parity
band (+10,-2.25) equilibrium exchange rate market exchange rate Entry into
ERM II
Revaluation of parity
Entry into euro area
Time
Exchange rate
4. Conclusions
The aim of this paper is to investigate the monetary policy options of a euro area accession country during the period of fulfillment of the Maastricht exchange rate and inflation criteria. We first analyze the “rules of the game” (i.e. how the two criteria are implemented by the Commission and the ECB) and then we identify possible monetary policy strategies within these rules.
We point out that some degree of ambiguity is contained not only in the wording of both criteria in the Treaty and the Protocols, but also in their interpretation of both criteria as recorded in the past Convergence Reports of the Commission and the ECB. Hence there is a need to search for
successfully or unsuccessfully, undergone the evaluation. Even at the end of this search, however, some ambiguities still persist with respect to both criteria, hence the efforts of the euro-candidates to satisfy these criteria are, to some extent like shooting at a target which is only vaguely defined.
We then give some thought to the question of whether and how a candidate can steer a course through the probable interpretations of the two criteria (with all their ambiguities). The considerations of the national central bank of a euro-candidate country in the period of fulfilment of the criteria are not concentrated solely on fulfilment of the criteria; the central bank must also keep in mind other aspects such as the internal consistency and economic appropriateness of its monetary policy, transparency, and continuity with the previous monetary policy regime. A deeper analysis of these aspects reveals that for most of the euro-candidates there is no regime which would satisfy all the above-mentioned desirable aspects to the full and hence that for the majority of the euro-candidates the choice of monetary policy regime for the period of fulfilment of the criteria represents a challenge to find a suitable compromise between the aspects mentioned.
In line with the prevailing current trend of favouring “corner” solutions in the exchange rate regimes, we have focused our attention on two specific exchange rate regime options for a euro-candidate country: a completely fixed exchange rate and an exchange rate fluctuating within the widest fluctuation band compatible with fulfilment of the exchange rate criterion. The choice between these two regimes depends on many factors which are typically country-specific, such as expected equilibrium real appreciation, the previous monetary policy regime and its credibility
or the ability and willingness of the government to coordinate fiscal policy. In the text, therefore, we investigate the advantages and disadvantages of both exchange rate regime options and make proposals for the specific implementation of the chosen regime until the setting of the central parity. It is, of course, up to the policy-makers in the relevant countries to set all these considerations into the specific context of their economy and to identify the approach that will maximize the chances of successful adoption of the euro.
References
Angeloni, I., Flad, M. and F. P. Mongelli (2005) ‘Economic and Monetary Integration of the New Member States: Helping to Chart the Route’, ECB Occasional Paper, No. 36.
Bank of Finland (2005) ‘Bank of Finland Bulletin’, 1/2005.
Bank of Greece: Economic Bulletin, various issues.
Barabas, G. (ed.), (2003): Coping with the Speculative Attack against Forint’s Band, Magyar Nemzeti Bank Background Studies, No. 2/2003.
Blinder, A. (1998) ‘Central Banking in Theory and Practice’, MIT Press, Cambridge.
Borghijs, A. and L. Kuijs (2004) ‘Exchange Rates in Central Europe: Blessing or Curse?’ IMF Working Paper, No. 2.
Buiter, W. and C. Grafe (2002) ‘Anchor, Float or Abandon Ship: Exchange Rate Regimes for the Accession Countries’, Banca Nazionale del Lavoro Quarterly Review, 55, pp. 111–142.
Buiter, W. (2004) ‘To Purgatory and Beyond: When and How Should the Accession Countries from Central and Eastern Europe Become Full Members of the EMU?’ CEPR Discussion Paper No. 4342.
Central Bank of Ireland: Inflation Report, various issues.
Coricelli, F. (2002) ‘Exchange Rate Policy during Transition to the European Monetary Union:
The Option of Euroization’, Economics of Transition, pp. 405–417.
Coricelli, F. (2004) ‘Fiscal Policy in Enlarged Europe’, Revue de l'OFCE, special issue, pp. 191–
209.
Coricelli, F., Jazbec, B. and I. Masten (2006) ‘Exchange Rate Pass-Through in EMU Acceding Countries: Empirical Analysis and Policy Implications’, Journal of Banking and Finance, 30(5), 1375-1391.
Crespo-Cuaresma, J., Egert, B. and R. MacDonald (2005) ‘Non-linear Exchange Rate Dynamics in Target Zones: A Bumpy Road Towards a Honeymoon’, The William Davidson Institute Working Paper, No. 771.
Crespo-Cuaresma, J. and C. Wojcik (2006) ‘Measuring Monetary Independence: Evidence from a Group of New EU Member Countries’, Journal of Comparative Economics, 34, pp. 24-43.
Dabrowski, M. and J. Rostowski (eds.) (2006) ‘The Eastern Enlargement of the Eurozone’, Springer, Dodrecht.
De Grauwe, P. and G. Schnabl (2005) ‘Nominal Versus Real Convergence – EMU Entry Scenarios for the New Member States’, Kyklos, 58 (4), pp. 537–555.
ECB (2003) ‘Policy Position of the Governing Council of the European Central Bank on Exchange Rate Issues Relating to the Acceding Countries’, 18th December 2003.
ECB ‘Report on the Functioning of ERM II’, annual reports for the years 1999–2004.
Égert, B., Kierzenkowski, R. and T. Reininger (2005) ‘Asymmetric Fluctuation Bands in the ERM and ERM II: Lessons and Challenges for New EU Member States of Central and Eastern Europe’, Eastern European Economics, pp. 81–144.
Égert, B., Halpern, L. and MacDonald, R. (2006) ‘Equilibrium Exchange Rates in Transition Economies: Taking Stock of the Issues’, Journal of Economic Surveys, 20 (2), pp. 257-324.
Fischer, S. (2001) ‘Exchange Rate Regimes: Is the Bipolar View Correct?’ Journal of Economic Perspectives, Vol. 15, pp. 3–24.
Garganas, N. (1998): Greece and EMU: Prospects and Challenges, Economic Bulletin No.12, Bank of Greece, December 1998, pp.7-20.
Hochreiter, E. and G. Tavlas (2004) ‘On the Road Again: an Essay on the Optimal Path to EMU for the New Member States’, Journal of Policy Modeling, 26 (7), pp.793–816.
Masson, P. and F. Ruge-Murcia (2005) ‘Explaining the Transition between Exchange Rate Regimes’, Scandinavian Journal of Economics, 107 (2), pp. 261–278.
Mishkin, F. (2004) ‘Can Central Bank Transparency Go Too Far?’, NBER working paper, No.
10829.
Mourmouras, I.A. a M.G. Arghyrou (2000): Monetary Policy at the European Periphery: Greek Experience and Lessons for EU Candidates, Springer, Berlin
Annex: The Experience of Selected Countries
In the Annex we look at the experience of Ireland and Greece as regards fulfilment of the exchange rate and inflation criterion and also at the experience of Hungary as regards concurrent targeting of the exchange rate and inflation.
The Irish and the Greek experience is interesting primarily from the point of view of the interpretation of the exchange rate criterion, as the development of the currencies of these countries in the period reviewed by the Convergence Report was rather volatile and deviated markedly from the central parity. As a result, it provides a precedent for the interpretation of the vague wording of the exchange rate criterion in terms of allowed deviation of currency from central parity. We discuss the fulfilment of the inflation criterion rather as a side issue, as this criterion is interpreted by the Commission and the ECB in still in clearer terms than exchange rate criterion. In the case of the inflation criterion the question is rather whether it is too “strict”
for economies undergoing real convergence and whether the rate of inflation implied by this criterion is sustainable (Buiter and Grafe, 2002). Both Ireland and Greece recorded a lower rate of inflation in the reference period than before and after this period. The rate of inflation in the reference period was influenced by appreciation of currency and, in the case of Greece, also by cuts in indirect taxes. The Commission’s estimate in the Convergence Report 2000 states that the cuts in indirect taxes in Greece led to inflation being 0.7–1.0 percentage point lower in the reference period (under the assumption of full pass-through of the tax changes to consumer prices).
The Hungarian experience is also noteworthy, as with its dual targeting Hungary is de facto shadowing the ERM II regime in that it is maintaining its exchange rate within a fluctuation band of ±15% around the set parity while declaring an inflation targeting regime. The Hungarian experience also shows the importance of monetary and fiscal policy consistency.
I. Ireland
The Commission’s Convergence Report 1998 found that Ireland had fulfilled the exchange rate criterion, as, in words of the Commission, the currency had not experienced severe tensions nor had its central rate been devalued during the period under review, i.e. between March 1996 and February 1998. Afterwards, in March 1998, the Commission proposed to the Council that Ireland had fulfilled all the preconditions for adopting the euro. On 3 May 1998, the Council decided that Ireland, along with another ten countries, had fulfilled the necessary conditions for adopting the euro. Ireland adopted the euro on 1 January 1999.
Ireland’s experience during the ERM is interesting primarily from the point of view of the interpretation of the exchange rate criterion, as the development of the Irish currency during the period reviewed in the Convergence Report was rather volatile, as Chart I below shows. The chart illustrates the deviation of the currency from the central parity in per cent. It is clear that the Irish pound remained within the narrow margin of ±2.25% only from around April 1996 to October 1996, i.e. for only for 7 of the 24 months under review. At the start of the reference period the currency was even below the depreciation level of -2.25%, staying there for at least one month (to be precise for 32 trading days, i.e. 6% of all the trading days during the review
period).5 The maximum deviation of the pound from its parity was -4.24% (calculated against the
“median” exchange rate, as this approach was used by the Commission when evaluating exchange rate stability6). This historical experience of Ireland, in line with the principle of equal treatment, leads to a legitimate assumption that a transitory breach (lasting a month and a half at least) of the depreciation level of -2.25% is tolerated.7 In such a situation, however, much will also probably depend on how the Commission evaluates the reasons which led to this short-term swing of the currency in the depreciation direction and on the ability of the country to defend such a swing.
Roughly from October 1996 until the end of the period under review, conversely, the Irish currency fluctuated above the appreciation level of +2.25% (the currency appreciated significantly from April to November 1996). The maximum deviation from the central parity was 10.91%. This appreciation was due in particular to optimism connected with the buoyant growth of the Irish economy and also to a strong appreciation of the UK pound. In the course of 1997 the exchange rate began to move slowly back towards the parity. On 16 March 1998 (after the close of the Commission’s two-year review period in February 1998), the parity was revalued by 3%, taking the exchange rate very near to the central parity. The Central Bank of Ireland justified this step by stating that without the revaluation the currency, given its fixing to the previous central
5 A similar situation arose with the Finnish mark and Italian lira. Both currencies were fluctuating well below the depreciation band of -2.25% during 1996; nevertheless, the two currencies did not enter the ERM until October and November 1996 respectively, by which time they were fluctuating within the narrow band of ±2.25%.
6 The deviation from the parity was calculated as follows: A separate central parity against the ECU was set for the exchange rate of each country in the ERM; from this it was possible to calculate the percentage deviation of each exchange rate from this parity. The median currency was then selected as the currency for which the percentage deviation from its parity was the median of all the deviations of the individual exchange rates from their parities.
Then, the percentage deviation was calculated for each currency by deducting this median deviation from the percentage deviation of the exchange rate from its parity against the ECU. This calculation was “necessary” due to
parity, would have had to depreciate too much, which, in turn, would have jeopardized price stability. The revaluation had been expected by the market. The Annual Report of the Central Bank of Ireland for 1998 also states that the interventions conducted in the foreign exchange market in 1997 reduced the official external reserves by £1,098 million, whereas there were no direct interventions in 1998. On 31 December 1998, ECOFIN announced the conversion rate of the Irish pound at £0.79 to the euro.
Chart A.I: Deviation of the Irish pound vis-à-vis the median currency, March 1996–
December 1998
1.3.96 1.6.96 1.9.96 2.12.96 4.3.97 4.6.97 4.9.97 5.12.97 7.3.98 7.6.98 7.9.98 8.12.98
Revaluation of parity Appreciation
II. Greece
Greece did not fulfil the convergence criteria in 1998 as it had not participated in the ERM, and so, unlike the other 11 EU countries, it did not adopt the euro on 1 January 1999. Greece entered the ERM on 16 March 1998 and then moved smoothly into the ERM II when that came into being on 1 January 1999. This means that when assessing exchange rate stability the
Commission in 1998 took into consideration the development of the drachma vis-à-vis the median ERM currency, and from 1999 onwards the relevant indicator became the development of the drachma in relation to its parity against the euro.
Greece entered the ERM with its central parity markedly depreciated against the market exchange rate in the period before entry (the parity was set at 357 GRD/ECU, i.e. 12.3% more appreciated than the market exchange rate). The setting of the central parity was evaluated by both the Bank of Greece and the financial markets as sustainable and consistent with the overall euro adoption strategy. The devaluation of the parity was a result of the so-called “hard drachma” policy practised by the Bank of Greece in the mid-1990s, aimed at bringing down the rate of inflation.8 This policy resulted in appreciation of the real exchange rate, so the setting of a
“depreciated” parity was evaluated as a return towards equilibrium. Entry into the ERM was accompanied by a declaration by the government of its intention to consolidate public finances.
Following a jump depreciation connected with the devaluation of the parity, the drachma began to gradually appreciate, thanks to a high interest rate differential and market optimism regarding the future development of the Greek economy. This appreciation was briefly interrupted by the Russian crisis at the end of the summer of 1998 (see Chart II). The large appreciation of the drachma significantly aided the fulfilment of the inflation criterion.
The Commission’s Convergence Report 2000 (p. 26) states that: “The drachma had been relatively stable against the ERM currencies in the review period but had at times experienced
tensions which were counteracted by increases in domestic interest rates and by foreign exchange intervention”. Such measures were particularly necessary during the crisis in Russia and Asia. The drachma was 5.7% above its parity on average in 1998. The maximum and minimum distances from the parity were +8.2% and +2.4% respectively (see Chart II).
Greece entered the new ERM II on 1 January 1999 with a central parity of 353.109 GRD/EUR.
This parity had been moderately revalued relative to the ERM parity (357 GRD/ECU), although this was merely the result of a recalculation of the parity via the final conversion rates. The revaluation was therefore a “technical”, not an “economic”, one. The average deviation from the ERM II parity during the review period was 6.76%. The maximum and the minimum deviations during the ERM II were +9.16% and +1.78% respectively. After the decision to set the conversion rate at the central parity, the exchange rate gradually converged towards the central parity. The drachma was therefore more appreciated than the central parity throughout its participation in the ERM II (as in the ERM).
The drachma’s membership in the ERM II was characterized by depreciation, coupled with a reduction of the interest rate differential, and gradual convergence towards the parity. This convergence was hastened by a 3.6% revaluation of the parity on 17 January 2000. Thanks to this, the drachma did not have to depreciate so much in order to attain the parity.
Annual HICP inflation fell to approximately 2% during the reference period and increased to 3–
4% after adoption of the euro. Cuts in indirect taxes implemented in 1998–1999 were another factor that aided fulfilment of the inflation criterion.
On 9 March 2000, Greece submitted an official request for the preparation of a Convergence Report and a subsequent assessment of the convergence criteria by the Council. On 19 June 2000, the Council decided that Greece had fulfilled all the necessary conditions for the adoption of the euro and set the conversion rate of the drachma at the existing central parity and also set the date of adoption of the euro. Greece adopted the euro on 1 January 2001.
Chart A.II: Deviation of the Greek drachma vis-à-vis the median currency (1998) and the euro (1999–2000)
0%
2%
4%
6%
8%
10%
16.3.98 17.6.98 11.9.98 8.12.98 15.3.99 15.6.99 13.9.99 14.12.99 15.3.00 14.6.00 14.9.00 14.12.00
Revaluation of parity
Appreciation
III. Hungary
In May 2001, Hungary abandoned its crawling peg and widened the fluctuation band of the forint from ±2.25% to ±15%. At the same time, the Hungarian central bank introduced inflation targeting and set inflation targets for 2001 and 2002. This put the Hungarian National Bank in a situation where it was targeting two variables simultaneously – the exchange rate and inflation.
temporary, aimed at bringing inflation down to the Maastricht criterion level and achieving rapid adoption of the euro. The fluctuation band of ±15% was evaluated as sufficiently wide to avoid conflicts between the inflation and exchange rate targets. This evaluation, however, was based on an assumption of restrained fiscal policy supporting disinflation. The approaching elections in April 2002, however, brought a large fiscal expansion, and in order to attain the inflation target tighter monetary conditions became necessary. The central bank responded by raising rates by 1 percentage point during the summer of 2002. As a result of the higher rates the Hungarian forint gradually appreciated, reaching the edge of the fluctuation band towards the end of 2002 (see Chart III).
Meanwhile, at the end of 2002, the EU accession treaties were signed and the Hungarian government communicated its willingness to markedly decrease the public finance deficit from 2003 onwards. On the strength of this development, the market believed the government’s announcements in favour of the fastest possible adoption of the euro (Barabas, 2003). These factors fostered a short-term decrease of the risk premium and consequently also a further appreciation of the forint (by less than 1% towards the stronger margin of the band). However, the government, fearing a loss of competitiveness of Hungarian exporters on account of the strong forint, insisted that the exchange rate regime and the existing fluctuation band must not be abandoned (a change of exchange rate regime requires agreement between the government and the Hungarian National Bank). The Hungarian National Bank thus found itself in a situation where it evidently would not be able to fulfil one of the targets it had set itself (either the exchange rate target or the inflation target).
This economic policy inconsistency triggered a speculative attack on the strong boundary of the fluctuation band of the forint in January 2003. The Hungarian National Bank withstood the attack by means of a large interest rate cut (by 2 percentage points) and interventions in the foreign exchange market (over the two days of the speculative attack – 15–16 January 2003 – it purchased a total of EUR 5.3 billion) and thus de facto gave priority to the exchange rate target
This economic policy inconsistency triggered a speculative attack on the strong boundary of the fluctuation band of the forint in January 2003. The Hungarian National Bank withstood the attack by means of a large interest rate cut (by 2 percentage points) and interventions in the foreign exchange market (over the two days of the speculative attack – 15–16 January 2003 – it purchased a total of EUR 5.3 billion) and thus de facto gave priority to the exchange rate target