Policy Paper 10: Sustainable Regimes of Capital Movements in Accession Countries

Policy Paper 10 is available on request from our sales team at [email protected] or 020 7878 2903 The European Union can now look forward to the entry of ten new members, following the negotiations for entry completed under the Danish presidency. As the accession countries embark on the next phase of the path toward formal entry into the EU, most are expected to join the Exchange Rate Mechanism (ERM-II) in short order, prior to ultimate adoption of the euro. This period could be a time of heightened vulnerability to financial instability, requiring extremely adept economic management. With limited exchange rate flexibility under ERM, disinflationary conditions, and no exemptions from full international capital mobility, EU accession countries are likely to experience large "convergence play" capital inflows. Alarmingly, large capital inflows figured in virtually every financial crisis of the 1990s. Managing an exchange rate regime designed to limit the movements of a currency to prespecified bands while holding open the realignment option is very challenging in a world of high capital mobility. Capital inflows also stress the banking system by fuelling a lending boom, which can lead to investment in increasingly poor quality assets if the system is poorly managed or regulated, and a sudden reversal of capital flows can seriously threaten an economy with a fragile banking system. Clearly, there are major challenges ahead for the accession economies in the run up to euro adoption. They must implement an exchange rate regime consistent with the prospect of greatly increased capital inflows, and select appropriate macroeconomic and financial policies so as to avoid an outbreak of financial instability. And they must adapt the regulation of their banking and financial systems to contain these risks. Building on the lessons learned from past financial crises and comparable transitional periods prior to monetary union by other EU countries, this Policy Paper makes recommendations for how the accession countries might establish sustainable capital mobility regimes, as they negotiate the tricky path to full global financial integration and monetary union.