European Monetary Union: A Perspective on the Capital Markets
Evans, Gay H., The Journal of Lending & Credit Risk Management
The 1992 Maastricht Treaty stipulates that European Monetary Union (EMU) will irrevocably fix exchange rates and introduce a single currency now referred to as the euro. The common European monetary policy will be run by a new supra-national institution to be created in mid-1998, the European Central Bank, whose forerunner, the European Monetary Institute, was established in 1994. The efficiency and competitive advantages afforded by a single currency - as well as the problems implicit in same - have since been extolled and debated with ever greater frequency.
EMU encompasses 15 member states: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Italy, Ireland, Luxembourg, Netherlands, Portugal, Spain, Sweden, and the U.K. Other members can join later than 1999, although the obligation to fulfill a number of criteria met by their predecessors will remain. Nonmembers will be assessed for membership every two years.
Much of the EMU discussion has centered on five convergence criteria stipulated in the treaty and created to guarantee cohesion among the states. This cohesion forms a solid base for a stable European currency. While convergence criteria might seem an abstruse technical matter, they go to the heart of the debate over Europe's future and the prospects for its new currency. The five criteria are as follows:
1. Inflation rates, observed over a period of one year, must not be more than 1.5% above the average of the three best performing members.
2. Long-term interest rates, observed over a period of one year, must not be above 2% of the average of the best three member states in terms of price stability.
3. Member states' budget deficits (including central, regional and local governments) should not exceed 3% of gross domestic product (GDP), unless they are temporary and exceptional.
4. Public debt ratio should not exceed 60% of GDP, but this criterion is also satisfied if the public debt ratio approaches the reference value at a satisfactory speed.
5. Currencies must have respected the normal fluctuation margins provided by the exchange rate mechanism of the European Monetary System without severe tensions or unilateral devaluations for at least the last two years.
In addition, the national central banks must be granted full independence.
The importance of the criteria is fourfold:
1. The price stability criterion ensures that a member state does not diverge from the European trend. Competitiveness between countries would be threatened if inflation showed large discrepancies.
2. Fulfilling the interest rate is a criterion that is the consequences of long-lasting stability and convergence policies.
3. The exchange rate criterion prevents countries from misusing the exchange rate as an artificial competitiveness factor.
4. The public deficit and debt criteria prevent member states from damaging stability achieved by other member states through lax deficit spending policies.
Although too-strict application of the convergence criteria could put EMU at risk, there must be certain limits to their interpretation. If EMU is not perceived as stable, it risks losing public support and the confidence of the financial markets, with resulting higher interest rates.
According to the timetable laid down in the Maastricht treaty, there are three stages in establishing EMU. The first two stages are transitional, promoting monetary cooperation, coordination and convergence. Stage three marks the beginning of monetary union.
1. Stage 1 began July 1, 1990, when it was important to fully recognize liberalization of capital movements and closer cooperation among countries on economic, fiscal, and monetary matters.
2. Stage 2 began January 1, 1994, with the establishment of the European Monetary Institute, a ban on central bank financing of public deficits, and enhanced coordination of economic and fiscal policies. …