Description
It starts off with the history of Euro and then goes on to explain about the Bretton Woods and ERM system.It then explains the Euro Zone and the scenaios for adoption. It then goes on to explain the UK crisis and also the benefits of Euro.
9/7/2009
EURO REUNIFICATION
European Integration – Historical Background
Modern European integration began in earnest in the 1950s with the signing of several treaties among Belgium, France, Germany, Italy, Luxembourg, and the Netherlands. These countries pooled their coal and steel resources in 1951, establishing the European Coal and Steel Community. Later, the Treaties of Rome (1957) created the European Economic Community (EEC) and the European Atomic Energy Community, giving the EEC's institutions sole responsibility. By 1968, customs duties and quantitative limits on trade were abolished in intraCommunity trade, while a common external tariff was introduced to replace national customs duties in trade with the rest of the world. EEC was enlarged with the inclusion of Denmark, Ireland, and the United Kingdom. Indeed, member states agreed to an exchange rate mechanism designed to maintain their exchange rates within certain fluctuation margins. In that context, the European Currency Unit (ECU), which can be viewed as a predecessor to the euro, was created. In the 1980s, renewed initiatives for European integration were launched, while additional members joined the European Economic Community (Greece, Spain, and Portugal). In particular, the Single European Act signed in 1986 led to a reinforced common market (i.e., free movement of citizens, goods, services, and capital) by the end of 1992. Subsequently, the Delors Report (1989) set out in detail the conditions to be met in order to establish economic and monetary union, proposing a three-stage plan for its achievement. The report was the basis for the "Maastricht Treaty on European Union" that was signed in 1991 by the European Community's leaders. Its objective was to start the final stage of the transition to EMU by 1999 at the latest. Mean-while, with the addition of Austria, Finland, and Sweden since 1995, the European Union (EU) (renamed from the European Economic Community when the Maastricht Treaty came into force in November 1993) now includes 15 states.
ERM (Exchange Rate Mechanism)
Exchange Rate Mechanism was one of the foundation stones of economic and monetary union.. It was hoped that the mechanism would help stabilise exchange rates, encourage trade within Europe and control inflation. The ERM gave national currencies an upper and lower limit on either side of this central rate within which they could fluctuate. In 1992 the ERM was wrenched apart when a number of currencies could no longer keep within these limits. On what became known as Black Wednesday, the British pound was forced to leave the system. The Italian lira also left and the Spanish peseta was devaluated.
European Economic and Monetary Union
Visions for a united Europe after WWII were primarily guided by political and economic considerations. When the dream for a politically united Europe became unattainable, interest shifted toward building the foundations for an economically integrated Europe. The process began in 1951 with the European Coal and Steel Community. Milestones
1951/52 Paris 1957/58 Rome 1965/67 1986/87 1992/93 Maastricht 1997/99 Amsterdam 2001/03 Ilice 2007/till date Lisbon
Brussels SEA European atomic Energy community European Coal & Steel community European Economic community
European Union (EU) P I L L A R S Economic community Justice & Home Affairs Police and Judicial cooperation in Criminal maters
European communities European Political Cooperation Western Union European
Common Foreign and Security Policy
Road towards EMU ? ? ? ? ? In 1951 ESCS was first established to create a single market in those resources The success of this Community led to the creation of the EAEC and EEC in 1957 through Treaties of Rome In 1967, the Merger Treaty combined these separate executives to become "European Communities" In 1970, meeting of heads of state or government in The Hague to draw up a plan for economic and monetary union. An expert group chaired by Luxembourg’s Prime Minister and Finance Minister, Pierre Werner, presented in October 1970 the first commonly agreed blueprint to create an economic and monetary union in three stages (Werner plan). This project experienced serious setback from the collapse of Bretton Woods’s system in 1971 and from rising oil prices in 1972. Tiffin’s dilemma: this theory was proposed by Robert Tiffin. Theory was based on observing the dollar glut, or the accumulation of the dollar outside of the U.S. As a result
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the U.S. had to run balance of payments deficit (BOP), this decreased confidence in the dollar. As a result the system could not maintain both liquidity and confidence. With failure of Bretton wood’s system, an attempt to limit the fluctuations of European currencies, using a snake in the tunnel, failed. The debate on EMU was fully re-launched in June 1988, when Delors Committee was asked to propose clear, practical and realistic steps for creating an EMU. The Delors report of 1989 set out a plan to introduce the EMU in three stages.
Stage one: 1 July 1990 1 July 1990 to 31 December 1993 7 February 1992 Stage Two: 1 January 1994 to 31 December 1998 16-17 June 1997
Exchange controls were abolished, thus capital movements were completely liberalised in the European Economic Community. Treaty of Maastricht The European Monetary Institute is established
3 May 1998 1 June 1998 31 December 1998 Stage Three: 1 1 January 1999 January 1999 and continuing 1 January 2001 January 2002 1 January 2007 1 January 2008 1 January 2009
The European Council decides to adopt the Stability and Growth Pact, and a new exchange rate mechanism (ERM II). The 11 initial countries that will participate in the third stage from 1 January 1999 are selected. The European Central Bank (ECB) is created The conversion rates between the 11 participating national currencies and the euro are established. Euro launched
Greece joins the third stage of the EMU. The euro notes and coins are introduced Slovenia joins Cyprus and Malta join Slovakia joins
European Monetary System (EMS)
The most important part of EMS was the Exchange Rate Mechanism (ERM), in which the participating currencies were tied together by a system of fixed exchange rates, known as central parity rates. In ERM system currencies were allowed to float within the fixed band. In case it varied too much central bank correct the situation by intervening through the Forex Market.
EUR/USD Chart Jan 1st, 1991 to Jan 1st, 2005
UK Crisis – How German Economy was affecting its ERM partners?
Since the end of WW-II, U.K was in the worst recession, with unemployment rates in excess of 10%. There could be a typical mismatch witnessed between its internal and external policies. In isolation, the U.K would have resorted to expansionary monetary policy to get out of the slump but they were handcuffed by the fixed exchange rate system. While this loss of autonomous policy was stifling the UK economy, things became much worse following the reunification process and the tightening of German monetary policy. • There are 3 impacts of the events in Germany on the UK: 1. The fall in output in Germany results in fewer imports being purchased from elsewhere in the ERM (NX falls) 2. The appreciation of the mark vis-a-vis non-ERM currencies implicitly makes the pound appreciate against those currencies as well - NX falls even more. The combined effect is to move IS in to IS0. 3. The higher interest rates in Germany and the Rest of the World - the BP curve shifts up to BP0 and there is a monetary outflow from the U.K. Under a fixed exchange rate
system, an outflow of money leads to a monetary contraction as the central bank exchanges foreign currency for domestic currency. The monetary contraction shifts the LM curve back to LM’ and output in the U.K economy falls to Y2 as the slump deepens in the U.K. This will continue until external balance has been restored. [See Fig. 1]
• The important thing to note is that the slump is worse under fixed exchange rates than it would have been under flexible exchange rates. Under a flexible exchange rate system, the outflow of money will lead to exchange rate depreciation. This will push the IS curve out and move the BP curve in. Thus output in the U.K. economy will be higher under a flexible exchange rate system than under fixed exchange rates. [See Fig. 2] • The above analysis indicates that the temptation to leave the ERM was high for the U.K. The same held true for many other struggling European economies like Italy, Spain and Portugal as well as for countries like Sweden and Finland to break off their fixed exchange rate system. • At this point, speculators figured that many European nations would be forced to leave the ERM and devalue their currencies, and attacked the Finnish markka, the Swedish krona, the British pound and the Italian lira by borrowing large sums of these currencies and selling them for German marks. Essentially, these speculators were betting that the pound would lose value and started selling pounds in exchange for other foreign currencies, thus causing reserves at the Bank of England to dry up and putting further devaluation pressure on the pound. • In terms of UIRP, we can translate this as showing that instead of i = i* now we have external balance at i = i * + where e1 is the new devalued exchange rate. (Before = 0) . This means that the BP line has shifted up, so there is an outflow of money from the U.K.
• The British Central Bank, for example, lost a lot of reserves trying to defend the pound (i.e. by selling D-Marks and buying pounds) and withdrew from the EMS, Paul Krugman writes that George Soros made a billion dollars betting against the pound. • These attacks continued well into 1993 and several countries including the U.K left the EMS and countries like France saw their currencies come under such heavy attack that the exchange bands were widened so much that they were effectively floating currencies
Scenarios for adopting the euro
Three scenarios has been used to change the whole economy from one currency in to another which was very complex process and also it helped in the introduction of euro. For the introduction of euro in 1999,member states introduced Madrid Scenario which was agreed at European council meeting in Madrid in 1995. This scenario set the legal framework and the timetable for the adoption of the euro, which involved a gradual changeover during a threeyear transitional period:
1.
On 31 December 1998, the euro conversion rates for the national currencies of the Member States adopting the euro were fixed. On 1 January 1999, the euro became the official currency of the participating countries and the national currency units became 'sub-units' of the euro, and national banknotes and coins remained in circulation. Governments, financial institutions and companies began its operation in euro, e.g. for wholesale transactions and for issuing debt. The euro was use as ‘book money’ and as a unit of account.
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3.
On 1 January 2002, Euro banknotes and coins were first introduced in the euro-area countries. During a dual circulation period where both euro and national cash were legal tender, the latter one was progressively withdrawn from circulation, mainly collected by shops and banks. The dual circulation period came to an end on 28 February and then from 1 March 2002 only euro banknotes and coins were accepted for payment in the euro area.
Two others scenarios have been introduced in the EU legal frame work are as follows:The big bang scenario in which there is no transitional period. Euro banknotes and coins enter use on the same day as the euro officially becomes the country’s new currency and the big bang scenario with phasing-out period of up to one year during which certain new legal instruments, such as contracts, may still refer to the national currency unit. It has helped in swift introduction of euro and helped in phasing out the national currency. The combination of these two scenarios was changeover scenario in which will be taken by future euro countries and which will inform the EU institutions of their choice, and will also decide on the duration of any transitional or phasing-out periods, and the duration of dual circulation, within the limits set by the EU.
Euro Zone
The euro area consists of those Member States of the European Union that have adopted the euro as their currency. It currently consists of Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain. All European Union Member States are part of Economic and Monetary Union (EMU) and coordinate their economic policy-making to support the economic aims of the EU. When the euro was first introduced in 1999 – as 'book' money –, the euro area was made up of 11 of the then 15 EU Member States. Greece joined in 2001, just one year before the cash changeover, followed by Slovenia in 2007, Cyprus and Malta in 2008, and Slovakia in 2009. Today, the euro area numbers 16 EU Member States. Denmark and the United Kingdom have opted out from the treaty. Sweden has not yet qualified to be part of the euro area. Monaco, San Marino and the Vatican City have adopted the euro as their national currency . However, as they are not EU Member States, they are not part of the euro area and also they have signed formal agreements with the EU to use the euro, and to mint their own coins. Monetary policy of the zone is the responsibility of the European Central Bank, though there is no common representation, governance or fiscal policy for the currency union.
The five convergence criteria
What is measured:
Price stability
Sound public finances
Sustainable public finances
Durability of convergence
Exchange rate stability
How it is measured:
Consumer price inflation rate
Government deficit as % of GDP
Government debt as % of GDP
Long-term interest rate
Deviation from a central rate
Convergence criteria:
Not more than 1.5 percentage points above the rate of the three best performing Member States
Reference value: not more than 3%
Reference value: not more than 60%
Not more than 2 percentage points above the rate of the three best performing Member States in terms of price stability
Participation in ERM II for at least 2 years without severe tensions
EMU: Who does what
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European Council: Reunites the heads of state and government of the EU Member States, who set the main policy orientations. The Council of the European Union (the 'Council'): Comprises representatives of Member State governments. It is the EU’s main decision-making body. ECOFIN is the Council of the European Union in its configuration of ministers of economy and finance. The Council coordinates economic policy-making and takes decisions on the operations
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of the Stability and Growth Pact and the application of the Treaty. It also decides whether a Member State may adopt the euro.
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Euro group: An informal grouping of ministers of economics and finance of the euro area, who meet to discuss matters of common concern for the euro-area countries, thus contributing to economic policy coordination. European Commission: Monitors performance and compliance with the Treaty and the Stability and Growth Pact, and makes assessments and recommendations to the Council on decisions to be taken. European Central Bank: The central bank for the euro area, which sets monetary policy, with price stability as its primary objective. The ECB is part of the Eurosystem, which unites the central banks of those Member States which have adopted the euro, and is responsible for implementing monetary policy.
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Conversion and rounding rules
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Introduction of the euro may not alter the terms of legal instruments, for example mortgage agreements for house purchases or sales agreements between companies. This ensures continuity in all financial transactions. The conversion rate from national currency to the euro is expressed with 6 significant figures – not to be confused with 6 decimal points – for example SIT 239.640 equals €1. When conversions are made, it is prohibited to round or truncate the conversion rate. This ensures the exactness of conversion operations. Once the conversion from the national currency has been made, then the euro amount can be rounded up or down to the nearest euro cent: if the number in the third decimal place is less than 5, the second decimal remains unchanged (for example, €1.264 becomes €1.26); but if the third decimal is 5 or above, then the second decimal must be rounded up, for example €1.265 becomes €1.27.
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Fixed euro conversion rates
Euro-area Member State Belgium Germany Ireland Greece Spain France Italy Cyprus Luxembourg Malta The Netherlands Austria Portugal Slovenia Slovakia Finland
Old national currency Belgian franc (BEF) German mark (DEM) Irish pound (punt) (IEP) Greek drachma (GRD) Spanish peseta (ESP) French franc (FRF) Italian lira (ITL) Cyprus pound Luxembourg franc (LUF) Maltese lira (MTL) Dutch guilder (NLG) Austrian schilling (ATS) Portugese escudo (PTE) Slovenian tolar (SIT) Slovak koruna (SKK) Finnish markka (FIM)
Conversion rate to €1 40.3399 1.95583 0.787564 340.750 166.386 6.55957 1936.27 0.585274 40.3399 0.429300 2.20371 13.7603 200.482 239.640 30.1260 5.94573
European Central Bank
The European Central Bank (ECB) is one of the world's most important central banks, responsible for monetary policy covering the 16 member States of the Euro zone. It was established by the European Union (EU) in 1998 with its headquarters in Frankfurt, Germany
The primary objective of the ECB is to maintain price stability within the Euro zone, or in other words to keep inflation low. The Governing Council defined price stability as inflation (Harmonized Index of Consumer Prices) of below, but close to, 2%. The key tasks of the ECB are to define and implement the monetary policy for the Euro zone, to conduct foreign exchange operations, to take care of the foreign reserves of the European System of Central Banks and promote smooth operation of the money market infrastructure under the Target payments system. Furthermore, it has the exclusive right to authorize the issuance of euro banknotes. Member states can issue euro coins but the amount must be authorized by the ECB beforehand (upon the introduction of euro, ECB also had exclusive right to issue coins). The bank must also co-operate within EU and internationally with third bodies and entities. Finally it contributes to maintaining a stable financial system and monitoring the banking sector.
What is ERM II?
The Exchange Rate Mechanism (ERM II) was set up on 1 January 1999 as a successor to ERM to ensure that exchange rate fluctuations between the euro and other EU currencies do not disrupt economic stability within the single market, and to help non euro-area countries prepare themselves for participation in the euro area. The convergence criterion on exchange rate stability requires participation in ERM II. Within the euro area, there is only one currency – the euro – but there are EU countries outside the euro area with their own currencies, and avoiding excessive fluctuations in their exchange rates with the euro or misalignments helps the smooth operation of the single market. It is ERM II that provides the framework to manage the exchange rates between EU currencies, and ensures stability. Participation in ERM II is voluntary although, as one of the convergence criteria for entry to the euro area, a country must participate in the mechanism without severe tensions for at least two years before it can qualify to adopt the euro.
How does ERM II work?
In ERM II, the exchange rate of a non-euro area Member State is fixed against the euro and is only allowed to fluctuate within set limits. ERM II entry is based on an agreement between the ministers and central bank governors of the non-euro area Member State and the euro-area Member States, and the European Central Bank (ECB). It covers the following: ? ? A central exchange rate between the euro and the country's currency is agreed. The currency is then allowed to fluctuate by up to 15% above or below this central rate. When necessary, the currency is supported by intervention (buying or selling) to keep the exchange rate against the euro within the ±15% fluctuation band. Interventions are coordinated by the ECB and the central bank of the non-euro area Member State. Non-euro area Member States within ERM II can decide to maintain a narrower fluctuation band, but this decision has no impact on the official ±15% fluctuation margin, unless there is agreement on this by ERM II stakeholders. The General Council of the ECB monitors the operation of ERM II and ensures coordination of monetary- and exchange-rate policies. The General Council also administers the intervention mechanisms together with the Member State’s central bank.
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Benefits of Euro
The advantages of Euro are far reaching and have a wide impact on the social, political and economic well-being of the constituent countries. Various benefits are listed below under different headers: 1) Consumer Benefits: There are multiple opportunities for EU citizens and consumers to benefit from the euro. These arise because the euro and its political framework, the Economic and Monetary Union, offer lower costs, stable prices, more transparency and economic stability. ? Market Competitiveness:
As a single currency is used across the EU nations the consumers can easily compare prices which have increased market competitiveness in the EU and has kept a downward pressure on the prices. ? Stable Prices:
As the countries of the EU had started preparing for the inception of the Euro, the inflation rate started to fall from nearly 20% to the current 2% levels. This has led to better protection of the savings of the common man and has improved the purchasing power.
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Easier, Safer and Cheaper borrowings:
As the inflation rates are low the interest rates are also lower. This makes consumer loan cheaper and the repayment more predictable.
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Lower travel costs:
No cost of exchanging money at the border. ? More growth and jobs:
In a single market with a single currency, doing business across borders is cheaper for companies as they no longer need to include the risk of currency fluctuations into their prices nor to pay exchange costs. 2) Business Benefits: The single currency benefits business in many ways, in addition to cutting costs and risk. It encourages investments and brings more certainty to business planning – thus allowing businesses to be more effective overall. ? More cross-border trade:
Now companies can buy and sell throughout this area without worrying about different currencies. ? Better borrowing, better planning and more investment:
Sound and prudent management by EMU has encouraged the organisations to invest in the areas also low inflation has made the interest rates more predictable for the companies to borrow and lend. ? Better access to capital:
It has led to integration of the financial markets across the area. ? More international trade
3) Economic Stability and Growth: Economic stability is desirable because it encourages economic growth that brings prosperity and employment, and is one of the main objectives enshrined in the management of Economic and Monetary Union and the euro. ? Sound and sustainable public finances:
According to the rules set out in the Stability and Growth Pact, to become eligible countries have to keep their government and debt deficits under specified limits which gives stability to the economic environment. ? Better Government Budgeting:
Low inflation in a strong, well-managed euro area makes government borrowing less expensive. This means that interest repayments on national debt, which can be substantial, are reduced. ? ? More resistance to external shocks More Cohesion
4) Single financial market The introduction of the euro in 1999 provided major impetus to the integration of financial markets in Europe, thus making them more efficient and competitive, and reducing the costs of cross-border money transfers in euro. 5) An International Currency Due to commitment to sound economic policies, large catchment area, integration of economies Euro has become attractive to other countries and trading blocks in the global economy. It is the second largest currency after the dollar.
doc_632624535.docx
It starts off with the history of Euro and then goes on to explain about the Bretton Woods and ERM system.It then explains the Euro Zone and the scenaios for adoption. It then goes on to explain the UK crisis and also the benefits of Euro.
9/7/2009
EURO REUNIFICATION
European Integration – Historical Background
Modern European integration began in earnest in the 1950s with the signing of several treaties among Belgium, France, Germany, Italy, Luxembourg, and the Netherlands. These countries pooled their coal and steel resources in 1951, establishing the European Coal and Steel Community. Later, the Treaties of Rome (1957) created the European Economic Community (EEC) and the European Atomic Energy Community, giving the EEC's institutions sole responsibility. By 1968, customs duties and quantitative limits on trade were abolished in intraCommunity trade, while a common external tariff was introduced to replace national customs duties in trade with the rest of the world. EEC was enlarged with the inclusion of Denmark, Ireland, and the United Kingdom. Indeed, member states agreed to an exchange rate mechanism designed to maintain their exchange rates within certain fluctuation margins. In that context, the European Currency Unit (ECU), which can be viewed as a predecessor to the euro, was created. In the 1980s, renewed initiatives for European integration were launched, while additional members joined the European Economic Community (Greece, Spain, and Portugal). In particular, the Single European Act signed in 1986 led to a reinforced common market (i.e., free movement of citizens, goods, services, and capital) by the end of 1992. Subsequently, the Delors Report (1989) set out in detail the conditions to be met in order to establish economic and monetary union, proposing a three-stage plan for its achievement. The report was the basis for the "Maastricht Treaty on European Union" that was signed in 1991 by the European Community's leaders. Its objective was to start the final stage of the transition to EMU by 1999 at the latest. Mean-while, with the addition of Austria, Finland, and Sweden since 1995, the European Union (EU) (renamed from the European Economic Community when the Maastricht Treaty came into force in November 1993) now includes 15 states.
ERM (Exchange Rate Mechanism)
Exchange Rate Mechanism was one of the foundation stones of economic and monetary union.. It was hoped that the mechanism would help stabilise exchange rates, encourage trade within Europe and control inflation. The ERM gave national currencies an upper and lower limit on either side of this central rate within which they could fluctuate. In 1992 the ERM was wrenched apart when a number of currencies could no longer keep within these limits. On what became known as Black Wednesday, the British pound was forced to leave the system. The Italian lira also left and the Spanish peseta was devaluated.
European Economic and Monetary Union
Visions for a united Europe after WWII were primarily guided by political and economic considerations. When the dream for a politically united Europe became unattainable, interest shifted toward building the foundations for an economically integrated Europe. The process began in 1951 with the European Coal and Steel Community. Milestones
1951/52 Paris 1957/58 Rome 1965/67 1986/87 1992/93 Maastricht 1997/99 Amsterdam 2001/03 Ilice 2007/till date Lisbon
Brussels SEA European atomic Energy community European Coal & Steel community European Economic community
European Union (EU) P I L L A R S Economic community Justice & Home Affairs Police and Judicial cooperation in Criminal maters
European communities European Political Cooperation Western Union European
Common Foreign and Security Policy
Road towards EMU ? ? ? ? ? In 1951 ESCS was first established to create a single market in those resources The success of this Community led to the creation of the EAEC and EEC in 1957 through Treaties of Rome In 1967, the Merger Treaty combined these separate executives to become "European Communities" In 1970, meeting of heads of state or government in The Hague to draw up a plan for economic and monetary union. An expert group chaired by Luxembourg’s Prime Minister and Finance Minister, Pierre Werner, presented in October 1970 the first commonly agreed blueprint to create an economic and monetary union in three stages (Werner plan). This project experienced serious setback from the collapse of Bretton Woods’s system in 1971 and from rising oil prices in 1972. Tiffin’s dilemma: this theory was proposed by Robert Tiffin. Theory was based on observing the dollar glut, or the accumulation of the dollar outside of the U.S. As a result
?
?
the U.S. had to run balance of payments deficit (BOP), this decreased confidence in the dollar. As a result the system could not maintain both liquidity and confidence. With failure of Bretton wood’s system, an attempt to limit the fluctuations of European currencies, using a snake in the tunnel, failed. The debate on EMU was fully re-launched in June 1988, when Delors Committee was asked to propose clear, practical and realistic steps for creating an EMU. The Delors report of 1989 set out a plan to introduce the EMU in three stages.
Stage one: 1 July 1990 1 July 1990 to 31 December 1993 7 February 1992 Stage Two: 1 January 1994 to 31 December 1998 16-17 June 1997
Exchange controls were abolished, thus capital movements were completely liberalised in the European Economic Community. Treaty of Maastricht The European Monetary Institute is established
3 May 1998 1 June 1998 31 December 1998 Stage Three: 1 1 January 1999 January 1999 and continuing 1 January 2001 January 2002 1 January 2007 1 January 2008 1 January 2009
The European Council decides to adopt the Stability and Growth Pact, and a new exchange rate mechanism (ERM II). The 11 initial countries that will participate in the third stage from 1 January 1999 are selected. The European Central Bank (ECB) is created The conversion rates between the 11 participating national currencies and the euro are established. Euro launched
Greece joins the third stage of the EMU. The euro notes and coins are introduced Slovenia joins Cyprus and Malta join Slovakia joins
European Monetary System (EMS)
The most important part of EMS was the Exchange Rate Mechanism (ERM), in which the participating currencies were tied together by a system of fixed exchange rates, known as central parity rates. In ERM system currencies were allowed to float within the fixed band. In case it varied too much central bank correct the situation by intervening through the Forex Market.
EUR/USD Chart Jan 1st, 1991 to Jan 1st, 2005
UK Crisis – How German Economy was affecting its ERM partners?
Since the end of WW-II, U.K was in the worst recession, with unemployment rates in excess of 10%. There could be a typical mismatch witnessed between its internal and external policies. In isolation, the U.K would have resorted to expansionary monetary policy to get out of the slump but they were handcuffed by the fixed exchange rate system. While this loss of autonomous policy was stifling the UK economy, things became much worse following the reunification process and the tightening of German monetary policy. • There are 3 impacts of the events in Germany on the UK: 1. The fall in output in Germany results in fewer imports being purchased from elsewhere in the ERM (NX falls) 2. The appreciation of the mark vis-a-vis non-ERM currencies implicitly makes the pound appreciate against those currencies as well - NX falls even more. The combined effect is to move IS in to IS0. 3. The higher interest rates in Germany and the Rest of the World - the BP curve shifts up to BP0 and there is a monetary outflow from the U.K. Under a fixed exchange rate
system, an outflow of money leads to a monetary contraction as the central bank exchanges foreign currency for domestic currency. The monetary contraction shifts the LM curve back to LM’ and output in the U.K economy falls to Y2 as the slump deepens in the U.K. This will continue until external balance has been restored. [See Fig. 1]
• The important thing to note is that the slump is worse under fixed exchange rates than it would have been under flexible exchange rates. Under a flexible exchange rate system, the outflow of money will lead to exchange rate depreciation. This will push the IS curve out and move the BP curve in. Thus output in the U.K. economy will be higher under a flexible exchange rate system than under fixed exchange rates. [See Fig. 2] • The above analysis indicates that the temptation to leave the ERM was high for the U.K. The same held true for many other struggling European economies like Italy, Spain and Portugal as well as for countries like Sweden and Finland to break off their fixed exchange rate system. • At this point, speculators figured that many European nations would be forced to leave the ERM and devalue their currencies, and attacked the Finnish markka, the Swedish krona, the British pound and the Italian lira by borrowing large sums of these currencies and selling them for German marks. Essentially, these speculators were betting that the pound would lose value and started selling pounds in exchange for other foreign currencies, thus causing reserves at the Bank of England to dry up and putting further devaluation pressure on the pound. • In terms of UIRP, we can translate this as showing that instead of i = i* now we have external balance at i = i * + where e1 is the new devalued exchange rate. (Before = 0) . This means that the BP line has shifted up, so there is an outflow of money from the U.K.
• The British Central Bank, for example, lost a lot of reserves trying to defend the pound (i.e. by selling D-Marks and buying pounds) and withdrew from the EMS, Paul Krugman writes that George Soros made a billion dollars betting against the pound. • These attacks continued well into 1993 and several countries including the U.K left the EMS and countries like France saw their currencies come under such heavy attack that the exchange bands were widened so much that they were effectively floating currencies
Scenarios for adopting the euro
Three scenarios has been used to change the whole economy from one currency in to another which was very complex process and also it helped in the introduction of euro. For the introduction of euro in 1999,member states introduced Madrid Scenario which was agreed at European council meeting in Madrid in 1995. This scenario set the legal framework and the timetable for the adoption of the euro, which involved a gradual changeover during a threeyear transitional period:
1.
On 31 December 1998, the euro conversion rates for the national currencies of the Member States adopting the euro were fixed. On 1 January 1999, the euro became the official currency of the participating countries and the national currency units became 'sub-units' of the euro, and national banknotes and coins remained in circulation. Governments, financial institutions and companies began its operation in euro, e.g. for wholesale transactions and for issuing debt. The euro was use as ‘book money’ and as a unit of account.
2.
3.
On 1 January 2002, Euro banknotes and coins were first introduced in the euro-area countries. During a dual circulation period where both euro and national cash were legal tender, the latter one was progressively withdrawn from circulation, mainly collected by shops and banks. The dual circulation period came to an end on 28 February and then from 1 March 2002 only euro banknotes and coins were accepted for payment in the euro area.
Two others scenarios have been introduced in the EU legal frame work are as follows:The big bang scenario in which there is no transitional period. Euro banknotes and coins enter use on the same day as the euro officially becomes the country’s new currency and the big bang scenario with phasing-out period of up to one year during which certain new legal instruments, such as contracts, may still refer to the national currency unit. It has helped in swift introduction of euro and helped in phasing out the national currency. The combination of these two scenarios was changeover scenario in which will be taken by future euro countries and which will inform the EU institutions of their choice, and will also decide on the duration of any transitional or phasing-out periods, and the duration of dual circulation, within the limits set by the EU.
Euro Zone
The euro area consists of those Member States of the European Union that have adopted the euro as their currency. It currently consists of Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain. All European Union Member States are part of Economic and Monetary Union (EMU) and coordinate their economic policy-making to support the economic aims of the EU. When the euro was first introduced in 1999 – as 'book' money –, the euro area was made up of 11 of the then 15 EU Member States. Greece joined in 2001, just one year before the cash changeover, followed by Slovenia in 2007, Cyprus and Malta in 2008, and Slovakia in 2009. Today, the euro area numbers 16 EU Member States. Denmark and the United Kingdom have opted out from the treaty. Sweden has not yet qualified to be part of the euro area. Monaco, San Marino and the Vatican City have adopted the euro as their national currency . However, as they are not EU Member States, they are not part of the euro area and also they have signed formal agreements with the EU to use the euro, and to mint their own coins. Monetary policy of the zone is the responsibility of the European Central Bank, though there is no common representation, governance or fiscal policy for the currency union.
The five convergence criteria
What is measured:
Price stability
Sound public finances
Sustainable public finances
Durability of convergence
Exchange rate stability
How it is measured:
Consumer price inflation rate
Government deficit as % of GDP
Government debt as % of GDP
Long-term interest rate
Deviation from a central rate
Convergence criteria:
Not more than 1.5 percentage points above the rate of the three best performing Member States
Reference value: not more than 3%
Reference value: not more than 60%
Not more than 2 percentage points above the rate of the three best performing Member States in terms of price stability
Participation in ERM II for at least 2 years without severe tensions
EMU: Who does what
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European Council: Reunites the heads of state and government of the EU Member States, who set the main policy orientations. The Council of the European Union (the 'Council'): Comprises representatives of Member State governments. It is the EU’s main decision-making body. ECOFIN is the Council of the European Union in its configuration of ministers of economy and finance. The Council coordinates economic policy-making and takes decisions on the operations
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of the Stability and Growth Pact and the application of the Treaty. It also decides whether a Member State may adopt the euro.
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Euro group: An informal grouping of ministers of economics and finance of the euro area, who meet to discuss matters of common concern for the euro-area countries, thus contributing to economic policy coordination. European Commission: Monitors performance and compliance with the Treaty and the Stability and Growth Pact, and makes assessments and recommendations to the Council on decisions to be taken. European Central Bank: The central bank for the euro area, which sets monetary policy, with price stability as its primary objective. The ECB is part of the Eurosystem, which unites the central banks of those Member States which have adopted the euro, and is responsible for implementing monetary policy.
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Conversion and rounding rules
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Introduction of the euro may not alter the terms of legal instruments, for example mortgage agreements for house purchases or sales agreements between companies. This ensures continuity in all financial transactions. The conversion rate from national currency to the euro is expressed with 6 significant figures – not to be confused with 6 decimal points – for example SIT 239.640 equals €1. When conversions are made, it is prohibited to round or truncate the conversion rate. This ensures the exactness of conversion operations. Once the conversion from the national currency has been made, then the euro amount can be rounded up or down to the nearest euro cent: if the number in the third decimal place is less than 5, the second decimal remains unchanged (for example, €1.264 becomes €1.26); but if the third decimal is 5 or above, then the second decimal must be rounded up, for example €1.265 becomes €1.27.
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Fixed euro conversion rates
Euro-area Member State Belgium Germany Ireland Greece Spain France Italy Cyprus Luxembourg Malta The Netherlands Austria Portugal Slovenia Slovakia Finland
Old national currency Belgian franc (BEF) German mark (DEM) Irish pound (punt) (IEP) Greek drachma (GRD) Spanish peseta (ESP) French franc (FRF) Italian lira (ITL) Cyprus pound Luxembourg franc (LUF) Maltese lira (MTL) Dutch guilder (NLG) Austrian schilling (ATS) Portugese escudo (PTE) Slovenian tolar (SIT) Slovak koruna (SKK) Finnish markka (FIM)
Conversion rate to €1 40.3399 1.95583 0.787564 340.750 166.386 6.55957 1936.27 0.585274 40.3399 0.429300 2.20371 13.7603 200.482 239.640 30.1260 5.94573
European Central Bank
The European Central Bank (ECB) is one of the world's most important central banks, responsible for monetary policy covering the 16 member States of the Euro zone. It was established by the European Union (EU) in 1998 with its headquarters in Frankfurt, Germany
The primary objective of the ECB is to maintain price stability within the Euro zone, or in other words to keep inflation low. The Governing Council defined price stability as inflation (Harmonized Index of Consumer Prices) of below, but close to, 2%. The key tasks of the ECB are to define and implement the monetary policy for the Euro zone, to conduct foreign exchange operations, to take care of the foreign reserves of the European System of Central Banks and promote smooth operation of the money market infrastructure under the Target payments system. Furthermore, it has the exclusive right to authorize the issuance of euro banknotes. Member states can issue euro coins but the amount must be authorized by the ECB beforehand (upon the introduction of euro, ECB also had exclusive right to issue coins). The bank must also co-operate within EU and internationally with third bodies and entities. Finally it contributes to maintaining a stable financial system and monitoring the banking sector.
What is ERM II?
The Exchange Rate Mechanism (ERM II) was set up on 1 January 1999 as a successor to ERM to ensure that exchange rate fluctuations between the euro and other EU currencies do not disrupt economic stability within the single market, and to help non euro-area countries prepare themselves for participation in the euro area. The convergence criterion on exchange rate stability requires participation in ERM II. Within the euro area, there is only one currency – the euro – but there are EU countries outside the euro area with their own currencies, and avoiding excessive fluctuations in their exchange rates with the euro or misalignments helps the smooth operation of the single market. It is ERM II that provides the framework to manage the exchange rates between EU currencies, and ensures stability. Participation in ERM II is voluntary although, as one of the convergence criteria for entry to the euro area, a country must participate in the mechanism without severe tensions for at least two years before it can qualify to adopt the euro.
How does ERM II work?
In ERM II, the exchange rate of a non-euro area Member State is fixed against the euro and is only allowed to fluctuate within set limits. ERM II entry is based on an agreement between the ministers and central bank governors of the non-euro area Member State and the euro-area Member States, and the European Central Bank (ECB). It covers the following: ? ? A central exchange rate between the euro and the country's currency is agreed. The currency is then allowed to fluctuate by up to 15% above or below this central rate. When necessary, the currency is supported by intervention (buying or selling) to keep the exchange rate against the euro within the ±15% fluctuation band. Interventions are coordinated by the ECB and the central bank of the non-euro area Member State. Non-euro area Member States within ERM II can decide to maintain a narrower fluctuation band, but this decision has no impact on the official ±15% fluctuation margin, unless there is agreement on this by ERM II stakeholders. The General Council of the ECB monitors the operation of ERM II and ensures coordination of monetary- and exchange-rate policies. The General Council also administers the intervention mechanisms together with the Member State’s central bank.
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Benefits of Euro
The advantages of Euro are far reaching and have a wide impact on the social, political and economic well-being of the constituent countries. Various benefits are listed below under different headers: 1) Consumer Benefits: There are multiple opportunities for EU citizens and consumers to benefit from the euro. These arise because the euro and its political framework, the Economic and Monetary Union, offer lower costs, stable prices, more transparency and economic stability. ? Market Competitiveness:
As a single currency is used across the EU nations the consumers can easily compare prices which have increased market competitiveness in the EU and has kept a downward pressure on the prices. ? Stable Prices:
As the countries of the EU had started preparing for the inception of the Euro, the inflation rate started to fall from nearly 20% to the current 2% levels. This has led to better protection of the savings of the common man and has improved the purchasing power.
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Easier, Safer and Cheaper borrowings:
As the inflation rates are low the interest rates are also lower. This makes consumer loan cheaper and the repayment more predictable.
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Lower travel costs:
No cost of exchanging money at the border. ? More growth and jobs:
In a single market with a single currency, doing business across borders is cheaper for companies as they no longer need to include the risk of currency fluctuations into their prices nor to pay exchange costs. 2) Business Benefits: The single currency benefits business in many ways, in addition to cutting costs and risk. It encourages investments and brings more certainty to business planning – thus allowing businesses to be more effective overall. ? More cross-border trade:
Now companies can buy and sell throughout this area without worrying about different currencies. ? Better borrowing, better planning and more investment:
Sound and prudent management by EMU has encouraged the organisations to invest in the areas also low inflation has made the interest rates more predictable for the companies to borrow and lend. ? Better access to capital:
It has led to integration of the financial markets across the area. ? More international trade
3) Economic Stability and Growth: Economic stability is desirable because it encourages economic growth that brings prosperity and employment, and is one of the main objectives enshrined in the management of Economic and Monetary Union and the euro. ? Sound and sustainable public finances:
According to the rules set out in the Stability and Growth Pact, to become eligible countries have to keep their government and debt deficits under specified limits which gives stability to the economic environment. ? Better Government Budgeting:
Low inflation in a strong, well-managed euro area makes government borrowing less expensive. This means that interest repayments on national debt, which can be substantial, are reduced. ? ? More resistance to external shocks More Cohesion
4) Single financial market The introduction of the euro in 1999 provided major impetus to the integration of financial markets in Europe, thus making them more efficient and competitive, and reducing the costs of cross-border money transfers in euro. 5) An International Currency Due to commitment to sound economic policies, large catchment area, integration of economies Euro has become attractive to other countries and trading blocks in the global economy. It is the second largest currency after the dollar.
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