The irrevocable fixing of the conversion rates
1. The irrevocable fixing of the conversion rates of the currencies of the participants in EMU is an important and complex issue.
It is an important issue for each of the participants as the irrevocable euro conversion rates adopted will determine their respective starting position in the euro zone in terms of competitiveness, purchasing power and relative asset/liability values.
It is a complex issue as the procedure for the fixing of the conversion rates has only been sketchily spelled out in Art. 109L(4) of the Treaty which reads as follows : "At the starting date of the third stage, the Council shall, acting with the unanimity of the Member States without a derogation, on a proposal from the Commission and after consulting the ECB, adopt the conversion rates at which the currencies shall be irrevocably fixed and at which irrevocably fixed rate the ECU shall be substituted for these currencies, and the ECU will become a currency in its own right. This measure shall by itself not modify the external value of the ECU."
One addendum : the Madrid Summit, in a unanimous and definitive interpretation, ruled that "ECU" is a generic term and that the ECU, when shedding its basket definition to become a currency, shall be called "euro".
A first overview
2. Though sketchy, article 109L(4), as inter-preted and complemented by the Madrid and Dublin Summits, is informative on the following points :
a) the irrevocable conversion rates will be fixed on the starting date of EMU. This is almost a truism as it is the irrevocable fixing itself that initiates EMU. However, since the Dublin Summit has decided that EMU shall start on January 1, 1999, it follows that the irrevocable fixing has to take place on that date and cannot be undertaken before.
b) Three Community Institutions are involved in the decision process : the Ecofin Council (unanimous decision by the designated participants), the Commission (proposal) and the ECB (consultation). This Community procedure and the pre-announced "fixing date" are in sharp contrast with the "snap" decisions on EMS central rates by the Finance ministers or their representatives and Central bank governors.
c) The Treaty text refers both to the irrevocable fixing between the bilateral conversion rates of the participating currencies and of their respective euro conversion rates. This ties in with another Treaty provision specifying that the euro will "rapidly" be introduced as the single currency. But, as according to its legal status, the euro is to become "immediately" the single currency of the participants, only euro conversion rates will be fixed.
(d) "This measure (the fixing) shall by itself not modify the external value of the euro".
This provision is the exact replica of the one laid down in para 2.3 of the Brussels Council resolution (1978) on the creation of the EMS and of the ECU.. Its purpose was to ensure that a revision of the ECU did not, by itself, have the effect of an appreciation/depreciation of the ECUís value in terms of its component currencies and third currencies. To achieve this goal the "new" ECU had to start-off with the "old" ECUís values as they were on "revision day". Revisions took place in 1984 and 1989. On both occasions, the "equal external value" rule has been strictly observed.
Applied to the irrevocable fixing of the euro conversion rates, this rule would imply that, on "fixing day", the last ECU basket rates in terms of the participating currencies are to be chosen as the latterís irrevocably fixed euro rates.
However, two other ways of phrasing this provision have been advanced. For some, the "external value" refers to the ECUís dollar rate only. Accordingly, on "fixing day", the dollar rate of the euro should be identical to the last dollar rate of the ECU. In the Commissionís draft regulation on the legal status of the euro, the "equal external value" provision is explained as follows : "one ECU in its composition as a basket becomes one euro".
3. Summing up, this review of the relevant texts makes clear that the irrevocable fixing of the conversion rates is not to be equated with a fixing or changing of central rates in the EMS : the decision makers are different, the date is known and the choice is final.
In addition, the decision should respect an "equal external value" constraint. But, opinions differ on how to understand it. This needs to be clarified before going any further.
A prerequisite : what is meant by the Treaty provision "no change in the external value of the ECU/euro"?
4. The answer should take into account the following facts :
- Fact 1. This Treaty provision refers to the "official" ECU, whose value in terms of its components and of a number of third currencies is calculated, once a day, by the Commission on the basis of the dollar rate of each component currency as registered at 2.15 p.m. on its exchange market
- Fact 2. The 1984 and 89 revisions were managed as follows :
- Fact 3. On the following day, the "new" ECUís first market based rates were practically identical to those of the "old" ECU on the day before, any minor difference being due to exchange market developments from one day to the other. But, the revision, "by itself", played no role in it.
5. Based on these facts, the following assessment of the various understandings of the "external value" provision is presented :
a) "On fixing day, the participating currenciesí ECU rates of December 31, 1998 will be chosen as their irrevocably fixed euro rates".
This reading presents a 100 % conformity with the way in which an identical provision was implemented in 1984 and 1989 for the ECUís revisions. It excludes any realignment on "fixing" day and ensures a transition without value disruptions between the participating currencies and the euro, as well as between the ECU and the euro.
b) "The dollar rate of the euro must be identical to ECUís dollar rate of December 31, 1998".
This interpretation confuses the role of the dollar as the common unit chosen for the calculation of the ECUís exchange rates and the "equal external value" rule itself. Actually, it is perfectly possible to calculate the ECUís value by using another "calculation " currency.
In fact, this "equal dollar rate" interpretation would allow, on "fixing day", to adopt euro conversion rates for the participating currencies that would differ from their last day ECU market rates. As such, it would offer the decision makers the possibility to discard market rates which they consider unfit to become euro rates. In short, it allows a last-minute realignment.
Technically speaking, the exercise would be relatively easy to perform, provided at least one of the non-participants in EMU allows the dollar rate of his component currency to be adjusted to the extent necessary to maintain the dollar value of the basket ECU unchanged, whatever the size of the appreciation/depreciation of the participating component currencies vis-à-vis each other. Otherwise ...
Describing this method, by itself(!), highlights the artificial nature of the whole exercise and its self-defeating character. Indeed, this method, - in fact, a realignment - would equalise the dollar rate of the ECU and the euro only on the sheet of paper on which the calculation is made. But it would, "by itself", trigger a change because the dollar rate of the euro, when the markets open next day, would be rather different from the ECUís last day dollar rate. This has been the case for the ECUís dollar rate whenever, in the past, an EMS realignment occurred.
c) "One ECU in its composition as a basket becomes one euro". This is the understanding of the "equal external value" provision in the Commissionís proposal on the legal status of the euro. The identity - an ECU is an ECU - was self-evident in the 1978 Brussels Council Resolution. But the name "Euro" given to the ECU might confuse some. All the more so since, until recently, some favoured a 1 to 1 ratio between the single currency and their own currency. This is now definitively laid to rest by this statement and reassuring to the ECU market. Moreover, it is fairly obvious that a 1 to 1 ratio between the ECU and the euro implies the identity between the participating currenciesí euro rates and their last ECU rates.
6. The conclusion of this "interpretational" overview is this : though the "irrevocable fixing of the conversion rates" is not a "ECU revision", the choice of identical "equal value" provisions for these two events demonstrates the intent to obtain identical results. Consequently, according to the "fixing" procedure of Art. 109L(4) and to the legal identity between one ECU and one euro, the basket ECU rates for the participating currencies on December 31, 1998 are to be the euroís irrevocably fixed conversion rates.
This being established, how should one proceed in order to ensure a satisfactory implementation of this provision?
The need for a pre-announcement
7. The latest exchange and interest rates troubles triggered by rumours about a delay in the start of EMU have shown, once again, that financial operators thrive and prosper on volatility. And if it does not come naturally, they are likely to give a helping hand in creating it! Consequently, it would be risky to assume, once the EMU participants are chosen in the spring of 1998, that the remaining months, up to the irrevocable fixing of the conversion rates on January 1, 1999, will be trouble free. Indeed :
8. These factors (and others) are likely to maintain a climate of uncertainty, fuel speculation and generate tensions among the participating currencies and, consequently, among the future participants in EMU.
A way to pre-empt such unwelcome developments would consist in a pre-announcement by the decision makers on how they will proceed on "fixing" day.
The content of the pre-announcement
10. Two main approaches are presently considered. It is important to note that both aim at mobilizing market support to help implement the intentions of the decision makers.
(A) The announcement that the conversion rates, chosen on January 1, 1999 for each of the participating currencies, will be the average of their respective exchange rates over a preceding period. Thus, if a two year period were chosen, the Euro conversion rates would be determined by a combination of past rates (January 1997 up to May 1998, date of the announcement) and of future rates (June 1998 up to 31 December 1998).
(B) The announcement that the conversion rates, chosen on "fixing day", will be the central rates of the participating currencies.
Provided the announcement is credible, one may expect that either of these approaches will help stabilise exchange rate expectations. Market rates of the participating currencies would tend to converge towards the average of the preceding period, in approach (A) or converge towards the central rate, in approach (B). Consequently, in either approach, on Dec. 31, 1988, market rates of that day should be identical to their average over the previous period or to their central rates. Indeed, a market transaction concluded, on that day, at another rate would generate losses for one party, gains for another. No sensible operator would be party to it.
A technical difficulty
11. Each of these approaches presents the following technical difficulty :
- according to Art. 109L(4) of the Treaty, the participating currenciesí ECU rates of December 31, 1998 will become their euro rates;
- but, it is not possible to apply this provision by stating, in a pre-announcement, that the euro conversion rates chosen for the participating currencies will be :
Indeed, being a basket, ECU rates are calculated rates, derived from the market rates of all its components. Consequently, any given ECU rate in terms of a component currency can potentially result - not from one - but from many different exchange rate combinations among the ECUís components, some of which will not participate in EMU. Consequently, market forces cannot possibly drive the participants ECU rates towards the desired goal : i.e. the identity of the participantsí ECU market rates on December 31, 1998 with, - according to the approach adopted - either their ECU central rates or their [ 2] year ECU average.
12. The solution to this problem consists in a three step technique :
a) Step 1 : designation of one of the participating currencies as the reference or calculation currency. This could be the DM, but it could be another currency as well.
Consequently, in approach (A), the exchange rate averages calculated for the participating currencies would be their respective DM rate; in approach (B), it would be their respective DM bilateral central rate (e.g. for the BF : 20.6255).
On Dec. 31, 1998 it is to be expected that, for each of the participating currencies:
b) Step 2 : the calculation of the last day ECU rates. For this purpose, the average DM rates or DM central rates mentioned above are to be used and in addition, in order to complete the basket, the DM rates of that day of the non-participating component currencies. Why use, for this calculation, the average DM rates of the participating currencies or their central rates and not their last day rates which should be identical to these average/central rates? Simply because it is the statement, in the pre-announcement, that averages or central rates shall be chosen as conversion rates which will induce the markets to equalize the participantsí last day rates with these stated values. "Ex post", both ways of calculating should display the same results.
c) Step 3: choice of the euro conversion rates. The last day ECU rates of the participating currencies, as calculated above, shall then be officially chosen as their euro conversion rates as stipulated in Art. 109L(4).
13. Needless to stress that the identity between the last ECU rates and the euro conversion rates is crucially important for the ECU market which might be expected to grow significantly in the run-up to EMU. Especially, the "basket-makers" need to be reassured on the identity euro rates/Ecu rates. If so, a closing of the gap between the ECUís theoretical exchange rates and its market rates may be expected
Choice of the pre-announcement
14. The pros and cons of both approaches are to be assessed by the Authorities, preferably in consultation with market operators.
At first glance, it would appear that :
- the "average" approach offers the advantage of a certain exchange rate and interest rate flexibility, though progressively less as the period runs out. Such moves would not unduly alarm the markets. Moreover markets would not expect central banks to be committed to hold a given rate. But there could be a problem if markets sensed a deliberate attempt at "steering" the rates by some participants. Moreover, this method does not exclude a realignment during this period.
- The "central rate" approach provides the markets with an official commitment to a precise target rate. An important advantage of this approach is the message conveyed to the markets that the participants are in agreement over their future bilateral "conversion rate" relationship in EMU. Problem : the markets are likely to expect central banks to back up their commitment, if needed, with support actions and possibly interest rate adjustments. If so, a new EMS or a "de facto" EMU would exist. If not, the credibility of the commitment could be questioned.
The need for credibility
15. The main issue in any approach : how to ensure credibility?
The status of those making the announcement and its timing could contribute to it. Ideally, the fixing method adopted should be announced in the wake of the European Council meeting where the decision on EMU membership will be taken. At this stage, it is difficult to assess whether it should be announced by the EMU participants only or by the 15 Member States, as preparatory work will involve all.
One thing is certain : the main support to credibility would come from a smooth decision on membership of EMU and from the ongoing convergence by its future participants.