamentale du système qui avait été adopté était que les marges de fluctuation des taux de change entre les monnaies de la CEE seraient réduites sans pour autant réduire les marges entre les monnaies de la CEE et le dollar E.U. On aurait atteint cet objectif en rétrécissant la bande à l’intérieur de laquelle on aurait laissé fluctuer les monnaies de la CEE vis-à-vis du dollar à un moment donné mais en laissant cette bande se déplacer dans le temps à l’intérieur des limites existantes (ou, peut-être, de limites plus larges). Le niveau de la bande serait déterminé d’un commun accord par les banques centrales de la CEE. Cela signifiait que la CEE, considérée en tant que groupe, conserverait pour ses taux de change, sur une longue période, le même degré de flexibilité dont jouissaient alors ses membres, mais que chaque pays de la CEE pris individuellement ne serait pas en mesure à un moment donné d’utiliser pleinement les marges de fluctuation autorisées vis-à-vis du dollar.
Ce système implique également, pour les pays participants, une limitation de leur autonomie dans le domaine de la politique des taux d’intérêt car, en l’absence de toute spéculation portant sur un changement de parité, l’ampleur autorisée des fluctuations du cours au comptant limite les primes ou les décotes des cours à terme, et, par conséquent, les écarts entre taux d’intérêt qui peuvent se manifester avant que commence l’arbitrage. La CEE dans son ensemble jouirait, toutefois, vis-à-vis du reste du monde d’une marge d’autonomie plus large dont le degré effectif serait fonction des limites à l’intérieur desquelles on laisserait fluctuer la bande de la CEE.
En ce qui concerne les variations des réserves officielles, le système préconisé pourrait avoir un effet déstabilisant, c’est-à-dire qu’un pays membre de la CEE ayant une monnaie “faible” perdrait des réserves : 1) si le niveau de la bande de la CEE ne permettait pas à sa monnaie d’être à son niveau potentiel le plus bas vis-à-vis du dollar; 2) parce que, même s’il était à son niveau le plus bas vis-à-vis du dollar, le rétrécissement des marges à l’intérieur de la CEE réduirait le gain potentiel pour les spéculateurs dans les autres pays de la CEE, et, par conséquence, les entrées de capitaux stabilisatrices.
Le système proposé impliquait ainsi des limitations volontaires de la flexibilité des taux de change et comportait le risque de mouvements de capitaux déstabilisants. Le degré minime du rétrécissement proposé aurait toutefois réduit au minimum les difficultés possibles, et ce rétrécissement aurait constitué une première étape vers l’union monétaire et la complète élimination des fluctuations des taux de change à l’intérieur de la CEE.
Trascendencia de las propuestas para estrechar los márgenes de fluctuación de los tipos de cambio entre las monedas de la CEE
Resumen
En este trabajo se estudia el funcionamiento de un sistema de márgenes más estrechos, como el acordado por los bancos centrales de la Comunidad Económica Europea (CEE), previsto para entrar en vigor el 15 de junio de 1971, pero que luego quedó aplazado, y su trascendencia, en cuanto a la flexibilidad de los tipos de cambio, la política del tipo de interés, y los movimientos en las reservas oficiales. La característica esencial del sistema que se había seleccionado era que se estrecharían los márgenes del tipo de cambio entre las monedas de la CEE, sin estrechar los márgenes entre las monedas de la CEE y el dólar de EE.UU. Esto se habría logrado estrechando la banda dentro de la cual se permitiría que las monedas de la CEE fluctuaran frente al dólar en un momento determinado, pero permitiendo que dicha banda se moviera a través del tiempo dentro de los límites existentes (o, quizás, otros más anchos). El nivel de la banda quedaría determinado mediante un acuerdo entre los bancos centrales de la CEE. Esto significaba que aunque el conjunto de la CEE retendría, a lo largo del tiempo, el mismo grado de flexibilidad del tipo de cambio que disfrutaban entonces los países miembros, los distintos países de la CEE no podrían hacer uso pleno en un momento determinado de su margen permisible de fluctuación frente al dólar.
El sistema implicaba también una limitación en el grado de autonomía que tendrían los distintos países en el campo de la política del tipo de interés, porque, no habiendo especulación respecto a las variaciones en la paridad, el ámbito permitido de fluctuación del tipo de cambio al contado limita las primas o descuentos de los tipos de cambio a plazo e, igualmente, las diferencias de tipos de interés que pueden surgir antes de que comience el arbitraje de intereses. No obstante, el conjunto de la CEE disfrutaría de un mayor grado de autonomía frente al resto del mundo, dependiendo de los límites dentro de los cuales se permitiera fluctuar a la banda de la CEE.
Por lo que se refiere a los movimientos en las reservas oficiales, el sistema propuesto podría ser desestabilizador, ya que un país de la CEE con moneda “débil” perdería reservas 1) si el nivel de la banda de la CEE no le permitiera a su moneda llegar al nivel más bajo posible frente al dólar, y 2) porque, aun si se hallaba a su nivel más bajo frente al dólar, al estrecharse los márgenes dentro de la CEE se reduciría la ganancia potencial de los especuladores en otros países de la CEE, así como las entradas equilibradoras de capital.
De modo que el sistema propuesto implicaba la imposición sobre sí mismos de limitaciones en cuanto a la flexibilidad del tipo de cambio y comportaba el peligro de ocasionar movimientos de capital desestabilizadores. Sin embargo, la moderada dimensión del estrechamiento propuesto habría minimizado los posibles inconvenientes, y habría constituido un primer paso hacia la meta de la unión monetaria y la completa eliminación de las fluctuaciones de tipos de cambio dentro de la CEE.
Miss Lambert, a graduate of the University of Liège and of Yale University, was an Assistant Division Chief in the European Department of the Fund when this paper was prepared. She is now an Advisor in the Studies Department of the National Bank of Belgium.
Mr. de Fontenay, a Senior Economist in the European Department, is a graduate of the Universities of Aix-en-Provence and Paris and of Yale University.
The Executive Directors of the International Monetary Fund decided on July 24, 1959 that “the Fund does not object to exchange rates which are within 2 per cent of parity for spot exchange transactions between a member’s currency and the currencies of other members.” (Selected Decisions of the Executive Directors and Selected Documents (Washington, Fourth Issue, April 1, 1970), p. 16.)
In the absence of “concerted” action, the system could lead to conflicting interventions in the market, as it would be technically possible for any EEC country to neutralize the action of another EEC country in the foreign exchange market by selling or buying the currency of the latter.
The narrowing of the band could, however, lead per se to some accumulation of dollars by the EEC central banks. The private sector used to trade internationally in dollars and to hold dollars, inter alia, because the maximum exchange loss on dollars—owing to a fluctuation of the rate within the ± 0.75 per cent band—was only half of the maximum loss on other currencies. A narrowing of the EEC band would reduce, pari passu, the risk involved in holding uncovered EEC currencies. To the extent that it might induce private holders to shift to EEC currencies, it would increase the amount of dollars that EEC central banks would have to buy on the market.
The discussion that follows assumes an absence of speculation regarding parity changes, so that spot and forward exchange rates are expected to remain within the prevailing intervention points, and freedom of capital movements.
Assume that the Belgian franc is at its maximum of 1 per cent above parity with respect to the Italian lira, and the interest rate on three-month money is 8 per cent per annum higher in Belgium than in Italy. If the Belgian franc and the lira are expected to completely reverse their relative positions in three months, so that the lira ends up 1 per cent above parity with respect to the Belgian franc, the cost of forward cover, i.e., the difference between the spot rate of Lit 12.626 to the Belgian franc and the forward rate of Lit 12.375 (Table 1, in the Appendix) would, in principle, offset the interest rate differential for an Italian investor.
Including, for this purpose, the Euro-dollar market.
Both expressed in dollars.
By contrast, fiscal policy would become more effective: fiscal restraint, e.g., would normally produce a lowering of interest rates, which, in turn, would generate capital outflows that would reinforce the initial policy measures. See William Fellner, “Specific Proposal for Limited Exchange-Rate Flexibility,” Welt-wirtschaftliches Archiv, Band 104, Heft 1 (1970), pp. 20–35.
As can be seen from Chart 3, actual interest rate differentials in the past have remained well below their theoretical maximum values, even though forward exchange rates were permitted, at times, to exceed the intervention points. However, Chart 3 underestimates interest rate differentials because it is based on monthly averages or end-of-period figures.
Prior to May–August 1971, speculators had to assess only the likelihood of recovery of one currency against the dollar. After a narrowing of the EEC band, they would have had to assess the combined likelihood of recovery of one currency and of upward movement of the band. The latter may reduce the likelihood of future maximum appreciation of a weak currency if it is believed that the band will not be raised enough to allow that currency to appreciate to its highest potential level against the dollar. On the other hand, it may reinforce the likelihood of a future small appreciation of a weak currency if there are good reasons to believe that the Community level for the dollar will move upward in the near future (because one or more of the other EEC currencies is at the upper limit of the band, pulling up the rate of the weaker currency). The final result of speculators’ expectations on capital movements is obviously difficult to assess.
Similar views were expressed by Mr. Emilio Colombo, when he was Minister of the Italian Treasury. See also Rinaldo Ossola, “The European Economic Community at the Crossroads,” in Essays in honour of Thorkil Kristensen (Organization for Economic Cooperation and Development, 1970), pp. 91–134.
