At a CEPR lunchtime meeting on 11 June, José Viñals examined the reasons for Spain's 1989 entry into the Exchange Rate Mechanism of the European Monetary System (EMS), the impact of membership to date and the potential medium-term benefits of membership. Dr Viñals is Deputy Chief of the Research Department, in charge of International Economic Studies, at the Banco de España and a Research Fellow in CEPR's International Macroeconomics programme. His talk was based on CEPR Discussion Paper No. 389, entitled `The EMS, Spain and Macroeconomic Policy'. The meeting was held as part of a new CEPR research programme on `Financial and Monetary Integration in Europe', funded by the Commission of the European Communities. The opinions expressed by Dr Viñals were his own, however, and not those of the Banco de España, the CEC or CEPR.

Viñals noted that for most of the period 1986-8 the peseta had deliberately been kept within a 6% band relative to the EMS currencies. Spanish policy-makers were therefore faced in 1989 with the choice of maintaining this managed float or formally setting exchange rate targets inside the EMS.

Given the increasing integration of the Spanish economy with the rest of the European Community, they considered the benefits from avoiding exchange rate misalignments and from reducing exchange rate uncertainty to be important. They viewed the EMS as a useful device for reducing the size of short-run, unpredictable and self-reversing changes in exchange rates, and for allowing the authorities to accommodate medium-run exchange rate movements through suitable realignments. In view of the increasing ineffectiveness of autonomous Spanish monetary policy in controlling domestic inflation, they also hoped that joining the EMS would enable Spain to import Germany's anti-inflationary stance. They thus hoped to use EMS membership to combat both the destabilizing effects of financial innovation on the demand for and supply of money and the political pressures inherent in the subordination of the domestic monetary authority to the Treasury, and to consolidate and lock in the anti-inflationary gains already made.

Viñals maintained that there were two main prerequisites for the successful entrance of the peseta into the EMS, which both appeared to be satisfied by mid-June of 1989. First, the inflation differential between Spain and the established EMS member countries had fallen from 8.9 percentage points in 1986 to 3.8 in 1989, and thus seemed small enough to justify entry. Nevertheless, it seemed safer for Spain to enter with a band of 6% rather than 2.25%, at least during a transitional period.

Second, Spain had made considerable progress in the agreed programme to liberalize its trade with the rest of the Community since its entry on 1 January 1986, which involved major changes in the structure of effective tariffs and subsidies and significant reductions in quotas and other non-tariff trade barriers. It had already dismantled many of the quantitative restrictions to EC trade and had also achieved about half the agreed reduction in the 14% basic tariff. Although a basic tariff of 6.65% still remained to be eliminated after 1989, it seemed that an exchange rate band of 6% would probably be sufficient to accommodate the remaining changes in relative prices and intersectoral reallocation of resources between the tradable and non-tradable sectors that had become necessary as a result of liberalization.

Viñals noted that the choice of the central exchange rate vis-à-vis the rest of the member currencies was as important as the timing of entry and the width of the bilateral fluctuation band, and he argued that it should be guided by two factors. First, the central rate should allow the potential anti- inflationary gains to be reaped from EMS membership, without at the same time putting too great a burden on the external competitiveness of the economy. Second, the chosen central rate should be sustainable inside the EMS, at least in the short run.

Standard purchasing power parity calculations indicated that the peseta was slightly overvalued by June 1989, but policy-makers felt that any attempt to devalue the peseta significantly would have been rapidly offset by the market, given the very large interest rate differentials in favour of the peseta at that time. They therefore chose a central rate to be consistent with the interest rate differentials, which they accepted would remain in the short run, so that their chosen rate was consequently close to the actual market rate. Further, given the relatively high degree of de facto wage indexation in Spain, any significant devaluation would have exacerbated wage- price pressures at a time when inflation was already rising in response to the strong growth of domestic demand. Any favourable effects on competitiveness arising from a devaluation would therefore have been small and transitional, while its impact on inflation would have offset the anti-inflationary benefits expected from the entry. The central rate was therefore set at 65 pts/DM, which proved to be reasonably close to the closing market rate of 64.3 pts/DM on 16 June, on the eve of entry.

Viñals noted that peseta has so far been able to hold its own inside the EMS, and that it has proved to be one of the `stronger' member currencies. During this period the Spanish economic authorities have tried to achieve both price and exchange rate stability with monetary policy alone, rather than with a combination of monetary and fiscal policies. Spain's fiscal stance has remained expansionary, and this has necessitated a sharp monetary contraction in order to control inflation, which has led in turn both to the maintenance of existing capital controls and to the introduction of new credit guidelines.

Viñals concluded that the constraints imposed by formal membership of the EMS have significantly increased the difficulties faced by the Spanish authorities in sustaining the current macroeconomic policy mix and that the private sector knows this. Spain's membership of the EMS may therefore make it easier for the authorities to enforce fiscal policies that are less expansionary than those they would apply if the peseta had remained outside the EMS.