presented to the Graduate School of Business of the University of Stellenbosch in partial fulfilment of the requirements for the degree of Master of Business Administration by FLORIAN BÖHLANDT Subject: Economics Lecturer: Prof. A. Roux Date: 26 September 2006
Report for Economics STUDENT NUMBER : 14959747 SURNAME: BÖHLANDT INITIALS : FMB TELEPHONE NUMBER: 072 270 9058 SUBJECT: Economics NUMBER OF PAGES 16 (INCLUDING THIS PAGE) LECTURER: Prof. A. Roux COURSE: MBA FULL-TIME 2006 DUE DATE : 26/09/2006 Confidentiality : None CERTIFICATION I certify the content of the assignment to be my own and original work and that all sources have been accurately reported and acknowledged, and that this document has not previously been submitted in its entirety or in part at any educational establishment. Florian Böhlandt VIR KANTOORGEBRUIK / FOR OFFICE USE DATUM ONTVANG: DATE RECEIVED :
Table of Contents The Economic and Monetary Union (EMU)...4 Convergence Criteria of the Maastricht Treaty of 1992...5 Benefits of the EMU...6 United Kingdom s Euro perspectives...7 Should the UK join the EMU?...8 Outlook...9 Sweden s Euro referendum...9 Sweden s case for the Euro... 10 Outlook... 10 Denmark and the Euro... 11 Denmark s case for the Euro... 11 Outlook... 11 The prospect of additional members to the EMU... 12 Concluding remarks... 13 References... 15 3
The Economic and Monetary Union (EMU) Contrary to the anxieties of many economists, the Euro has become the second most important reserve and trading currency in the world. After its initial depreciation from 1999 onwards, the Euro recovered in 2002 and proved to be a strong and reliable currency. So far, the project of introducing a common currency in Central Europe can be seen as a success. The Treaty of Maastricht in 1992 marks the beginning of the Economic and Monetary Union (EMU), in which all members of the European Union (EU) are required to participate. Until today, 12 of the now 25 Union members have adopted the Euro as their common currency 1. All states entering the EU are required to fulfil the requirements for monetary union within a reasonable time frame. With the enlargement of the EU in 2004, it can be expected that all 10 new members 2 will join the Euro in the near future. Similarly, countries negotiating to become a member of the EU will also take the Euro as their currency in the years following their accession. In addition, all newly appointed members will be required to join the European System of Central Banks. According to the Maastricht Treaty, these new members will enter the EMU with derogation, until they have fulfilled the convergence criteria laid out in the treaty. In the Delors Report of 1989, a plan was set out to introduce the EMU in three stages and define the establishment of the relevant institutions such as the ESCB. At the beginning of 1999, stage three marked the introduction of the Euro as a real currency under the authority of the European Central Bank (ECB). On 1 January 2001, the most recent member, Greece, joined the third stage of the EMU. However, three of the original 12 countries of the EU prior to its enlargement in 2004 have not participated in the third stage of transition. The United Kingdom (UK), Sweden and Denmark decided to forego adopting the Euro. In 1992, following a period of exchange rate turbulence and bond market crises, the United Kingdom withdrew from the European Exchange Rate Mechanism (ERM) that defined the bands of exchange rate fluctuations. Following the devaluation of the British Pound, UK parliament decided not to join the monetary union. Since 1998, responsibility for monetary policy has been shifted back to the independent Bank of England. Similarly, the public referendums in 1 Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain 2 Cyprus, The Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia 4
Denmark and Sweden prevented these countries from adopting the Euro as their common currency. In the course of this report, I will briefly describe the requirements and convergence criteria of the 1992 Maastricht Treaty. Subsequently, the report will assess possible EMU memberships of the other 13 members of the EU, with particular reference to Denmark Sweden and the UK. I will portray the benefits and risks for these countries associated with adopting the Euro, and explain reasons why some of them have decided against the common currency. The report will conclude by depicting the future of the EMU and the possibility of new entries to the common currency in the near future. Convergence Criteria of the Maastricht Treaty of 1992 In order to join the third and final stage of the EMU, countries have to fulfil five tests or criteria to guarantee the stability of the pact. These criteria were laid out in the Treaty of Maastricht in 1992. Firstly, the budget deficit (money owed by government) must not exceed 3% of the Gross Domestic Product (GDP), representing the total output of an economy. The public debt, the cumulative total of each year s budget deficit, has to be less than 60% of the GDP. Thirdly, inflation rates within countries should be kept within a range of 1.5% of the three EU countries with the lowest rate in order to push down inflation rate and ensure price stability. In addition, long-term interest rates must be within 2% of the three lowest interest rates in the EU. Finally, exchange rates must be kept within the margins of the ERM. The ERM established an upper and lower limit for national currencies on either side of the central exchange rate with the ECU (European Common Currency). In turn, pegging national currencies against the ECU should give them stable cross-rates against one another. A country s exchange rate should have operated normally within the ERM without pressure to devalue against other currencies. When the treaty was signed in 1992, member currencies were required to operate within 2.25% bands to the ECU. The original mechanism (ERM I) derives from the European Currency System (ECS) that was established in 1979. Following 1992, the last criterion proved to be the most critical one. By the end of 1993, the United Kingdom and Italy withdrew from the ERM. Sweden, Norway and Finland floated their currencies, which were previously pegged to the ECU, and Spain was forced to devalue the Peseta on three different occasions. Only in 1995, some stability returned to the bond markets and the prospect of a single currency moved into focus again. By the end of 1996, all 5
countries, with the exception of Ireland, were operating within 2.25% bands. In 1997, Italy rejoined the ERM. Following the crisis on the currency markets, the bands were broadened to +/-15%. In 1999, Greece and Denmark joined the ERM II. Whilst Greece has adopted the Euro in 2001, the Danish Krone remains pegged to the Euro within 2.25% bands. Until today, five member of the EU have not joined the ERM II: The Czech Republic, Great Britain, Hungary, Poland, and Sweden. By choosing to stay outside the ERM II, these countries have found a loophole to avoid the 1995 EU accession treaty (which requires EU member countries to join the Euro). Although all countries are required to adopt the common currency, Denmark and the UK are exempt from complying with the treaty. Between 2002 and 2006, following the economic recession in Central Europe, the budget deficit criterion was repeatedly violated by France and Germany. As a result, the confidence in the Euro as a stable currency and the control mechanisms of the ECB deteriorated. The Stability and Growth Pact that was adopted in 1997 refers to a country s fiscal policy and its ability to maintain the Economic and Monetary Union. The pact was originally designed to strengthen the provisions on fiscal discipline in EMU (budget and public deficit limitations). However, the European Commission failed to apply sanctions against France and Germany. The treaty requires sanctions against countries that breach the deficit criteria in three consecutive years. However, the EU council relaxed some of the provisions of the stability pact to adapt deficit criteria to economic cycles and to allow France and Germany to battle their recession. It has been argued that by loosening up the budget criteria, the EU council promotes the growth component of the treaty. However, the lax application of the pact s requirements has led shed doubt on the stability of the Euro. In addition, other EU countries criticized that convergence criteria should be enforced against all EMU members, regardless of their economic influence within the EU. Benefits of the EMU As exchange rate related risks are being reduced, direct foreign investments become more attractive (as the costs for hedging against currency risks are being reduced). In addition, profits generated within in the EU can be transferred between entities, without risking the partial or entire loss due to exchange rate fluctuations (limiting transaction and transfer risks). As European countries are heavily dependent on exporting to and importing from other EU members (Doyle, 2005: EU member countries conduct between 55% and 75% of their trade with other EU members), the elimination of currency risks can be seen as one of the largest 6
benefits of the EMU. Additionally, the common currency has proven to be an incentive to increase trade volumes with other euro-zone members. Increased liquidity and efficiency of financial markets is another beneficial result of the introduction of the Euro. Businesses within the euro-zone can more easily tap financial resources across Europe, thus decreasing their financing and financial servicing costs. Stock market capitalization can be increased, whilst costs for public and private debts are decreasing, as companies and private consumers enjoy greater freedom to borrow across national borders. Also, with increasing price parity across the euro-zone, competition amongst companies will increase. As a result, inflation will be contained and consumers benefit from stable prices and higher price transparency. Inflation rate within the EU is expected to remain at 1.6% (Economist 2006). Thanks to lowered inflation rates and central bank independence, macroeconomic stability is improved throughout the euro-zone. It is the main objective of the ECB, to keep inflationary pressures low. Hence, it is independent from national pressures to intervene in times of economic downturns (e.g. to spike economic growth or decrease unemployment). In turn, confidence in ECB policies to maintain the stability of the Euro is increased. It can be argued that a common currency for a large diverse area such as Europe disallows for fine-tuning of the central banks monetary policies. Thus, the ECB cannot decrease interest rates to support economic recovery in France or Germany. Economists argue that European economies are too dissimilar to allow for a centralized monetary policy. However, a centralized policy forces countries to follow a stringent and responsible fiscal policy, without increasing public debt beyond reason (Economist, 2006: Germany is expected to keep fiscal deficits below 3% in 2007). United Kingdom s Euro perspectives In November 1997, Britain s minister of treasury Gordon Brown, set out five economic tests to measure whether the country is prepared to join the monetary union. Each of the tests is designed to measure benefits and shortfalls for the British economy: convergence of business cycles, flexibility of central bank policy, increases in direct foreign direct investments, influence on the competitiveness of UK s financial service industry and the promotion of higher growth, stability and employment. With the exception of an expected increase in direct foreign investments in the UK, all other tests, according to Mr. Brown, failed to show 7
improvements for the British economy. In the subsequent sections, this report evaluates theses five criteria in today s economic environment. Should the UK join the EMU? A general argument in favour of monetary unions is a decrease in transaction costs. On average, EMU members benefit from savings in dealers margins of 0.4% of GDP (European Commission, 1990). With the UK s relative sophisticated banking system, savings would decrease to 0.1% of GDP, resembling 1 billion. Most transactions between Euro and British Pounds are conducted through computerized banking systems, resulting in zero extra costs in the conversion process. In comparison, changeover costs from pounds to euros are estimated to amount to 30 billion (Minford, 2004). Elimination of exchange rate related risks, reduced costs of capital and increasing direct foreign investments are another argument in favour of joining the EMU. In order to realize theses benefits, Great Britain should conduct a substantial proportion of its foreign trade with countries in the euro-zone. In fact, a major proportion of direct foreign investments in the UK come from the United States (Investment Bulletin, 2005: The US remains the largest source of direct investments). Over the past 6 years, the euro-dollar exchange rates have been highly volatile, whilst the British Pound enjoys lower volatility when not being tied to either the US- Dollar or the Euro (Minford, 2004). Secondly, it is doubtful whether exchange rate risks pose a major threat to the British economy. As derivative markets become more effective, currency related risks can be easily diversified away. The country s large financial intermediaries are able to neutralize these risks in large portfolios, thus reducing the impact of exchange rate volatilities. In addition, foreign exchange rate risks have been found to be of minor importance when deciding on direct investments (Leach, 2001). Consumers are said to benefit from higher price stability and transparency within a monetary union. In consequence, consumers can benefit from greater competition and price similarity between countries of the euro-zone. As Great Britain does not share land borders with the euro-zone (with the exception of Ireland), these benefits of price similarity can be disregarded. Whilst the alleged benefits of joining the EMU are questionable, they have to be compared with the costs and downsides of adopting the Euro. Joining the currency union would mean to 8
give up separate interest rate policies for Great Britain. It has been argued in the past that Great Britain s economic cycles are substantially dissimilar from those of Central European economies ( optimal currency area conditions [OCA]). Relying on ECB policies rather than interventions of the Bank of England might increase the variability of the UK economy, and thus susceptibility to economic shocks, by as much as 75% (Minford, 2002). Hence, joining the EMU would eliminate Britain s economic shock absorbers, whilst exposing it to additional shocks from the euro-zone. It is also argued that Great Britain, when joining the EMU, will be greatly effected by the economic downswings and state pension crisis in France and Germany. With increasing economic and monetary integration, English taxpayers might become liable for economic fallouts in these two countries. Considering the marginal benefits from joining the EMU, in conjunction with the substantial direct and indirect costs associated with this decision, there is little incentive for the UK to adopt the Euro as its currency. Outlook Regardless of the analysis above, Great Britain is moving closer to the EMU. Political pressure is increasing on Tony Blair to move Great Britain closer to the European Union, as UK trade market share with the rest of Europe is decreasing. In medium and long term, Britain s position as a leader in Europe and Mr. Blair s credibility as a pro-european prime minister is not sustainable without the country joining the monetary union. A number of countries are expected to join the Euro before the end of the decade. Reforms of the decision making procedures within the EMU, including the deprivation of national central bank powers, will be conducted without the influence of Britain if the country has not decided to join. In addition, London is the most important financial hub within Europe. In 2001, 41% of all currency transactions in the country capital involved the Euro (Kenen, 2001), thus outranking the importance of the Pound. This development may well challenge the preeminence of London as the prime trading spot in Europe. Mr. Brown s five economic tests and his criticism of the Stability and Growth Pact alone is keeping Britain out of the EMU for the next couple of years to come. Sweden s Euro referendum When Sweden entered the EU in 1995, the country was not formally exempt from the parts of the Treaty of Maastricht that dealt with the single currency. Nonetheless, in 1997, Sweden declared it would not introduce the Euro in 2002. Whilst Prime Minister Göran Persson was hoping to avoid a public referendum, the parliamentary parties agreed to hold the referendum 9
in 2003. Although the political majority was expecting and working towards a Yes to the Euro, the political elite failed to convince the majority of the voters. The confederations of Swedish Enterprises, as well as the majority of the labour unions were supportive of the EMU. The Calmfors Report, published in 1996, was the basis for public Euro-scepticism in Sweden. The report identified two expected benefits from a Swedish membership in the EMU: reduction of international transaction costs and the abolishment of uncertainty of exchange rate fluctuations. The report found that the costs of asymmetric shocks to the domestic economy, in the event of surrender of monetary policy autonomy, would outweigh the benefits of increased efficiencies of the common currency. Sweden s case for the Euro Remaining outside the EMU involves some economic and political costs for Sweden. Expected interest rates in Sweden lie 20 basis points above the euro-zone average (Economist, 2006), making capital relatively more expensive. Contrary to Denmark, Sweden s floating exchange rate is subject to exchange rate related risks. Consequently, if Sweden were to remain outside the EMU, the country will continue to display a risk premium compared to Euroland. Private consumers as well as small to medium-sized firms are at a competitive disadvantage compared to their central European counterparts in terms of raising capital. As a significant part of Sweden s foreign trading activities involve member countries of the EMU, the transaction costs compose a considerable proportion of the country s GDP. It must be noted, however, that cross-border transactions and payments with Denmark and Norway (as both countries are not part of the EMU) will not be affected by Sweden s decision to adopt the Euro. Increasing pressure will be put on the country s financial service industry. More medium-sized to large companies demand euro-based financial services, thus increasing the service costs for local banks relatively to banks situated in the euro-zone. From a political perspective, the country s voice in pan-european issues will be marginalized in the future. Outlook Considering Sweden s close ties to the European Union, and the Union s relative importance for the country s foreign trading activities, it is likely that it will reconsider its position on the Euro. Today, Swedish companies can already make up their income statements and balance sheets in Euros and redenominate their share capital. In order to remain a competitive financial market, with more and more Swedish companies having their stocks listed in Euroland, Sweden should join the EMU. The Calmfors Report acknowledges the long-term economic benefits of adopting the common currency. With the population s No to the Euro, 10
Sweden is set to remain outside the Euro until 2013. A new referendum in 7 years time, backed by the international success of the Euro as the second currency next to the US-Dollar, might tilt the favour towards the EMU. Denmark and the Euro Similar to Great Britain, Denmark is exempt from joining the Euro, as laid out in the provisions of the Maastricht Treaty. However, Denmark chose to peg its currency to the Euro (previously being tied to the Deutsch Mark), allowing the Danish Krone to move within 2.25% bands. Three years prior to the referendum in Sweden, Danish voters decided to reject the Euro in 2000. One of the reasons for rejecting the Euro was the common currency s depreciation relative to the US-Dollar since its launch in 1998. Whilst economic concerns were the predominant drivers in Sweden s decision, the reasons behind the Danish No vote derive from the country s reluctance of European integration. Similar to Sweden, trade unions and employers organizations backed the Euro in the upcoming referendum. However, as a large proportion of the Danish workforce is employed or being supported by the state, the population worried that joining the Euro would expose them to international economic markets (thus threatening Denmark s extensive welfare system). Denmark s decision on a Euro also had an impact on Sweden s referendum, backing opposition against the single currency. Denmark s case for the Euro Since Denmark s Krone is pegged to the Euro, it is less susceptible to exchange rate volatilities than the Swedish Krona. Denmark s national bank follows the interest rate policies of the ECB. Hence, a strengthening/weakening of the US-Dollar will have similar effects on the Danish economy as on the economies within the euro-zone. In 2006, Denmark will conduct two-thirds of its trade with members of the EU, many of which are members of EMU (Datamonitor, 2005: with 19% share of total exports, Germany is the country s most significant trading partner). Hence, the country is heavily reliant on remaining competitive in the euro-zone markets. Since Denmark s monetary policy is already constrained by the demands of ERM II, a full EMU membership would confer additional benefits in terms of central bank credibility. Outlook The current government announced that Denmark will not hold another referendum to decide on its full membership in the EMU until 2008. The generous social safety net and the euro- 11
scepticism remain an obstacle for a full adoption of the Euro. In theory, Denmark, being exempt from the preconditions of the Maastricht Treaty (opt-out clause), could remain outside the euro-zone indefinitely. In reality, however, Denmark s economic ties with the rest of the EU are much stronger compared to the UK. The country s solid economic indicators should make way for the Denmark s full integration into the monetary union. Despite the fact that Denmark negotiated the opt-out of EMU, the government currently continues to meet the criteria set out by the Maastricht Treaty in case the Danish electorate should decide that Denmark should in fact join the euro-zone. The prospect of additional members to the EMU Although the majority of the 10 new members to the European Union do not fulfil the convergence criteria of the Maastricht Treaty, they will be required to join the EMU in the near future. Most new member countries have signalled that they would adopt the Euro rather sooner than later. Also, the majority of new members would prefer s shorter time in the ERM II. At the same time, the ECB takes a more cautious approach to the adoption of the Euro by the new members. Conflicts between the exchange rate and inflation criterion due to fast economic growth as well as the possibility of asymmetric economic shocks pose a challenge to the integration of the enlarged EU into the monetary union. Estonia, Slovenia and the Czech Republic strive to join the euro has soon as possible. Whilst the Czech Koruna was pegged against the Euro prior to 1997, the country was then forced to change to a floating exchange rate system. Currently, strong exports support the economic growth in the country, whilst the central bank is able to keep inflation at bay (Economist 2006: 2% expected inflation). Estonia, on the other hand, is being troubled by inflationary effects due to increase in oil prices. Unless the country can tame its inflation, it will not be able to meet the criteria for Euro entry from early 2007. The required structural reforms and fiscal discipline in Slovenia could be disturbed by a change in the ruling coalition during 2006. On the other side, it is questionable whether the ESCB is able to cope with up to 25 members. The current decision making process involving all national reserve banks does not allow for an efficient and swift way of determining the ECB s monetary policy, and could be replaced by a rotation scheme in the medium term. With an increased number of members and the increased probability of economic shocks (some countries experiencing booms along with 12
inflationary pressures while others are in the midst of a recession) the ECB could become paralyzed in its decision making process, not knowing whether to increase or decrease interest rates. On the other hand, EMU members will be disappointed with ECB policies not reacting to economic conditions of individual member countries. One of the questions to be answered is, whether an enlarged EMU will be an optimal currency area. The higher the economic divergence of member countries, the higher the costs associated with a monetary union. It can be argued that, because of the low degree of economic integration, the Eurozone-25 does not compose an optimal currency area (Grauwe, 2003). However, deciding upon monetary union could set in motion a process of economic integration across the member countries, in turn decreasing the divergence amongst the member countries (thus forcing countries to create conditions that make the union work). In the transition process, however, the existing 12 members of the monetary union will experience ECB policies as less responsive to their national economic needs. From the perspective of the new 10 members of the EU, adopting the Euro could improve their welfare and spike economic growth and foreign direct investment. Unsurprisingly, these countries want to benefit from the EMU as quickly as possible. However, to make the EMU work in the long run, countries must fulfil the convergence criteria of the Maastricht Treaty. Considering the somewhat erratic real growth rates of these countries, remaining an exchange rate within the 15% bands of the ERM will prove to be a challenging task for the new member countries. Whilst leading economies within Europe such as France and Germany are struggling to fulfil their deficit criteria, little commitment can be expected from less developed countries in Eastern Europe to comply with these criteria once they have joined the EMU. This, in turn, could threaten the stability and reliability of the Euro as a reserve currency alongside the US-Dollar. Hence, new members to the EMU should only be expected in the medium term. Concluding remarks Central to the discussion of the EMU is the question whether the euro-zone indeed qualifies as an optimal currency area. Whilst the Euro has appreciated during the last three years, gradually replacing the US-Dollar as an important reverse currency, the question remains whether other countries should join the monetary union. From our analysis above, we ca subdivide the potential candidates into three groups. The United Kingdom derives little direct 13
economic benefit from adopting the Euro, since the timing and characteristics of the country s economic cycles are significantly different from the rest of the EU. However, Great Britain s desire to take up a leading role within the Europe might require a change of politics. When Gordon Brown will step down from his position, the path is set to bring the UK closer to the EMU. Denmark and Sweden, although somewhat reluctant to join the EMU, will eventually adopt the Euro as their common currency. Political pressures and their close trade ties to the eurozone leave the countries with little choice but to join the monetary union. Contrary to the UK, these countries might be able to realize immediate economic benefits from a membership in the EMU. Sweden will have to fulfil the criteria of the ERM II in two consecutive years before joining the EMU. The new 10 members of the EU have all ratified the provisions of the Maastricht Treaty. In consequence, each of the new member countries will join the EMU eventually. It is questionable, however, whether any of the new members will be able to meet the convergence criteria by the end of the decade. Most important, the European council should enforce deficit criteria with all EMU member countries to re-establish confidence and credibility of the monetary union. Only then can the new members be expected to comply with budget and fiscal discipline when joining the EMU. 14
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