The Dubrovnik economic conference series, organised by the Croatian National Bank, has established a solid reputation as a forum for economic analysis and policy debate. I am very pleased to address this year’s conference, which is special because it marks the tenth anniversary of the creation of the series. This year’s conference acquires additional significance as it takes place only two weeks after the European Council decided that Croatia is now a candidate country for membership of the European Union and that accession negotiations will start in early 2005. I would like to take the opportunity to congratulate our Croatian colleagues on this remarkable success, which is also a reflection of the significant progress Croatia has made towards meeting the Copenhagen criteria.
Of course, the start of accession negotiations is only the beginning of a rather lengthy process. A lot remains to be accomplished for Croatia to join the EU. In the economic field, achieving the main objectives of high durable growth and price stability – or, to use the alternative expression, achieving real and nominal convergence – will require continued efforts to implement the appropriate macroeconomic policies and the necessary structural reforms. Similar challenges are also faced by some of the new Member States. The general policy prescriptions are by now broadly accepted. Yet policy-makers must carefully define the specific policies to be pursued and implement them in an effective and resolute manner.
The European Central Bank has always had an open and positive attitude towards EU enlargement and has been ready to assist our future partners in the ESCB and the Eurosystem. I can assure you that this attitude will continue to characterise the ECB’s approach to all candidate countries, now also including Croatia. It is thus only natural that our long-standing cooperation with the Croatian National Bank will become increasingly closer as the time of accession approaches.
In my remarks, I will address a number of monetary policy issues and challenges that new and future Member States are likely to face on the path to the euro. Some of these issues have been discussed in previous sessions of this conference. I will be selective, focusing on those that in my view are particularly important.
To tackle these issues in a structured manner, it is useful to distinguish between the conduct of policy during two different phases of the process leading to the eventual adoption of the euro by a new Member State. The first phase is the period after acceding to the EU and before joining the exchange rate mechanism II (ERM II). The second phase starts with entry into ERM II and stretches all the way to the actual introduction of the euro, including a final period between the official EU Council decision for a country to join the euro area and the adoption of the euro. Both of these phases will entail different challenges for monetary policy.
Before addressing these issues, I find it useful to make a number of general observations concerning the process towards euro adoption. These observations can help to outline the broad framework and define the goalposts of our debate.
The first observation is that there is no single trajectory towards the euro. There is neither a single path which can be considered appropriate for all, nor is it possible to identify and recommend a unique policy approach to all new Member States. This is the logical conclusion derived from the fact that Member States differ considerably in nominal, real and structural terms and they employ very different monetary and exchange rate strategies. It is obvious that this diversity of economic situations and policy strategies calls for an assessment on a case-by-case basis.
The second observation is that policy-making takes place in a multilateral framework. This means that, at every stage of the monetary integration process, major policy decisions concerning one country or currency are collective decisions made by all EU Member States or by the euro area countries and the ECB.
Third, the principle of equal treatment is important and applicable. Comparable situations and cases will be treated in a comparable manner, both across countries and over time.
We should keep these key observations in mind when we are discussing monetary policy issues and ERM II participation. Monetary policy on the road to the euro is not conducted in an institutional vacuum. On the contrary, the monetary integration of the new Member States will take place in a well-defined institutional setting.
Let me now turn to the conduct of monetary policy during the initial phase, that is, the period before ERM II entry. What does the Treaty tell us about this phase? As you know, upon EU accession a new member country becomes a “Member State with a derogation”. This means that although it will not adopt the euro right away, it is expected to do so eventually, once it fulfils the convergence criteria. The Treaty also requires that each Member State pursue price stability as the primary objective of monetary policy. Furthermore, the exchange rate of a country’s currency is no longer exclusively its own business; rather, it is to be treated as a matter of common interest.
Given these policy requirements regarding the orientation of monetary policy and the treatment of the exchange rate, the conduct of monetary policy in the pre-ERM II period can be based on different strategies. This is indeed the case at present, with the new Member States employing a wide variety of monetary policy strategies. Some of these countries, including Estonia, Latvia, Lithuania, Cyprus and Malta, have adopted an exchange rate objective, whereas Hungary, Slovakia and Slovenia pursue an inflation objective, while allowing for some degree of exchange rate flexibility. Two other Member States, the Czech Republic and Poland, have adopted direct inflation targeting in a context of floating exchange rates. The choice of the appropriate strategy has presumably been made by taking into account, among other things, features of a country’s financial and economic structure, including the size and degree of openness of its economy.
The challenges that may be faced by a central bank during this pre-ERM II phase will partly depend upon and reflect its strategic framework. But the main common challenge will be to achieve and maintain price stability in economies that are growing strongly and are going through profound structural changes – as I know from my own experience at the Bank of Greece. The catching-up process in terms of living standards and the liberalisation of prices is likely to result in upward pressures on inflation and an appreciation of the real exchange rate. Moreover, new Member States may face pressures on government budgets owing to an expansion of the welfare state, the ageing of the population and acquis-related obligations. Large budget deficits would increase inflationary pressures and adversely affect the current account and international competitiveness. The challenge for policy-makers is how to conduct macroeconomic policy effectively under such circumstances, so as to maintain price and exchange rate stability in parallel and in a sustainable manner.
Participation in ERM II can help a country to maintain price and exchange rate stability on the path to euro adoption. And, of course, ERM II participation for a minimum of two years is required by the Treaty in order to fulfil the convergence criterion concerning exchange rate stability. There are four key questions which must be addressed with regard to ERM II participation:
When to enter ERM II?
What should the central parity be?
How wide should the fluctuation band be?
How long to stay in the mechanism?
First, when to enter ERM II? Entry into the mechanism is not subject to any pre-established criteria or formal preconditions. In principle, a Member State can request to enter ERM II at any time. Indeed, a number of the new Member States have already indicated their wish to do so soon after accession. A smooth entry and participation in the mechanism, however, depend on a country’s economic situation and its macroeconomic policy strategy and orientation. These must be carefully assessed before decisions are made about the timing of ERM II entry. To ensure successful participation in ERM II, it would be necessary for some countries to undertake major policy adjustments – for example with regard to price liberalisation and fiscal policy – before they join the mechanism. For some countries it would be essential to adopt and start implementing a credible fiscal consolidation strategy before joining. More generally, as with any exchange rate regime, participation in ERM II is only one element of the overall policy framework and, hence, we should not regard it in isolation. The commitment to exchange rate stability – which is the essence of ERM II membership – must be compatible with the other elements of this overall policy framework, namely the monetary, fiscal and structural policies being pursued.
Second, the choice of the central rate. Finding the “right” central rate is crucial for successful participation in ERM II. While it is obvious that the central rate should reflect the best possible assessment of the “equilibrium exchange rate” at the time of entry into the mechanism, we know that estimating the equilibrium rate is not a trivial task. To limit the risk of tension and misalignments, it is essential to analyse a broad range of economic indicators and developments and also to take the market rate into account. Furthermore, it is essential that the chosen central rate be sustainable, and be perceived by the markets to be sustainable, considering the orientation of macroeconomic policies in the future, after ERM II entry, and the likely effects of expected structural change on competitiveness. If, however, a participating country is exposed to permanent changes in its economic structure, the central rate should be realigned. In this case, a realignment may indeed be a necessary and useful instrument to offset the impact of lasting disturbances, as shown by the past experience of other countries, such as Greece and Ireland. In any case, it must be kept in mind that the choice of the central rate is subject to mutual agreement by all parties involved.
Third, what should be the width of the fluctuation band? As you may know, formally agreed fluctuation bands narrower than the standard one may be set at the request of the non-euro area Member State concerned. Such decisions will be taken on a case-by-case basis and would be deemed exceptional – as they were in the past – taking into account that the standard band is appropriate for Member States that are engaging in a convergence process. In our view, multilaterally agreed narrow bands can only be considered at a very advanced stage of convergence, as in the case of Denmark. In this context, let me underline that the width of the fluctuation band within ERM II will not prejudice our eventual assessment of the exchange rate stability criterion. The assessment of exchange rate stability against the euro – in the context of the convergence evaluation – will focus, as in the past, on the exchange rate being close to the central rate, while also taking into account factors that may have led to an appreciation, as I have explained before.
Fourth, how long should participation in the mechanism be? There are no restrictions beyond the minimum period of two years prior to the convergence assessment. A number of the new Member States have already signalled their intention to adopt the euro following a convergence assessment soon after the minimum period of two years in ERM II. It should be kept in mind that the move from ERM II to the euro implies giving up, forever, monetary policy autonomy and exchange rate flexibility vis-à-vis the euro area. Especially for those countries which benefited from a certain degree of exchange rate flexibility in the past, this can be expected to have wide-ranging implications: adjustments to changes in economic circumstances or to losses in competitiveness will have to come from other policy instruments or market mechanisms, such as fiscal policy or wage and price flexibility. Against this background, it may actually be much easier for some countries to foresee a longer stay in ERM II, as this would allow them to make use of the wide fluctuation band and, if needed, to realign the central rate.
As I said before, ERM II membership is the second stage on the road to the euro. In some of the new Member States, ERM II is sometimes perceived as a “waiting room” which is almost seen as putting a brake on a desired rapid adoption of the euro. At the ECB, we see it more as a “training room” or a “testing room”, enabling new Member States to prepare their economies for euro adoption and to test the sustainability of the convergence process and of the central exchange rate which can be chosen as the conversion rate of the national currency to the euro. Participation in ERM II can be an important means to anchor exchange rate and inflation expectations and to promote discipline. It can help orient macroeconomic policies to stability, while at the same time allowing for a degree of flexibility, if needed, through the wide fluctuation band and the possibility of adjusting the central parity. These features can provide the monetary authorities of a Member State that participates in the mechanism with the necessary leeway to deal with disturbances and market-driven volatility, as well as with more fundamental adjustment needs.
This may all sound to you like plain sailing in ERM II. There remains, however, a very important question in this context, and not just for academics but especially for policy-makers: how should monetary policy react to shocks that lead to a temporary trade-off between price stability and exchange rate stability? My colleagues and myself in the ECB’s Governing Council have a clear position on this: priority should be given to price stability. This view is in line with the ERM II Resolution of 1997, which clarifies the principles and objectives underlying the mechanism. Lasting convergence of economic fundamentals, including inflation, is a prerequisite for exchange rate stability, especially in economies where convergence has only recently been achieved. The experience of older EU members demonstrates this. Take, for example, my own country, Greece: an important factor behind the successful participation of the drachma in the ERM was that we maintained a restrictive monetary policy stance and gave priority to achieving our price stability objective. This was important to mitigate the inflationary impact of the devaluation of the drachma upon ERM entry in 1998 and the effects of other inflationary shocks to price stability during the period of ERM participation. To this end, appreciation of the exchange rate within the wide fluctuation band was allowed and it contributed to offsetting such shocks and mitigating the effects of substantial capital inflows on liquidity.
Another important ingredient for a smooth and successful participation in ERM II is fiscal discipline. I do not need to emphasise to such a knowledgeable audience that fiscal policy should be consistent with the preservation of the central rate. Financial markets attach great importance to a sound fiscal position, and for good reason. Moreover, the credibility of the policy framework depends not only on the existing fiscal position and the budgetary outlook, but also on the track record of the preceding years. Fiscal consolidation will be helped by the convergence of interest rates, especially in countries with relatively high public debt and incomplete interest rate convergence. But this is not enough. The focus should be on the sustainability of consolidation by tackling structural problems instead of relying on one-off fiscal measures. If ERM II participation is based on, and accompanied by, a consistent set of credible economic policies aiming at stability and the preservation of competitiveness, the risk of destabilising capital flows is minimised and should not be overplayed.
Fiscal consolidation can also directly support and speed up real convergence. The academic literature, as well as experiences in a number of countries (such as Ireland and Greece in the 1990s), have highlighted that fiscal contractions might have favourable effects on economic activity, in contrast to the predictions of traditional Keynesian theory. For example, contractionary fiscal policies may reduce risk premia and thus interest rates by increasing confidence in government solvency, which could support investment. Furthermore, expansionary effects on private consumption are possible via so-called Ricardian effects. Fiscal consolidation could signal lower future taxes, thereby raising the expected lifetime income of economic agents. Finally, via the supply side of the economy, expansionary effects are also possible if fiscal contractions contribute to an improvement of the economy’s competitiveness, for example by moderating wage demands. The empirical literature has found support for these effects, though the possible expansionary impact of budgetary adjustments depends on a number of factors, including the size of the adjustment, its persistence, the speed of implementation and the initial state of the public finances. There is, however, broad agreement that an expenditure-based adjustment tends to be more growth-friendly and lasting than a tax-based adjustment without expenditure retrenchment.
Lastly, allow me to touch very briefly on the final period between the official EU Council decision that a country will join the euro area and the actual adoption of the euro. Ideally, interest rates should have converged and the exchange rate should be close to the conversion rate. If this is not so, the main monetary policy challenge during this phase relates to the careful management of demand. The completion of interest and exchange rate convergence entails a monetary impulse which increases the risks to price stability, and these risks may persist beyond a country’s entry into the euro area. In such a situation, fiscal policy should be used to counter the monetary impulse. In addition, inflationary pressures during the final phase could also be countered by implementing structural reforms to improve productivity growth and enhance market flexibility and competition well ahead of entry into the euro area.
While all of this may sound rather general and abstract to you here in Dubrovnik, it is by no means a purely academic issue. Even though Croatia, as a candidate country, is still in the pre-EU membership phase of the process that leads to the eventual adoption of the euro, some of the challenges that I have mentioned are already present at this early stage. Croatia has recently seen a growing external debt and a relatively large current account deficit. In this context, fiscal consolidation would be decisive in addressing the challenge posed by these external imbalances. Regarding exchange rate issues, the position that I outlined earlier will also apply to Croatia as it moves from being a candidate country to become an EU Member State.
Croatia also faces the potential challenges posed by a high degree of de facto euroisation. On the one hand, the case of Croatia shows that such a high degree of de facto euroisation does not necessarily complicate a successful disinflation process. At the same time, it may entail some specific financial stability risks, especially if the degree of de facto euroisation in assets and liabilities does not match. These risks call for tight prudential regulation. Let me also add that, while the adoption of the euro will eventually do away with these problems, it should not be regarded simply as a means to the end of overcoming these risks. Rather, the challenge is to enhance the attractiveness of financial intermediation in local currency, which would help to lessen the incentives to use foreign currencies in domestic transactions.
From what I have said, it is clear that the path towards euro adoption presents many challenges for policy-makers, both in the new Member States and in candidate countries, like Croatia. I believe we have plenty of evidence that the objective of convergence towards stability and sustainability can be a crucial compass in designing credible policies to address these challenges.
Progress towards Monetary Union, and ERM II participation in particular, should be based on, and accompanied by, a consistent set of credible economic policies aiming at stability and the preservation of competitiveness. I have emphasised the role of fiscal policy throughout the process leading towards the adoption of the euro. Fiscal consolidation based on durable and growth-enhancing measures is essential. Structural reforms which can increase market flexibility are also important, for several reasons: to ensure that current account positions and the central rate remain sustainable, and to help pursue nominal convergence in parallel with real convergence. Simultaneous progress towards nominal and real convergence can be expected to have mutually reinforcing effects and speed up both the progression towards euro adoption and the catching-up process.
The current new Member States have the opportunity to set a shining example in this regard. Learning from their experience, not least through analysis and debate of their monetary and economic policies at future Dubrovnik conferences, will help candidate countries like Croatia to prepare for and pursue a successful path towards monetary integration.
I believe I would be shown the yellow card if I were to continue further and prevent you any longer from enjoying the last course of our lunch. Thank you very much for your attention.
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