Mr. Heikenstein discusses the advent of the euro and EMU in relation to
Speech by the Deputy Governor of the Bank of Sweden, Mr. Lars Heikenstein, at
Sweden
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 World Trade
Day '98. The introduction of a new currency is due in our vicinity in little more than four
months' time. This is the first instance in modern times of a large group of sovereign states
establishing a monetary union with a single currency. Along with the collapse of the Iron
Curtain, the creation of the European Monetary Union is probably the most significant European
event since World War Two.
Today I shall be focusing on what the birth of the euro may mean for
developments in the currency market. I shall not, however, be attempting to predict the euro's
future strength or weakness. Instead, I shall begin by discussing factors that could affect the
single currency in the course of the changeover and the somewhat longer term. Then I shall
consider how the euro is likely to affect the position of Sweden's currency, the krona. I can say
right now that, basically, I do not believe that the euro will fundamentally alter either the role of
the krona in Sweden's economy or, for that matter, the value of the krona in the long run. In view
of the discussion that this matter occasions from time to time, there may be reason to say
something about the view of the Riksbank.
1. A new currency is created
A new currency will see the light of day in January 1999. Eleven countries in
Europe are forming a monetary union and will accordingly be having a currency, a monetary and
exchange rate policy, and a central bank in common. The euro will be the domestic currency of a
major economic area. Today, the euro area's share of world output is around 30 per cent, as
against around 35 per cent for the United States. As regards world trade, the share for EMU's
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 process
was initiated in the 1950s with agreements on the joint control of certain means of production,
the European Coal and Steel Community. The idea was to forge economic bonds between
nations as a way of promoting peace in Europe. The establishment of the Common Market in the
1980s was a further step, aiming at freedom of movement within the Community for goods,
services, capital and individuals. With the introduction of a single currency, the countries of
Europe will come still closer to each other in economic and political terms. At the same time, yet
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 project. Most
analyses, however, have tended to concentrate on the union's pros and cons in an economic
context. The advantages that have been cited for the participating countries include lower
transaction costs for trading in a common currency, increased transparency and competition in
the single market, and low, stable inflation. The lack of an exchange rate as an instrument for
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 support. The
decision was made after a committee of experts had reported on participation's advantages and
drawbacks for Sweden. The commission was basically in favour of Sweden being a member of
EMU but was of the opinion that, given the disadvantages considered, Sweden should not
participate from the start. The costs in terms of stabilisation policy were assumed to exceed the
benefits from economic efficiency. The report's assessment of political aspects favoured Swedish
membership of EMU.
The report gave the Riksbank an occasion to present its appraisal of the monetary
union. This differed and amounted to a recommendation that Sweden should participate from the
start. We considered that the commission had overestimated the costs for stabilisation policy,
while the economic and political benefits were likely to be even greater than envisaged in the
report. Since the compilation of report, moreover, the political reasons for participating from the
start have grown in that more countries than expected will now be members from the beginning.
2. The euro's stability
The euro will exist as an account-based currency as of next January. While
banknotes and coins denominated in euro will not yet be in circulation, it will be possible to
make transactions in euro. So what will be the euro's role in currency markets? Will it be stable?
And will it compete with the dollar as an international reserve currency? As we all know,
predicting exchange rate movements is difficult. In general, one can say that a currency's
nominal exchange rate is determined by the real exchange rate together with differences in
inflation with the rest of the world. A currency's real exchange rate can be described as the price
of goods and services in that country relative to the rest of the world. If a difference in inflation
grows, a corresponding depreciation of the currency is needed to keep the real exchange rate
stable. The current exchange rate is also influenced by expectations of future rates. The
credibility of economic policy's commitment to long-term price stability is thus important for
exchange rate tendencies. The value of a currency is also susceptible to influences of a more
temporary nature. Cyclical factors may play a part. When the economy is in an upward phase, a
country may need a tighter monetary policy, which normally leads to an appreciation of its
currency. Deviations from the exchange rate's more fundamental level may also be occasioned
by matters to do with credibility. In addition, the exchange rate may be affected by transitory
shifts in the currency market's demand and supply. Such shifts may arise from portfolio
adjustments. In certain periods these mechanisms may tend to accentuate exchange rate
movements even though economic fundamentals point in a different direction. One example of
this is the large movements in the US dollar.
Against this background I shall now look at some factors that will probably be
important for the development of the euro. I shall take the fundamentals first and then point out
some factors that could be of transitory significance for the euro.
Fundamental factors
Provided economic policies in the euro area focus credibly on price stability
accompanied by a corresponding low-inflation policy in the rest of the world - it is probable that
the euro's nominal exchange rates with other countries will display a high degree of stability.
However, cyclical disparities between currency blocs and some uncertainty about monetary
policy signalling are factors that could generate certain fluctuations.
EMU is constructed so that monetary policy will be formulated collectively by the
ECB's Executive Council and the national central banks in the light of the overall picture of
inflation in the euro area, while fiscal policies are formulated at the national level.
Monetary policy
The European Central Bank (ECB), which will be accountable for EMU's single
monetary policy as of next January, was established on July 1st. The monetary policy objective is
price stability. The objective has not yet been defined more specifically but statements suggest
that there will probably be an intermediate money supply target and that price stability will be
represented by an inflation rate of 2 per cent or less. The latter has raised the question of whether
Sweden ought to revise its inflation target. The question is somewhat premature in that the
ECB's target formulation has still to be finalised. Moreover, the suggested formulation is in line
with what has applied in Germany, where on average in recent decades monetary policy has not
resulted in a rate of inflation below 2 per cent. In view of this, together with the advantages of an
inflation target that is symmetrical, there are no grounds at present for considering any change in
Sweden's inflation target.
The ECB has been given a high degree of independence in fulfilling the price
stability target without any short-run political considerations. The institutional conditions for
monetary policy credibility are accordingly good. By itself, however, this is not enough.
Credibility must also be achieved continuously, through a responsible monetary policy that is
properly understood and supported by society in general. At first there may be considerable
uncertainty about how the single monetary policy functions and how signals from the ECB
should be interpreted. Much will therefore be required initially of the ECB in explaining its
policy, presenting the analyses behind its decisions in an understandable way and creating a
broad understanding of the monetary policy in every part of the union. This understanding may
be tested particularly severely if price pressure in a particular country deviates from the average
so that the repo rate is not perceived as appropriate to the national situation. The national central
banks in the euro area should be able to lend a hand here, both in communications with the
public and by providing sound analyses of tendencies in their home country.
This brings me to the discussion about the ECB Governing Council. Concern has
been voiced in the debate because the composition of the Council, the ECB's supreme
decision-making body, might lead to policy being influenced by strong national interests at the
expense of the total picture. One source of this concern is that so many of the Council's decision
makers are national central bank governors, who might allow for national interests. Comparisons
are made with the US Federal Reserve, whose decision-making body has a smaller proportion of
regional governors. Another cause of this concern is that political accountability in the European
Community is essentially exacted at the national level; it is largely in the national arena that
economic policy is discussed. While these problems cannot be dismissed out of hand, I believe
they have been exaggerated. The members of the Council are jointly responsible for making the
ECB a success and establishing price stability in the euro area. In this sense they are all in the
same boat and nothing is more likely to capsize the boat that a national preference. That, I
believe, will characterise what happens in practice. In any event, a distinct, transparent policy
right from the start is vital in order to avoid unnecessary uncertainty that could result in
exaggerated movements in exchange rates and interest rates.
Other components of economic policy
In the long term it is the construction of monetary policy that determines the rate
of inflation. In the shorter run, however, price movements are also influenced by other economic
factors. Other components of economic policy - that is, fiscal, labour-market and structural
policies - therefore have to be constructed so that they support the policy drive for sustainable
price stability. If these components do not work, the burden on monetary policy becomes
additionally heavy.
Economic policy apart from monetary policy will continue to be a national matter
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 to some
extent its scope is restricted by the Stability and Growth Pact, to which all the EU countries
subscribe. This Pact requires each country to conduct a responsible fiscal policy, defined as
achieving a general government budgetary balance or surplus over the medium term. Each
country is also to allow continuous monitoring of its government finances by the other EU
countries. A government budget deficit is normally not to exceed 3 per cent of GDP, though
there is room for certain exemptions. If a country in the euro area does have a budget deficit
above 3 per cent and this cannot be explained by factors that are exceptional and temporary,
sanctions are to be imposed. EU countries outside the euro area are not liable to sanctions,
however; they are only included in the monitoring provisions of the Pact.
The task of establishing price stability in the euro area will be facilitated if low
inflation in the area is also promoted by fiscal policies. The importance of fiscal policy lies both
in creating sustainable government finances, which contribute to the general credibility of
economic policy, and in countering tendencies to excessive price pressure in the economy. In that
the single monetary policy is to be constructed in relation to the overall situation in the euro area,
more will be required of fiscal policy in the context of national stabilisation policy - fiscal
instruments will still be available for stabilising national economic trends. But this in turn does
presuppose that there is room for manoeuvre in the national budgets. Partly on this account, the
Stability and Growth Pact's medium-term objective of a government budget balance or surplus is
reasonable and it is highly important that the countries meet this undertaking. Today this is the
case in just a few countries, of which Sweden is one.
Monetary policy's interaction with fiscal policy will be important, at both national
and EMU level, for the perceived credibility and consistency of economic policy in general. A
constructive dialogue is therefore needed between the ECB and the governments of the euro
countries. The arrangements are not yet clear but an intense discussion of this and other matters
is now under way in Europe. The Treaty provides a number of opportunities for contacts between
the two spheres.
Functional economic structures must also be in place so that the single monetary
policy can establish low inflation without eliciting unnecessary economic tensions. A matter of
particular importance in this context is the workings of the labour market. A labour market that
functions properly reduces the risk of regional unemployment and thereby of political problems
that could ultimately pose a threat to the monetary union.
Temporary factors
The discussion of the euro's development has included the point that the
introduction of the single currency will trigger widespread portfolio rearrangements, mainly by
private investors but also in public reserves.
The euro will alter the composition of exchange risks in investors' portfolios and
this could result in flows to restore the degree of diversification. Investors who achieved
diversification previously with holdings in German marks and Italian lire, for example, will have
to adjust their portfolios when both these currencies are replaced by euro. Demand for euro may
also be affected by the single currency's conceivable international importance, so that the use of
euro exceeds what one would expect from the area's economic weight. To achieve international
status, a currency needs to be stable, liquid and large. It should be born in mind that the German
mark is currently an international currency. So perhaps the changeover to the euro will not make
such a notable difference even if a potential exists for the position of the euro becoming even
stronger.
It is generally assumed that exchange rates will not be permanently affected by
portfolio rearrangements which do not stem from more fundamental considerations. But as the
euro's entry into currency markets is something entirely new, it is hard to tell whether the scale
of portfolio changes will be such that euro exchange rates are influenced at least for a time. And
as the rearrangements will probably include both investment and borrowing in euro, neither is it
clear what their net effect might be. As I mentioned earlier, the development of the euro will
ultimately depend on expectations of inflation in the euro area relative to the rest of the world.
3. Role of the euro in Sweden
How will the euro affect Sweden's currency, the krona? On the basis of theoretical
analyses of what ought to determine a country's use of a currency, together with information the
Riksbank has obtained from interviews and surveys of Swedish firms and households, we have
concluded that the introduction of the euro will not appreciably alter the role of the krona in the
Swedish economy.
The krona has important functions in Sweden's economy, both as a means of
payment and as a unit of account and a repository of value.
The krona is already exposed to competition from other currencies. EMU can be
seen as a continuation of this process. One indication of the competition is the very sharp
increase in exchange market turnover. Since 1986 this turnover has grown by a factor of eight,
whereas foreign trade and GDP have no more than doubled. Only 5 per cent of the exchange
market turnover stems from transactions directly connected with foreign trade.
In what respects, then, might the advent of the euro alter the position of the krona?
What is the line of reasoning behind such a scenario?
The discussion about a marginalisation of the krona has started from the view that
Swedish export companies will choose to switch to euro in order to reduce the competitive
disadvantage of being outside the euro area. With this area as an important field for trade,
Swedish firms have to meet the increased price competition which the monetary union entails
without reaping the benefits which their euro area competitors reap from decreased exchange
costs and access to a large, liquid market for capital. In order to reduce these disadvantages, firms
can try to match their euro income with their expenditures in Sweden, for example for wages
costs and payments to suppliers. The exchange risk would then be passed on to domestic players
- 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 competitive
disadvantages will actually be for export companies. Another aspect that can be discussed is the
extent to which households and Swedish-owned companies are prepared to accept an exchange
risk. They will want to receive income in the same currency as their expenditures. Otherwise they
take an exchange risk that makes the real income uncertain.
Even when the monetary union has started, most of the expenditures of
households and Swedish-owned companies will presumably be expressed in the national
currency. Retailers set prices and accept payments in Swedish kronor. The status of the krona as
legal tender means that they are under no obligation to accept payments in other currencies.
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 on a
large scale, it is thus not clear that they would be able to pass the exchange risks on to
households and suppliers.
Large Swedish companies might be interested, on the other hand, in changing over
to the euro as their unit of account, including the denomination of equity capital. Some business
representatives have made statements to this effect. By reporting equity, deciding dividends and
having their shares quoted in euro, companies with transactions in euro might possibly improve
their access to the euro capital market and reduce their costs for handling currencies in the
management of liquidity. Swedish law does not currently permit the use of currencies other than
the krona but the possibility of having other currencies as the unit of account is being
investigated.
Today, many companies invest their surplus liquidity in Swedish kronor, partly
because their dividends are paid out in kronor. If companies choose the euro as the unit of
account, this could have consequences for their asset management. One such consequence might
be a preference for investing surplus liquidity in euro. This alters their investment portfolio,
which brings us back to what I said earlier about short-run exchange rate movements.
Presumably, however, the portfolio adjustments would be gradual, leaving the krona's exchange
rate more or less unaffected by the flows. And even if the flows were to be so large as to
influence the krona's rate, there is no reason to suppose that they would have a permanent effect
on the krona's exchange rate against the euro. These flows would be accompanied by many other
types of currency transaction.
The krona's long-term level will depend instead on Sweden's economic policy.
When economic policy is credible and focused on low inflation, there are no grounds for
believing that the krona would go on weakening continuously or that it would relinquish its
position in Sweden's economy.
4. Concluding remarks
To round off what I have been saying, the development of a currency - be it the
euro relative to the US dollar or the Swedish krona relative to the euro, for example - is
dependent on the direction and results of economic policy. If the policies in the countries and
regions we have been discussing are credible, focused on low inflation and successful, in the
longer run the exchange rates ought not to diverge.
The legal framework for economic policy in EMU provides a good foundation for
a credible low-inflation policy. But it is still important that all the components of economic
policy back up the objective of price stability right from the introduction of the single currency.
The ECB can do this by conducting a credible monetary policy and explaining it clearly. The
national governments can contribute by ensuring that combined fiscal policies in the euro area
comfortably comply with the Stability and Growth Pact; this is not yet the case. Measures that
improve labour markets can also help to enhance conditions for the success of the monetary
union.
In the same way, the institutional changes and economic developments in Sweden
in recent years herald good conditions for a stable krona. The framework for both monetary and
exchange rate policy has been strengthened. The status of the Riksbank is being made more
independent and the budget process is now considerably more disciplined. Certain flows in the
currency market may be generated simply as a consequence of the new currency's introduction
but what ultimately matters is the economic fundamentals. This suggests that the advent of the
single currency - the euro - will not lead to any marked changes either in the krona's role in the
Swedish community or in its value.