Ministers to relax exchange rate rules for EU newcomers

Date: 07/09/00

By Tim Jones

INCOMING EU member states will be allowed to continue operating fixed exchange rate systems as they move towards monetary union, despite concern that this will leave them lacking vital experience in running an independent monetary policy when they join the euro zone.

Under an agreement to be rubber-stamped by EU finance ministers this weekend, some applicant countries will be allowed to stick with tried-and-tested currency regimes instead of complying with the rules of the Exchange Rate Mechanism (ERM II).

The decision marks a political victory for the Baltic states and Bulgaria, and follows intense lobbying by the International Monetary Fund (IMF), which has dismissed fears that this approach could cause problems.

Some existing euro-zone countries, led by France, had argued that the agreement would result in officials from new member states joining the European Central Bank's governing body with no experience of monitoring inflation or changing interest rates to control the economy. But they have now dropped their objections in the face of IMF pressure.

Under the new rules, set to be endorsed by ministers at an informal meeting on Saturday (9 September), applicants will be allowed to choose which currency regime to apply until they join the Union. After that, they will be required to treat their exchange-rate policy "as a matter of common interest" in line with Article 124 of the EU treaties and to join ERM II once they have met basic conditions on financing their budget deficit and central bank independence.

Under the ERM II regime, an applicant currency's central rate against the euro is set by mutual agreement between the ECB, euro-zone ministers and their equivalents in the candidate country. The currency can then trade 15% either side of the central rate, at which point the ECB is a guaranteed buyer or seller.

But subject to rules due to be approved this weekend, applicants could instead be allowed to import successful currency board arrangements (CBA) such as that long practised in Hong Kong.

Under this system, monetary authorities guarantee to exchange limitless domestic currency for a specified reserve currency at an exchange rate fixed by law, so preventing the central bank from printing money. This means that decisions taken by the reserve currency country's central bank have a profound impact on the economy of the nation concerned and responsibility for monetary policy is effectively taken out of its hands. The Estonians have applied such a system for close on a decade and the Bulgarians have pegged the lev to the deutschmark at 1,000 to one since July 1997. The IMF insists this does not mean those countries lack the discipline necessary to comply with the demands of euro-zone membership. "The CBAs of these countries have already been tested by severe shocks and they have so far passed the test," it stated in a policy paper earlier this year. "CBAs should be seen as an ERM II-compatible framework, entailing a discipline which is in line with what will be required of these economies in the EMU."

The Versailles agreement, which will guide European Commission negotiators as they discuss euro-zone membership terms with the 12 applicant states, will entail significant changes in most candidates' regimes.

Once inside the European Union and applying to join the euro zone, new member states will have to abandon free-floating systems such as that only just taken up four months ago by guardians of the region's most traded currency, the Polish zloty. Hungary will also have to adapt its 'crawling peg' scheme, under which the forint is allowed to devalue at set intervals within tight fluctuation bands against the euro.

No currency will be allowed to be pegged against any currency other than the euro. The Bank of Lithuania has already announced its intention to switch from the US dollar to a full euro peg in the second half of next year.

Incoming EU Member States will be allowed to continue operating fixed exchange rate systems as they move towards monetary union, despite concern that this will leave them lacking vital experience in running an independent monetary policy when they join the euro zone. Under an agreement set to be rubber-stamped by EU finance ministers, some applicant countries will be allowed to stick with tried-and-tested currency regimes instead of complying with the rules of the Exchange Rate Mechanism (ERM II).