VoxEU Column Exchange Rates

Who's afraid of the Eurozone?

Written in June 2003: EU Commissioner Pedro Solbes announced that aspiring Eurozone members must keep their exchange rates within the old, narrow ERM band. If EU Finance Ministers agree, this is very bad news, raising the possibility of exchange rate crises. It is in the EU’s common interest to recognise that the new members are different; they should be given two options: early euro-isation or the Swedish-type oblivion of the wide-band ERM.

Catching everyone by surprise, EU Monetary Affairs Commissioner Pedro Solbes has announced in Prague that, to qualify for EMU membership, the newly accessing countries will have to keep their exchange rates within the old, narrow ERM bands of 2.25%. If confirmed, this would clear up an issue which has long been clouded in studied ambiguity. One of the five criteria for admission to EMU, set in 1991 by the Maastricht Treaty, requires two-year ERM membership "within normal fluctuation margins", without devaluation or serious tensions. Back then, "normal" was indeed 2.25%. History, however, threw a wrench in the definition of normality. Following the wave of speculative attacks that all but wrecked the ERM after Italy and the UK were forced to leave, the normal margins were extended to 15% in 1993. Which of the two normal margins should apply to the next round of enlargement? Officials have never said much about this thorny case of euro-semantics and most observers had concluded that the relevant margins are the existing ones. In drawing this conclusion, they were relying on legal considerations (no retroactive change of the rules), fairness (these were the margins used for determining the list of the initial euro area team) and economic rationale. Indeed, many economists consider that the currently existing wide band of 15% is already too restrictive for the transition countries, so aiming at the narrow band is clearly an overkill.

The new EU member countries are mostly transition countries from Central and Eastern Europe. These countries are in the process of catching up with the west, which means faster growth and rising standards of living. Right now, though, costs of production there are low, which makes them highly attractive for foreign investment, especially as EU membership will soon mean that goods produced there enjoy unfettered access to the common market. In fact, foreign investment is one of the ingredients that will allow these countries to catch up. All good news, it would seem.The hitch is that good long-term investment tends to be accompanied, actually overwhelmed by more volatile short-term capital inflows. Attracted by high returns these inflows can be footloose, ready to leave at the mere prospect of even minor hiccups. And hiccups tend to happen with disarming regularity. When they do, the short-term capital inflows promptly turn into panic exit, and the exchange rate takes a big hit. From Latin America to South East Asia, sudden capital reversals have wrecked once virtuous countries. This is why most of the serious discussion has focused on whether the new normal margin is wide enough. The optimists, mostly found in official circles, thought so. They were proven wrong last winter when several countries in the regionthe Czech Republic, Hungary and Polandsaw their exchange rate promptly rise by 10 to 15% under the pressure of capital inflows prompted by the agreement that accession to the EU would take place next May. The cautious view, that 15% is not wide at all for the transition countries, seemed to have won the argument. Not so, says Mr. Solbes, without much of an explanation.

If the Finance Ministers, who will have the last word, go along, this is very bad news for the accessing countries. Unless they are blessed with a good luck that has eluded most recent economic miracles, the accessing countries will face the flux and reflux of capital flows that bedevils all countries which integrate themselves in the world financial markets. The only way to cope with such movements is either to let the currency float, or to give up the currency altogether. The Maastricht Treaty closes both doors. ERM membership is compulsory; there are no more opt-outs. Direct adoption of the euro is also ruled out by the two-year ERM membership criterion. The least bad solution was the wide-band ERM, already a high risk undertaking. So what is likely to happen? A wave of reversals, leading to forced devaluations that set the clock back, again and again. Maybe that is what Mr. Solbes secretly wishes, but then he deludes himself in believing that the old West will be spared the pain of recurrent currency instability within the expanded EU. We have gone through currency instability in the 1980s, and we did not like it a bit. The reason then was that a number of countries did not rein inflation in. Paradoxically, the transition countries stand to attract more capital the more virtuous they are, only to see it flee for the kind of unpredictable reasons that have created havoc in emerging markets. During the accession negotiations, the Commission has systematically worked to make the candidate countries bear all the risks. Here it goes again, but this time the incumbents will not go unhurt. The common interest is to recognise that the accessing countries are different. They should be given either of two reasonable options: early euro-isation or the Swedish-type oblivion of ERM.

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