Lorenzo Bini Smaghi: The euro area's exchange rate policy and the
experience with international monetary coordination during the crisis
Speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at a conference entitled "Towards a European Foreign Economic Policy", organised by
the European Commission, Brussels, 6 April 2009.
* * *
Introduction
Ladies and gentlemen, it is a pleasure to be here today. The title of today's conference
"Towards a European foreign economic policy" could hardly be more topical. Indeed, the
world is facing challenges not seen for decades - challenges that are truly global. The
solutions will thus need to be global too.
Inevitably, the political power and economic weight of individual states and regions will
matter when designing these global solutions. If Europe wants to punch in proportion to its
economic weight, moving towards a common foreign economic policy is essential. I have
expressed my preference for such a policy on various occasions.
In the area of exchange rate policy - the topic of my speech today - the euro area has
already achieved unity. It speaks with one voice. Exchange rate policy is the exclusive
competence of the Community. Hence, the individual Member States can no longer act
autonomously in this field.
At the same time, in its resolution of 1997, the European Council stated that "exchange rates
should be seen as the outcome of all other economic policies". This represents a general
feature of exchange rate policies, as the exchange rate cannot be determined by one single
actor. It always depends on the decisions and actions of at least two parties. Indeed, any
bilateral exchange rate depends on the actions and policies of both sides. Moreover, this rate
can also be influenced by the actions and policies of third countries.
As a consequence, exchange rate policy is by nature international and needs to operate in a
context of international cooperation. The euro area's exchange rate policy cannot be seen in
isolation from those of the US, Japan, China, and many others.
The international dimension of exchange rate policy and its implications for global economic
stability came sharply into focus during the 1930s, when a series of competitive devaluations
plunged the world into an economic depression. For this reason, the Bretton Woods
conference assigned a central role to the IMF in the monitoring of exchange rate policies.
Given the deepening integration of the world economy over the last decade, the IMF decided
in 2007 to strengthen its surveillance of exchange rate developments, in particular to ensure
that exchange rate policies do not jeopardise the stability of the world economy.
Today I intend to cover four items: the implications of the single currency for exchange rate
policy, the institutional arrangements for the euro area's exchange rate policy, exchange rate
developments during the crisis and, finally, some other dimensions of international monetary
cooperation.
A single currency - a single exchange rate policy
What did the creation of the euro mean for exchange rate policy? Prima facie, the answer is
straightforward. Having a single currency automatically implies having a single exchange rate
and thus also a single exchange rate policy. Yet the repercussions of EMU go beyond these
"automatic" consequences.
Prior to EMU, Europe consisted of open and, for the most part, small economies. Because of
the very large size of the external sector compared with the national economy, the exchange
rate played a very important role in the economic performance of these countries. The move
to monetary union implied the creation of a new economic entity - "euroland" - which is
much bigger and much more closed than its component states. This obviously reduces the
importance of the exchange rate for "domestic" economic developments.
In addition, monetary union - by definition - did away with nominal exchange rates between
its participants. As a result, gone are the days when an economic or financial crisis could
also trigger an exchange rate crisis.
By setting up a bigger and less open economic entity and by eliminating intra-area exchange
rates, the euro acts as a shield against external turbulence.. The economic crisis has clearly
demonstrated this. In rough financial waters, it pays off to be on a large, solid and stable ship
rather than on a small vessel. Size matters in a global world. Allow me therefore to make a
bold point: the euro has arguably been the best exchange rate policy decision which Europe
has ever taken.
Institutional arrangements for exchange rate policy in the euro area
This brings me to my second topic: the institutional arrangements for the euro area's
exchange rate policy. In describing these arrangements, we should distinguish between
three categories of countries: EU countries which do not take part in ERM II, EU countries
which are part of ERM-II, and non-EU countries.
First, consider the EU countries which do not take part in ERM II. As EU Member States,
these countries are subject to the Treaty. And the Treaty is crystal clear: each country must
treat its exchange rate policy as a matter of common interest.1 This obligation should not be
taken lightly. In fact, it should be taken very seriously. The question arises whether the single
market can function smoothly when the exchange rate is allowed - or even encouraged - to
depreciate sharply. Using the exchange rate as an instrument to gain a competitive
advantage over others may fuel resentment and stoke protectionist pressures. It falls upon
the Commission and the Council to ensure respect for this Treaty provision.
Second, consider the EU countries which do take part in ERM II. ERM II is an exchange rate
arrangement that links the currencies of some EU Member States outside the euro area with
the single currency. The framework helps to ensure that euro area candidates orient their
policies towards stability and sustainable convergence. By simulating some of the economic
conditions which exist within a monetary union, ERM II also functions as a "training room"
which prepares and helps prospective euro area entrants on their road towards adopting the
euro.
Finally, with respect to non-EU countries, the euro area has adopted a flexible exchange rate
regime. The external value of the euro vis-à-vis the currencies of third countries is thus
determined by the market. By adopting this line, the euro area has continued the policy
towards third countries pursued by its component countries prior to EMU. The rationale
behind this decision is twofold. First, the absence of an exchange rate commitment allows
the ECB to focus squarely on its euro area objective, which is the preservation of price
stability. Second, the creation of the euro implied the creation of a bigger and less open
economic entity - the euro area - in which the exchange rate plays a much less influential
role. Accordingly, it would have been nonsensical to subject the euro area's monetary policy
to an external requirement - namely an exchange rate target - rather than internal
requirements. The euro area was not alone in adopting a flexible exchange rate regime. Most
mature economies and some emerging economies also pursue a floating exchange rate
regime.
This begs an important question: if you leave it to the market to determine exchange rates,
does this mean that there is no role to be played by policy-makers at all? The answer is
clearly no. Also countries with a floating exchange rate conduct an exchange rate policy.
There are three reasons for this.
First, exchange rate markets are prone to episodes of overshooting and undershooting.
Public intervention - in the form of public statements or even outright interventions in FX
markets - may thus be warranted.
Second, inadequate macroeconomic or structural policies in a neighbouring country may
provoke substantial exchange rate movements that have a detrimental impact on the euro
area. Again, public intervention may be warranted.
And third, not all countries have adopted a floating exchange rate regime. These countries
may sometimes take steps to prevent the necessary adjustment of their exchange rates,
which in turn impacts on economic developments in the euro area. Also here, public
intervention may be warranted.
This leads me to another question: does the euro area have the instruments and procedures
it needs to effectively implement its exchange rate policy? Here, the answer is clearly yes.
The euro area is fully equipped to implement an effective exchange rate policy. Such a policy
requires four main ingredients:
•
first, monitoring and assessing exchange rate markets and developments;
•
second, discussing market developments with the other major partners;
•
third, making public statements; and
•
fourth, intervening in the foreign exchange markets.
In practice, the role of the main actors, typically governments and central banks, depends on
the precise architecture of foreign exchange policies, as I will explain. The central bank has
to be involved, given its economic and technical expertise, but also because any intervention
must be consistent with the monetary policy stance. Finance ministries are often involved
because they own the foreign reserves. Moreover, the success of exchange rate policies
also depends on supportive domestic policy action. Indeed, regardless of the precise design
of competences, all institutional arrangements in this policy field provide for a close
interaction between governments and central banks. Let's now consider these four elements
in greater detail.
1. Monitoring and assessing exchange rate markets and developments. This is not an
easy job. Indeed, there is no fully reliable compass for assessing whether an
exchange rate is out of line with fundamentals. Moreover, there is no single indicator
for exchange rate developments. Rather, the indicator to be chosen depends on what
we want to find out. Bilateral exchange rates shed light on the relative movements of
the economies of the two countries. Yet for many other questions - such as overall
competitiveness developments - we need to have a look at the effective exchange
rate. In the euro area, exchange rate developments are regularly monitored and
assessed by the ECB. These assessments are shared, as appropriate, with euro area
finance ministers and the Commission in the Eurogroup. Since the start of the euro,
there have been no disagreements at the technical level either on the assessment or
on the action to be taken.
Discussions with the other major partners.
2. This is key, since the effectiveness of
policy action critically depends on it being coordinated with other relevant countries.
The euro area conducts such discussions at three levels. First, in the context of the
G7, the Presidents of the Eurogroup and of the ECB represent the euro area and are
closely involved in the relevant deliberations. Second, discussions on exchange rates
also take place at the IMF. Here, the potential for the euro area to speak with one
voice has not yet been fully exploited. A third forum for discussing exchange rate
issues is in the context of bilateral relations. Progress has also been made on this
front, notably by setting up a forum for discussion with the Chinese authorities.
Public verbal
3. interventions. Statements of this kind are sometimes made on
exchange rates in the context of the G7. Both the Eurogroup and ECB
representatives make a major contribution to the preparation of the relevant
communiqués. The views expressed by the two representatives have always been
consistent and ensured an effective message.
4. Interventions in foreign exchange markets. The euro area is fully equipped to conduct
- if necessary - such interventions. It did so, very effectively, in the autumn of 2000.
This instrument is in the hands of the ECB, which can assess when and how to use it
in the light of the prevailing market conditions and its monetary policy stance.
To sum up, the euro area has all the necessary instruments to implement an effective
exchange rate policy for the euro. Is there scope for improvement? I see three areas where
further progress should be made.
First, there is a need for verbal discipline when making statements on exchange rates.
Especially in the early years of EMU, public statements on exchange rate developments
were too frequently made by individual policy-makers who were not mandated to speak on
behalf of the euro area. At times, this has undermined the credibility and effectiveness of the
euro area's exchange rate policy. Only the President of the ECB and the President of the
Eurogroup should comment on the exchange rate of the euro. The authorities which are not
mandated to speak should heed the adage: "silence is golden".
Second, policy-makers should take into account the potential implications of their domestic
policies on exchange rate developments.
Third, the euro area should speak with one voice on exchange rate issues in all international
institutions. This holds in particular for the IMF, which since 2007 has been enhancing its
surveillance of exchange rate policies. Even though a single currency implies a single
exchange rate, the euro area representatives in the IMF Executive Board do not always sing
from the same hymn sheet when discussing exchange rate developments in other major
countries. It is my conviction that a unified representation of the euro area countries at the
IMF would strengthen the exchange rate policy of the euro.
Exchange rate developments during the crisis
Let me now turn briefly to exchange rate developments since the outbreak of financial
turbulence in the summer of 2007. During the last year and a half, foreign exchange markets
have witnessed sharp swings in all major bilateral rates. Foreign exchange volatility - both
realised and implied - has reached historical levels (see Fig. 1). More recently, the situation
seems to have improved as realised volatility eased substantially. Yet the markets'
perception of risk still remains elevated compared with longer term averages.2
Despite the extremely volatile environment, the spot foreign exchange market seems to be
functioning normally. Looking at the euro/dollar bilateral rate, bid-ask spreads (expressed as
percentages of the spot rate) have remained largely unaffected by the rise in realised and
implied volatilities (see Fig. 3), and broadly in line with their averages since 2004.
Nonetheless, some tensions have emerged in the forward foreign exchange market. The US
dollar funding needs have led to tensions in global money markets3 and forced many
institutions to convert euros into dollars through FX swaps. In addition, tensions have not
remained confined to the shortest horizons, but also spread to longer maturities, as banks
have realised that the financial crisis might last longer than anticipated.4
Turning to exchange rate movements, until the summer of 2008, the US dollar weakened
against the euro, while the Japanese yen remained broadly stable. This reflected the market
perception that the turbulence originated in the United States (see Fig. 4).
Subsequently however, and especially after the Lehman collapse, the euro weakened both
against the US dollar and the Japanese yen. The dollar benefited from increasing risk
aversion worldwide as well as from temporary factors associated with a widespread shortage
of dollar liquidity in financial markets. The yen for its part was boosted by falling policy
interest rates worldwide and rising financial volatility. Combined, these factors led to a
massive unwinding of the carry trade positions that had been established in the low-volatility
environment before the summer of 2007.
On 27 October of last year the G7 issued a joint statement warning about disorderly
developments in the foreign exchange of the yen. The Japanese currency stabilised
thereafter.
Overall, the euro did not record exceptional movements in nominal effective terms. It
appreciated by around 5%5 between September 2007 and March 2009. This appreciation
stemmed from significant gains vis-à-vis the pound sterling and other central and eastern
European currencies, and was balanced by the euro's depreciation against the Japanese
yen, the Swiss franc and the US dollar (see Fig. 5). Notably, in its last report on the World
Economic Outlook, the IMF considered the real effective exchange rate of the euro to be on
the strong side of medium-term fundamentals.6
Looking more closely at the euro-dollar exchange rate, some observers have expressed their
surprise at the appreciation of the dollar against the euro since mid-2008. Some considered
this appreciation to be at odds with the US-related origin of the crisis, especially the
weaknesses in the US financial system, and the persistent - albeit gradually improving - US
current account deficit.
It is said that the recent dollar appreciation can be traced back in part to the markets'
perception of the international status of the dollar, playing the role of safe haven in periods of
heightened risk aversion. The strong correlation between rising volatility and US dollar
strengthening at a daily frequency points in this direction. The dollar appreciation at the end
of 2008 is consistent with a significant rise in net portfolio inflows into the US (in particular for
short-term liabilities, including T-bills).7
Tensions have also been visible between the currencies of some of the new EU Member
States; indeed, the currencies of most of those countries weakened significantly vis-à-vis the
euro. Beyond country-specific factors, this reflected the sharp deterioration in economic
activity and outlook and, most notably, a reversal of capital flows, as a result of heightened
global risk aversion and increased home bias. The functioning of ERM II was overall not
adversely impaired, despite the exceptional rise in foreign exchange volatility.
Other dimensions of international monetary coordination
Apart from exchange rate policy, there are other important aspects of international monetary
coordination which have come to the fore in the current crisis. On top of their regular
exchanges of information and views, central bankers have engaged in unprecedented joint
actions to provide liquidity, reduce financial market strains, and counter negative spillover
effects on the real economy. For example, on 8 October 2008 the ECB cut interest rates
simultaneously with six other central banks, against a backdrop of lower inflationary
pressures.
Another example can be found in the area of liquidity management. A key tool in this respect
has been the US dollar Term Auction Facility, in which the ECB agreed with the US Federal
Reserve to grant loans in dollars to euro area banks. These USD liquidity- providing
operations have increased over time in terms of size and number of participants, with a
substantial number of central banks now participating. The Eurosystem has also entered into
an agreement with the Swiss National Bank in order to facilitate the provision of liquidity
denominated in Swiss francs to euro banks. Finally, the Eurosystem has signed agreements
with the central banks of several European countries in order to improve the provision of euro
liquidity to their banking sectors.
Since the start of the crisis, we have therefore achieved a level of trust and cooperation
within the central banking community that some would have considered unthinkable a couple
of years ago. As the ECB President put it a couple of weeks ago, global cooperation by
central banks is now mirroring the globalisation of finance.
Conclusions
To conclude, the euro area has an exchange rate policy and it has been implementing it over
the last ten years, with full cooperation between the authorities in charge, including over the
recent months.
International monetary coordination has gone beyond exchange rates, and involved several
aspects of central banking, including on one occasion a coordinated interest rate change.
Such coordination is aimed at the specific circumstances of the crisis and has helped to
restore confidence in financial markets. Having said that, financial and economic conditions
do differ across the major countries, and we should not expect that coordination means
uniformity of action. Monetary policy in the different areas of the world needs to take into
account the specificities related in particular to the shocks that affect the economies and the
transmission mechanism of monetary policy. When these specificities are appropriately taken
into consideration, the actions of the various monetary authorities appear overall quite
homogeneous and consistent.
Appendix:
Figure 1: Developments in volatility
Panel A: realised volatility
Equity markets
euro/dollar exchange rate
Panel B: implied volatilities
Source: Bloomberg, Thomson Financial Datastream and ECB staff calculations.
Note: daily data, % annualised. Last observation 10 March 2009.
Figure 2: Developments in the term structure of the euro/dollar rate volatility
Note: The chart shows the implied volatilities, at selected dates, taken from at-the-money options on the
euro/dollar rates, at the six options' maturities reported on the x-axis.
Figure 3: euro/dollar rate: bid-ask spread and volatilities
Note: weekly data; last observation is 16 March 2009; the bid-ask spread is expressed as a percentage of the
spot rate. Implied and realised volatilities are expressed as percentages in annualised terms.
Figure 4: Developments in main bilateral rates
Note: daily data since 1 Sep. 2007; last observation 17 March 2009.
Figure 5: Changes in the nominal effective and in selected bilateral rates of the euro