Accession countries run risk of crisis in ERM-II

CEPR Policy Paper No.10 - 'Sustainable Regimes of Capital Movements In Accession Countries'

Authors: David Begg (Imperial College, London and CEPR), Barry Eichengreen (University of California at Berkeley and CEPR), László Halpern (Hungarian Academy of Sciences and CEPR), Jürgen von Hagen (Zentrum für Europäische Integrationsforschung, University of Bonn, Indiana University, and CEPR) and Charles Wyplosz (Graduate Institute of International Studies and CEPR)

The European Union is now preparing for the entry of ten new member countries. As the accession countries (ACs) embark on the next phase of the path toward formal entry into the EU, most are expected to join the successor to the Exchange Rate Mechanism, the ERM-II, prior to adoption of the euro. This period will be a time of heightened vulnerability to financial instability that will raise the possibility of a currency crisis and require extremely adept economic management. Currency crises are not new, but financial integration is raising the costs of unsound policy design. Currency crises are particularly unwelcome in ACs hoping to make the smooth transition to EU membership and then to full adoption of the euro.

Many transition economies have been shielded from capital movements by capital controls that have not yet been dismantled and by autonomy over the choice of monetary and exchange rate policy, including the option of exchange rate flexibility as a means to curtail capital movements. With limited exchange rate flexibility under ERM-II, disinflationary conditions, and no exemptions from full international capital mobility, EU accession countries are likely to experience large ‘convergence play’ capital inflows - such inflows arise because investment opportunities are large but domestic savings are small and the domestic financial system is still developing; and because a rising real exchange rate offers the prospect of attractive returns - alarmingly, large capital inflows figured in virtually every financial crisis of the 1990s. Building on the lessons learned from past financial crises, CEPR Policy Paper No.10 makes a number of observations and recommendations for the ten accession countries as they negotiate the tricky path to global financial integration and monetary union.

Although ERM-II may be compatible with many exchange rate regimes, from currency boards to relatively wide bands, the authors of Policy Paper No.10 believe that its central characteristic as a fixed but adjustable exchange rate peg without the protection of capital controls makes it an interim stage of some danger. Whatever prudential supervisory arrangements are adequate for Western European financial institutions may not be sufficient for financial institutions in accession countries. This stage therefore requires a period of even longer prudential supervision.

The Report’s analysis indicates that real exchange rates will still be appreciating during the ERM-II phase. If there is pressure for ACs exchange rates to remain within invisible bands the result will be additional and unnecessary inflation. Since low inflation is a requirement of the Maastricht criteria, ERM-II may impede entry to the euro. Policy Paper No.10 argues that the dangerous combination of high capital mobility and intermediate exchange rate peg could be avoided if ACs adopted the euro unilaterally without becoming full members of the euro area. This makes sense for countries that are seeking fast entry into the euro area, that have achieved fiscal responsibility, price stability and a sound banking sector.

Official readings of the Maastricht Treaty rule out unilateral euroization. At the moment it is necessary for ACs to join the euro area by the same process as the current members. These conditions include the attainment of low inflation and sustainable public finances and the requirement not to devalue the central parity within two years adoption of the euro. Policy Paper No.10 concludes that when viewed in isolation, these requirements make little sense: what was necessary to establish the rules of the game is not necessary once the rules have been in place for some time. To believe it wise to make all ACs undergo this process, it is necessary to disregard the experience of the 1990s currency crises that were associated with intermediate exchange pegs. The authors argue that the economic arguments for unilateral euroization are strong enough for the European authorities to reconsider this option.