What of volatility in the reformed EMS ?

P. Praet, J. Romainville *

1. Currency risk perceptions

The ERM crisis which has resulted in the widening of the fluctuation bands for most currencies to 15 % has led to a surge in demand for currency and interest rate hedging instruments. Resources are being added in terms of economic and financial research, product development, back office, etc to supply these products. The high exchange rate and interest rate spread volatilities within Europe have also increased the cost of the products based on historical volatility.

This is in sharp contrast with the tendency which has prevailed in recent years, in particular within the so-called group of core EMS currencies. These currencies had for a number of years been characterized by both reduced exchange rate volatility and reduced interest rate spread volatility. As a result, the demand for cur-rency hedging instruments within these countries had fallen significantly.

Today, market participants are still influenced by the considerable volatilities observed during the last two years. Lack of a reference value to "normal" volatility in the reformed system is likely to lead not only to fast-growing demand for currency and interest rate derivatives for European currencies, but also to a further concentration of these activities among a small group of large and well capitalized institutions only (supposedly) capable of supplying good counterparty risk.

It is indeed hazardous to predict what volatility will be like in the coming years. The broadening of fluctuation margins was intended to create more uncertainty for "speculators" and thus fewer "one way bets" on the foreign exchange markets. In fact its purpose should rather be to reduce extreme volatility in crisis periods, i.e. chaotic currency adjustments following long pe-riods of exchange rate stability.

Chaotic corrections of exchange rate misalignments are no doubt more damaging to business than more frequent but smoother correc-tions; but will the reformed system deliver the kind of smooth volatility that business can live with ? European firms are unlikely to assume that it will be the case. Evidence of floating rates shows that even in countries with good inflation credentials and an independent central bank, the financial markets' reactions to political or other events can be quite out of proportion (see for example the recent behaviour of the New Zealand dollar). Currency expectations will perhaps be based on the assumption of some stability in the real exchange rate, but with the permanent fear of occasional chaotic conditions. The present currency crisis is not only damaging to the internal market because of the increased transaction costs that it implies, but also because of the fear of acute crisis periods on the foreign exchange markets, and high interest rate volatility in countries with good inflation records has been particularly damaging to business confidence. For example, in Belgium the short-term interest rate spread with Germany increased from -50 basis points in July 1993 to 590 basis points in September 1993. The sharp inversions of yield curves during currency crises were also detrimental to the profitability of financial intermediaries and contributed to the climate of extreme caution in the supply of bank credit. Business also suffered from the broadening of spreads on foreign exchange operations in periods of tension.

Increased uncertainty is not conducive to investment and growth; perceptions of unfairness during currency crises are not conducive to a positive climate of market liberalization.

2. Market-imposed discipline in the reformed system

One important feature of the discipline of the former EMS was the non-accomodation of inflation differentials through currency realig-nments. Schematically, from 1979 until 1983, the purpose of realignments was to offset imbalances in competitiveness created by inflation differentials. From 1984 to 1986 however, realignments only partially compensated for inflation differentials, and from 1987 to September 1992 realignments were avoided. The main idea was that if such a rule were credible (ie the "no bailing-out" of excessive wage claims through currency depreciation) price and cost discipline would ensue.

Lack of flexibility in nominal exchange rates led however to a persistent real appreciation of the currency in several countries and to excessive rallies on their bond market. In the real depreciating currencies it created a false feeling of security in terms of competitiveness, reducing the pressure for adjustment to market developments. When exchange rate cor-rections came with their unavoidable overshootings, many firms felt unfairly treated as revealed by the continuous complaints of "competitive devaluations".

The crisis also revealed that stability on the foreign exchange markets needs much more than just fulfilling of the Purchasing Power Parity condition (inflation convergence). The speculative attacks on countries with good inflation fundamentals reminded us of the importance of policy-mixes for orderly conditions on the foreign exchange markets. It is now well recognized that the inappropriate policy-mix of the anchor country has led countries with low inflation to follow sub-optimal policies. Since monetary policy was constrained by the exchange rate commit-ment, a country like France had for a while a too restrictive policy-stance overall. Something had to give. The market (wrongly) speculated that it would be monetary policy; but it was fiscal policy. It is ironic to see that France has progressively been led to adopt (although to a lesser degree) the unsound policy-mix of Germany.

Rightly, the new President of the European Monetary Institute has stressed that one the main tasks of the Institute would be to address the problem of "policy-mix" within the European Union. Addressing the problem does of course not solve it. In the simple Mundell-Fleming frame, the question of policy-mix is crucial for determinating exchange rates. However in the real world, the dynamics of exchange rates is much more complicated. There are in particular many difficult questions related to the formulation and transmission mechanisms of policies on the economy which both will give speculators plenty to get their feeding. No doubt, guesses as to the political will to pursue a long-term strategy of fiscal consolidation will be an important factor in determining currency expectations as it is increasingly recognized that a major issue for the coming years will be the problem of social consensus. The liberalization of product and financial markets throughout the world changes the very nature of our democracies by increasingly limiting the choices of governments in main policy decisions (eg distributional objectives) and on the timing of policies. Policy-makers find it increasingly difficult to conciliate the pressure of the capital markets with voters' preferences. In a recent comment in the Financial Times, W. Nilling former member of the Bundesbank Council and President of the Hamburg Landes-zentralbank between 1982 and 1992, expressed the view that: "It is no exaggeration to speak of an abdication of democracies in the face of anonymous, uncontrolled market forces"" and suggested that: "... a tax on speculative currency movements (...) could have a stabilizing effect" ( 22 oct. 93).

Since one can be sceptical on the feasibility of control-ling (selected) capital movements (not to mention the question of need), the ability of governments to steer the economy under the pressure of both capital markets and voters will be a crucial element in the formation of currency expectations. As the preferences of capital markets may not be consistent with voters' preferences, policy-makers' ability to govern with such opposing forces will be a determining factor for the stability of currency markets. For example after the liberal victory in the October 93 elections in Canada, the Financial Times reported: "Economists say a lot depends on whether rating agencies downgrade Canadian govern-ment debt at the first sign of an expansionary policy" (27 oct. 93). The pressure of capital markets for fiscal discipline can be considered as a positive factor for European economies. However the timing imposed by markets on policies is often sub-optimal. For example measures can be taken too quickly under market pressure in order to benefit from an announcement effect, but without sufficient political or social consensus or even technical work.

Another major issue revealed by the crisis is related to the transmission of monetary policies in the different countries. Community-wide monetary policy shocks appeared to have asymmetrical effects as a result of important differences in the financial structures of the countries: level of private and/or public debt, degree of bank intermediation, profitability of banks, relative impact of short term and long term interest rates on economic activity, etc. The question of an appropriate policy-mix cannot be based solely on an assessment of public finances, but should also take into account all aspects of monetary policy. For example to what extent do optimal domestic policy-mixes differ from country to country to taking into account the different financial structures of the economies ? It is not enough to say that for each country fiscal policy can only be more restrictive in the coming years and monetary policy softer.

3. The monitoring of the reformed EMS

The surveillance role of the EMI on exchange rate developments in the European Union could (and should) become much more important than many analysts foresee.

The following can be singled out :

- The past crisis has shown that the monetary authorities have not taken sufficient notice of the opinions of market analysts in drawing up their policies. Efficient interventions on the foreign exchange markets with a view of smoothing market trends (cf the fear of "acute currency crisis" by businessmen) require good research capabilities on a pan-European basis ("market watchers" are too often absent in Central Banks). The capacity of Central Banks to anticipate the markets' next moves has often been surprisingly weak. Research should focus on cyclical divergences within the Union, the problems of policy-mix, etc. In this way, monetary policy coordination could be (modestly) improved.

- Markets need to be continuously re-assured as to the long-term commitments of countries in terms of price stability and fiscal consolidation. The formal inde-pendence of national central banks and the elaboration of convergence reports by governments are not sufficient to satisfy markets

The following could improve the Union's credibility :

- The publication of quarterly "inflation reports" (along the lines of the report prepared by the Bank of England) and "public finance reports" for the European Union and its different member states would signal that the continuous and collective surveillance of national policies is not only the privilege of the international capital markets.

- These "inflation reports" should not only analyze to what degree inflation is under control and comparable between countries, but also discuss issues related to the level of prices. Similar inflation rates do not necessarily mean the absence of imbalances.

- "Public finance reports" should in particular take into consideration the sources of the deficits (consumption or investment, cyclical or structural, etc).

- The clarification (in legal terms) of the restrictions on the financing of budget deficits (eg monetary finance) and a special comment in the "public finance reports" on this issue should be a priority.

- The elaboration on a regular basis of broad guidelines of the economic policies of the Member States (as foreseen) endorsed by the national Parliaments would send clear messages of a large socio-political consensus at the national level on coherent Europe-wide policies.

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These proposals are more difficult to implement than it may seem as they imply a large autonomy of judgement on the part of the EMI not found at present in international organizations. They are also unlikely to reduce business perception of the risks of acute foreign exchange crisis related to specific political or other events. Crisis management has clearly to be improved in the European Union. Although the precise role that the EMI could play in the management of acute currency crises is likely to be controversial for a while, the pooling and processing of sensitive information for currency markets by a European staff of central bankers could be a first step.