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Accession Countries Face Increased Instability 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 members. 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 Exchange Rate Mechanism (ERM-II), prior to adoption of the euro. This period will be a time of heightened vulnerability to financial instability, requiring extremely adept economic management. 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 10 makes the following observations and recommendations for 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, its central characteristic as a fixed but adjustable regime 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 therefore impede entry to the euro. The dangerous combination of high capital mobility and an intermediate exchange rate peg could be avoided if ACs were to unilaterally adopt the euro without becoming full members of the euro area. This makes sense for countries that are seeking fast entry into the euro area, and which 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. 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 case for unilateral euroization is strong enough for the European authorities to reconsider this option.
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