Risks the EMU could face during the phase 3A

Gilles Marion (*)


What will happen when Europe enters a Monetary Union ? This question hurts the financial markets, as no clear answer could be given to it, and they do not appreciate uncertainty. As a once overall changeover into the single european currency is not possible, the third stage foreseen in the Maastricht Treaty might be divided into three subperiods. These periods are the consequences of the possible time delays existing between the happening of three main changes paving the way for achieving the EMU.

The Countries will enter a EMU through the fixing of parities, which is the main change to the present EMS. Then, a foreseeable second sub-stage would begin with the use of Ecu by the European Central Bank as means of monetary policy. The EMU will be only achieved when the third event occur : the use of Ecu coins and banknotes by all citizens. "The Expert Group on the changeover to the Single Currency" predicts that a unique Big Bang is not foreseable, what implies that there will be a succession of smaller Bangs, especially between the last two events, the main one consisting of banks and corporates being obliged to use Ecus (1). But nothing is told to the financial markets on the timing, especially on how long will last the period 3A. This period begins with the fixing of parities and lasts untill Ecus are used for monetary policy purposes.

Theoritically, this is period represents by itself a EMU, but obviously this would not achieve the aim asserted in the Maastricht Treaty. Moreover, while analysing this period, we can find out that this period is the most dangerous one of the whole process.

If we shall fail, then no EMU with single currency would be realised. Indeed, in order to secure the path towards the aim, two main risks must be taken into account : the credibilty of the whole system, and the policies which must be implemented.


I. THE CREDIBILITY OF THE SYSTEM

The Maastricht Treaty asserts that parities will be fixed between choosen currencies, once we know which countries are allowed to enter the EMU. We can hold for sure that the markets will keep on speculating on the parities linking currencies belonging to the "core"-EMU (with fixed parities) and those remaining outside it and which fluctuate aside in the then new implemented EMS. But it is really difficult to foresee the influence financial markets would have on the "core" : could the irrevocably fixed parities be revised under financial market pressure ? The case is to be studied, in particular if the period between the fixing of parities and the use of Ecu as the single means of monetary policy and interventions lasts too long.

What happens if the players in the financial market estimate that the Deutsche Mark is worth more than 3,395 French Francs, for example that 3,60 should be the real parity ? This could occur because, before Ecu becomes the single currency, national currencies might still be traded on financial markets. As long as they do not merge in a replacing supranational single currency, currencies will still be seen as the product of a country, whose economy may not evoluate in the same way as that of the other countries linked through fixed parities. As long as many currencies exist in a Monetary Union, market players will value them, in regard of their relative performances (labor costs, productivity, etc). Some people think this will be no longer the case, as they are identificating fixed parities to unified economy. Practically it is not true : a currency is mainly the mirror of an economy, and fixed parities should mirror economies fluctuating in parallel. Clearly, fixed exchange rates can survive in the long run only if the economies move in a parallel fashion. This was the origin of the Mexico Peso crisis, because the economies of the USA and Mexico were not converging. In such cases, the problem originates in the setting of the original level of fixed exchange rates and develops due to the possible incapacity of the countries to regulate their differences or manage economic crises, thus setting the implicit exchange rates (applying to foreign trade) at unrealistic levels which are incompatible with the economic outlooks.

Moreover, we can think that the core countries which will fix their parities will be the "best" ones, as they are fulfilling the convergence criteria. They will apparently have the lowest interest rates levels. So, if a Member-State allows the public debt and deficit grow (by simply acting as a free rider), it thereby pressures long term interest rates which could hence no longer converge (in contradiction to what economic theory suggests in the case of a Monetary Union). This was the case in the Bretton Woods System, which collapsed in 1971 due to the debt and deficits of the USA, which were no longer accepted by France and Germany.

There is another case which should be taken into account : an eventual political crisis. If a representative political leader wants to leave the system of fixed parities, then he will put the whole system in danger. An example of this is the confidence crisis which occured against the canadian dollar, when a growing number of people expressed their will of independance of Quebec.

The international markets have few possibilities to directly pressure fixed exchange rates, but they could bring the European Monetary Union to bursting point, if no common fiscal policy is conducted throughout the Union. This probability is very low, because the countries would have to respect converging criteria, especially on foreign debts and public deficits, otherwise the exchange rates will no longer correspond with their fair value, which equals the value ratio of the economies.

A question has to be answered before we could enter a Monetary Union : what will happen if a country goes bankrupt ? If transferts are agreed, then the insolvent country would be refunded (and its currency disappear) ; if not, should it leave the Union ? We should not forget that if the system appears to be shivering because of internal crises, then it might collapse due to incredibility : why should the financial markets have confidence in a system which would not be internally trusted ?

For example, to speculate on the parities between the "core" currencies is equivalent to speculate on the parities between Francs of Belgium and Luxemburg. Therefore, in order to avoid internal crises, which are dangers for the Union during this period 3A, its members must at least cooperate and coordinate their fiscal policies, the best being to lead a common fiscal policy. If it is not the case, the system could be brought to its bursting point, especially if the delay before a single currency circulate lasts so long that an interest rate crisis could occur.

The markets haven't much opportunity to react and force European countries to revise the parities, but they will use any chance they would have.


II. THE REQUIREMENTS OF PEGGING

To give as few opportunities as possible to the markets, some conditions must be respected between the currencies. linked through fixed parities. Indeed, pegging currencies to each other has three main implications.

First of all, parities are irrevocably fixed. This implies that the present spot is the one which will continuously applies, any time in the future been considered. In the markets, the future spot can be priced and is known as the forward price of the currency. Pegging a currency to another one implies then the continuous equality of the forward exchange rate to the spot exchange rate. This means that there are no longer any deports nor reports. This suggests the continuous equality of the interest rates, which can be expressed as followed : pegging a currency to another one requires, for the stability of the relation in the long run, that both yield curves attached to the currencies are merging in a single one.

Secondly, pegging requires that if any difference should occur, due to any reason, the Central Bank should act to oppose any appreciation or depreciation of its currency, which asks the question of interventions.

Thirdly, it requires that the Central Bank has enough capacity to act and react, which is a problem of credibility.

Imagine that a currency is attacked : pegging requires that there is no response on the yield curve. This means that even if the financial markets have a direct access to national currencies, no "hot money" searching for higher yields will move from a core currency to another one (as there is a single yield curve applying to the different currencies). But if this condition cannot be respected (i.e. interest rates rise to defend a parity) then room is made for a possible divergence, leaving hence place for "hot money" to move. But the question is : how can the European Central Bank implement a single unified yield curve and defend it ?

The only answer to this question is to get an integrated money market. This means that the countries accept to let the European Central Bank manage their own currency, implying that if one part of the core is under pressure, then the currency may no longer circulate (being replaced by other ones). Indeed, from the point of view of the European Central Bank, all national "core"-currency are different faces of a same monetary aggregate. This has nothing to do with costs in terms of foreign exchange reserves of the Central Banks, as was the case in every crisis the EMS went through ; the adjustments will take place, not between the currencies linked through fixed parities, but between the Union and all the other currencies. Indeed, foreign reserves of the European Central Bank will consist of such currencies as the American Dollar or the Japanese Yen, where Deutsche Mark, French Franc and other European "core" currencies belong to its monetary aggregate. So, if the whole market wants to buy Deutsche Mark, the European Central Bank will issue them but will issue less French Francs or other currencies, leaving the aggregate unchanged. This suggests that issuing French Francs is equivalent to issuing Deutsche Mark to the European Central Bank and that any commercial bank can change its Francs into Deutsche Mark without any transactions costs, implying an integrated money market between core currencies.

The consequence is that in such a market all currencies belonging to the EMU should have legal tender too in the other countries belonging to it and are totally equivalent. Moreover, to secure fixed parities, some signals should be sent in advance by the European Central Bank to the financial markets regarding for example its targets (if any) and its instruments, which already expresses a need for harmonization in the national monetary policies. If this is reached, then credibility could be granted to the European Central Bank.

In their interim report, the "Group of experts" seems to be certain Ecu will naturally be granted such a strength. It is not so sure. Credibility is long to be granted but can vanish quickly. In the case of the Ecu, its strength is dubious as the System of European Central Banks may not have as much credibility as the Bundesbank has in the market. Indeed, the german Central Bank is independant since over 40 years with clearly defined aims, when other Central Banks became independant in the last recent years. So, nobody can predict how the European Central Bank will react : will it have a real independance from national political powers will be a main issue of its credibility ; to give the European Central Bank an anti-inflationary aim is not enough.

Credibility will be imported from the Bundesbank to the European Central Bank, but this could be offset if too many non-(or few-) credible Central Bankers belong to the European Central Board of Directors. Credibility is necessary to cope up with financial pressures. Indeed, while not all the currencies take part in a fixed exchange rate mecanism, the financial markets can speculate on the relationships linking the currencies in the newly created EMS, where certain currencies acknowledge fixed parities and others limited floating rates. Therefore, EMS crises could still arise in the third stage, between countries entering the strictly defined Monetary Union and the others. This could oblige the European Central Bank to intervene (in which currency ? it is still not known), which in the end means it wants to make up for market forces through use of credibility (although it is not sure that it is credible). A failure would undoubtedly injure the strength of the currency, although the aim is to grant Europe with a strong currency in its own rights.

But there is another issue : how will the Ecu be supported if it is not the single currency of the European Central Bank ? Indeed, if the Ecu is not used as the intervention means and announced to be the single instrument used by the European Central Bank, there is no reason why the financial markets should use the Ecu, which implies that Ecu should not be merely a paralell currency. Surely strength comes inside out from the ability of the Central Bank to achieve its aim, but this must be perpetuated through a self-fulfilling process, which can be quickly interrupted by the markets. Thus, to ensure a strong single currency, the role of the Ecu must be originally clearly defined, which is not the case.

The Group of Experts holds for unavoidable that the Ecu will co-exist with national currencies, for an unlimited time period. The strengh of the Ecu will come from its utility which has to be prepared during the phase 3A. In particular, it should be clearly announced how Ecus wil be used : is it a parallel or a common currency ?

On one hand, if the European unit were to circulate parallel to the national currencies, then its strength will not really be intern but will come out the strength ofthe different parts linked together in the basket, and then we could wonder if the composing national currencies are strong and notice that if a crisis on one currency occurs then the strength of the Ecu is endangered .

On the other hand, if the Ecu was the common currency for the whole Union as soon as a deal concerns any agent outside the Union, foreign agents wouldn't then have access to the national currencies, which obviously eliminates the chances of a speculative attack : only those taking part in the Monetary Union would have access to the national currencies in the Union and it would not be in their own interests to destabilise the system of fixed exchange rates. But this means that the Ecu will be used for intervention purposes and for the monetary policy, which is not foreseen for the period 3A.

Analysing the succession of sub-periods, we can conclude that in order to achieve the construction of the EMU some highly political conditions must be respected. The fixing of parities is different from entering a EMU and does not ensure the stability of exchange rates if an integrated economy is not previously achieved. This integration should attempt completing an integrated money market without any transaction costs and prevent from non-parallel shift in economical evolutions. Otherwise, the system may not survive any internal crises which could endanger the credibility of the choosen path towards single currency.

To secure this way, we might suggest that : first of all, the parities are fixed at economically sustainable levels ; secondly, the periods don't last too long ; thirdly, the fiscal policies are coordinated, and even better should be unified, underlying the need for a political union.

30-03-1995


(*) Dr. Gilles Marion, Berliner Handels-und Frankfurter Bank. Frankfurt am Main. The usual disclaimer applies.

(1) The strategy of a succession of small Bangs was discussed in "Wirtschaft Dienst" der BHF-BANK in the issue dated January, 28th 1995.


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