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LONG-RUN ECONOMIC ASPECTS OF THE EUROPEAN UNION’S EASTERN ENLARGEMENT6.4.3 THE INTEREST RATE AND EXCHANGE RATE CRITERIAInterest rate convergence will result from a stable exchange rate. For this reasonthe exchange rate stability criterion can be viewed together with the criterion oninterest rates. Most candidate countries already now orient their exchange ratepolicies towards the Euro. As our analysis of inflation trends will show, there is noreason why they should not be able to achieve exchange rate stability comparableto that within the pre-1992 ERM. However, a problem might arise because theTreaty speaks of ‘the observance of the normal fluctuation margins provided forby the exchange rate mechanism of the European Monetary System, for at leasttwo years, without devaluing against the currency of any other member state.’118This is a provision that needs to be re-interpreted in the light of enlargement.Taken literally, it would seem to imply that formal membership of the EMS for twoyears is a pre-condition for admission to the Euro area. In order to give candidatecountries a chance to join the Euro immediately upon enlargement they wouldhave to be allowed to join the EMS already before joining the EU. Whether or notnon- EU members could join the ERM-II as it exists, or whether one would need toconstruct at least formally a sort of ERM-III needs to be discussed. If neither ofthese solutions can be implemented, insisting on formal EMS membership wouldseem to be manifestly absurd in cases like Estonia. This country is de facto alreadya unilateral member of the Euro area and, by the time it joins the EU, will have hadten years without any exchange rate instability.There is another problem with the exchange rate stability criterion. Experience hasshown that the most serious difficulties arise during the final phases of inflationconvergence if capital controls have already been lifted. A number of candidatesare entering this dangerous period right now, and one cannot exclude that theywill have to face speculative attacks on their currencies. The argument that theperspective of enlargement protects them against attacks similar to that againstthe Russian rouble, is not convincing, as is shown by the episodes of speculativeattacks even within the EU.The ERM-II will in any way be quite different from its predecessor. The existingformal provisions for the ERM-II have not been tested yet. They are so vague as togive little guidance to the market, should problems arise. In our view the ERM-II(or any ERM-III arrangement) is likely to remain de facto a unilateral peg. The keyfactors determining the nature of the relationship between the Euro area and thecandidate countries' currencies are their huge differences in size and reputationfor price stability. The Euro area is likely to remain at least twenty to 40 timeslarger than the accession countries combined. This is even more lop-sided than therelative weights that made the links of the Dutch Guilder and the AustrianSchilling to the Deutschmark (DM) so one-sided.
EMU, EURO AND ENLARGEMENTIf the ECB were to follow a policy of never intervening, the ERM-II would function ina similar way as these links to the DM. However, if the ECB were to deviate even alittle from a policy of ‘benign neglect’ it would immediately dominate the relationship.Even unlimited intervention by the ECB in favour of any currency of the candidatecountries could never endanger price stability in the Euro area. If marketsunderstood this they would not even test the resolve of the ECB. But how the ECBwill handle this issue is not yet clear.6.4.4 INFLATIONOne of the criteria in Article 109j (original numbering) is ‘the achievement of ahigh degree of price stability; this will be apparent from a rate of inflation which isclose to that of, at most, the three best performing members in terms of pricestability’. The numerical ceiling of 1.5 per cent is fixed only in an accompanyingprotocol. This is important because in the case of the CEECs one could argue that ifthey grow fast enough to catch up within a reasonable period they should have aninflation rate, as measured by the consumer price index (CPI), that is substantiallyabove that of the Euro area.This is suggested by the so-called Balassa-Samuelson (B-S) effect which is basedon the empirical regularity that productivity grows faster in the traded goodssector (essentially industry) than in services (many of which are not traded). If thecandidate countries maintain a stable exchange rate against the Euro the prices oftraded goods should increase in line with prices in the Euro area. But prices ofservices are likely to increase faster since wage increases are determined, at leastpartially, also by the high productivity industrial sector. A fast growing countrycould thus have a substantially higher inflation rate than the Euro area even whilepegging tightly to the Euro, and without running up external imbalances. It isoften objected that this idea is inconsistent with the experience of Ireland, whichover the last decade achieved very rapid catch-up without noticeable higher inflation.This argument is analysed briefly in box 6.1, where it is found that Irelandconstitutes a special case which seems unlikely to repeat itself (see also Annex 1containing a formal exposition of the theoretical underpinning of the Balassa-Samuelson effect).119Although the B-S effect is often mentioned, there are few reliable estimates of itsmagnitude. The ECB’s Monthly Bulletin of October 1999 dealt with this issue fromthe point of view of the Euro zone. The ECB does not provide a precise estimate ofthe B-S effect, but it claims there is a close association between absolute pricedifferentials and the inflation rate (measured over the period mid-1998 to 1999).However, the differences are not very large within the Euro zone. For example,Portugal, whose price level stands at close to 70 per cent of the EU average, had aninflation rate that was about 1.5 percentage point higher than that of the Eurozone’s core, whose price level corresponds roughly to the average.
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WORKING DOCUMENTS W 109LONG-RUN ECO
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CONTENTSCONTENTSPreface 3Summary 91
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CONTENTSAnnexes1 The Balassa-Samuel
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LONG-RUN ECONOMIC ASPECTS OF THE EU
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INTRODUCTION1 INTRODUCTIONThe Europ
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INTRODUCTION4 To what extent do the
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INTRODUCTIONefficiency-based (first
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INTRODUCTIONThe exercise is not so
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PROBLEMS OF ACCESSION TO THE INTERN
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ANNEXESANNEX 2WHY IT PAYS TO JOIN T
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ANNEXESThe key item in equation (4)
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ANNEXEScommon reserve pool of the E
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ANNEXESANNEX 3THE VARIABILITY OF TH
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ANNEXESTable A4Correlation coeffici
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ANNEXESVariability of relative CPIM
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ANNEXESANNEX 4AVERAGE FARM NET VALU
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ANNEXESANNEX 5EU BUDGET 1997 COMPAR
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ANNEXESTable A10Estimated expenditu
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ANNEXESANNEX 6 EFFECTS OF THE BERLI
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ANNEXESANNEX 8TECHNICAL ASPECTS AND
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