A new exchange rate mechanism in stage three of EMU and reinforced convergence procedures
Mary R. McCarthy
In December 1995, the European Council in Madrid confirmed that the third stage of EMU would begin on 1 January 1999. In this context, the European Council requested the Council, the EMI and the Commission to study the issues that would arise from the fact that not all EU countries would participate from the start in the euro area. Issues related to monetary instability, in particular, were highlighted and it was decided that the future relationships between Member States participating in the euro area and non-participants would have to be defined prior to the move to stage three.
The European Council in Florence in June 1996 urged the Ecofin Council, the EMI and the Commission to pursue their work on the new exchange rate mechanism and on the relations between Member States participating in the euro area and non-participating Member States. Since then, the EMI and the Commission have both produced reports on these topics. The proposals for a new exchange rate mechanism in stage three of EMU were discussed at the European Council in Dublin on 13-14 December 1996 and the overall structure of the new mechanism was agreed.
The European Council requested the Ecofin Council to prepare, for the European Council in June 1997, a draft resolution setting out the fundamental elements of the new exchange rate mechanism, following the precedent set in 1978 in relation to the present ERM. The EMI was also invited to prepare in parallel, a draft for an international bank agreement, for submission to the ECB and the central banks of the Members States not forming part of the euro area.
This paper is organised as follows. Section two deals with the main elements of the new system. Section three contains some conclusions.
2. A new exchange rate mechanism and reinforced convergence procedures
In order to provide for the prospect of full participation in the euro area and to protect the single market, a new exchange rate mechanism is required for stage three of EMU. While respecting the overriding priority of price stability throughout the Community, the design of the new exchange rate mechanism should therefore reflect the objective of fostering nominal convergence among the non-participant member states to the high standard of stability in the euro area. The lessons of the ERM crisis in 1992-3 argue strongly in favour of retaining a high degree of flexibility - as reflected in relatively wide fluctuation bands - in the new arrangement.
The new mechanism is designed to be an expression of monetary solidarity within the Union, while fostering convergence and exchange rate discipline among the "pre-ins". The main elements of the new mechanism will be as follows:
·It will be a "hub-and-spokes" model, consisting of bilateral links between the euro and the "pre-in" currencies. This will clearly identify the euro as the anchor of the mechanism. It will focus on the need to achieve convergence among the "pre-ins" towards the high standard of macro-economic stability in the euro area;
·Central rates and fluctuation margins will be set using a common procedure involving Ministers, Governors of the European Central Bank (ECB) and of the non-participant national central banks (NCBs), and the Commission, after consultation of the Economic and Financial Committee. Standard fluctuation margins will be wide. It will also be possible to establish closer links between the euro and "pre-in" currencies based on progress in terms of convergence;
·Intervention support, with appropriate financing facilities, will be automatically available at the margins. In principle, this intervention will be unlimited. However, the ECB or relevant NCB will have the right to suspend intervention if its overriding policy objective of price stability is jeopardized. With some adjustments, the current Very Short-term Financing (VSTF) facility will continue to be used. Practical ways to limit the fluctuation between the currencies of the "pre-ins" within the standard margins are also envisaged;
·Realignments should be made in a timely manner and by common procedure so that significant misalignments may be avoided. All parties involved in the common procedure will have the right to trigger a procedure which might result in a realignment;
·Membership of the new mechanism will not be compulsory.
Lasting convergence of economic fundamentals is essential for sustainable exchange rate stability. Past experience has demonstrated that macro-economic management plays a crucial role in generating sustainable exchange rate stability. In this context, soundly-based macroeconomic management among the "pre-ins" in stage three will be reflected in their steady progress toward achieving a high degree of sustainable convergence. Thus, one would expect the successful implementation of a credible convergence programme to minimize the risk of sustained weakness in the exchange rate of a "pre-in". This being the case, the Commission would foresee a role for reinforced convergence programmes in the management of the new ERM.
For example, the progress achieved by a "pre-in" toward its convergence objectives might be used as a reference in deciding on the sustainability of central rates. A favourable performance relative to convergence objectives would be expected to strengthen the case for support for a "pre-in" currency in the event of speculative pressures. Of course, the use of convergence programmes as a reference in the context of the new ERM would not interfere with the ECB's prerogative to safeguard its price stability objective with respect to its intervention obligations. This convergence-based approach to operating the new ERM would preserve flexibility while ensuring an appropriate level of exchange rate discipline. Moreover, as a more "preventive" than "corrective" approach, it also seems well-suited to the needs of the "pre-ins".
A high degree of exchange rate stability is important for achieving nominal convergence, in particular where inflation and nominal (long-term) interest rates are concerned. As long as "pre-in" countries have not achieved a satisfactory degree of convergence, an EMS-type exchange rate mechanism is probably the best instrument for achieving convergence. However, a relatively large degree of flexibility must be preserved so as not to jeopardise the stability objective of monetary policy.
An exchange rate regime of itself is no more than a complementary instrument for fostering convergence. An exchange rate arrangement must be supported by consistent macroeconomic policies. In this respect, a quasi-fixed nominal exchange rate mechanism like the present ERM must be accompanied by a fiscal-wage-structural policy mix which is consistent with the inflation objective of the currency area to which the exchange rate is linked i.e. the euro.