125220 Topic 15: The Euro Area
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Aims of economic & monetary union:
- 1. Elimination of regulatory barriers for free flow of goods, capital & workers ⇒increase economic growth
- 2. An integrated trading block to compete against rivals such as U.S.A.
First proposed in 1952 by political leaders who signed treaty of Paris & founded European Coal and Steel Community (ECSC)
Legal Background to European Monetary Union (EMU)
- 1. Werner Report (1970) set out 3 stages- but plans never realised
- 2. European Monetary System created in 1979 with main feature ERM
- 3. Single European Act (1986) created single market, no common currency
- 4. In 1988, Delors Committee examined the possibility of economic & monetary union & in 1989 reported union could be done in 3 stages.
- 5. In 1992, the Maastricht treaty signed by members of the European Union that provided for economic, monetary union & political union as well as creation of a European central bank- important part- laid down fiscal limits.
- - So European Community became European Union (EU)
- - Laid down timetable for union
Three Stages towards EMU
- 1. Began in 1990 with all restrictions on movement of capital abolished
- 2. Creation of central institutional structure with establishment of the European Monetary Institute (EMI); later becomes ECB
- 3. Final stage with irrevocable locking of FX rates of the 11 Member states & conduct of single monetary policy & single currency under ECB on Jan 1999.
Background to formation of common currency:
- 1. European Common market set up FX policy called 'snake' in 1972, which was designed to keep currencies within band.
- 2. European Monetary System (EMS) established in 1979 set up three systems:
- – The Exchange Rate mechanism (ERM)
- – The European Currency unit (ECU)
- – The European Monetary Cooperation Fund (EMCF)
With this arrangement, member currencies agreed to keep their FX rates within an agreed band
Some Features of monetary union timetable
1.If nations could meet convergence conditions then EMU by 1999.
- 2. Convergence conditions of- each country has to have:
- –Inflation rate within 1&1/2 of best three
- –L/T interest rates within 2% of the average of best three.
- –Currency within 2.25% band for 2 years before (but 2.25% → 15%)
- –Guidelines for fiscal policy & public debt- govt. debt 60% of GDP & annual govt. deficit of 3% of GDP ⇒ sound public finances.
3. A European central bank (ECB) set up 6 months before 1999 to carry out the usual tasks of a central bank- so individual nations gave up their own monetary policy.
4. Fixing amounts for basket of currencies in 1994
ECU and the ECU Bond Market
- • Up to Jan 1999, European Currency Unit (Ecu) was the official composite foreign currency of the EMS.
- • Set up in 1979 but was NOT a transaction or payment currency
- • Replaced by euro Jan 1999.
- • Ecu - a basket of currencies containing fixed amounts of national currencies – a weighted average based on relative trade & GDP, with provision for changing the rates every 5 years
Who borrowed in Ecu currency?
Who lent? (investors)
- Who borrowed in Ecu currency?
- 1. EEC official institutions
- 2. Government borrowers in EMS system
- 3. European, US & Japanese banks
- 4. Non-Banks institutions such as World Bank
- Who lent? (investors)
- 1. ECU bonds tended to have yields higher than in domestic country e.g. Netherlands
- 2. Diversification purposes
The ECU bond market saw considerable growth from its beginnings in 1981.
On January 1 1999, 11 out of 15 member currencies replaced by the single currency euro:
- EUR1 =
- = BEF 40.3399
- = DEM1.95583
- = ESP 166.386
- = FRF 6.55957
- = IEP .787564
- = ITL 1936.27
- = LUF 40.3399
- = NLG 2.20371
- = ATS 13.7603
- = PTE 200.482
- = FIM 5.94573
Tasks of the Eurosystem = ECB + NCBs of euro
- 1. Carry out monetary policy adopted by Governing Council of ECB- President of ECB is the Italian Mario Draghi
- 2. Conduct FX operations
- 3. Hold & manage official reserves
- 4. Promote smooth operation of payment systems
In 2013, ECB has been given some bank supervision powers-be able to conduct a asset-quality review of euro area banks otherwise it has no direct supervision power. This move towards supervision- controversial
The monetary policy instruments of the ECB
- • ECB Governing council sets 3 interest rates-main indicator = interest rate on refinancing operations = rate that Eurosystem (ECB) lends to banks (they need to hold collateral with ECB)
- • To do this, they use input from NCBs & other committees
- • Weekly open market operations by NCBs- currently 18 nations
- • NCBs operate repos & FX intervention
- • Banks borrow from ECB through repos (held weekly). These loans have maturity 2 weeks to 3 months- liquidity into economy different from US system of buying/selling of Treasuries in OMO
- • System of reserves-compulsory deposits with NCBs & a reserve ratio of 2%
European Union After Jan 1 1999: General points
- 1. Difficulty of implementing monetary policy - need to balance countries w. different growth rates (inflation). Say ECB ↑ interest rates to counter inflationary pressures, then member countries with weaker economies could face recession. However, for first few years price stability has been maintained.
- 2. New law about fiscal conduct May 1999-govt budgets to be kept close to balance or small surplus ‘Stability and Growth Pact” – all countries in EU are part, not only those of EMU
- 3. No rules for the exit of one or more member countries.
- 4. Asymmetric shocks to individual countries.
Status of ECB
- – So far, the ECB- accused of secretiveness (its first president Weisenberg ruled no publishing minutes for 12 yr). Of late, improved information release
- – It focuses on price stability - sets crucial interest rates (not economic growth & business cycles).
- – As well, ECB = most independent & unaccountable central bank in world to date (drawn up to be NOT a lender of last resort)
- – However, ECB must submit to questions from European Parliament & publish annual & quarterly reports
Features Of EMS:
- • A single market within which people, goods & services can move freely (Euro area- one of largest economies in world with 505 million people & 18 countries using euro)
- In 2006, US was largest economy with 19.7% of world’s GDP, then euro area 14.3%, then Japan 6.3%
- • Competition policies & other measures aimed at strengthening market mechanisms
- • Common policies aimed at structural change & regional development
- • Macroeconomic policy co-ordination including binding rules for budgetary policies.
- • transparency of prices & services
- • saving to importers/exporters of buying/selling FX- less FX derivative management
- • Travelling through area is simpler
- • more integrated & deeper financial markets
- - euro interbank market fully integrated
- - euro-denominated bond market deep & liquid ⇒ helps financing of economic growth & so creation of jobs
- • reduction of cost of capital for companies
- • Domestic &cross-border mergers & acquisitions ↑
- • Does one size fit all?
- • Weaknesses such as high labour costs not being tackled
- • Problems still of matching regulations, tax etc
- • Large migration of eastern Europeans to work in high waged countries
- • In 2002, Portugal confessed to running deficit higher than 3% allowed under EMU rules
- • France & Germany in 2003 running deficits > 3%.
- • In 2010 Greece with huge debt, & unable to have usual economic adjustment for a country- weaker currency
- • Other PIGS with large debt burdens
Events To date, after introduction
- 1999 - Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain
- 2001 - Greece joins
- 2007 - Slovenia
- 2008 - Cyprus, Malta
The following members of the European Union do not use the euro:
Bulgaria, Czech Republic, Denmark, Croatia, Lithuania, Hungary, Poland, Romania, Sweden & the United Kingdom.
Events To date
Period around GFC
- Fiscal pressures after GFC in 2007 in euro area e.g. Ireland.
- 2008 - (with ongoing credit crisis) European governments started spending to keep economies going.
- 2010 - Greek debt crisis (suggestion previous Greek govt. ‘fudged” its debt level so as to qualify for membership)
- 2010 - European fiscal crisis forced Trichet to buy govt. bonds
- Ongoing fiscal pressures. Nov 2010 Ireland announces severe budget measures e.g. sales tax increase, state jobs lost, trim welfare payments in order to get bailout from EU & IMF.
- Dec 2010 - ECB has bought up 67 billion euro of Greek, Irish & Portuguese debt, as well loaned euro 523b to struggling banks (becoming a lender of last resort- change of role).
Events to date
- Since 2011
- Dec 2011 ECB supplies euro 490 billion funds at 1%, 3 year loans to European banks.
- Sept 2012 ECB announces outright monetary transactions (OMTs)- buying of eurozone govt. bonds on the secondary market (not legally allowed to buy on primary markets)- so not monetising govt. bonds but buying existing govt. bonds (unlike USA’s quantitative easing)
- Oct 2013 - European Stability Mechanism (ESM)- euro zone’s permanent rescue fund set up for country bailouts.
- 2014, ECB cuts benchmark rate to 0.05% & starts program of buying asset-backed securities
- Late 2014, ECB pays -0.2% on money banks have deposited with it
- Jan 2015, ECB announces quantitative easing will begin in March
- July 2015 Greek debt crisis- banks closed- country running out of cash
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