House of Lords - European Union

Select Committee on European Union Written Evidence

Memorandum by Joaquín Almunia, Commissioner for Economic and Monetary Affairs, European Commission

Thank you very much for your kind letter dating from 8 February 2007 and for the interest the House of Lords European Union Committee shows in the development of the euro and the euro-area economy.

The euro is a key symbol for EU integration and, as recently recalled in the Declaration of Heads of States at the occasion of the 50th anniversary of the Treaty of Rome, "it makes us [the European Union] strong". The euro has raised both, trade inside the euro area and trade of the euro-area Member States with the rest of the world It has also contributed to the increased integration of European capital markets. Furthermore, a look at broad exchange rate indicators and longer time horizons reveals that movements in the euro exchange rate since 1998 have not been abnormally large. At current, the euro's real effective exchange rate is standing just above its long-term average. Turning to fiscal policy, the reformed Stability and Growth Pact has increased the economic rationale of the fiscal surveillance framework The experience with the revised Pact has been rather positive. The overall budgetary situation as well as economic development in the euro-area Member States has improved remarkably in the recent past, supported by the ECB's stability-oriented policy framework, providing a stimulus through low interest rates, and by consistent fiscal policy decisions. Euro-area enlargement is also proceeding although at a different speed than originally envisaged.

In Annex 1, you will find the detailed answers to the questions raised in your letter.

Annex 2 gives list of links to key documents from the Commission, or economic papers by Commission officials, relating to subjects raised by the Committee's list of questions.

I would be very grateful if you could keep me informed on the outcome of your current inquiry.

30 March 2007

Annex 1

1. What contribution has the introduction of the euro made to the levels of trade within the euro zone, and between the euro zone and the rest of the world?

With a seminal paper, A.K. Rose launched the debate on the euro's trade effects.i Rose concluded that monetary integration could lead to quite substantial increases in trade. According to his first estimates, trade between countries sharing a common currency could be up to three times larger than trade between otherwise similar countries. Given its magnitude, this initial estimate was greeted with substantial scepticism and Rose's methodology was criticised on several grounds. Estimation techniques and models were henceforth amended and refined by a number of researchers, including Rose himself These methodological improvements led to a considerable reduction of the size of the estimate but the overall conclusion of a significant effect of common currency on trade remained.

In recent years, with data on intra euro-area trade flows becoming progressively available, a number of studies have endeavoured to assess the size of the so-called Rose effect in the euro area, taking advantage of the existence of a control group of countries (the UK, Denmark and Sweden) sharing many common features with euro-area Member States except the currency. Most of these studies have reported evidence of a positive effect of the euro on trade with initial estimates ranging between 5 and 30%.ii Some of this work does not seem to be fully exempt of the methodological weaknesses that beset some of the earlier Rose estimates and, in a 2006 critical review of the literature, R. Baldwin has proposed a narrower, but still significant, range of 5-15%.iii It is important to note that the euro not only boosted trade among euro-area Member States, but also between the euro area and the rest of the worldiv, including with the UK whose exchange rate with the euro has been very stable over the last few years.

2. What effect has the introduction of the euro had on the functioning of European capital markets?

The introduction of the euro has eliminated currency risk in the bulk of cross-border financial flows in the EU. In consequence, financial transaction costs were lowered and the demand—both actual and latent—for cross-border financial services has increased. In this way, the euro has already contributed directly to a more integrated EU financial system. Secondly, the euro has also made an important indirect contribution to financial integration, by highlighting the opportunity costs of the remaining sources of market fragmentation. The pace of integration has been faster in the case of financial instruments with agreed definitions, common conventions and common infrastructure while progress has been slower for instruments which are more affected by national regulations, market conventions, taxation, and legal frameworks.

Accordingly, the euro area's money and derivatives markets have rapidly become fully integrated. This has been fostered by the monetary policy of the ECB, which has implemented monetary-policy operations on the basis of euro-area wide demand for liquidity. As a result, the price differential for interbank lending operations has largely vanished and operations are based on the uniform price references EONIA (Euro Overnight Index Average) and EURIBOR (Euro-Inter-Bank Offered Rate), while the EUREPO is the benchmark rate for secured money market transactions in the euro area's repo market.

Moreover, the re-denomination of the amounts outstanding of first eleven and now thirteen national bond markets created a substantially larger and more homogenous bond market. Yield differences between euro-area sovereign borrowers have been reduced to very low levels. The increased competition for investors has generally encouraged cross-border diversification of portfolios and reduced the traditional "home bias" in the purchase securities. In equity trading, the impact of the euro has resulted in a re-orientation of asset managers' investment strategies towards a sectoral, pan-European approach.

3. Are there any lessons to be drawn from the changes in the euro exchange rates since 1998?

The euro experienced a marked depreciation in the first 2½ years after its inception and an appreciation. thereafter. However, a look at broad exchange rate indicators and longer time horizons shows that the movements of the euro exchange rate have not been abnormally large.

It is useful to extend this analysis using "synthetic" euro exchange rates, which are calculated on the basis of the euro's predecessor currencies for the period before 1999. This reveals that the last period of euro depreciation against the US dollar had started already in late 1994 and lasted until mid-2001. However, the depreciation of 1994-2001 was smaller than the depreciation in the first half of the 1980s. Against the yen, the euro depreciated almost 30% from January 1999 to November 2001 and thereafter appreciated gradually, almost reaching JPY 160 in early 2007. The comparison over longer time horizons shows that the low at JPY 91 in 2001 was unprecedented, while the current exchange rates could be observed for the last time in 1998.

In real effective terms, the euro was at a level almost 20% below its long-term (1980-2005) average by the end of 2000 and was widely considered undervalued. Its overall appreciation since then has been far more muted than the bilateral exchange rate against the US dollar or the yen would suggest, since the currencies of other trading partners have appreciated against the euro in the past three years. In early 2007, the euro's real effective exchange rate is standing just above its long-term average. Hence, euro-area exports are not particularly expensive at the moment.

4. Was the recent reform of the Stability and Growth Pact appropriate?

The review of the Stability and Growth Pact (SGP) took place against the background of deteriorating budgetary performance in many EU Member States and increasing economic diversity in the enlarged EU. In September 2004, the Commission issued a Communication suggesting that an enriched fiscal framework with a strong economic rationale would contribute to an enhanced credibility and greater ownership of the SGP in the Member States. The revised SGP formally entered into force in summer 2005, with the adoption by the Council of a corresponding package of secondary legislation. Overall, the Council reached a balanced agreement, confirming the fundamental rules and principles of the Treaty and increasing the economic rationale of the framework.

Among other things, the revised SGP gives greater attention to the implementation of structural policies that enhance growth potential and long-term sustainability of public finances. It requires Member States to strengthen budgetary consolidation in economic good times. An increased focus is put on structural fiscal consolidation efforts rather than only on short-term nominal results. Finally, the revised SGP no longer requires a Member State to aim for a uniform budgetary position in the medium term. Rather, differentiated medium-term objectives are set for each Member State, taking into account country-specific economic and budgetary circumstances. The 2005 reform of the Pact also recognised that—complementary to the Pact—national institutional conditions for fiscal and statistical governance have a crucial role to play in ensuring fiscal discipline and in helping countries to achieve their budgetary targets.

In June 2006 the Commission made an early assessment on the functioning of the revised SGP, one year after its inception. The Commission concluded that the experience with the revised SGP was rather positive. It notably welcomed the smooth and consistent implementation of the excessive deficit procedure and the improvement in the overall budgetary situation.

Importantly, however, the preventive part of the reformed Pact is becoming increasingly relevant with most Member States formerly under the Excessive Deficit procedure now having to achieve their medium term objective of close to balance or in surplus. This effort has to be seen against the background of favourable economic conditions, which should be fully used to complete the consolidation. The Commission attaches high importance to avoiding the mistakes of the past and taking advantage of this "good times".

5. What effect has the introduction of the euro had on individual member countries' economic development?

EMU has created a stable macroeconomic framework, which is beneficial to all participants. Among other things, it has brought low inflation, low interest rates and clear incentives for securing sound public finances. As the introduction of the euro happened in parallel with a number of adverse shocks in the global economy, it is easy to confuse the outcomes of the two phenomena. In fact, EMU has provided a better framework to cope with the challenges of globalisation and the euro has served as a shelter from international turbulences rather then amplifying them. Still, growth performance of the euro-area economy has been lacklustre in recent years. Although the euro area achieved an average annual economic growth rate of 3.2% in the first two years of the single currency's existence, annual growth since 2001 has averaged only 1.5%. Overall, average growth was close to 2% in both the 1992-98 and the 1999-2006 periods.

The rather subdued growth performance of the euro area as a whole hides differences between individual countries. Many smaller euro-area countries have performed better than the larger ones. Since 2001, Finland has had an average growth rate of 2.9%, Spain 3.3%, Luxembourg 3.7% and Ireland 5.1%. These growth rates compare well with the growth performance of advanced economies outside the euro area. Average growth in the euro area has been influenced by country-specific adverse developments in Germany and Italy. German growth has been dragged down by structural rigidities and by economic adjustment to unification. Italy as well has been suffering from structural rigidities translating in an erosion of its international competitiveness in recent years. It is important to note that the disappointing economic performance in Germany and Italy pre-date the launch of the euro. Without these two countries, the euro area grew by 2.5% from 1999-2006, a figure that is close to other industrialised countries.

Effective implementation of the Lisbon agenda can help the euro area to cope better with economic challenges in the future. Although much remains to be done, positive signs have already been recorded. Euro-area growth is expected to reach 2.7% in 2006, the best outcome since 2000. Labour market reforms have improved job creation: from 2000-06 close to eight million jobs were created in the euro area. The more balanced growth pattern in the euro area and the ongoing structural reforms are expected to further stimulate potential growth, leading to a more sustained expansion than in past upturns.

6. Has the ECB's monetary policy been too restrictive?

The Treaty gives the ECB the mandate to focus primarily on price stability. Price stability makes relative prices more transparent, reduces inflation-risk premiums in interest rates, leads to better resource allocation, reduces distortions of tax systems, and prevents arbitrary redistribution of wealth (eg from creditors to debtors). Thus, from a theoretical perspective, it is widely accepted that price stability leads to higher welfare.

The ECB has established an impressive track record of forward-looking, stability-oriented policy since 1999. It has succeeded in anchoring medium-term inflation expectations of markets, businesses and social partners. Interest rates—both in nominal and real terms—have also been at low levels. By ensuring that medium to long-term inflation expectations in the euro area remain solidly anchored at levels consistent with price stability, the ECB helps to support economic growth and job creation in the euro area.

Monetary policy indeed played an important role in the euro-area's recent economic recovery. Following the decline in economic activity since the cyclical peak in 2000, it has helped to spur economic activity and to promote confidence through historically low interest rates. Between 2003 and 2005, the ECB's policy interest rates were at a lower level than ever attained by the Bundesbank in the period prior to monetary union. As the recovery was becoming more firmly established in 2005 and 2006, the stimulus provided by monetary policy was gradually withdrawn.

7. What impact will the expected enlargement of the euro zone have on the functioning of the euro zone economy and on the management of monetary policy in the euro zone?

The economic weight of the recently acceded Member States (RAMS-12), ie the countries that joined the EU in May 2004 and January 2007, is small in comparison to euro area as a whole. Their aggregate nominal GDP currently accounts for about 10% of the euro-area aggregate. Broad money (M3) in the RAMS-12 represents around 2% of euro-area M3. This suggests that the effects on euro-area macroeconomic aggregates and growth dynamics resulting from accession of RAMS-12 countries to the euro area can be expected to be rather limited. Euro-area enlargement would only substantially affect the euro area as a whole if Denmark, Sweden and, in particular, the UK joined the euro area, as their weight in euro-area aggregates would be much higher. In fact, the recent most successful introduction of the euro in Slovenia is a good example of the smooth integration of a RAMS-12 country into the euro-area.

Preparing the ECB Governing Council for future enlargements of the euro area, the decision-making procedure was amended in 2003. According to the current institutional arrangements, the Governing Council consists of six Executive Board members and the central bank Governors of the euro-area Member States. In order to maintain the Governing Council's capacity for efficient and timely decision-making as its membership widens, it was agreed that the number of NCB Governors exercising a voting right should not exceed 15. When the number of NCB Governors exceeds 15, they will exercise a voting right on the basis of a rotation system. The rotation system is designed to ensure that the NCB Governors with the right to vote are from Member States which, taken together, are representative of the euro-area economy as a whole. Consequently, the NCB Governors will exercise a voting right with different frequencies depending on an indicator of the relative size of the economies and financial systems of their Member States within the euro area. Based on this indicator, NCB Governors will be allocated to different groups. This allocation determines how often they can exercise a voting right. Initially, there will be two groups and, once there are 22 euro-area Member States, there will be three groups.

REFERENCES

i Rose, A.K. (2000), "One money, one market: the effect of common currencies on trade", Economic policy, 30, pp. 7-45.

ii eg Bun, M. and Klaassen, F. (2002), "Has the euro increased trade?", Tinbergen Institute Discussion Paper No. 108/2, University of Amsterdam; Micco, A., Stein, E. and G. Ordonez (2003), `The currency union effect on trade: early evidence from EMU', Economic Policy, October, pp. 316-356; Flam, H. and H. Nordström (2003), "Trade volume effects of the euro: aggregate and sector estimates", Institute for International Economic Studies, Seminar Paper No. 746.

iii Baldwin, R. (2006A), "In or out: does it matter? An evidence-based analysis of the trade effects of the euro", Center for Economic Policy Research.

iv Baldwin, R. (2006B), "The euro's trade effect", European Central Bank, Working Paper No. 594, March; Baldwin, R. (2006A), Mongellia, F.P. and Vega J.L. (2006), "What effect is EMU having on the euro area and its Member Countries", European Central Bank, Working Paper No. 599, March.

Annex 2

STABILITY AND GROWTH PACT

— European Commission (2004) Communication, "Strengthening economic governance and clarifying the implementation of the Stability and Growth Pact", COM (2004)581. http://ec.europa.eu/economy_finance/publications/sgp/com2004581 en.htm

— European Commission (2005), "Public Finances in EMU 2005—Evolving budgetary surveillance", Directorate-General for Economic and Financial Affairs, European Economy, No 3.

http://ec.europa.eu/economy_finance/publications/european_economy/public_finances2005_en.htm

— Council Regulations (EC) No 1055/05 and (EC) No 1056/05 amending Council Regulations (EC) No 1466/97 and (EC) No 1467/97 of 7 July 2005

http://ec.europa.eu/economy_finance/about/activities/sgp/edp_en.htm

http://ec.europa.eu/economy_finance/about/activities/sgp/scp_legal texts guidelines en.htm

— Communication from the Commission to the Council and the European Parliament, "Public Finances in EMU 2006—The first year of the revised Stability and Growth Pact" COM(2006) 304 final, Brussels, 13.6.2006

http://ec.europa.eu/economy_finance/publications/european_economy/public_finances2006_en.htm

— Elena Flores, Gabriele Giudice and Alessandro Turrini "The framework for fiscal policy in EMU: What future after five years of experience?" EUROPEAN ECONOMY. ECONOMIC PAPERS. No. 223. March 2005

http://ec.europa.eu/economy_finance/publications/economic_papers/economicpapers223_en.htm