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Part 1 Fundamentals of International Finance - Lecture n° 5

International Finance. Part 1 Fundamentals of International Finance - Lecture n° 5 Money integration in the European Union. European Monetary Union. Introduction

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Part 1 Fundamentals of International Finance - Lecture n° 5

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  1. International Finance Part 1 Fundamentals of International Finance - Lecture n° 5 Money integration in the European Union

  2. European Monetary Union • Introduction • European Union : case study for exchange rate co-operation leading to a monetary union. Catalogue of lessons about benefits and costs of a single currency, and of advantages and disadvantages of different institutional structures. • History: • European Monetary System (EMS) started in 1979 with relatively flexible target zones, becoming progressively more rigid. • 1987 - 1993 : rigid exchange rate fluctuation bands • 1993 : large speculative attacks, causing a large threat on the system. Introduction of Euro postponed of 2 years. • 1999 : Euro as scriptural common currency • 2002 : Euro as fiduciary common currency

  3. European Monetary Union • The European Monetary System (EMS) • Main objective of EMS : promotion of monetary stability within Europe. • Three immediate aims as established in 1979 : • Reduction of inflation in EU countries • Promotion of exchange rate stability to favor trade flows and investments • Gradual convergence of economic policy, allowing for more fixed exchange rates. • Features of the EMS • Three main elements : the European Currency Unit (ECU), the Exchange Rate Mechanism (ERM) and the European Monetary Cooperation Fund (EMCF).

  4. European Monetary Union • The ECU : weighted average of all EU currencies, weights depending on the size of each country and its importance in intra-EU trade (DM, FRF, Sterling). • ERM : exchange rates allowed to fluctuate up to 2.25% or 6% on either side of the central rate. • July 1993 : fluctuation bands were extended to 15%. • Currencies maintained within bands through compulsory interventions by the monetary authorities. • Possibility for the central rate to be realigned (7 until 1987; DM and DG always revalued) • EMCF : provides credit for members to help in adjusting balance of payments problems, at short-term (9 months) or medium-term (2-5 years).

  5. European Monetary Union • The European Monetary System (EMS) • The achievements of the ERM : • Stability of the exchange rates • The cost of higher interest rates volatility (to reduce pressure on X rates) has been avoided thanks to the capital controls in the ERM in the 1980’s. • Question of the benefits of exchange rates stability on the intra-EU trade. Khalid & Sapir (1990) find little evidence of the effect of X rate volatility on prices -> little impact on commercial trade activities • Reduction of inflation • Argument : due to asymmetry effect in fixed X rates regime, deficit countries have to disinflate, whereas surplus countries could avoid inflationary policies by sterilisation.

  6. European Monetary Union • Reduction of inflation in EU - empirical evidence • Number of pieces of evidence which suggests that ERM has worked asymmetrically. • Intervention within the system support the view that Germany was the leader. • Inflation in initially higher inflation countries did converge on German levels. • Idea of a reduced cost of disinflation (in terms of unemployment), thanks to the credibility bonus brought by the pegging of currencies to low inflation countries (Germany). • However, empirical evidence is mixed on this view. But high costs in ERM countries might be due to the nature of the labour markets (half way between high centralisation and high decentralisation).

  7. European Monetary Union • The European Monetary System (EMS) • The stability of the ERM : why the ERM has been so successful during such a long period of time? • Five factors identified in the literature : • (1) Co-operation among ERM countries and the existence of the various financing facilities. • ERM is part of a wider, institutionalized, co-operation framework among European countries : Single Economic Market (1992), Agricultural policy, … Financing facilities in provide Central Banks of large amount of money in case of speculative attacks.

  8. European Monetary Union • The European Monetary System (EMS) • Five factors of stability for the ERM : • (2) Clever operational features in the design of the exchange bands : • Co-existence of narrow bands (2.25%) and wider bands (6%), providing some flexibility for high inflation countries, allowing them to gradually adapt their economic policies. • Wider bands can help realignments : a narrow band country (e.g. France) can realign (ex : +3.5%) while a wider band country may avoid realignment (since 3.5%< 6%). Therefore, speculator can expect the sense of realignment for France, but face greater uncertainty on the case of Italy -> reduce the probability of a speculative attack. • Timing of realignment decided very quickly (until Sept 1992) decreased speculative pressures.

  9. European Monetary Union • The European Monetary System (EMS) • Five factors of stability for the ERM : • (3) Luck. Several fortuitous circumstances promoted stability within ERM. • Co-operation of policy goals among several ERM governments, focusing on disinflation and willing to accept the discipline implied by the system (in the 1980’s). • UK was not a member : DM was the only large currency in the system, and policy disagreements - possibly - have been avoided. • Strength of the dollar in the 1980’s reduced the pressure for appreciation on the DM. The dollar’s fall had then been managed according to the Plaza and Louvre agreements.

  10. European Monetary Union • The European Monetary System (EMS) • Five factors of stability for the ERM : • (4) Existence of capital controls • Allow some monetary independence to the countries, by preventing large capital flows if interest rates differentials. Ex. tight monetary policy of Spain in the late 1980’s (high interest rates). Peseta protected from depreciation pressures thanks to controls on capital inflows. • Help to prevent speculative attacks, by reducing the amount of money flowing in or out of a currency. Allowed then to delay some realignment decisions and anti-inflation policy to develop (without deprecation as soon a inflation rises). • Capital controls within ERM slowly eliminated by the end of the 1980’s.

  11. European Monetary Union • The European Monetary System (EMS) • Five factors of stability for the ERM : • (5) Growing credibility of the exchange rate parities • Some authors argue that the system would have been viable even without capital control, since it was credible, and realignments were not credible (the 1993 crisis proved the contrary). • Crises of the ERM - Facts • September 1992 : speculative attacks leading to the departure of Italy and the UK from the system. Peseta devalued by 5%. Ireland, Portugal and Spain tightened their capital controls. • July 1993 : Several realignments of Ireland, Portugal and Spain. Pressure on the FRF and bands extended to 15%.

  12. European Monetary Union • Crises of the ERM - Triggering Factors • Breakdown in the economic policy agreement. France wanted to focus on growth and unemployment, Germany trying to absorb the shock of the reunification. Recession on major industrialised countries. • Release of capital controls, according to the Delors plan to monetary union, implying lesser flexibility on exchange bands (2.25% for all) and no capital controls.

  13. European Monetary Union • Economic and Monetary Union - plan • Delors report (1989), basis of the Maastricht Treaty : • Monetary union to be achieved by a gradualist and parallel approach: • Parallel : economic convergence to achieve at the same time as monetary union (the one needing the other) • Gradualist : economic integration is a slow process • Stage 1 : all countries join ERM with 2.25% fluctuation bands, capital controls removed, single financial area. • Stage 1 began on July 1, 1990. • Maastricht Treaty signed in December 1991, setting a timetable for the whole process. • Stage 1 was supposed to be completed by end of 1993, but the exchange rate crises set back the process.

  14. European Monetary Union • Delors report (1989), basis of the Maastricht Treaty : • Stage 2 : exchange rate commitment more stringent. Realignments expected to be more infrequent. Creation of a central European body in charge of the monetary policy. • Started in January 1994. • The European Monetary Institute (EMI) was created to co-ordinate monetary policy. • Stage 3 : irrevocable fixing of the exchanges rates, replacement of the national currencies. Monetary policy fully transferred to the European Central Bank. • From January 1997. • Adoption of the Euro of 11 members in January 1999, Greece joined in 2001.

  15. European Monetary Union • Delors report (1989), basis of the Maastricht Treaty : • Stage 3 : Convergence criteria • Inflation max 1.5% above the average of the 3 lowest inflation countries. • Interest rates on LT government bonds max 2% above the average of interest rates in the 3 lowest inflation countries. • Government deficit does not exceed 3% of the GDP. • Government debt to GDP ratio does not exceed 60%. • The exchange rate must have been fixed within its ERM without a realignment for at least 2 years. • The statutes of the central banks should be compatible with those of the ECB.

  16. European Monetary Union • Costs and Benefits of the EMU • Benefits • The European Commission estimated to gains to 10% of the EU GNP. Benefits should come from : • suppression of transaction costs (0.5%) • greater monetary stability • elimination of the exchange rate risk • Emerson (1990) : single currency will promote efficiency, stability, and equity by better and most efficient allocation of the resources and more relevant price signaling. Weak econometric evidence, but large support from survey data.

  17. European Monetary Union • Costs and Benefits of the EMU • Costs • Depends on several factors : • The extent to which the area in question suffers from asymmetrical shocks (see Reichlin): newer and poorer countries of the union could have more problems than the others. • However, opinions are mixed regarding the likelihood of occurrence of asymmetrical shocks in single currency zones. • Business cycles might also have adverse effects. Cycles are the outcome of 3 factors : shocks - propagation mechanisms - and policy response. • Shocks and cycles could both be costly for the EMU.

  18. European Monetary Union • European Monetary Policy and ECB • Main goal : provide an institutional structure that helps to provides the objectives of stability and low inflation within the union. • The European Central Bank is established in Frankfurt, according to the Treaty. It is modeled after the US Federal Reserve System. The ECB is independent from the governments and dominates the country central banks, which continue to regulate bank within their borders. • All financial market intervention and the issuance of euros is the sole responsibility of the ECB. • ECB is free of political pressure (like the Fed and the Bundesbank) to safeguard the price stability and the anti-inflation policy.

  19. European Monetary Union • Fiscal policy and EMU • Fiscal autonomy is useful to individual countries if they are affected by asymmetric shocks (since monetary policy is no longer available). • However, the constraints on the public debt to GDP ratio limit the fiscal autonomy of the EC members. • In a limited fiscal autonomy framework, the EU central budget should play a greater role, to • equalise the effect on different regions (transfer fiscal resources to badly affected regions) • provide an automatic stabilisation for regions suffering from a temporary loss of income • spread the costs of a adverse shocks over the entire area.

  20. European Monetary Union • The transition to Euro • Eleven member states of the EU initiated the EMU, adopting the Euro on Jan 4th 1999, replacing their national currencies on the financial markets. • Countries are : Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, and Greece 2 years later. UK, Sweden, and Denmark choose to keep their national currencies. • The final fixed rates have been determined on Dec. 31, 1998. • The value of Euro against the $ slid steadily following its introduction, from $1.19 in Jan 1999, to $0.87 in Feb 2002. Its lowest was $0.825 in Nov. 2000. • The fiduciary introduction of the Euro started Jan 1st, 2002. Since the spring 2002, the Euro gained in value against the $.

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