Ardian Fullani: Concerns of the prospective ERM II members
Speech by Mr Ardian Fullani, Governor of the Bank of Albania, at the conference "The Mission of
Contemporary Central Bank" organized by the National Bank of Poland, Warsaw, 15 December 2006.
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Your Honor Mr. Balcerowicz,
Honorable Governors,
Dear Colleagues,
Ladies and Gentlemen,
I would like to take this opportunity to thank Mr. Balcerowicz and the National Bank of Poland for the
invitation. It is an honor for me to take part in this discussion and to share my thoughts concerning the
challenges facing prospective ERM II members.
The central theme of this conference - the mission of the contemporary central bank with the focus on
euro adoption - is of crucial importance for countries aspiring to become members of the big EU family
in the not-too-distant future. Drawing from the experience of current and prospective members,
accession to this family is a complex and challenging process.
As a test of the nominal convergence of a country, the ERM II mechanism has attracted a lot of
academic interest and criticism. Conceptually speaking, the ERM II directly precedes the full
integration in the EMU.
(I) ERM II as a step towards EMU
To put the ERM II in a proper context, we need to be clear on the fact that it is an early necessary step
before Euro adoption. Therefore, entry into ERMII is conditional on the economic and political
readiness for entering the EMU. Several considerations need to be made. By adopting a single
currency, the country foregoes independent monetary policy and the central bank can not act as a
lender of last resort. The loss of monetary policy independence can be problematic if a country has
achieved little in the way of real convergence (both structural and cyclical convergence) and is
susceptible to asymmetric shocks. On the other hand, the loss of the lender of last resort function by
the national central banks implies high and protracted fiscal costs in the case of financial crises. For
this reason, a healthy and resilient financial system would be required for participating in the monetary
union.
It is partly a reflection of these economic challenges that the new EU members appear to be
following different trajectories towards EMU. On one hand, Slovenia, the Baltic countries,
Malta, Cyprus and Slovakia have proceeded to join the ERM II with a view to enter EMU in the
future. The other countries, notably the larger Central European ones, have opted to stay out of
the ERM II in order to have more time to do the necessary economic adjustments.
(II) Challenges of the ERM II
Once the economic argument and the political consensus are strong enough to support EMU
membership, the acceding country can decide to enter the ERM II mechanism. What could go wrong
for accession countries during the ERM II? Some often-cited issues are related to fiscal consolidation,
financial stability and the choice of the central parity. Let me say a few words about these issues.
- The exchange rate stability is one of the five (nominal) Maastricht convergence criteria.
Consumer price stability, long-term interest rate convergence and fiscal consolidation are the
other conditions a country has to fulfill in order to gain EMU membership. Clearly, the burden
of ensuring compliance with these conditions does not fall solely and exclusively on the
monetary policy authorities. The fiscal and labor policies must be aligned with the monetary
policy objectives and the achievement of political commitment to ERM II is of paramount
importance. I find the practice of monetary and fiscal policies dialogue, as stipulated in
Accession Strategies of some of these countries, a commendable achievement.
- Financial instability has been identified as a potential negative outcome of the bilateral fixing
of the exchange rate for accession countries. Limited exchange rate flexibility under ERM-II
and disinflation conditions expose the EU acceding countries to large 'convergence play'
capital inflows.1 If the exchange rate in accession countries is forced to fluctuate within a
relatively narrow band, the outcome might be additional and unnecessary inflation. The
central bank's reaction to increasing inflation would restrict economic growth. Such an
outcome is even more likely in the presence of the Balassa-Samuelson effects, commonly
experienced by the transition economies.2 In such a scenario, the dual task of preserving the
domestic and international value of the currency can be jeopardized. It is on these grounds
that the ERM II design has come under attack, as an unnecessarily lengthy period.3
Thus, it is not surprising that some acceding countries prefer to stay there for the shortest time
possible.
- The last issue I would like to discuss is the determination of the central parity rate. The
potential implications of an exchange rate misalignment are large, as the corrective burden
would fall on the real sector. An undervaluation or overvaluation of the exchange rate would
result in higher inflation or lower economic growth until the real exchange rate returns to
equilibrium. In the absence of a nominal exchange rate channel the adjustment process
would tend to be slow.
Now let me briefly turn to the policy implications the aforementioned issues pose.
The ECB policy stance on ERM II (ECB, 2003) emphasizes the primacy of the inflation objective
over the exchange rate stability. Approaching the EMU in the context of an IT regime seems
quite a plausible option, and one which is even encouraged by the ECB. The period of
residence in the ERM II needs however to be as short as possible, so as to avoid the inherent
incompatibility of these two targets in the face of the Balassa-Samuelson effects and increased
capital inflows. The countries approaching the EMU from a fixed exchange rate regime might
have a different perspective on the subject. However, even these countries will experience the
Balassa-Samuelson effects, facing a difficulty to reconcile the fulfilment of the exchange rate
and price stability criteria. At the same time, given the wide fluctuation bands that are foreseen
by the ERM II template, the credibility gain is likely to be marginal.
(III) Policy implications
As a conclusion, let me re-emphasize the need for a careful approach to the EMU in that a
certain degree of real economic and structural convergence is needed. The EMU membership
can not be delayed by much however. First, a really high degree of economic convergence
might require a lengthy period of time to be achieved and people could perceive an
enlargement without EMU as incomplete. Second, in adopting the single currency the
exchange rate risk will be eliminated, resulting in positive impulses to the financial market
development. Thirdly, the endogeneity forces of trade and financial integration discussed in
the literature might be an additional driver of real convergence that is worth exploring. Neither
economic theory nor central banking practices offer an optimal approach to ERM II from the
point of view of the monetary regime. The alternative theories agree however, on the need to
stay there for the shortest time possible
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To conclude my speech, let me briefly say a few words on the Albanian case.
(IV) The Bank of Albania approach to EU accession
The monetary policy of the Bank of Albania focuses on maintaining price stability through the control of
monetary aggregates which are used as intermediate target. Indirect instruments are used to transmit
interest rate and liquidity signals to the market. Repo rate is the leading indicator for short term interest
rates while repo and reverse-repo operations are used to manage liquidity.
Over the last five years the Bank of Albania stability oriented monetary policy has generated low and
stable inflation; it has also ensured that medium and long run inflation expectations have been well
contained.
The economic growth has been robust at around 5-6 percent of GDP, while enjoying a high degree of
financial stability. (In other words, it seems like we are already close to the ERM II standards.) Such
results reflect the opinion that economic convergence should not be held back by the political one.
Political processes dictate that ERM II and EMU should be preceded by entry into the EU. The Bank of
Albania has a clear view of the EU accession process. The design of the current and future monetary
policy strategies is in line with the ultimate objective of EU accession.
- On the policy side, it is striving to maintain monetary conditions in line with the Maastricht
Criteria. In this respect, Bank of Albania is carefully considering all available alternatives of
monetary policy regimes, among which priority is given to fully fledged inflation targeting
strategy.
This framework will provide a more sophisticated approach to decision-making and will create a better
platform for communicating our commitment to price stability, ultimately leading to a better anchoring
of inflation expectations. However, the choice of the new regime will be a conditional decision based
upon results of current ongoing research, evaluation of the preconditions and building up of capacities.
To this end, we are carefully refining our technical capacities and decision-making processes,
following the necessary preconditions, working to achieve real independence for the monetary policy,
upgrading our analytical capacities and designing appropriate internal processes.
- On the structural side, the Bank of Albania is also pushing the reform agenda in the financial
sector. The reform agenda in the Albanian financial sector aims at gradual implementation of
the Acquis Communnautaire standards in banking legislation. We are revising the legal
infrastructure.
In this regard, a new Draft Banking Law is prepared by the Bank of Albania; likewise a new Law on
Securities will be introduced shortly. In addition, efforts are underway to revise legislation on Pension
and Investment Funds, and draft a Law on the Payments Systems, which will substitute several
sublegal acts issued by the Bank of Albania until now. Prudential regulations have been tightened in
response to rapid credit growth and intensified competition in the banking system. We are working to
ensure proper supervision over the parts of the Albanian financial sector that are outside the Bank of
Albania's jurisdiction, while trying to preserve fair competition across the sector. The Bank of Albania
is assisting the MoF to improve its debt-management capacities. I believe our hard work will be
reflected in a satisfactory rating of our sovereign debt, due to be carried out early next year.
The competence, credibility and professionalism of our monetary policy provide necessary conditions
to support and guarantee achievement of economic goals and successfully fulfill economic
convergence toward ERM II preconditions. However, our achievements will not last in the absence of
a careful fiscal policy and conservative fiscal expansion. The Bank of Albania is not the only major
economic player. Therefore, we must find and implement clear anchors to guarantee the compliance
of other players' economic policies. In this respect, we can transform ERM II preconditions into an
important foreign anchor to preserve the credibility of our reforms in the future.
As a pre-accession country, Albania will be facing ERM II problems in the medium term. We are well
aware of the difficult road ahead and the challenges we will face. Nevertheless, we remain committed
toward economic and legal reforms considering it as a natural approach toward EU accession
process.
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References
Begg, B., Einchengreen, B., Halpern, L., Hagen, J. Wyplosz, CH. (2002). "Sustainable Regimes of
Capital Movements in Accession Countries", CEPR.
Buiter, W.H. and Grafe, C. (2002). "Anchor, Float or Abandon Ship: Exchange Rate Regimes for the
Accession Countries", EBRD 10 Year Anniversary Conference.
European Central Bank, (2003). "Policy Position of the Governing Council of the European Central
Bank on Exchange Rate Issues Relating to the Acceding Countries.'