European Monetary Union

The Way Forward

Prof H M Scobie

• Publisher: Routledge
• Year: 1998
• Topic: Business
• eBook ISBN:
  9781134687855
• Subtopic: Business General
• Index: Business

A detailed analysis of the economic effects of the changeover to a unified European currency and the pressures caused by a dual-currency system over the transition period to the Euro. Subjects discussed include:* fiscal transfer payments: the implications of the US structure for the EMU* consequences of parallel currency 1999-2002* feasibility of a

1
THE CHANGEOVER TO A UNIFIED EUROPEAN CURRENCY

Why a ‘big bang’ approach is necessary

H.M.Scobie, S.A.Buckley and R.Fox

European Economics and Financial Centre, London

1 INTRODUCTION

A question mark still hangs over the way in which a European common currency (hereafter referred to for convenience as the ‘Euro’) can be introduced. The debate on the subject has been about whether the national currencies and the ‘Euro’ should be allowed to circulate together over a fairly long period of time, or whether the latter should be introduced through a ‘big bang’.

This study examines the ‘critical mass’ method of launching the single currency, and compares it to the ‘big bang’ method.¹ It analyses the pros and cons of each system, and highlights the problems associated with ‘critical mass’. It also poses a series of questions to which the decisionmakers for the changeover to the single currency must address themselves.

It is argued in this study that changing to a new European currency at one instant of time would be feasible, and would be the best approach, i.e. one that stands the least risk of break-up.

2 BACKGROUND

Since the signing of the Maastricht Treaty on 7 February 1992,² a number of working groups have been engaged to produce various consultation documents and analyses. They have endeavoured to develop some practical solutions, and project some workable scenarios.

Among the groups to produce publications are the ‘Expert Group on the Changeover to the Single Currency’, which was chaired by Mr Cees Mass³ (referred to here as the Cees Mass group), ‘the European Commission Green Paper’, and the ‘EMU Committee of the London Investment Banking Association (LIBA)’.

Figure 1.1 Countdown to EMU

The Cees Mass group presented two sets of reports; one was in the form of an Interim Report, presented to the European Commission on 20 January 1995.⁴ Another was in the form of a Progress Report, presented to the Commission on 10 May 1995. ⁵

Following this Progress Report, the European Commission published on 31 May 1995⁶ a Green Paper which presents a reference scenario for the changeover to the single currency (pp. 23–30). In response to the Green Paper, the London Investment Banking Association (LIBA) produced a report on 17 October 1995,⁷ which voices some caveats associated with the transition.

In the above mentioned documents, alternative procedures for the introduction of the single currency have been proposed. Among these are the following.

2.1 ‘Big bang’ method

The ‘big bang’ approach is one where the conversion to the single European currency would occur on a specific date. Accordingly, after an overnight switchover, all monetary transactions would take place in the new common currency. One notable precedent for this approach is the conversion of Ostmarks to Deutschmarks in Germany on 1 July 1990, described below in Section 5 of this chapter. Another is the decimalisation of sterling in 1971, when there was a change from pounds, shillings and old pence to pounds and new pence.

2.2 ‘Critical mass’ method

Under the ‘critical mass’ approach, monetary union would begin with national currencies and the ‘Euro’ circulating together over a very lengthy period of time, as long as three years, while the national currencies become fixed and irrevocable. It would end with the adoption of the ‘Euro’ as the single currency of the participating countries. Thus, there would be a time lag between these events.

This approach assumes that monetary policy would be conducted in ‘Euros’ immediately after the fixing of exchange rates. It also assumes that interbank and capital markets, and new issues of public debt would be in ‘Euros’. This volume of transactions would constitute a ‘critical mass’, and is estimated to account for 90% of all transactions. Consumers would continue to use their own currencies.

Figure 1.2 The introduction scenario proposed by the Expert Group for the Changeover to the Single Currency, 10 May, Luxembourg

2.3 ‘Mounting wave’ method

Another terminology used to describe the launch of the single currency is the ‘mounting wave’. This implies that the new currency, the ‘Euro’, would initially be used only in transactions between central banks and commercial banks. From there, its use would gradually spread to other transactions nationally.

2.4 ‘Delayed big bang’ method

The single currency may also be introduced via the ‘delayed big bang’ approach, which was advocated by Germany’s Bundesbank. Under this approach, the new currency would exist only in central bank ledgers for around three years after the fixing of exchange rates. Subsequently, the new currency would rapidly replace the old one. This would avoid the costs associated with national currencies and the ‘Euro’ circulating together.

3 THE GREEN PAPER

The European Commission’s Green Paper of 31 May 1995⁸ highlights the ‘hurdles to cross’ in the transition to the single currency, and proposes steps to overcome them. The publication takes the gradualist ‘critical mass’ approach, and divides the transition to a single currency into three phases. These phases are outlined in Figure 1.3. The specific starting time for the transition has yet to be decided by ‘the Council’, which comprises Heads of State or Heads of government of the European Union member states.

3.1 The Green Paper’s proposed Phase A

Assuming that monetary union begins in January 1999, Phase A should begin in January 1998 at the earliest. It is a phase in which preparations will be made for the move to Stage III of EMU, as provided for in the Maastricht Treaty. This phase is not explicitly provided for in the Maastricht Treaty, which proposes a swifter transition between the decision to form EMU and the act of forming it (see Article 109, shown in Appendix A, of this chapter).

At the start of Phase A, ‘the Council’ will decide to go ahead with EMU (Appendix A, Articles 109j and 1091). The European System of Central Banks (ESCB) and the European Central Bank (ECB) will be created. These institutions will make the preparations for monetary policy to be carried out in ‘Euros’. ‘The Council’ will also specify the length of the delay before the introduction of ‘Euro’ notes and coins. This should not exceed a maximum of four years from the beginning of Phase A. During Phase A the following steps need to be taken:

• First, legal changes required for the launch of the new currency must be made.
• Secondly, the particulars and precise features of the new currency have to be determined.
• Thirdly, ‘national steering structures’ need to be set up to oversee the introduction of the new currency.
• Fourthly, banks and financial institutions in each country should decide upon a plan for the transition.

3.2 The Green Paper’s proposed Phase B

The start of Phase B will be characterised by three fundamental developments:

1. the establishment of the European Central Bank as well as the European System of Central Banks by ‘the Council’;
2. the irrevocable announcement of parities of European currencies;
3. the ECU becoming a currency on its own (say the ‘Euro’), rather than a basket of currencies.

The basket ECU’s exchange rate with non-participating countries should become the ‘Euro’s’ initial rate with these countries (see Appendix A, Articles 109g and 1091(4)). However, ‘the Council’ retains the right to override this (Appendix A, Articles 109(1) and 109(3)).

Interbank and capital markets and new issues of public debt must be denominated in ‘Euros’ after the start of Phase B. Taxes and major public expenditures may also be in ‘Euros’. Consumers would continue to use their old national currencies.

3.3 The Green Paper’s proposed Phase C

All that remains of the old currencies will be replaced by ‘Euros’. This phase will last as long as this process takes, which, according to the European Commission, should be several weeks.

4 DRAWBACKS OF THE ‘CRITICAL MASS’ APPROACH

This section highlights the problems and risks associated with the ‘critical mass’ approach, as compared with the ‘big bang’ approach. It is demonstrated that delays in introducing the new currency could subject the system to severe risks, and could undermine efforts to make EMU irreversible.

Figure 1.3 The introduction scenario proposed by the Green Paper

Source: European Commission, One currency for Europe—Green Paper on the Practical Arrangements of the Single Currency (1995), Office for Official Publications of the European Communities, Luxembourg, 31 May.

Ostensibly, once the currencies are fixed irrevocably, they should move against other non-EMU currencies in exactly the same proportion. However, another picture can emerge. For as long as national currencies are in operation, and are used in day-to-day foreign trade, the demand and supply for those currencies will be affected by the size of exports and imports in those currencies.

Thus, if a country has a persistent external trade surplus against, say, the US, its national currency, e.g. the Deutschmark, can appreciate against the US dollar. If this pattern continues, it can experience further appreciation against the US dollar. The reverse can be true for an EMU member country with a trade deficit against the US. Accordingly, a downward pressure would develop for that currency against the dollar.

The longer the delay in entirely replacing the national currencies with the ‘Euro’, the higher the risk that the proposed single currency will collapse. This delay could bring about turmoil in the currency market, destroy confidence in the fixed exchange rates and act as a source of great instability. The causes of the instability are spelled out below.

4.1 Arbitrage risk

During Phase B, countries participating in EMU will still have separate exchange rate relationships with other non-EMU countries. These would include the non-participating European Community countries, as well as others such as Japan and the United States. It may be possible for one EMU member currency, say sterling, to depreciate against a non-EMU currency, say, the dollar, while another EMU currency, say the Deutschmark, appreciates against the dollar. This would give rise to arbitrage opportunities.

The arbitrage opportunities thus arising could be exploited by first converting dollars into sterling, then converting the sterling into Deutschmarks at the fixed rate, and finally converting the Deutschmarks back into dollars. That is to say, arbitrage positions could arise through one EMU currency appreciating or depreciating at a different rate relative to another EMU member currency. In this situation, by converting a non-EMU third currency, say, the dollar, into one EMU currency, then converting at the fixed rate into another EMU currency, and back again to the original currency, a considerable gain could be made. This can be demonstrated by means of an example of three currencies, say the US dollar, the Deutschmark and sterling. Assuming that both the UK and Germany will join the monetary union at the beginning of Stage III, i.e. on 1 January 1999 it is assumed, and the currencies of these two are fixed irrevocably.

This example is shown in Table 1.1, and should help to demonstrate

Table 1.1 Demomstration of an arbitrage system

the argument. Let us assume on 1 January 1999, when the third stage of monetary union begins, the following exchange rates hold:

• Deutschmark to sterling rate is 2.16.
• Dollar to sterling exchange rate is 1.60.
• Deutschmark to dollar rate is 1.35.

These exchange rates are shown in column 1 of Table 1.1. At this stage, the sterling to Deutschmark exchange rate becomes fixed irrevocably.

At the beginning of Stage III, i.e. 1 January 1999, using the rates quoted in this example, if one converts $10 to sterling, then to Deutschmarks, and back to US dollars one would reobtain $10 (namely, $10 converts to £6.25, which in turn converts to DM13.50, which converts back to $10).

It should be noted that these examples are highly exaggerated in order to demonstrate the argument. A much smaller imbalance in an EMU member currency against another can still lead to arbitrage positions.

Two scenarios can be considered for 1 July 1999, i.e. half a year into Stage III of EMU. Under one scenario, the Deutschmark appreciates against the dollar, moving from DM1.35 to the dollar to DM1.25 to the dollar while sterling depreciates against the dollar, from $1.60 to the pound, to $1.55 to the pound. On 1 July 1999, converting $10 to sterling gives £6.45, which converts to DM13.93, which in turn converts to $11.14. The gain from this transaction is $1.14.

Under the second scenario, the Deutschmark appreciates against the dollar from DM1.35 to the dollar to DM1.25 to the dollar, a rise of 7.4%. Sterling appreciates against the dollar, from $1.60 to the pound to $1.62 dollars to the pound, a rise of 1.25%. As the Deutschmark to dollar rate is appreciating faster than the dollar to sterling rate, arbitrage opportunities emerge again. Converting $10 to sterling gives £6.17, which gives DM13.33. Converting DM13.33 to dollars gives $10.66. The gain from this transaction is $0.66. The gain from this arbitrage position is smaller than that from Scenario 1, which was $1.14, though it remains, nevertheless, a gain.

Intervention by the European central banks will still remain a powerless tool, for the size of any central bank’s intervention is limited by the reserves of that central bank and its supporting central banks. While the size of the world currency dealing today exceeds 1 trillion dollars per day, the limit of the central bank reserves run...

Table of contents

• Cover Page
• Title Page
• Copyrigth Page
• Figures
• Tables
• 1 The Changeover to a Unified European Currency
• 2 Fiscal Transfer Payments
• 3 European Monetary Union
• 4 The Single Currency
• 5 EMU
• 6 The United Kingdom and Europe
• 7 Some Thoughts on the Monetary Framework in EMU
• 8 Finland on the Way to the EMU
• 9 The International Competitiveness of European Manufacturing
• 10 Austria on the Way to EMU
• 11 Adhering to the Convergence Criteria