EU Enlargement And Exchange Rate Policy

Publication date
Thursday, 25.04.2002

Authors
Augusto Lopez-Claros

Series
EU Enlargement Issues

Annotation
In this article, we look at the mirror image of this question: namely, the extent to which the exchange rate of the euro vis-`a-vis the major currencies could itself have an impact on the enlargement process. In a forthcoming article, we will explore the issue of how the Exchange Rate Mechanism II, consisting of the bilateral links between the euro and the currencies of member states outside the euro area, is expected to provide a framework for exchange rate management for new members.

We continue our review of different aspects of European Union enlargement. In our most recent article, we focused on the likely effects of enlargement on the euro and whether, as the EU-15 turns into the EU-25 as early as 2004, the euro might come under downward pressure.[1] In this article, we look at the mirror image of this question: namely, the extent to which the exchange rate of the euro vis-`a-vis the major currencies could itself have an impact on the enlargement process. In a forthcoming article, we will explore the issue of how the Exchange Rate Mechanism II, consisting of the bilateral links between the euro and the currencies of member states outside the euro area, is expected to provide a framework for exchange rate management for new members.

The impact of movements in the exchange rate of the euro on the enlargement process and, more specifically, on the exchange rate policies of candidate countries, will partly reflect the particular exchange arrangements adopted by them. The table below provides a brief summary of the regimes now in place in the 12 candidate countries, showing a fairly broad range of preferences and institutional set-ups. These differences notwithstanding, the authorities of all candidate countries seek to pursue policies that aim to limit nominal exchange rate fluctuations and misalignments in the real exchange rate. The European Commission notes that for countries for which the euro area “is by far the biggest trading partner group” - with import and export shares rapidly on the rise - “pegging the domestic currency to the currency of the main trading partner is an obvious way of reducing exchange rate fluctuations.” [2]

Exchange rate regimes in EU candidate countries

Offsetting the benefits of pegging to the euro, it is necessary to note the arguments made in connection with the loss of independence in the implementation of monetary policy and the need to adjust to possible external shocks. One argument often made against fixing the exchange rate is that it can reduce the authorities’ room for maneuver in the presence of macroeconomic shocks. A real shock - such as a sharp increase in the price of oil, a real enough event with potentially large implications for EU candidates who are all energy importers - will require adjustments in relative prices and the absence of sufficient flexibility in the domestic price level in the short run will mean that flexibility in the nominal exchange rate will make it easier to achieve the desired level in the real rate. This might be important, because the real shock makes necessary an improvement in the balance of payments.

The extent to which this lack of short-run flexibility associated with pegged regimes is seen to be a serious disadvantage depends on the nature of the real shock and the relative size and openness of the country. If real shocks are large and persistent and/or if the economy is relatively large and closed, exchange rate flexibility can help facilitate the necessary change in the real exchange rate. On the assumption that domestic financial policies in the candidate countries over the medium term will be largely geared toward convergence with respect to the EU and that the largest exogenous shocks may well be behind them, the vulnerability associated with pegged regimes may not be especially important. In any event, even in the context of uncertainties concerning the role of future shocks, and considering that EMU is still some years off, the option to add a degree of flexibility to the exchange rate regime will always be open to the authorities in candidate countries.

Partly related to the difficulties which a country might face in adjusting to shocks, the constraints imposed by a pegged regime on the implementation of an active monetary policy, can sometimes impose certain costs. There may be instances when the presence of a peg prevents an adaptation of monetary policy to specific domestic conditions. An often-cited case concerns Hong Kong in the early 1990s when the link to the US dollar involved importing low interest rates from the US at a time when a domestic asset price boom would have made monetary restraint the desirable policy option. Thus, the loss of monetary autonomy is seen by some as an important potential disadvantage, particularly in the case of countries perceived to be still some way from average income per capita EU levels and still subject to various imbalances and structural rigidities.

The extent to which this loss of autonomy is regarded as a problem is partly a function of the role which the authorities see monetary policy playing in influencing real economic variables, such as unemployment or output growth. If there is a view that the primary aim of monetary policy should be to achieve sustained price stability (leaving to structural and fiscal policies the task of dealing with rigidities and supply constraints), the relevant question is whether it is easier to control inflation with an “independent” monetary policy in the context of a flexible exchange rate, or through some type of fixing or some targeting mechanism involving reduced autonomy. On this issue, the literature is clear: monetary autonomy can work if given certain inflationary expectations, the authorities do not give in to the temptation of accelerating money growth in the hope of stimulating output and monetary policy is not held captive to pressures stemming from the need to finance large fiscal deficits and/or large wage increases.

Whether these conditions will be satisfied simultaneously in the EU candidate countries in the period ahead is an open question. Financial policies have been cautious on the whole, but some of this caution may have been itself strengthened by the existence of pegged regimes in some of these countries.

The above lends support to the EU Commission’s conclusion that “there is no common path which can be described for the exchange rate policies of all candidate countries in the period before accession and in the early years of EU membership.” There are at least two other areas in which the exchange rate of the euro is likely to have an impact on enlargement. First, the impact on export competitiveness, depending on whether the candidate country’s currency is pegged to the euro, a basket, or is floating. Less directly, the performance of the euro in the world’s currency markets may also affect public opinion in the candidate countries about the enlargement process, the likely success of EMU, and longer-term prospects for the EU itself.

In any case, we share the Commission’s assessment that the impact of the euro exchange rate on the candidate countries and the enlargement process is likely to be dwarfed in importance by the domestic economic policy requirements associated with candidate countries’ efforts successfully to confront the challenges of EU membership, including in the all-important area of making additional progress in the implementation of structural reforms.


[1] See “EU Enlargement: Implications For The Euro”, Global Weekly Economic Monitor, 29 March 2002.

[2] See “Enlargement Papers,” European Commission, Directorate-General for Economic and Financial Affairs, September 2001.

Contents
HTML

Notes

Go to other releases