European Central Bank, Frankfurt am Main Deputy Director General, DG Economics
ECONOMIC, FINANCIAL AND MONETARY CHALLENGES IN THE RUN-UP TO EURO-ZONE
LESSONS FROM THE RECENT PAST RELEVANT TO ACCESSION COUNTRIES
PARIS, 12 October 2001
Lecture in the Great Debate seminar 'Enlargement of the EU - Preparing for the Accession of the First Wave'
Ladies and Gentleman,
It is a great pleasure for me to have the opportunity to present to you my thoughts on an issue that I believe to be of considerable and growing importance for policy making in your countries, namely the enlargement of the EU and the euro area. I would like to start my deliberations today by making a few preliminary comments on the general approach of the ECB concerning this issue. This will be followed by some important lessons in the field of inflation and of exchange-rate arrangements that can be drawn from the convergence experience made by some of the current member countries of the euro area. Finally, I would like to convey to you some thoughts on the importance of perceiving the process of accession to the euro area as a continuous and - possibly - challenging process for which, candidate countries should, hence, prepare well in advance.
ECB Supportive of the Accession Process
The first message I wish to convey to you is the positive and supportive attitude the ECB has always taken towards the accession process. Already in 1999, the first full year of the ECB's existence, we launched a regular dialogue with accession countries' central banks. As part of this dialogue the ECB, together with the national central banks of the euro area, initiated a series of high level seminars with the central banks of accession countries. The first of these meetings took place in Helsinki on the 12th of November 1999, in the context of which the ECB made very clear its supportive and open attitude vis-à-vis the process of accession. A second similar meeting took place in Vienna in 2000, focusing mainly on the price dynamics of accession countries, while this year this event will be held in Berlin in December, covering issues related mainly to financial stability. These seminars, which have become a regular opportunity to discuss policy issues related to EU accession at the highest level, are being complemented with a considerable number of more technical multilateral workshops, covering not only economic issues but also related aspects such as statistics, payment systems, and legal affairs. Moreover, central banking co-operation between the Eurosystem and accession countries' central banks has been substantially enhanced through the organisation of numerous bilateral visits and seminars.
Distinguishing Three Phases in the Accession Process
Against this background of multifaceted co-operation, the ECB is carefully assessing the economic implications of the various phases of the accession process both on the candidate countries themselves as well as the euro area. In this context it is important to distinguish between at least three separate phases of the accession process.
The first phase is the integration of the candidate countries into the EU and, by definition, the integration of the acceding countries' central banks into the European System of Central Banks.
The second phase relates to the participation of future EU member countries in the exchange rate mechanism ERM II.
While the third stage is full EMU membership and the adoption of the euro.
These distinct phases are of course closely interconnected. Not only is it a precondition for EMU membership to be an EU Member State but it is also expected by the EU that the future Member States will have the desire to participate in ERM II and ultimately to become full members of EMU with all rights and obligations that this implies. The transition between the various phases, however, is not automatic. In particular a full EMU membership depends on the positive outcome of a convergence assessment as required by the EU treaties. In this context it is also important to point out that there is a clear-cut difference between ERM II membership and the convergence criterion that relates to exchange-rate developments. Whereas two years of membership in ERM II is a necessary condition for satisfying this convergence criterion, the convergence examination goes beyond this somewhat formalistic aspect of exchange rate stability. In particular the exchange rate volatility during the examination period, i.e. the last two years prior to a convergence report, plays an important role in assessing whether the exchange rate criterion is fulfilled.
What Lessons Can Be Learned?
Let me now turn to the second part of my presentation, which focuses mainly on the lessons that one can draw from the initial establishment of EMU with its eleven founding countries on 1 January 1999 and the accession of Greece as the 12th euro area member country on 1 January 2001. It appears to me that there are at least two important general messages coming from the past. First, the present framework has proven to be capable, beyond the expectations of many perhaps, to promote a culture of stability. Second, the final years of the convergence process have been on the whole rather smooth, because the system had already built in a considerable degree of flexibility, which has helped to guarantee a successful process of transition. The smoothness of the process however, originates also from the considerable convergence efforts member countries were prepared to undertake for a good number of years. This in turn required a strong willingness to take all the necessary steps that were required, a willingness which was particularly demanding at the beginning of the process. Although we are in many ways still in the early days of EMU, the experience that we gathered is definitely reassuring, suggesting that the institutional framework, which has evolved over time, is well geared up to help countries learn to face the challenges related to monetary union as well.
A Successful Reduction of Inflation in the Euro-Zone
The disinflation experience of those EMU member countries that had a tradition of relatively high levels of inflation shows that the prospects for a substantial and sustained reduction of the inflation rate depends on the ability of monetary policy to break with previous beliefs and behaviour. Whereas this is of course a challenging and difficult task, it appears that the convergence criteria played an important role in transmitting a culture of stability and in facilitating the successful disinflation process. The approaching of EMU, with all its associated provisions, appears to have been of considerable importance in generating credible low-inflation expectations, which in turn contributed to the moderation of wage claims and overall price developments in the economies concerned. One can thus clearly speak of a virtuous circle. It is important to keep in mind, however, that it is crucial to build up a general consensus on the long term benefits of taking the steps required to fullfil the convergence criteria.
Will Candidate Countries Be Able to Follow a Low Inflation Strategy:
How Valid is the Balassa-Samuelson Effect?
Whereas a successful disinflation process is a challenging task for any country, it is often suggested that it will be even more difficult for the accession countries than it was for the current euro area members. This line of reasoning is frequently based on the so-called Balassa-Samuelson (BS) - effect. Put in a nutshell, the BS-effect suggests that the prices of non-tradable goods in fast-growing economies grow at a faster pace than the prices for tradable goods. This reflects higher productivity growth in the tradable sector relative to the non-tradable sector, which - under a well-known set of conditions - may ultimately contribute to consumer price inflation.
There are considerable uncertainties with regard to empirical estimates of the BS-effect and there remain also some doubts on whether this model is not perhaps an excessive simplification of the price dynamics of a fast growing country. However, disregarding for a moment the limitations of this approach, it is worthwhile to review the experience of those current EMU members whose initial level per capita income is relatively low compared to the euro area average, namely Greece, Spain and Portugal. The empirical analyses for the so-called "EU cohesion countries" suggest that during the 1990s BS-effects played a role, but that their quantitative importance was relatively small and that these effects may, at least in part, have been alleviated by exchange rate flexibility. The available estimates typically suggest that the impact of BS-type inflation on average annual price changes did not exceed to percentage points. The past convergence reports confirmed that the key to success was to deal with other sources of inflation, whereas the BS-effect could be handled with relative ease. In particular, the monetary and fiscal policy mix and the prevailing wage expectations proved to be the main determinants in the dynamics of prices. We, indeed, expect these to remain the key factors for achieving nominal stability also in the future. Further confirmation for this assessment come from a number of studies that have also been conducted for selected accession countries, which have come to the conclusion that the BS-effect is probably also contained within the range of one to three percentage points.
Entry into ERM II Immediately After Accession?
Turning to the ERM II, it is interesting to note that most accession countries have already indicated their intention to join the mechanism as soon as possible after entry into the EU. In this context, I should like to stress that the past experience of current member states reveals that the time between EU accession and entry into ERM II can vary considerably. So far only one country, namely Austria in 1995, joined the ERM immediately following accession to the EU. It should be mentioned, however, that Austria could be probably thought of as a special case, considering its low inflationary environment even before accession and its experience of exchange rate stability, which derived from the prolonged and credible shadowing of the D-Mark.
Participation in ERM II should not be seen as a necessary waiting room prior to the adoption of the euro. Instead it should be regarded as a meaningful and flexible framework for increasing nominal and real convergence, as well as an opportunity for tackling the challenges of monetary union. Let me be quite frank with you. In view of the different degrees of structural convergence of the accession countries, it is conceivable that limiting the duration of the period within ERM II to the minimum permissible time to qualify for full EMU membership, namely two years, may not be the best solution for all accession countries. A longer membership of the ERM II may in some cases be helpful or even necessary to meaningfully retain the option of exchange rate realignments during the catching up process, a flexibility, which may prove to be useful both in the direction of appreciations but also of depreciations. In the context of upward realignments it is worth recalling the revaluation of the Greek Drachma on 17 January 2000. This revaluation took place at the request of Greece and with the agreement of the EU's economics and finance ministers, as well as the EU's monetary authorities, in order to support the Greek efforts to ensure sustainable price stability without endangering the competitiveness of the Greek economy. A well-targeted degree of exchange rate flexibility can indeed cushion the potential inflationary impact associated with the above-mentioned BS-effect. Looking at the recent experience of accession countries with exchange-rate flexibility, a number of accession countries' central banks have at times used nominal exchange rate appreciations in order to cushion excessive inflationary tendencies. Furthermore, some countries, such as the Czech Republic, Slovakia, Poland and, since May 2001, Hungary, have moved toward more flexible exchange rate regimes, again with the intention to strengthen their anti-inflationary efforts. These appreciations, however, were in some occasions followed by a rapid weakening of the exchange rate, for example in July 2001, suggesting that downward realignments may not be excluded in all circumstances, particularly when inflationary differentials remain large and current account and fiscal imbalances widen.
The whole issue of the timing of participation to ERM II, both when to join and how long to remain inside the system, depends of course on the somewhat larger question whether the discipline that this system imposes on its members is advantageous for transition countries. What are indeed the advantages of limiting exchange-rate flexibility in the case of transition countries? The first issue to look at relates to the size and volatility of capital inflows in the run-up to euro area membership and the resulting exchange-rate volatility. It is undeniable that these factors constitute an important challenge to monetary policy in the accession process to EMU. The experience of countries such as Greece and Portugal shows, however, that in spite of some of difficulties involved, large and volatile capital flows can be managed within exchange rate mechanisms such as ERM II and its predecessor, the ERM. In this context it is important to recognise, that the bands of ERM II are relatively wide, thus introducing a relatively larger degree of flexibility into the system than in the days of the original ERM with narrow fluctuation bands. This implies that the risk for possible speculators has increased. Furthermore, in contrast to the ERM, ERM II is not based on a grid system involving a number of currencies. Instead it uses the euro as single reference currency, which simplifies the system and limits the possible areas of speculative attacks.
To sum up, the convergence experience of current euro area Member States in the field of inflation and exchange-rate developments, strongly suggests that the existing institutional framework for accession to the euro area, including the convergence criteria as defined in the Maastricht treaty, is sound. Furthermore, the framework apppears flexible enough to meet some of the new challenges associated with likely entry of accession countries. However, the ultimate goal of acceding to the euro is an ambitious one and for this reason it is necessary to start preparing for this prospect well in advance. In a way one could compare it with an athlete, which starts to prepare a long time in advance for participation in the Olympics. In this context, it is helpful for candidate countries to envisage the accession to the EU as a first important step on the way to EMU membership. Broadly speaking, membership in the EU requires respectively encourages all the macro- and micro-economic policies that are necessary to spark the virtuous cycle of that was experienced by the current euro area members in the past. Experience shows, of course, that the future Member States may encounter difficulties and moments of pause during the further stages of the process, i.e. during the transition from EU membership to full EMU membership. In this context I would like to recall the experiences made during the second stage of EMU, such as the ERM turmoil in 1992 and 1993. However, and this is very important to keep in mind, dealing with difficulties may in the end prove to be very helpful. It is a way of learning how to achieve the right monetary and fiscal policy mix within a highly integrated common market, how to deal with free capital mobility and possibly very substantial capital and, eventually, how to manage credibility.
Let me finish by saying a few words about the implications of new countries joining EMU for the euro area itself and in particular on the ability of the ECB to ensure the preservation of price stability in the euro area. It is obvious that enlargement willl imply important new challenges for the monetary policy of ECB. On a technical level, it will be necessary to employ new monetary and non-monetary aggregates. This was also the case when Greece joined the euro area and the expertise gathered in the context of the accession of Greece to the euro area will prove to be very valuable. Beyond this technical issue, however, there is no doubt that the ECB will be able to ensure the continuation of price stability even in an enlarged euro area in a credible and lasting manner.
Looking at the broader picture, however, there are other types of challenges that one should also consider. These challenges are closely related to the already discussed divergence of per capita income levels between current and potential future Member States. The first challenge is the increased possibility of asymmetric shocks. Furthermore, the emergence of inflation differentials within the currency area, leading to diverging levels of competitiveness across the euro area, is also a distinct possibility. In this context, it should be realised that the entry of new Member States into the euro area will not lead the ECB to redefine the scope for monetary policy, which is formulated for the euro area as a whole. If individual countries are faced with an asymmetric economic development, national economic policies should be used to tackle the problems that might be the result of such an asymmetric development. Obviously, the acceleration of the catching up process of the accession countries would definitely facilitate the integration of these countries into the euro area. Besides the reduction of possible inflation diffences, a process in terms of real convergence and economic integration is also likely to reduce the risks of possible asymmetric shocks. Hence, in order to both achieve an acceleration of the real convergence process and to best cope with the challenges of accession and union, sound macro-economic policies combined with swift and comprehensive implementation of structural reforms are and will remain required.
It is also important to stress in this respect that monetary policy in an enlarged euro area would not and could not be included, as an own objective, the promotion of the catching up process of any participating country. Not withstanding the fact that catching up is of course desirable, not least from the point of view of monetary policy, the best contribution the ECB can provide for enhancing the growth prospects of current-and-new euro area participants is to guarantee stable pices in the euro area as a whole. Indeed, a stable macro-economic environment would help accession countries making the best of the advantages associated to currency union areas, such as the reduced risk premium, increased trade and the increased prospects to FDI inflows.
I should finish my presentation where I began earlier today. As I had already emphasised in the introduction, the ECB is committed to pursue the historical objective connected to the accession process through the establishment of economic and monetary union, which ultimately includes a single currency. We are determined to achieve this objective, preparing well in advance and without compromising what is essential to promote sustainable growth in a long term horizon, namely the preservation of price stability in the euro area.