European Integration
EMU and EFTA

As the European Community unifies its financial markets, fixes its exchange rates and moves towards a single currency, the EFTA countries are already liberalizing their capital markets and must choose whether to join the Exchange Rate Mechanism (ERM) of the EMS or maintain independent currencies and exchange rate policies. In Discussion Paper No. 586, Research Fellow William Branson reviews the constraints on current account financing and monetary policy that EFTA countries would face by attaching themselves to the ERM and participating fully in the unified European financial markets. He also examines three alternatives: an active exchange rate policy aimed at maintaining domestic price stability; a fixed peg with a different basket; and gradual adjustment of the real exchange rate against either basket. OECD Europe is already essentially self-financing, with its surplus countries financing its deficit countries. Such intra-European capital flows should increase with financial and monetary integration, which reduce exchange rate risk for borrowers and lenders alike. If the EFTA countries join the ERM, their governments will face the same borrowing constraints as their private sectors; provided all parties respect the arithmetic of dynamic debt solvency and sustainability, financial markets will provide the financing required to maintain payments balance within Europe.
Branson argues that the well-known tight constraint on EFTA countries' monetary policies implied by their joining the ERM in fact applies to any policy other than a floating rate once their capital markets are integrated with those of the European Community. Joining the ERM entails two decisions: pegging the nominal exchange rate, and choosing the ecu as the basket. Instead of pegging, a country could manipulate its nominal exchange rate to maintain domestic price stability. This may be appropriate for a small country in a turbulent environment, but not for the EFTA countries especially if German price stability continues as the nominal anchor of the EMS. They could peg to a basket other than the ecu, but with the UK and the Nordic countries in the exchange rate arrangements of the EMS, the ecu would itself closely approximate the most suitable trade-weighted basket; and the elimination of exchange rate risk this affords is probably essential if the potential gains from European financial integration are to be realized. The third alternative is gradual real exchange rate adjustment in the face of external disequilibria; but current account financing and market discipline for public and private borrowers probably make such adjustment unnecessary, and in a financially integrated Europe it is probably impossible. Branson therefore concludes that a policy of full participation in the European Community's financial integration, adherence to the EMS and joining the ERM is probably the best option available to the EFTA countries.

Exchange Rate Policies for the EFTA Countries in the 1990s
William H Branson

Discussion Paper No. 586, October 1991 (IM)