Speech by John Townend, Director for
Europe
To the British Embassy Lecture Series on
EU Candidates' Path to EMU, Helskinki, 16 March 2001
I am going to speak about the road to a larger membership of Monetary Union, and I should start by clarifying - and in the process no doubt disappointing some - that I do not intend to talk about the prospect and timetable for UK membership. That would quickly get me into hot water, or onto thin ice, so I intend to leave that on one side. Instead I am going to talk about the path to Economic and Monetary Union, or EMU as I shall refer to it from now on, for those countries which are not yet members of the European Union - not Switzerland of course, which has just voted a resounding 'no' to immediate negotiations, but primarily the countries just over the European Union border in Central and Eastern Europe. Altogether there are 13 officially-recognised candidates for accession, although only 12 of these have started negotiations (the odd one out being Turkey).
I recognise that enlargement is not universally viewed as to be welcomed. But the UK Government has consistently taken a strongly positive view, indeed been a 'champion' of enlargement. It believes in successful enlargement, and is actively engaged in trying to make this happen as soon as practicable. There is no question that, since the removal of the Berlin Wall in 1989, Europe has the opportunity to become reunited as a region of peace, freedom and prosperity. And enhancing European stability and security represents a fundamental strategic geopolitical objective. In addition, enlargement will enhance substantially the size of the single market, giving free access to perhaps half a billion consumers, many more than in North America, to the benefit of all European Union member countries; and it will help combat problems such as environmental pollution, cross-border crime and illegal immigration.
As our own Prime Minister said in Warsaw in September: "Enlargement to the East may be the EU's greatest challenge, but I also believe it is its greatest opportunity.". He called for new Member States to participate in the European Parliamentary elections in 2004 and the next Inter-Governmental Conference; and these calls, which had of course also been mooted by your Prime Minister, were endorsed at the Nice Summit last December. Nice also agreed a 'road map' for taking forward the negotiations over the next 18 months, which makes possible the end of negotiations in 2002. And, by completing the IGC last December, and addressing the necessary institutional changes to allow an enlarged European Union to continue to function effectively, it gave the green light to the possibility of enlargement from the end of next year. I simply note in passing the positive and constructive role which the UK Government played in achieving this outcome, which stands in some contrast to those who see Europe as a continual battle of "the UK versus the rest".
So much for the politics of enlargement - about which I shall say no more. But just as the economic arguments, for and against, are significant in relation to UK potential entry to EMU, so economics should play significantly in the approach of the accession countries - both in relation to European Union, and subsequently to EMU, membership. The accession countries as a group have already made significant progress in beginning to address the necessary economic and structural reforms, and to provide the necessary greater macroeconomic stability, essential for European Union membership but also in any event to their own national benefit. However, whilst we in the UK favour enlargement of the European Union as soon as practicable, I propose to address the question whether it necessarily follows that there are as strong arguments in favour of early EMU membership. It is in fact perfectly possible, as I shall argue later, that the earlier in time European Union entry takes place, the longer the interval which might be warranted before EMU entry.
To explain why, I would like to begin by considering the economic advantages and risks involved in joining EMU, as they are understood in the UK, before turning to the issues which the accession countries face on their road to European Union, and later EMU, membership.
The advantages and risks of joining EMU
In the UK, we have always recognised that EMU is fundamentally a political, as well as an economic, issue. EMU involves the pooling of sovereignty over monetary policy and requires close co-ordination of fiscal policy. But there is no historic parallel on this scale for a single currency among so many sovereign participant countries - 12, with Greece's entry at the beginning of this year. So it is not in practice clear how far the pooling of sovereignty needs to go, either to make EMU function properly or to achieve some broader political purpose. Since this is for politicians rather than central bankers, I shall have nothing to say on the subject, except to note that a successful single currency opens possibilities for further political integration which are unlikely to materialise if instead the single currency area becomes a region of great economic tension between the participants.
But EMU is not just about politics. It is also about economics. And the economics of EMU are not straightforward. There are both considerable potential benefits and equally considerable risks. One of the undoubted benefits of EMU is that the euro helps to establish deeper and more liquid financial markets in Europe. Previously, these were segmented by national currency. Now, instead of 12 different currencies, there is only one single currency; a much bigger financial market-place is being established and, when fully developed and integrated, this will be of benefit to investors and borrowers alike. In the process, Europe's capital markets will become more efficient and the euro more widely used. Perhaps surprisingly to some of you, the City of London is playing a key role in helping to achieve that goal. Indeed, this is arguably the most positive and constructive contribution that we in the UK can make to the success of the euro from the 'outside'.
There is another - even more fundamental - benefit from EMU. The introduction of the euro removes for its participants nominal exchange rate uncertainty, indefinitely into the future and across a wide economic area. This is naturally attractive to those exporting elsewhere within the euro area, so long as the exchange rate at which their currency has been locked to the euro is appropriate, in the sense of being a broadly sustainable rate. As companies can trade and invest across a wide area without any nominal exchange rate risk, prices become more transparent. Transaction costs are lowered. Competition is greater. And economic resources can be allocated more efficiently. No-one should be in any doubt that these are very real benefits indeed, and that if they are fully realised a much more dynamic euro area economy could result. Of course, if this prize could be readily secured, without any downside, then the participants would have discovered a 'free lunch' already for over 300 million people!
Regrettably, EMU also involves equally significant risks. The main risk is the 'one-size-fits-all' short-term interest rate throughout the euro area. EMU means by definition a single currency. A single currency necessarily implies a single monetary policy. And a single monetary policy means a single official short-term interest rate for the whole of the euro area. The risk is that this single interest rate may not in practice suit all the participants in EMU all the time: indeed, at any particular point in time, it may not precisely suit any of the participants. They may have different cyclical positions; they may have divergent fiscal positions; or they may be affected in different ways by what we call, in the economic jargon, 'asymmetric external shocks' - shocks from outside which affect different countries to a different extent, and may require potentially differentiated policy responses.
The famous Maastricht convergence criteria try to help reduce these risks, by addressing sustainable economic convergence. Inevitably, however, assessing sustainable convergence is a matter of judgment. Divergent regional needs already exist within countries, as well as between them, as we in the UK know only too well. But alternative adjustment mechanisms (like fiscal transfers between rich and poor regions) are better developed within countries than across the euro area as a whole, and I see no-one arguing to raise the small European Union budget to allow significantly greater transfers. This leads to the, by now conventional, wisdom that, for EMU to work well, the participating economies - current and prospective - need to be made as flexible as possible; and that the highest priority should as a result be attached to supply-side policies to improve the functioning of markets, particularly the labour market.
In the UK case, it is virtually indisputable that the balance of these economic arguments came out strongly against participation in EMU at the outset. But the British Government has maintained its position of support for UK entry in principle, and will put a decision to the British people in a referendum if and when joining EMU is judged to be clearly in the national economic interest. The Government has recently indicated that it will make its assessment within two years of the next General Election.
Relevance of UK experience to the accession countries
Before turning to the issues facing the accession countries in the period ahead, let me say something about the British experience and why it may be relevant to them. We have been wrestling over the entire post-war period with the most important, but intractable, practical problem for monetary and exchange rate policy-making. This is how best to achieve simultaneously both internal (domestic price) stability and external (exchange rate) stability.
In the process, we have applied any number of different monetary regimes, including hard and soft exchange rate objectives, intermediate monetary targets of one form or another, and most recently an inflation target. Many of these have achieved considerable success in delivering either internal (domestic price) or external (nominal exchange rate) stability. But what we have found hard is achieving, over any sustained period of time, both internal and external stability simultaneously. This is perhaps not surprising. With one monetary instrument, the interest rate, it is rather difficult to achieve two targets, at least other than for very short periods, certainly in such an open economy as the UK, both on trading and capital account.
Some people have suggested that the best prospect of achieving both together would - on the right terms and in the right circumstances - be for the UK to join EMU. But this could not guarantee complete stability, because the UK's inflation rate could continue to diverge from the rest of the euro area; and the euro obviously fluctuates against non-euro area currencies (which would affect the 40% or so of UK visible trade which is not with the euro area). Only a single world currency could achieve complete external stability, and this is not on the agenda even for the new Millennium - at least yet!
The reason I mention this issue of how best to deliver both internal and external stability, and the lessons which one might draw from the UK's experience, is that - as I will explain - many of the accession countries are also likely to face difficulties themselves in achieving both internal and external stability simultaneously. Of course, each accession country will need to decide for itself, in the light of its own particular circumstances, how best to balance the potential conflicts in determining its own optimal policy.
Obviously, from an institutional and legal point of view, the UK is in a different position from the accession countries. We have an 'opt out' from EMU, under the Maastricht Treaty; by contrast, once accession countries succeed in becoming members of the European Union, they have no choice about joining EMU. But they do have a choice about the timing of EMU entry, and I will argue that, as in the UK case, premature entry is unlikely to be in their best economic self-interest.
Meeting the Copenhagen criteria
Let me turn now directly to the issues which the accession countries face. There are distinct sets of criteria which they must meet for European Union and EMU entry. In order to join the European Union, accession countries must be judged to have met sufficiently the so-called Copenhagen criteria (after the Copenhagen European Council in June 1993); before entry to EMU, they must meet sufficiently the Maastricht criteria (after the Maastricht Treaty signed in February 1992). So self-evidently, since European Union entry must precede EMU entry, countries must meet the Copenhagen criteria before they are required to meet the Maastricht criteria; and this may have implications for the appropriate sequencing of particular policies.
The Copenhagen criteria include the establishment of: the rule of law; stable democratic government; a functioning market economy, including the establishment of property rights; the capacity to cope with competitive pressure and market forces within the European Union; transposing and implementing Community laws; and agreeing in principle to join EMU.
The European Commission reports regularly on progress by individual accession countries in achieving these objectives. In its most recent report last November, the Commission identified eight Central and Eastern European countries as 'functioning market economies', five of them being able to cope with competitive pressure and market forces in the European Union in the 'near' term, and three others in the 'medium' term. This willingness to differentiate between accession countries is welcome, and wholly consistent with the principle, set out at the Cardiff European Council in June 1998, that candidates should join the European Union at their own pace, when each is ready.
Clearly, the Copenhagen criteria themselves are open to interpretation. It is not possible to prescribe a precise level of structural convergence that needs to be achieved before accession. In any case, the process of structural convergence can continue after accession, as the experience of Portugal and Ireland for example shows. Since its accession in 1986, Portuguese GDP per head has increased from 30% of the European Union average to 50%. And Irish GDP per head has increased from 50% of the European Union average, on accession in 1973, to above the European Union average since 1996, though Ireland has benefited from an amount of agricultural support and financial aid that will not be available to the accession countries.
The European Union framework within which Ireland and Portugal achieved an increase in their living standards involved adopting a core 'acquis' from the outset, designed to safeguard the functioning of the internal market, while allowing limited transition periods after accession in specific areas. This model has much to commend it in the case of the accession countries in Central and Eastern Europe.
However, the experience of existing European Union member states, like Ireland and Portugal, suggests that the benefits of accession cannot be achieved without transitional costs. And the accession countries in Central and Eastern Europe are, on average, further behind than Ireland and Portugal were at the time of their accession, and so they have further to catch up. GDP per head in the accession countries ranges from about one-quarter of the European Union average (in the case of Bulgaria) to some three-quarters (in the case of Slovenia). Only Slovenia and the Czech Republic have a higher income per head now than Portugal had at the time of its accession. According to Dutch central bank estimates, countries like Poland and Hungary would need to grow by more than 10% each year on average for the next 20 years in order to reach the average income per head of Portugal, Spain and Greece.
Ireland and Portugal also had a head start in institutional terms, since before accession they had been for some time market-based, rather than centrally-planned, economies. Clearly, transforming a centrally-planned economy into a fully-fledged market economy is a much harder task. Some progress has already been made in the accession countries. But in order to catch up with living standards in the European Union, both in terms of income per head and price levels, there are still a number of major challenges for the accession countries to overcome. For example, in the financial arena, all accession countries have put in place a legal and regulatory framework for the banking sector, but in some cases they have had difficulty in implementing it effectively; financial sectors, and markets, remain substantially under-developed; and domestic saving is insufficient to finance the levels of investment that accession countries require to catch up, so external financing is required, yet in many countries some form of capital controls remain which hinder this. Dealing with these, and the myriad of other, issues in order to meet the Copenhagen criteria is clearly a major task for many of the accession countries.
Meeting the Maastricht criteria
Meeting the Copenhagen criteria should, however, also provide the foundation for meeting in due course the Maastricht criteria for joining EMU.
In principle, Central and Eastern European countries appear to satisfy many of the optimal conditions to form a currency union with the present euro area. Individually and collectively, they are small and very open economies - with external trade a high proportion of their GDP, and almost two-thirds of this with the euro area. Moreover the shape and structure of their economies is changing, with significantly less emphasis on agriculture and a growing diversification, which over time will make them less susceptible to asymmetric external shocks.
And in practice too, the accession countries as a group have already made some progress towards meeting the Maastricht criteria. For example, in 1999 their government debt averaged 36% of GDP, around half the euro-area average; moreover, although their fiscal deficits averaged 3.7%, a number were already below the 3% Maastricht ceiling; and inflation on average in the accession countries fell from 130% in 1997 to just under 11% last year (with Romania standing out as the only country where inflation is forecast still to be above 10% this year and next).
But, despite the progress they have made, this does not mean that rushed entry into EMU would be in the interests of the accession countries themselves.
There are a number of reasons why Central and Eastern European countries should be cautious about proceeding from European Union accession to EMU entry too quickly. First, although their economies have become somewhat more diversified, they are still quite vulnerable to external shocks, particularly because of their openness and dependence on foreign capital inflows. The market's response to the Russian crisis in 1998 is a good example, though foreign capital flows to Central and Eastern Europe did in practice hold up much better than to other emerging markets, because the shocks were smaller and their foreign currency defences were greater. Of course, it would be quite understandable if accession countries were to argue that their vulnerability to external shocks is itself a reason for joining EMU as soon as possible. However, joining EMU would not protect them from these external shocks, if their fundamental economic convergence with the euro area prior to joining EMU were insufficiently complete.
Second, the structural reforms which Central and Eastern European countries need to undertake are fundamental. Besides the establishment under the law of property rights, banking reform and enterprise restructuring, they include social security, health, education and pension reforms. Some of these reforms involve significant fiscal costs, which are estimated at around 2% of GDP annually over the next six years, even in the more advanced countries. In Poland, for example, there are costs in restructuring the coal and steel industries; environmental costs; social costs, arising particularly from reduced agricultural demand for labour; and, more generally, costs in making the labour market more flexible. For all these reasons, meeting the Maastricht criterion on budget deficits on a sustainable basis in the accession countries will not be straightforward.
A third, and more fundamental, reason why Central and Eastern European countries should not join EMU too early after European Union accession is because they are likely to experience real appreciation in their exchange rates. This is the so-called 'Balassa-Samuelson effect', whereby rapid increases in productivity in the traded goods sectors of their economies (spurred by structural reforms and foreign direct investment inflows as the catching-up proceeds) drive up wages and prices across the economy more generally and result in an appreciation in the real exchange rate. This real appreciation can take the form of either nominal appreciation in their exchange rates, or a relatively high inflation rate - or some combination of both. Even though productivity growth in the accession countries has slowed down recently, it is arguably still driving up consumer prices by as much as 3% per annum in the more advanced economies.
Looking at this issue in terms of the accession countries' exchange rate management, it is easy to see the potential for conflict between a number of different objectives. First, they naturally regard a stable exchange rate as generally desirable, given the scale and significance of their external trade. Second, to the extent that real exchange rate appreciation is inevitable in the catching-up process, it is important that any resulting nominal exchange rate appreciation is in practice smooth and orderly, so as to avoid losing competitiveness. And third, to meet the Maastricht inflation criterion, it is important not to allow too much of the real appreciation to come through faster domestic price inflation, which puts more of the upward pressure back on the exchange rate.
It is clear that there are no easy answers, and each accession country will have to decide how best to balance the conflicts, in its own circumstances. These issues are of course relevant to the accession countries throughout the period before they reach the final destination of EMU entry, both before and after they join the European Union.
If the accession countries were to join EMU too soon after joining the European Union, they would clearly lose the exchange rate as an adjustment mechanism. The 10 Central and Eastern European accession countries as a bloc represent only 6% of euro area GDP, on current data. So there can be no guarantee that the 'one-size-fits-all' monetary policy within the Eurosystem would suit them. Indeed the earlier the date they join EMU, and the more catching up therefore at that point still to do, the faster their likely rates of economic growth - and inflation - and the less likely the single interest rate would suit their particular circumstances.
It is therefore important for these countries themselves that they do not join EMU before they have achieved sufficient sustainable convergence with the euro area. This judgment is entirely consistent with the experience of Spain and Portugal, which after all had 13 years between European Union accession and EMU entry, and Ireland, which had 26 years.
Exchange rate regimes prior to EMU
This leaves the tricky question of precisely what exchange rate regime the accession countries should follow in the period ahead of EMU entry, from an economic policy point of view. Each country must make its own choices, but the key is that they should do so fully informed by the pros and cons.
It is clear that different countries have taken different decisions, and also in many cases changed their decisions over time. Some (like Poland and the Czech Republic) now have a relatively freely-floating exchange rate; whereas others have a more tightly constrained rate, including at the extreme a rigid currency board arrangement linked effectively to the euro (like Estonia and Bulgaria). This is not surprising. Each country has different experiences and traditions on which to draw, and no exchange rate regime is free from downsides.
Fixed exchange rate regimes tend to be particularly risky by providing targets for speculators, though currency boards are a potential exception, when they have established sufficient credibility, most obviously by being set in a coherent and prudent macroeconomic policy framework. On the other hand, more flexible exchange rate regimes - particularly in the circumstances facing accession countries - can lead to upward nominal exchange rate pressure, in response to large capital inflows, increasing balance of payments deficits on current account, and indirectly increasing vulnerability to shifts in investor sentiment.
In-between these so-called 'corner solution' extremes, of freely floating or rigidly fixed exchange rates, there are a whole range of different possible regimes. An intense international debate is currently taking place about whether any such intermediate solutions are viable in a world of international capital mobility and monetary policies dedicated to national goals. But this would have to be the subject of another lecture. I simply note in passing that ERM II is one particular form of intermediate exchange rate regime, which the accession countries are required to join before entering EMU, and there is a real question, given this international debate, about how viable such a step might be in their circumstances.
'Euroisation'
If the Central and Eastern European countries take time before joining EMU, what role can the euro play in their economies in the meantime? At one extreme, it has been suggested that there may be a case for accession countries to adopt the euro unilaterally as their official currency. This is sometimes referred to as 'euroisation'. There is a debate about whether euroisation in this sense would be consistent with the Amsterdam Treaty. But whether it would or not, it is clear that the Commission and the ECB are opposed to unilateral adoption of the euro by accession countries. This is because they believe it would complicate the negotiations on European Union and EMU entry, where the adoption of the euro is seen as the end-game in the convergence process.
On the other hand, 'euroisation' could also be interpreted to mean the use of the euro in parallel to a particular country's domestic currency. In the absence of exchange controls imposed by the euro area itself, there is no practical way of preventing the use of the euro as a parallel currency outside the euro area.
The euro is of course already extensively used in financial markets. But it is not yet clear how far the euro will be used internationally outside the financial system. That depends on the extent to which the euro builds up credibility as a means of exchange and store of value. The Deutschemark in particular has performed this role in Central and Eastern Europe recently, and it is quite possible that the euro will come to do so, once euro notes and coin are in issue. In other words, even where it does not yet act as the single currency of Central and Eastern European countries, the euro could come to serve as a common currency.
Monitoring and technical assistance
Finally, it is important to make the point that accession countries will not be treading the path to EMU on their own. They will be doing so with the encouragement and assistance of the European Union. Institutional and structural reforms in the accession countries will be closely monitored, not just through their own Pre-accession Economic Programmes; they will also be monitored by the Commission (in its annual assessments of macro-economic and financial stability in the accession countries); and through peer pressure for the adoption of 'best practice' on structural reform and employment, as already happens in the European Union under the Cardiff and Luxembourg processes. These initiatives need to continue after accession. And the Bank of England will continue to play its part by offering technical assistance to the accession countries, and by providing high-level training courses tailored to their needs.
Conclusion
So, in conclusion, my main message is this. Instead of entering EMU prematurely following entry to the European Union, the accession countries should consider carefully the economic condition in which they might find themselves. If, after a relatively early European Union entry, they still have considerable catching up to do, their economies will need greater rather than less flexibility. And to give up prematurely such a powerful instrument of flexibility as exchange rate adjustment, by entering EMU too early, would carry significant downside economic risks. We understand this all too well in the UK, and that is why the UK decision whether to join EMU in our own economic circumstances is so finely balanced.
