Mr. Heikensten discusses the advent of the euro and EMU in relation to Sweden  (Central Bank Articles and Speeches, 25 Aug 98)
Central bank: riksbank | Type: speech | Date: 1998-08-25

Mr.

Heikenstein discusses the advent of the euro and EMU in relation to Sweden Speech by the Deputy Governor of the Bank of Sweden, Mr. Lars Heikenstein World Trade Day '98 held at the Stockholm Chamber of Commerce on 25/8/98.I should like to begin by thanking our hosts for the invitation to Worl Day '98.

The introduction of a new currency is due in our vicinity in little more months' time.

This is the first instance in modern times of a large group of sovere establishing a monetary union with a single currency.

Along with the collapse of Curtain, the creation of the European Monetary Union is probably the most significant E event since World War Two.Today I shall be focusing on what the birth of the euro may mean developments in the currency market.

I shall not, however, be attempting to predict t future strength or weakness.

Instead, I shall begin by discussing factors that could single currency in the course of the changeover and the somewhat longer term.

Then consider how the euro is likely to affect the position of Sweden's currency, the krona right now that, basically, I do not believe that the euro will fundamentally alter eith the krona in Sweden's economy or, for that matter, the value of the krona in the long r of the discussion that this matter occasions from time to time, there may be reas something about the view of the Riksbank.

## 1.

A new currency is createdA new currency will see the light of day in January 1999.

Eleven countri Europe are forming a monetary union and will accordingly be having a currency, a moneta exchange rate policy, and a central bank in common.

The euro will be the domestic curre major economic area.

Today, the euro area's share of world output is around 30 per against around 35 per cent for the United States.

As regards world trade, the share external trade amounts to around 17 per cent and the United States around 15 per cent.EMU is a central component in the process of European integration.

This pr was initiated in the 1950s with agreements on the joint control of certain means of p the European Coal and Steel Community.

The idea was to forge economic bonds betwe nations as a way of promoting peace in Europe.

The establishment of the Common Market i 1980s was a further step, aiming at freedom of movement within the Community for go services, capital and individuals.

With the introduction of a single currency, the Europe will come still closer to each other in economic and political terms.

At the sam another obstacle to the creation of a large internal market in Europe will be removed.Thus, EMU is to be seen primarily as one aspect of a larger, political proje analyses, however, have tended to concentrate on the union's pros and cons in an ec context.

The advantages that have been cited for the participating countries incl transaction costs for trading in a common currency, increased transparency and compet the single market, and low, stable inflation.

The lack of an exchange rate as an ins stabilisation policy is mentioned as one of the drawbacks.Sweden's Parliament decided in December 1997 that Sweden would not be joining the monetary union from the start, mainly on account of the lack of public supdecision was made after a committee of experts had reported on participation's advanta drawbacks for Sweden.

The commission was basically in favour of Sweden being a member EMU but was of the opinion that, given the disadvantages considered, Sweden should participate from the start.

The costs in terms of stabilisation policy were assumed to benefits from economic efficiency.

The report's assessment of political aspects favoured membership of EMU.The report gave the Riksbank an occasion to present its appraisal of the mo union.

This differed and amounted to a recommendation that Sweden should participate fr start.

We considered that the commission had overestimated the costs for stabilisati while the economic and political benefits were likely to be even greater than envisa report.

Since the compilation of report, moreover, the political reasons for participat start have grown in that more countries than expected will now be members from the begi

## 2.

The euro's stabilityThe euro will exist as an account-based currency as of next January. banknotes and coins denominated in euro will not yet be in circulation, it will be make transactions in euro.

So what will be the euro's role in currency markets?

Will it And will it compete with the dollar as an international reserve currency?

As we a predicting exchange rate movements is difficult.

In general, one can say that a c nominal exchange rate is determined by the real exchange rate together with differ inflation with the rest of the world.

A currency's real exchange rate can be described of goods and services in that country relative to the rest of the world.

If a differen grows, a corresponding depreciation of the currency is needed to keep the real excha stable.

The current exchange rate is also influenced by expectations of future r credibility of economic policy's commitment to long-term price stability is thus impo exchange rate tendencies.

The value of a currency is also susceptible to influences temporary nature.

Cyclical factors may play a part.

When the economy is in an upward p country may need a tighter monetary policy, which normally leads to an appreciation currency.

Deviations from the exchange rate's more fundamental level may also be occa by matters to do with credibility.

In addition, the exchange rate may be affected by shifts in the currency market's demand and supply.

Such shifts may arise from po adjustments.

In certain periods these mechanisms may tend to accentuate exchange movements even though economic fundamentals point in a different direction.

One exampl this is the large movements in the US dollar.Against this background I shall now look at some factors that will proba important for the development of the euro.

I shall take the fundamentals first and the some factors that could be of transitory significance for the euro.

## Fundamental factorsProvided

economic policies in the euro area focus credibly on price stab accompanied by a corresponding low-inflation policy in the rest of the world - it is pr the euro's nominal exchange rates with other countries will display a high degree of However, cyclical disparities between currency blocs and some uncertainty about mon policy signalling are factors that could generate certain fluctuations.EMU is constructed so that monetary policy will be formulated collectively ECB's Executive Council and the national central banks in the light of the overall inflation in the euro area, while fiscal policies are formulated at the national level.

## Monetary policyThe European Central Bank (ECB), which will be accountable for EMU's singl monetary policy as of next January, was established on July 1st.

The monetary policy obj price stability.

The objective has not yet been defined more specifically but stateme that there will probably be an intermediate money supply target and that price stabil represented by an inflation rate of 2 per cent or less.

The latter has raised the quest Sweden ought to revise its inflation target.

The question is somewhat premature in ECB's target formulation has still to be finalised.

Moreover, the suggested formulation with what has applied in Germany, where on average in recent decades monetary policy h resulted in a rate of inflation below 2 per cent.

In view of this, together with the ad inflation target that is symmetrical, there are no grounds at present for considering a Sweden's inflation target.The ECB has been given a high degree of independence in fulfilling the stability target without any short-run political considerations.

The institutional c monetary policy credibility are accordingly good.

By itself, however, this is not Credibility must also be achieved continuously, through a responsible monetary policy properly understood and supported by society in general.

At first there may be cons uncertainty about how the single monetary policy functions and how signals from th should be interpreted.

Much will therefore be required initially of the ECB in expl policy, presenting the analyses behind its decisions in an understandable way and c broad understanding of the monetary policy in every part of the union.

This understand be tested particularly severely if price pressure in a particular country deviates fro so that the repo rate is not perceived as appropriate to the national situation.

The na banks in the euro area should be able to lend a hand here, both in communications public and by providing sound analyses of tendencies in their home country.This brings me to the discussion about the ECB Governing Council.

Concern been voiced in the debate because the composition of the Council, the ECB's su decision-making body, might lead to policy being influenced by strong national interes expense of the total picture.

One source of this concern is that so many of the Council makers are national central bank governors, who might allow for national interests.

Com are made with the US Federal Reserve, whose decision-making body has a smaller proporti regional governors.

Another cause of this concern is that political accountability in t Community is essentially exacted at the national level; it is largely in the nationa economic policy is discussed.

While these problems cannot be dismissed out of hand, I they have been exaggerated.

The members of the Council are jointly responsible for mak ECB a success and establishing price stability in the euro area.

In this sense they a same boat and nothing is more likely to capsize the boat that a national preferenc believe, will characterise what happens in practice.

In any event, a distinct, trans right from the start is vital in order to avoid unnecessary uncertainty that cou exaggerated movements in exchange rates and interest rates.In the long term it is the construction of monetary policy that determines of inflation.

In the shorter run, however, price movements are also influenced by other factors.

Other components of economic policy - that is, fiscal, labour-market and policies - therefore have to be constructed so that they support the policy drive for price stability.

If these components do not work, the burden on monetary policy b additionally heavy.Economic policy apart from monetary policy will continue to be a national m in the euro area, even though it is the subject of agreements at Community level.Fiscal policy will still be constructed by the national governments, though extent its scope is restricted by the Stability and Growth Pact, to which all the E subscribe.

This Pact requires each country to conduct a responsible fiscal policy, achieving a general government budgetary balance or surplus over the medium term. country is also to allow continuous monitoring of its government finances by the o countries.

A government budget deficit is normally not to exceed 3 per cent of GDP, there is room for certain exemptions.

If a country in the euro area does have a bud above 3 per cent and this cannot be explained by factors that are exceptional and t sanctions are to be imposed.

EU countries outside the euro area are not liable to however; they are only included in the monitoring provisions of the Pact.The task of establishing price stability in the euro area will be facilit inflation in the area is also promoted by fiscal policies.

The importance of fiscal po in creating sustainable government finances, which contribute to the general credi economic policy, and in countering tendencies to excessive price pressure in the econom the single monetary policy is to be constructed in relation to the overall situation in more will be required of fiscal policy in the context of national stabilisation po instruments will still be available for stabilising national economic trends.

But this presuppose that there is room for manoeuvre in the national budgets.

Partly on this ac Stability and Growth Pact's medium-term objective of a government budget balance or sur reasonable and it is highly important that the countries meet this undertaking.

Today case in just a few countries, of which Sweden is one.Monetary policy's interaction with fiscal policy will be important, at both and EMU level, for the perceived credibility and consistency of economic policy in ge constructive dialogue is therefore needed between the ECB and the governments of th countries.

The arrangements are not yet clear but an intense discussion of this and ot is now under way in Europe.

The Treaty provides a number of opportunities for contacts the two spheres.Functional economic structures must also be in place so that the single mo policy can establish low inflation without eliciting unnecessary economic tensions.

A particular importance in this context is the workings of the labour market.

A labour m functions properly reduces the risk of regional unemployment and thereby of political that could ultimately pose a threat to the monetary union.Temporary factorsThe discussion of the euro's development has included the point that introduction of the single currency will trigger widespread portfolio rearrangements, private investors but also in public reserves.The euro will alter the composition of exchange risks in investors' portfo this could result in flows to restore the degree of diversification.

Investors wh diversification previously with holdings in German marks and Italian lire, for example, to adjust their portfolios when both these currencies are replaced by euro.

Demand for also be affected by the single currency's conceivable international importance, so that euro exceeds what one would expect from the area's economic weight.

To achieve interna status, a currency needs to be stable, liquid and large.

It should be born in mind tha mark is currently an international currency.

So perhaps the changeover to the euro will such a notable difference even if a potential exists for the position of the euro be stronger.It is generally assumed that exchange rates will not be permanently affec portfolio rearrangements which do not stem from more fundamental considerations.

But euro's entry into currency markets is something entirely new, it is hard to tell wheth of portfolio changes will be such that euro exchange rates are influenced at least for as the rearrangements will probably include both investment and borrowing in euro, nei clear what their net effect might be.

As I mentioned earlier, the development of the ultimately depend on expectations of inflation in the euro area relative to the rest of

## 3.

Role of the euro in SwedenHow will the euro affect Sweden's currency, the krona?

On the basis of theor analyses of what ought to determine a country's use of a currency, together with inform Riksbank has obtained from interviews and surveys of Swedish firms and households, we concluded that the introduction of the euro will not appreciably alter the role of the Swedish economy.The krona has important functions in Sweden's economy, both as a means payment and as a unit of account and a repository of value.The krona is already exposed to competition from other currencies.

EMU can seen as a continuation of this process.

One indication of the competition is the increase in exchange market turnover.

Since 1986 this turnover has grown by a factor whereas foreign trade and GDP have no more than doubled.

Only 5 per cent of the exc market turnover stems from transactions directly connected with foreign trade.In what respects, then, might the advent of the euro alter the position of t What is the line of reasoning behind such a scenario?The discussion about a marginalisation of the krona has started from the vi Swedish export companies will choose to switch to euro in order to reduce the comp disadvantage of being outside the euro area.

With this area as an important field Swedish firms have to meet the increased price competition which the monetary union without reaping the benefits which their euro area competitors reap from decreased e costs and access to a large, liquid market for capital.

In order to reduce these disadva can try to match their euro income with their expenditures in Sweden, for example focosts and payments to suppliers.

The exchange risk would then be passed on to domestic - households and firms - and these in turn would want to pay their bills in euro.How probable is such a scenario?

One question is how serious the competi disadvantages will actually be for export companies.

Another aspect that can be discus extent to which households and Swedish-owned companies are prepared to accept an exch risk.

They will want to receive income in the same currency as their expenditures.

Other take an exchange risk that makes the real income uncertain.Even when the monetary union has started, most of the expenditures households and Swedish-owned companies will presumably be expressed in the natio currency.

Retailers set prices and accept payments in Swedish kronor.

The status of the legal tender means that they are under no obligation to accept payments in other cu Moreover, Swedish taxes and households' fixed long-term loans are paid in kronor.Besides the question of why export companies would want to switch to euro large scale, it is thus not clear that they would be able to pass the exchange households and suppliers.Large Swedish companies might be interested, on the other hand, in changing to the euro as their unit of account, including the denomination of equity capital.

So representatives have made statements to this effect.

By reporting equity, deciding div having their shares quoted in euro, companies with transactions in euro might possibly their access to the euro capital market and reduce their costs for handling curren management of liquidity.

Swedish law does not currently permit the use of currencies ot the krona but the possibility of having other currencies as the unit of account investigated.Today, many companies invest their surplus liquidity in Swedish kronor, p because their dividends are paid out in kronor.

If companies choose the euro as th account, this could have consequences for their asset management.

One such consequence be a preference for investing surplus liquidity in euro.

This alters their investme which brings us back to what I said earlier about short-run exchange rate move Presumably, however, the portfolio adjustments would be gradual, leaving the krona's ex rate more or less unaffected by the flows.

And even if the flows were to be so la influence the krona's rate, there is no reason to suppose that they would have a perma on the krona's exchange rate against the euro.

These flows would be accompanied by many types of currency transaction.The krona's long-term level will depend instead on Sweden's economic poli When economic policy is credible and focused on low inflation, there are no groun believing that the krona would go on weakening continuously or that it would relinq position in Sweden's economy.

## 4.

Concluding remarksTo round off what I have been saying, the development of a currency - be euro relative to the US dollar or the Swedish krona relative to the euro, for ex dependent on the direction and results of economic policy.

If the policies in the coregions we have been discussing are credible, focused on low inflation and successfu longer run the exchange rates ought not to diverge.The legal framework for economic policy in EMU provides a good foundation f a credible low-inflation policy.

But it is still important that all the components policy back up the objective of price stability right from the introduction of the sin The ECB can do this by conducting a credible monetary policy and explaining it clear national governments can contribute by ensuring that combined fiscal policies in the comfortably comply with the Stability and Growth Pact; this is not yet the case.

Meas improve labour markets can also help to enhance conditions for the success of the m union.In the same way, the institutional changes and economic developments in Swe in recent years herald good conditions for a stable krona.

The framework for both mone exchange rate policy has been strengthened.

The status of the Riksbank is being mad independent and the budget process is now considerably more disciplined.

Certain flow currency market may be generated simply as a consequence of the new currency's introd but what ultimately matters is the economic fundamentals.

This suggests that the adve single currency - the euro - will not lead to any marked changes either in the krona's Swedish community or in its value.