Lars Heikensten: The Riksbank and the euro
Speech by Mr Lars Heikensten, Governor of the Sveriges Riksbank, at the Society of International
Treasurers Convention, Stockholm, 17 June 2003.
* * *
Let me begin by thanking you for the invitation to come here and speak on the subject of EMU.
Approximately three months remain until 14 September when the Swedish people will vote on whether
to participate in monetary union. In the event of a "yes" vote, Sweden will enter monetary union in
2006 and introduce the euro as its currency. The right of determination over our interest rate level will
then be transferred to the European Central Bank (the ECB). On the other hand, a "no" vote would
generally imply "business as usual" for the Riksbank.
Today, I will be speaking about some of the implications for the Riksbank and our operations in the
event of a "yes" vote in the referendum. I will begin by speaking about the preparatory phase, that is,
from 14 September until 1 January 2006, during which time preparations will be conducted in the
Swedish economy for a changeover to the euro, and the krona will join the exchange rate mechanism,
ERM2. Subsequently, I will talk on the issue of monetary policy as it will be conducted by the ECB and
point to differences as well as similarities with how it is conducted today. Thereafter, I will touch upon
the effects of a changeover on our work with financial stability. Finally, I will mention a number of
issues concerning the role of the Riksbank in the event of entry into monetary union and the
implications for our operations.
But before I go into these issues I would like to emphasise a number of points. This is not a campaign
speech. In 1994 and 1997, the Riksbank adopted a position in favour of Sweden joining monetary
union from its inception. The General Council of the Riksbank was then of the opinion that the
advantages of participation outweighed the disadvantages. However, the Executive Board of the
Riksbank has decided against taking a position on the issue. We have interpreted our role as being a
provider of factual information to make it easier for the Swedish people to form their own opinion on
the matter. Having said that, there is nothing to prevent individual members of the Executive Board
from expressing their personal opinion on the issue. We have all done that. I myself am in favour of
Swedish participation in monetary union.
The preparations
Should a majority of the Swedish vote "yes" to the euro, work will begin to pave the way for Swedish
entry into monetary union. The Riksdag is then expected during the autumn to make a formal decision
that will enable Sweden in practice to become a member of monetary union. At the same time, it is
necessary that the legal and practical adaptations that are a precondition for our participation be
prepared and decided upon before the EU's finance ministers within the scope of the ECOFIN Council
take the final decision.
If the referendum results in a "yes" vote, the Riksbank will be required to help ensure that entry into
monetary union proceeds in a stable, smooth manner.
Since the middle of the 1990s, the Riksbank has been collaborating with the financial sector via the
SIFS group - Consultation and Information with the Financial Sector - with a view to ascertaining the
adaptation measures necessary ahead of a potential Swedish changeover to the euro and how long
these measures would take to implement. The aim has been to make the time between a Swedish
Riksdag decision in favour of participation and entry itself as short as possible. The Swedish
government has recommended that Sweden, in the event of a "yes" vote, should strive to enter
monetary union on 1 January 2006, and that this should be carried out through a direct changeover or
"big bang". The switch-over of all electronic transactions in society would then be made simultaneously
with the cash changeover. This proposal has been welcomed by the financial sector, and there are
good chances therefore of a smooth, efficient changeover to the euro at the beginning of 2006.
For the Riksbank, a changeover to the euro would of course be a major project. The practical
preparations would include ensuring the production of new banknotes and coins, as well as the
replacement of the old ones. The latter would entail a considerable logistical operation. For example, a
couple of hundred large lorries would be required simply to deliver the necessary coins at the time of
the introduction. But there is more to it than that. Computer systems would need to be converted, not
least at the Riksbank, but also in many other areas of society. The Riksbank would also expend a lot
of effort on providing information to the general public about the implications of a changeover. In
addition, there would be a number of changes in our own operations, which I will return to later.
Participation in ERM2
One important question that would become relevant during the preparatory phase is how best to
ensure exchange rate stability against the euro within the scope of the exchange rate mechanism
ERM2, the successor to the ERM system.
In this regard, there may be reason to say something about history. The Riksbank has previously,
mainly over the years 1995-1997, considered the issue of ERM participation and the possibilities for
combining this with the inflation target policy that has been conducted for a number of years. During
that time, the Riksbank was legally responsible for the exchange rate regime, and the reasons
therefore for considering ERM participation were quite simply to prevent the regime of floating
exchange rates from constituting a formal obstacle to Swedish participation in monetary union, in the
event this was to become a possibility. When the government then decided that there was insufficient
popular support for Swedish participation in monetary union, the question of changing the exchange
rate regime was dropped.
In connection with the Riksbank being made formally independent in 1999, new legislation on
exchange rate policy was also introduced. Nowadays, it is the government that decides upon the issue
of our exchange rate regime, although the Riksbank determines how it is to be implemented. In other
words, it is the government that would decide whether and when the krona should join the exchange
rate mechanism ERM2. Following that, the ministry of finance and the Riksbank would decide what
rate between the krona and euro we assess to be consistent with a stable development of the
economy. There are very good reasons to agree upon a common line of action. This is why we are
holding discussions already among toplevel officials about an appropriate line of reasoning, the results
produced by different estimation methods, etc. If we do not reach agreement, it is likely to be difficult to
hold effective discussions with our European partners.
A decision on participation in ERM2 and on the central rate and fluctuation bands at which the krona
should join would be taken through common accord of the finance ministers in the euro area Member
States, the ECB, the central bank governors and finance ministers of the applicant country and the
other ERM2 countries, i.e. Denmark at present. In practice, a decision would be preceded by contacts
between representatives of the ministry of finance and the Riksbank as well as with our colleagues in
a number of euro area Member States and Denmark. The first official step in the negotiations would be
taken within the framework of the EU's economic and financial committee (EFC). Only if the committee
should fail to reach agreement would direct negotiations between the concerned central bank
governors and finance ministers take place. Then, when the irrevocable conversion rate against the
euro is to be determined in connection with entry into monetary union, this would be decided
unanimously by the ECOFIN Council members from the euro area Member States and Sweden.
Central rate in ERM2
The central rate is the krona/euro exchange rate against which the criterion of exchange rate stability
would be evaluated prior to entry into monetary union. It is natural to seek to ensure that the central
rate is set at a level which also becomes the conversion rate for the Swedish krona in monetary union.
Generally, this has also been the norm; only in a couple of cases has a central rate been changed
during the two years preceding entry into monetary union.
It is important to point out that it is not possible to exactly determine a "best" central rate or irrevocable
conversion rate. What may appear to be the best value of the exchange rate for the economic climate
today does not have to be the most appropriate for all time when new data on the economy has been
received. A certain capacity for adjustment is therefore necessary within the economies to manage the
consequences of the altered circumstances with a fixed exchange rate.
With the aid of various models, we can describe conceivable development paths for the exchange
rate, given certain assumptions about how the economy will develop in other respects. When
performing these kinds of forecasts, the analysis is usually carried out in terms of the real exchange
rate instead of the nominal rate. The real exchange rate is the nominal rate adjusted for any
differences in the price level between the countries in question. The reason that it is often more
interesting to perform analyses using the real exchange rate is that the most important
macroeconomic relationships and theories about these are based on real instead of nominal exchange
rates. The real exchange rate is a relative price between baskets of goods in different countries, thus
reflecting both international competitiveness and purchasing power.
In principle, a suitable central rate for the krona could be estimated by producing a forecast for the
nominal krona/euro rate for the exact date on which ERM2 membership is expected to begin.
However, all of this is complicated by the existence of several theories for exchangerate determination
and the uncertainty of the forecasts themselves. Nor are models capable of encapsulating all the
relevant aspects that could conceivably affect the development of the exchange rate, which is why it
would be necessary to complement the modelbased analysis with different kinds of expert
assessments. This implies that we have to confine ourselves to narrowing in on an interval of
conceivable central rates.
In various situations, including the December Inflation Report in 2002, the Riksbank has shown
forecasts of the krona's real exchange rate against the euro according to a number of models under
the assumption of a floating nominal exchange rate in the future. Forecasts of this kind underline what
I've just said: the forecast outcome is highly dependent on the chosen model of application. Common
to all models, however, is that they predict a strengthening of the real exchange rate over the coming
years. According to the models, this strengthening is due to the expected development of a number of
factors including relative GDP, Sweden's relative net assets, our terms of trade, relative demography,
etc.
When we adjust the forecast of the real exchange rate for the expected difference in inflation between
Sweden and the euro area, we get similar development paths for the nominal krona/euro rate. As
differences in inflation are expected to be small, the forecast strengthening of the real rate is also
reflected in the nominal rate. Towards the end of the forecast period, the rate should lie, according to
the assessments of the Riksbank, within an interval of approximately 8.20 to 9 kronor per euro. The
forecast for the rate at the end of 2003, however, consists of a narrower interval, around 8.50 to
around 9 kronor per euro.
Consequently, should Sweden join ERM2 around the end of the year, this kind of estimate would
advocate a suitable central rate between the interval 8.50 to around 9 kronor per euro. It should be
noted that the models imply an expected strengthening in both real and nominal terms but that this
strengthening from next year onward will be rather limited.
When choosing a central rate, it is vital to find a rate vis-à-vis the euro that is consistent with a
balanced development in the Swedish economy in both the short and long term. It is important to
remember that the real exchange rate, i.e. the relative price between baskets of goods in Sweden and
the euro area Member States would be variable even if were to introduce the euro as our currency.
But the adjustment would then occur through the relative rate of price increases. A central rate that is
overly weak would therefore provide stimulus to the Swedish economy that could lead to higher
inflation than in the other participant countries as well as unemployment at a later stage when the
impact of the weaker competitiveness makes itself felt. With an overly strong rate, the risk instead is of
lower inflation than in the other countries, initially having a negative impact on growth and
employment. This line of reasoning also clearly demonstrates the connection to fiscal policy. A weaker
exchange rate requires tighter fiscal policy and vice versa.
In practice, it is not possible to base the choice of the central and conversion rate only on model
estimates of what is a desirable longterm rate. It is also important to take into account expected
developments in the coming years. It is not in the interests of either Sweden or the other involved
countries to have problems arise during the period of Swedish participation in ERM2. In this respect,
the economic climate is a factor that demands attention. Previous experience also indicates that
negotiations of a central rate would be influenced by the rate that has prevailed between the krona
and the euro in recent years. Recent market assessments have been in an interval between 8.50 and
9 kronor per euro, as I mentioned earlier.
Monetary policy strategy in ERM2
If Sweden were to join monetary union, the responsibility for ensuring a balanced development in our
economy would essentially lie with the government and the Riksdag. There is reason to underline the
fact that this would already occur during the ERM2 period, even if the shift in responsibility for
stabilising the economy from monetary policy to fiscal policy would be a gradual one. As the effects of
economic policy are exerted with a time lag, this is something that fiscal policy decisionmakers should
already be considering.
For the Riksbank, the issue would be to define a strategy for monetary policy in the light of the
boundaries imposed by fiscal policy and the central rate and conversion rates chosen for the krona
versus the euro. Essentially, it is a question of conducting monetary policy in a way that would make
the conditions as favourable as possible for ensuring both the attainment of the price stability target
and the objective of holding the exchange rate close to the central rate. This is a pre-requisite if we are
to meet the entry requirements, or convergence criteria, of monetary union. From this perspective, it is
interesting that the forecasts of the development of the exchange rate and inflation indicate that a
relatively stable development for both of these variables is to be expected over the coming years.
In ERM2, the Riksbank would still have control over the repo rate. Given the boundaries established
by fiscal policy in particular, this should be set with the aim of ensuring price stability, as is the case
today. Normally, this should not constitute a problem as regards the exchange rate. ERM2 provides
considerable scope for targeting monetary policy at price stability. This applies of course for the
normal band widths of ±15 per cent, but would also apply for the narrower bands of ±2.25 per cent,
which the European Commission has used in its evaluations. Just like today, there is therefore reason
to continue publishing inflation reports and to hold regular monetary policy meetings.
Swedish experiences from recent decades of fixed exchange-rate regimes have, as we all know, not
been entirely positive. The events of 1992 are still fresh in our memories. But a lot has happened over
the past ten years. Our economic policy has become credible and successful. In recent years, it has
followed the same principles as those in the euro area and has been characterised by efforts to
achieve price stability and sound public finances. Participation in ERM2 would not change the stance
or objective of policy of course. Tensions stemming from a lack of competitiveness in the Swedish
economy are also unlikely; the rate is set partly to ensure a reasonable level of competitiveness, while
inflation over the coming years can be expected to be more or less in line with that of the euro area.
Moreover, the process for other countries' entry into monetary union was smooth in spite of the fact
that the circumstances in many cases were less favourable at the time than in Sweden today. For
instance, the uncertainty surrounding the implementation of the third stage and the introduction of the
euro is now gone. In light of this, there is no reason for concern over participation in ERM2.
The objective of keeping the exchange rate stable and close to the central rate would be facilitated by
the fact that the central rate chosen for ERM2, as I mentioned earlier, can be expected to be the
conversion rate vis-à-vis the euro on a known date in the future. This is an absolutely crucial difference
compared with the systems of fixed exchange rates previously adhered to by Sweden. If the exchange
rate nevertheless should unexpectedly move to an extent considered inappropriate, interventions
could be made in the foreign exchange market. Such interventions would have certain potency due to
the fact that they would involve the purchase and sale of currencies that will be traded at the same
price for all time. To clarify this, interventions could be made in the form of futures contracts with a
maturity date beyond the date of entry.
The single monetary policy
Entry into monetary union would imply Sweden becoming part of the euro area and the European
Central Bank assuming responsibility for monetary policy.
Target and strategy
Both the Riksbank and the ECB have the task of maintaining price stability and, to the extent that it
does not conflict with the price stability target, promoting a balanced development of economic
activities.
The Riksbank's inflation target entails keeping annual inflation as measured by the consumer price
index, CPI, at 2 per cent with a tolerance for deviations of 1 percentage point upwards or downwards.
Given that monetary policy exerts its impact on the economy with a time lag, our work is based in
practice on ensuring that future expected inflation is 2 per cent. Our underlying assumption is that the
time lag in policy is mainly one to two years. However, there is sometimes reason to refrain from
achieving the target as defined in this way. This may be the case when inflation is affected by
transitory effects, such as quickly rising or falling energy prices or changes in indirect taxes or
mortgage interest expenditure. For this reason, the Riksbank also makes use of measures of inflation
that exclude such effects. Inflation measured by the index UND1X is one example. Moreover, there
may be reason after a shock to bring inflation back to the target in the somewhat longer term. This
enables us to avoid overly negative implications for production and employment.
The ECB measures price stability as a year-on-year increase in consumer prices of below, but close
to, 2 procent. The target relates to inflation measured by the Harmonised Index of Consumer Prices,
HICP. The idea is to reach the goal in the medium term, which implies that the ECB also disregards
transitory effects on inflation. Consequently, the ECB's definition is similar to our own. There are some
differences, however.
One is that the ECB's target is defined in terms of HICP. The consumption basket in HICP is narrower
than in CPI due to the fact that areas for which statistics are not yet harmonised have been excluded.
The differences between HICP and the different measures normally used by the Riksbank are
generally rather small.
Another difference is the target level. The Riksbank works with a definite central target surrounded by
a symmetrical interval. Previously, the ECB's target was for inflation to be below 2 per cent. It was at
the ECB Governing Council's evaluation of its monetary policy strategy in May this year that the target
of keeping inflation close to 2 per cent was specified. With this, the ECB has become more precise in
its definition. Compared with the Riksbank, the difference in target level is small and should not make
any great difference in practice.
The most significant difference in target definition is that the ECB's target relates to inflation for the
euro area as a whole, while the Riksbank's target applies of course to Sweden only. The ECB's policy
implies therefore that the rate of inflation in individual Member States can be both higher and lower
than 2 per cent without constituting neglect of the ECB's target. This is also the case in reality, as
shown clearly by the inflation outcomes that have been measured. The same applies to Sweden but
on a smaller scale; inflation can be different in Norrbotten and Skåne.
When formulating monetary policy, the ECB attaches special importance to monetary aggregate and
credit variables. A reference value for the annual increase in the monetary aggregate has been set,
currently amounting to 4.5 per cent. In general, however, the interest rate adjustments implemented by
the ECB have not been justified on the basis of developments in the monetary aggregate. This has
been clear on several occasions in recent years, when the refi rate has been lowered in spite of the
fact that the rate of increase in the monetary aggregate clearly exceeded the reference value. The
evaluation of the strategy in May also resulted in measures of the monetary aggregate being given a
role primarily as indicators of future inflation. Naturally, the Riksbank also follows monetary aggregate
and credit variables, even if we have not assigned them special significance when assessing inflation.
Therefore, the formulation of policy nowadays is also quite similar in this respect as well.
Finally, allow me to point out that despite the similarities in the formulation of policy, it can not be ruled
out that price and wage increases in Sweden may sometimes be both too high and too low. The main
reason is that the ECB's policy is targeted at average price increases in the euro area as a whole.
Partly as a result of this, there is reason to discuss both the role of fiscal policy and the functioning of
the labour market in the event of an introduction of the euro in Sweden. It is particularly important that
fiscal policy be conducted in a way that ensures that reserves will be available during economic
declines and that institutional conditions are created to facilitate necessary decisions for tighter fiscal
policy to be taken on time.
Decision-making and communication
In the event of participation in monetary union, the Riksbank Governor would become a member of the
ECB Governing Council, which is the highest decision-making body of the European Central Bank. I
would then, just like all the other members of the Governing Council, have the opportunity to say what
interest rate level I believe to be the best taking into account developments in the entire euro area. I
would be a member of the Governing Council in a personal capacity, i.e. I would not be permitted to
seek or receive instruction from other individuals or institutions.
One issue that has been the subject of much discussion is the voting modalities in the Governing
Council. Initially, the Riksbank Governor would always have the right to vote on interest rate decisions.
This would change in the future, however. Once the number of Member States in the euro area
exceeds 15, a new decision-making arrangement will enter into force. The Member States will be
divided into groups according to size, and the voting rights will be rotated between the participants in
the respective groups. For Sweden, the long-term implication is that the central bank governor, once
all current and new EU Member States are participating in monetary union, would be able to vote on
approximately 60 per cent of the decisions. The central bank governor of a large country like
Germany, on the other hand, which has around nine times as many inhabitants, would be able to vote
at 80 per cent of the meetings. However, all central bank governors would have the right of attendance
and expression at all meetings. From a Swedish perspective, this appears to be a rather
advantageous solution in my opinion.
The ability to exert influence on the formulation of policy is important of course, particularly from a
democratic point of view. But it is not simply a question of voting rights, which is the impression one
gets sometimes when listening to the debate. Firstly, it is important to remember that the central bank
governors must act in the interests of the entire euro area when setting interest rates. In other words,
they must not give priority to national interests. Thus far, there have not been any votes held in the
ECB Governing Council; rather, monetary policy has been determined through consensus. In addition,
all central bank governors have the right of attendance, even under the new proposal, and can
therefore be involved in discussions on the stance of policy. My own experience from other, similar
discussions in the central bank sphere is that solid, wellfounded arguments weigh heavily and, in
practice, play a more important role than the size of the country and the possibility to press a voting
button. What I know about how the ECB Governing Council works in monetary policy discussions
supports this viewpoint.
For my own part, I believe that too much attention has been paid to the voting modalities. Other factors
can be particularly important in ensuring effective monetary policy. Personally, I would emphasise the
internal discussion processes, which I believe to be vital. These should be of high quality and
transparent, and provide scope for different decision-makers to become involved on equal terms.
Clarity and transparency is also important externally, ensuring more precise and meaningful criticism,
which in turn can improve and speed up internal thought processes.
Also in these respects, there are a number of similarities between the Riksbank and the ECB. Both
institutions publish assessments of inflation prospects, hold press conferences in connection with their
interest rate decisions and justify and explain their formulation of policy before various political bodies.
In addition, a gradual evolution of intellectual thought takes place within both the Riksbank and the
ECB. It is likely that this will bring us closer together. The most significant differences, in my opinion,
relate to the clarity of the assessments, where the Riksbank and other countries that work with explicit
figurebased targets and publish inflation reports are clearer. The Riksbank also has an internal
preparation process with broad participation. Finally, we publish the minutes of Executive Board
meetings in which the opinion of each member is evident. The latter issue has a different "charge" at
European level since there is a risk that a genuinely single monetary policy would be undermined if
individual positions were made public.
Monetary union and financial stability in Sweden
The Riksbank not only has the task of maintaining price stability but also that of promoting a safe and
efficient payment system. In light of this, allow me also to say something about the potential
implications of entry into monetary union from this perspective.
The financial markets in Europe have developed rapidly over the past decade, partly as a result of the
fact that the freedom to trade financial services is fundamental to the cooperation in the EU.
Competition for the national banks has hardened. The single currency has contributed to the evolution
of a far better capital market outside the banks, which has increased competition further. In several
large European countries, a process of structural transformation in the banking systems is underway,
much like that experienced in Sweden in connection with the banking crisis at the beginning of the
1990s.
When competition grows stiffer, it can of course pose a threat to stability, especially if the banks are
not accustomed to competition and are also weakly capitalised. In Sweden, the banks have operated
in a competitive environment since the deregulation of the 1980s and have been forced into a process
of considerable rationalisation. Capitalisation is also satisfactory. There is reason to believe that the
Swedish banks would be able to take advantage of the less expensive borrowing conditions in a single
currency market and that they would be able to spread their risks over a greater number of
counterparties, which would be positive for stability. In the long run, the banks' customers may find it
easier to come into contact with other European banks. This is an important aspect of increased
competition, although wise lenders nevertheless respect the "church tower" principle, namely to lend
only to those that you know well - those that you can see from the local church tower. I do not believe
that a single currency in itself would increase credit risk in the banks.
If monetary union in the long run were to result in a more integrated market for financial services, the
current Swedish banks would most likely be rather small participants in this market, and each bank
would be less important for the effective functioning of the payment system. Their significance for
financial stability would decrease and the need for public intervention to safeguard stability in the
financial system would therefore also be reduced. The reason for this quite simply is that the effect of
one or a number of participants failing would not be as big if the system was supported at European
level by a large number of participants, as opposed to being dependent on a small number of
participants, as the Swedish system is today. A more advanced securities market would also serve as
a buffer, both for borrowers and savers. This would make the banks less systemically important.
All in all, I believe that the Swedish banks are well equipped to face stiffer competition and that the
effects of monetary union on stability in the financial system would primarily be positive.
The securities markets, both stock exchanges and systems for the clearing and settlement of
transactions, are presently undergoing rapid development in Europe. It is likely that the principal force
driving this development is technological advances that enable cost savings, and Sweden will be able
to take part in this whether we use kronor or euro. However, as with trade in other markets, trade on
stock exchanges is of course facilitated by a single currency.
As regards the system for large-value interbank payments - the real-time system for gross payments
known as RIX in Sweden and managed by the Riksbank - monetary union would involve major
changes. It is likely that we would not have a separate system for such payments after membership,
but in some way would connect to the new European system (TARGET2). There would be
considerable efficiency gains to be made here. However, the stability aspect of this must be given
attention. The operational risk would increase when a greater number become dependent on one big
system.
With regard to the Riksbank, the direct effects of participation in monetary union on the work with
financial stability would not be particularly large. Even if Sweden were to join monetary union, the
Riksbank, under present rules, would be responsible for making decisions on providing emergency
liquidity assistance to Swedish institutions. Furthermore, the vulnerability of the banks and the
payment system would not change overnight but would continue to be largely national in nature, as
long as the European banks and payment systems have not become genuinely integrated. The
oversight and management of crises would therefore have to be carried out by national authorities.
The big difference is that international cooperation would become even more important.
In the long term, as banks and securities markets become increasingly more integrated, new and
interesting issues would arise on how best to carry out inte