REPORT ON CONVERGENCE IN THE EUROPEAN UNION IN 1996 - (prepared in accordance with Article 109j (1) of the Treaty)
Date: 1996-11-06
Institutions: European Commission
Subjects: European Central Bank, European System of Central Banks, European integration, coordination of EMU policies, law of banking

COMMISSION OF THE EUROPEAN COMMUNITIES 

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Brussels, 06.11.1996 
COM(96) 560  final 

REPORT ON CONVERGENCE IN THE EUROPEAN UNION 

IN 1996 

(prepared in accordance with Article 109j(l) of the Treaty) 

(presented  by the Commission) 

1. 

INTRODUCTION 

CONTENTS 

2. COMPATIBILITY OF NATIONAL LEGISLATION WITH THE 
TREATY AND THE STATUTE OF THE EUROPEAN SYSTEM 
OF CENTRAL BANKS 
2.1  Adaptation  of national law since the signing of the Treaty 
2.2  Recapitulation  of relevant provisions of the Treaty and the 

ESCB  Statute 

2.3  Review of national legislation 
2.4  Current legislative initiatives 
Box: Review of central bank legislation:  some illustrative cases 

3.  PRICE  STABILITY7 
3.1  Treaty  provisions 
3.2  Price stability as assessed by the IICPs 
3.3  Inflation performance  during the second stage of EMU 
3.4  The sustainability of price convergence 
Box: Calculation of the inflation reference  value 
Box: Differences  between IICPs and CPIs 

4.  GOVERNMENT BUDGETARY POSITION 

4.1  Existence of an excessive  deficit 
4.2  Budgetary developments in 1996 
4.3  Progress with budgetary consolidation during the second stage of EMU 
4.4  Sustainability of budgetary  convergence 
Box: Excessive deficit  procedure 

5.  EXCHANGE RATES 

5.1  Treaty provisions 
5.2  Further analysis of exchange rate stability 

6.  LONG-TERM INTEREST RATES 

6.1  Interest rate  convergence 
6.2  Recent developments in long-term interest rates 
6.3  Explanatory factors and assessment 
Box: Data and reference value for the interest rate convergence criterion 

7.  SUPPLEMENTARY  INFORMATION 

7.1  Development of the ECU 
7.2  Results of the integration of markets 
7.3  Situation and development of balances of payments on current  account 
7.4  Examination of development of unit labour costs and other price indices 

8.  CONCLUDING  SUMMARY 
8.1  General assessment 
8.2  Summary by Member  States 

Page 
5 

7 

19 

32 

45 

50 

59 

72 

TABLES: 

3.1 
3.2 
3.3 
3.4 

3.5 
3.6 

4.1 
4.2 
4.3 

4.4 
4.5 
4.6 
4.7 
4.8 

6.1 
6.2 
6.3 

7.1 
7.2 
7.3 
7.4 
7.5 
7.6 

Inflation  convergence 
The average rate of  inflation 
Private consumption deflator  and consumer price index 
Inflation  convergence according to alternative methods for the calculation of the 
reference  value, IICP 
Difference  between IICPs and CPIs 
Inflation  convergence using IICPs and CPIs 

General government  deficit 
General government gross debt 
Changes from previous year in the actual and cyclically adjusted  general 
government  deficit 
Cyclical adjustment  of government deficit in 1996 
Factors, other than the deficit,  adding to the debt stock 
Revenue and expenditure shares, 1993 and  1996 
Government investment and deficit 
Objectives  for the general government deficit in  1997 

Long-term interest rate convergence in the .Member States 
Development of long-term interest rates 
Recent evolution of long-term interest rates 

Current account balance 
Labour costs 
Import price  inflation 
Contribution of import prices to the change of the final uses deflator 
Nominal effective  exchange rate changes relative to 23 industrial  countries 
Effects  of indirect tax changes on consumer price  inflation 

8.1 

Performance  of the Member States in relation to convergence in  1996 

GRAPHS: 

3.1 
3.2 

4.1 
4.2 
4.3 
4.4 

nCP for EUR and Member States 
Interim indices of consumer prices (IICP) 

General government  deficit 
General government gross debt 
Government deficit  and debt ratios,  1993-96 
Actual and cyclically adjusted  government deficit,  EUR 

ERM grid spread 

5.1 
5.2  Movements within the ERM band 
5.3 

Stability of exchange rate vis-à-vis the DM 

6.1 
6.2 
6.3 

Recent evolution of long-term interest rates 
Long-term interest rate convergence 
Average of government bond yields in the EC 

7.1 

International commodity prices 

1.  INTRODUCTION 
# 

This  report  has  been  prepared  in  accordance  with  Article  109j(l)  of  me  Treaty  which 
requires the Commission  to report to the Council on the progress made in the  fulfilment 
by  the Member  States  of  their  obligations  regarding  the achievement  of  economic  and 
monetary union (EMU). The European Monetary Institute (EMI) is similarly required  to 
report to the Council. 

These  reports  are  the  first  steps  of  the  procedure  set out  in Article  109j  which  leads  to 
the Council, meeting  in the composition  of the Heads of State or Government,  deciding 
for  the first time, not  later  than  31 December  1996, whether  a majority  of  the  Member 
States  fulfils  the necessary  conditions  for  the adoption of a single currency and  whether 
it is appropriate for the Community to enter the third stage. 

In practice  it has been  clear  for  some  time  that,  despite the considerable  progress  made 
by Member States with all aspects of convergence and with other preparations for  EMU, 
a  majority  of  Member  States  has  not  yet  achieved  a  sufficiently  high  degree  of 
sustainable  convergence.  This  is  notably  because  many  Member  States  have  not  yet 
reached a satisfactory  situation  as regards the sustainability of the government  financial 
situation.  The  European  Council  in  Madrid  in  December  1995  already  came  to  the 
conclusion that conditions  would  not be  appropriate  for  an early  start to the third  stage 
but confirmed  that the third  stage of EMU would indeed begin on  1 January  1999. This 
agreement  on  the  starting  date  was  reiterated  by  the  European  Council  in  Florence  in 
June 1996. The decisions about which Member  States will be in the first group  adopting 
the single currency will be made as early as possible in 1998. 

The role of the present report, apart from meeting the formal requirements of the Treaty, 
is  thus,  first,  to  examine  the  current  state  of  convergence  and  of  the  compatibility  of 
national legislation with Treaty  obligations  and, second, to review the progress that  has 
been made since the beginning of stage two of EMU on 1 January 1994. 

The  structure  of  the  report  follows  that  established  by  Article  109j(l).  Chapter 2 
examines the compatibility between each Member State's national legislation  (including 
the statutes  of its national  central  bank)  and Articles  107 and  108 of the Treaty  and  the 
Statute  of  the  ESCB.  The  following  four  chapters  (Chapters  3-6)  examine  in  turn  the 
convergence performance  of  the  Member  States  in relation  to  each  of the  four  criteria, 
concerning price stability,  the government  budgetary position, exchange rates and  long-
term interest rates. Chapter  7 looks  at developments  in several other areas that  are to  be 
taken  account  of  in  the  Commission  and  EMI  reports:  development  of  the  ECU,  the 
results  of the integration  of  markets,  the balances  of payments on current  account,  and 
unit  labour  costs  and  other  price  indices.  A  final  chapter  (Chapter  8)  summarises  the 
conclusions of the report. 

According  to  the  Edinburgh  agreement,  Denmark  has  announced  that  it  will  not 
participate in the third  stage of  EMU, but that  it remains fully  committed  to taking  part 
in  economic  and  monetary  cooperation  during  the  second  stage  of  EMU.  With  this  in 
mind, developments in Denmark  have been included in this report. 

Similarly,  although  the  United Kingdom  has  notified  the  Council,  in  accordance  with 
paragraph  1 of Protocol No  11, that it does not intend to move to the third stage in  1997, 
it might do so later and developments in the United Kingdom have also been included  in 
this report. 

On the basis of this report and that of the EMI the Commission  is separately  submitting 
to the  Council  a recommendation  for  the assessment  by the Council  in accordance  with 
Article  109j(2). 

2. COMPATIBILITY OF NATIONAL LEGISLATION WITH THE TREATY 
AND THE STATUTE OF THE EUROPEAN SYSTEM OF CENTRAL BANKS 

According  to the second  sentence of Article  109j(l)  of the Treaty, the reports drawn  up 
under  this  article  "shall  include  an  examination  of  the  compatibility  between  each 
Member  State's  national  legislation,  including  the statutes  of its national  central  bank, 
and Articles  107 and  108 of this Treaty and the Statute of the ESCB". 

The  present  chapter  is  devoted  to  this  examination.  The  first  section  summarizes 
adaptations  of  national  law  since  the  signing  of  the  Treaty  on  European  Union  in 
February  1992. The  second  section  includes  a recapitulation  of the relevant  provisions 
of  the  Treaty  and  the  ESCB  Statute.  The  third  section  summarizes  the  results  of  a 
review  of  national  central  bank  legislation  in  the  light  of  these  provisions;  it  indicates 
types of provisions which are still found to be incompatible with the requirements of the 
Treaty  or the Statute and  which  are expected  to'be changed  before  the establisliment  of 
the ESCB. The  fourth  section  indicates  legislative  reforms  which are at present  planned 
in the perspective of the third stage. 

2.1 Adaptation of national law since the signing of the Treaty 

Since the  signing  of the Treaty on  European  Union  and  its entry into  force,  statutes  of 
many  national  central  banks  (NCBs)  have  been  adapted  in  order  to  comply  with  the 
Treaty. 

Some of these changes  aimed  at ensuring  compliance with Article  104 which  prohibits 
central  bank  credit  to  the  public  sector  and  with  Article  104a  which  prohibits  the 
granting of privileged.access by governmental  or public bodies to financial institutions. 
These  rules  are  in  force  since  the beginning  of  the  second  stage. Member  States  have 
adapted  their  regulatory  framework  in  a  satisfactory  manner  to  these  requirements,  so 
that no significant  difficulties  have occured. 

The  statute  of  the Banque  de France  was  amended  in  1993. The  responsibility  for  the 
formulation  and the implementation  of monetary policy has been vested in a "Monetary 
Policy Council", which must not seek or accept instructions from the government or any 
other body, whilst a "General Council" carries out all other management  responsibilities 
at  the  bank.  Furthermore,  the  objective  of  the  bank  to  ensure  price  stability  has  been 
redefined. 

The  legal  regime  of  the  Banco  de  Espafia  was  adapted  in  1994.  The  law  established 
price  stability  as the primary objective  of monetary policy which is to be defined  and 
implemented by the bank. Neither the government  nor any  other public authority  may 
give  instructions  to  the  bank  regarding  either  the  objectives  or  the  implementation  of 
monetary policy. 

In  Belgium,  an  amendment  in  1993  restricted  opposition  and  suspension  rights  of  the 
Government  Commissioner  and  the  Minister  of  Finance  in  matters  concerning  the 

definition  and  implementation  of  monetary  policy,  the  conduct  of  foreign  exchange 
operations,  the holding  and  management  of official  foreign  reserves  and  the  promotion 
of the smooth operation of payment systems. 

In  Italy,  the  authority  to  determine  the  discount  rates  has  been  transferred  from  the 
Minister of the Treasury to the Governor of the Banca  d'ltalia in  1992. Furthermore,  the 
Banca  d'ltalia  has  been  given  the  responsibility  for  setting  reserve  requirements  within 
certain limits and  for overseeing payment systems. 

In Portugal, the amendments of the law on the Banco  de Portugal were adopted  in 1995. 
The  law,  inter  alia,  redefined  the  primary  objective  of  the  bank,  i.e.  to  maintain  price 
stability, taking into account the overall economic policy of the government. 

2.2 Recapitulation  of relevant  provisions  of the Treaty  and  the ESCB  Statute 

Article  107 of the Treaty ensures that the ESCB will  operate free from instructions  from 
third parties. It reads as follows: 

"Wlien exercising  the powers  and carrying out the tasks and duties conferred upon them 
by this Treaty and the Statute of the ESCB, neither the ECB nor a national central  bank, 
nor  any  member  of  their  decision-making  bodies  shall  seek  or  take  instructions  from 
Community institutions  or bodies,  from  any government  of a Member State or from  any 
other body.  The Community institutions  and bodies and  the governments of the  Member 
States undertake to respect this principle  and not to seek  to influence the members of the 
decision-making  bodies  of the ECB  or of the national  central banks in the  performance 
of their tasks. " 

Article  108  of  the  Treaty  obliges  Member  States  to  adapt  national  legislation  in 
accordance with the requirements of EMU: 

"Each Member  State  shall  ensure,  at  the  latest  at  the  date  of  the  establishment  of  the 
ESCB,  that  its national  legislation  including  the statutes  of its national central  bank  is 
compatible with this Treaty and the Statute of the ESCB. " 

The article refers  to the compatibility of national legislation with the Treaty's provisions 
in general. This  includes  compatibility  with Article  105(1) of the Treaty which  defines 
the objectives of the ESCB, the first two sentences of which read as follows: 

"The primary  objective  of  the  ESCB  shall  be  to  maintain  price  stability.  Without 
prejudice  to  the  objective  of  price  stability,  the  ESCB  shall  support  the  general 
economic policies  in the  Community  with  a view  to  contributing  to the achievement  of 
the objectives of the Community as laid down in Article  2." 

The Statute of the ESCB* includes in its Article 14.2 rules on the security of tenure: 

See  Protocol  (No  3)  of  the  Treaty. 

"The statutes  of the national central banks shall,  in particular, provide  that the term  of 
office of a Governor of a national central bank shall  be no less than five  years. 

A  Governor  may  be  relieved from  office  only  if  he  no  longer fulfils  the  conditions 
required  for 
the  performance  of  his  duties  or  if  he  has  been  guilty  of  serious 
misconduct... " 

By each of these four provisions, limits are put on national central bank  legislation: 

•  The prohibitions  and obligations  formulated  in Article  107 apply equally to both  the 
ECB and the NCBs in so far  as the performance  of ESCB-related tasks is concerned. 
While the prohibitions formulated  in the first  sentence of Article  107 are addressed to 
the NCBs  and  to  their  decision-making  bodies,  it  appears  that  rights  of third  parties 
to  give  instructions  in  some  form  or  other  are  incompatible  with  the  prohibitions. 
Furthermore,  any  national  provisions  of  which  the  purpose  or  effect  is  for  the 
government  to  seek  to  influence  the  members  of  the  decision-making  bodies  of  the 
NCB  in the performance  of their  tasks therefore  need to be brought; in line with  the 
second  sentence  of  Article  107.  The  term  "decision-making  bodies"  should  be 
understood  to mean  any organ  of  an NCB  whose  decisions  may  have  an impact  on 
the fulfilment  of its ESCB-related tasks. 

•  The primary objective  formulated  in Article  105(1)  is  assigned  to  the ESCB, which 
according  to  Article  1.2  of  the  Statute  is  composed  of  the  ECB  and  the  NCBs. 
Therefore,  the  objective  of  each  member  of  the  ESCB  must  be  compatible  with 
Article 105(1). 

•  Article  14.2 of the ESCB  Statute is exclusively  addressed to NCBs;  non-compliance 

with the limits set therein will require adaptations of national law. 

•  Apart  from  these  specific  provisions  in  the  Treaty  and  the  Statute  which  require 
compatibility,  there  are  likely  to  exist  a  number  of  national  provisions  - often  of  a 
technical  nature - which  may prove  to  be  at  odds  with  the prerogatives  of the  ECB 
vis-à-vis  NCBs  and  which  should  be  eliminated  so  that  the  new  compatible 
provisions  become effective  at the start of Stage Three  for  Member  States without  a 
derogation  and at the start of their  full  participation  in Monetary Union  for  Member 
States with a derogation initially or with a special status. 

It  is worth recalling  some provisions  which refer  to the time-frame  for  any  adjustments 
of national law and to the geographical  coverage of the respective rules. Right from its 
establishment  in  early  1998, the  ECB  will  have  to  take  decisions  which  predetermine 
the  conduct  of  its  monetary  policy  as  from  1  January  1999.  Article 108  therefore 
stipulates that compatibility  shall be achieved  at  this date at the latest. Besides, Article 
109e(5)  calls  upon  Member  States,  as  appropriate,  to  start  the  process  leading  to  the 
independence of its central bank during the second stage. 

10 

In  relation  to  the  application  of  Article  107 of  the  Treaty  on  central  bank  independence  and 
Article  108  of  the  Treaty  on  the  adaptation  of  national  legislation  and  NCBs'  statutes,  the 
Treaty  does not  make a distinction  between Member  States with  or without  a derogation  (see 
Article  109k(3)  of  the  Treaty). 

Denmark will be treated  as a Member  State with  a derogation  (Article  2, Protocol  No  12). Its 
central  bank  statute  will  therefore  have to be  compatible  with  Articles  107  and  108. 

In  the  event  that  the  United  Kingdom  will  not  participate  in  Stage  Three,  Article  2, 
Protocol  No  11 will exempt the United Kingdom from  the application of Articles  107 and  108 
of the Treaty.  Given the formulation  of Article  109e(5), until it notifies  that it intends to move 
to the third  stage, the United  Kingdom  is therefore  exempted  from  the  obligation  to start  the 
process  leading  to  the  independence  of  its  central  bank. 

It is made clear in  Article  107 that the requirements  for  compatibility  with the Treaty  and  the 
Statute  are  limited  to  ESCB-related  tasks.  Among  these  are  the  basic  tasks,  laid  down  in 
Article  105(2) of the Treaty  and Article  3.1 of the Statute, which  are to define  and  implement 
the monetary policy of the Community, to conduct foreign  exchange operations consistent with 
the  provisions  of  Article  109 of the  Treaty,  to  hold  and  manage  the  official  foreign  reserves 
of  the  Member  States  and  to  promote  the  smooth  operation  of  payment  systems. 

2.3.  Review  of  national  legislation 

Central bank statutes reflect  different  national traditions and institutional  frameworks  and vary 
significantly  between Member States with respect to many of their characteristics like the legal 
form  of  the  central  bank,  the  definition  of  its  objectives  and  tasks,  monetary  policy 
instruments,  relations  with  the  national  parliament  and  socio-economic  groups,  the  structure 
and  composition  of decision-making  bodies, and financial  rules.  Taking Articles  105 and  107 
of  the  Treaty  and  Article  14.2  of  the  ESCB  Statute  as  benchmarks,  a  review  of  present 
legislation  in  the  Member  States  leads  to  the  following  conclusion:  Many  characteristics  of 
national  legislation  are  within  the  limits  drawn  by  EC  law.  However,  in  a  number  of  cases 
adaptations  are  called  for.  Legislative  initiatives  for  such  adaptations  have  reached  an 
advanced  stage  in  several  Member  States  (see  section  2.4). 

In a few Member  States, legislation allows other bodies to give instructions to the central  bank 
in  matters  of  monetary  policy.  This  is  incompatible  with  the  requirements  in  the  third  stage 
of  EMU. 

In many Member  States, other legislative provisions are in force the effect  of which may  come 
close to the right  of third  parties to give straightforward  instructions.  Such provisions  include 
a right  of other bodies to interfere  in a decision taken by the ECB, a right to participate  in the 
voting  on  monetary  policy,  a right  to  be  consulted  before  the  central  bank  takes  a  decision, 
insufficient  financial  autonomy  of the central bank,  or membership  in decision-making  bodies 
of  the  central  bank  and  in  bodies  outside  the  ESCB.  In  some  cases,  the  borderline  between 
compatible  and  non-compatible  provisions  is difficult  to  draw;  however,  it  is  clear  that  most 
of  the  existing  provisions  of  this  type  need  to  be  amended. 

11 

In  a  few  Member  States,  the  provisions  on  the  security  of  tenure  for  the  Governor  are  not 
compatible  with  the  provisions  of  Article  14.2  of the ESCB  Statute. 

The  box  on  "Review  of  central  bank  legislation:  some  illustrative  cases" provides  examples 
of  provisions  in  national  legislation  which  serve to  illustrate  the  issues  at  stake. 

2.4  Current  legislative  initiatives 

In Ireland,  Luxembourg,  the Netherlands, Finland  and  - with  a more substantial  revision  than 
in  1993  -  in  Belgium,  preparatory  work  on  amendments  to  national  legislation  concerning 
central  banking  is  well  under  way. 

In  Ireland,  draft  legislation  on the  Central  Bank  of Ireland  includes provisions  on the  Bank's 
involvement  in  payment  systems,  the  collection  of  statistics,  prudential  supervision  and  the 
position  of the members  of decision-making bodies, including the term  of office  of Directors, 
which  is  fixed  at  five  years. 

In Luxembourg,  a draft  law on the Institut Monétaire Luxembourgeois and the monetary  status 
of  Luxembourg  was  submitted  to  Parliament  in  December  1993.  The  law  which  is  still 
pending  covers  inter  alia  the  IML's  objectives  and  tasks. 

In the Netherlands,  discussions between  the Ministry  of Finance  and the Nederlandsche  Bank 
with  a view to adapting the central bank legislation to the requirements  of EMU have reached 
an  advanced  stage. 

In  Finland,  draft  legislation  in  particular  addresses  the  future  role  of  the  Parliamentary 
Supervisory  Council  in  monetary  policy,  the  minimum  term  of  office  for  the  Governor  and 
the  grounds  for  dismissal. 

In  Belgium,  the  government  is  planning  to  propose  a comprehensive  reform  of  central  bank 
legislation  in the  near  future.  The draft  law aims at compatibility  between  the  Treaty  and  the 
ESCB  Statute  on  the  one  side  and  the  statute  of the National  Bank  of  Belgium  on the  other. 

12 

REVIEW  OF CENTRAL BANK  LEGISLATION: 
SOME ILLUSTRATIVE  CASES 

Compliance with Article  107 of the Treaty 

The  following  rights  of  third  parties  seem  to  be  at  odds  with  or  to  impinge  upon  the 
prohibitions and commitments formulated  in Article  107: 

a.  A general right to give instructions 

Provisions  which  subordinate  NCBs  to  instructions  are  in  contradiction  with  their 
obligation not to seek or take instructions. 

Section  4 of the Bank  of England  Act2 

"The  Treasury  may from  time  to  time  give  such  directions  to  the  Bank  as,  after 
consultation  with  the  Governor  of  the  Bank,  they  think  necessary  in  the  public 
interest. " 

The  right  to  give  such  instructions  is  also  incompatible  with  the  Treaty,  when  the 
central bank may object but eventually can be  defeated. 

Article  26 of De Nederlandsche Bank  Act 

"1.  The Minister  may, after consultation  with  the Bank  Council, give  such  directions 
to  the  Governing Board  as he  thinks  necessary for  the Bank's policy  to  be  properly 
co-ordinated  with  the  Government's  monetary  and  financial  policies.  Except  as 
in  paragraph  2  below,  the  Governing  Board  shall  comply  with  such 
provided 
directions. 

2.  If  the  Governing  Board  has  any  objections  to  the  directions  as  referred  to  in 
paragraph  I  above,  it  may  communicate  said  objections  to  the  Crown  in  writing 
within  three days of receiving directions.  The Crown shall decide  whether  or not the 
directions are to be complied with. 

3. (...) 

2  As  already  indicated,  the  provisions  of  Protocol  No  11  exempt  the  United Kingdom  from  the 
application  of  Article  107, unless  the  United Kingdom  notifies  that  it  intends  to  move  to  the  third 
stage. 

13 

4. If  the  Crown  decides  that  the  directions  are  to  be complied  with,  the  Governing 
Board's  objections  and  the  decisions  of  the  Crown  shall  be  published 
in  the 
Nederlandsche  Staatscourant,  if  in the  opinion  of  the  Crown  this is not  contrary  to 
the national interest. " 

Article  15 of the Act  on the Bank of Finland 

"The  administration  of  the  Bank  and  management  of  the  affairs  thereof  shall  be 
under  the surveillance  of  the Parliamentary  Supervisory Board  in accordance  with 
this Act and the Regulations  confirmed by Parliament " 

Article  17 of the same Act 

"It is the duty of the Parliamentary Supervisory Board to fix  the base rate of the bank 
and other rates of interest applied by the bank and the limits  thereof. 

b.  A right to approve, suspend, annul or defer a NCB's decision 

Any  such  provisions  constitute  a  right  to  give  instructions  of  a  specific  type;  the 
assessment is the same as for generally formulated rights to give instructions. 

Article  13(2) of the Bundesbank  Act 

"The  members  of  the  Federal  Cabinet  are  entitled  to  attend  the  meetings  of  the 
Central Bank  Council.  They have no right to vote, but may propose  motions. At  their 
request, a decision shall  be deferred for  up to two weeks. " 

c.  A right to censor decisions on legal grounds 

A right of the Government to control the legality of decisions of a central bank seems 
incompatible  with  Article  107. This  also  applies  when  the  Government's  right  can 
only be exerted  indirectly. 

Article  43 of the Organic Law of the Banco de Portugal 

"1.  The Governor shall  have a casting  vote at the meeting which he chairs and  may 
suspend  the  effectiveness  of  the  decisions  taken  by  the  Board  of  Directors  or  by 
executive  committees  which,  in  his judgement 
,  are  contrary  to  the  law,  to  the 
interests of the country  or of the bank. 

2.  The suspension shall  be notified to the Government, through the Finance  Minister, 
and shall be considered  waived, should  the Cabinet not confirm it \\ithin fifteen  days 
after its imposition. " 

14 

d.  A right to participate in decision-making bodies of a NCB with a right to vote. 

A  right  of  third  parties  to  vote  in  decisions  related  to  the  tasks  of  the  ESCB  as 
defined  in  Article  105(2)  is  inconsistent  with  their  commitment  not  to  seek  to 
influence  such decisions. 

Article 14 of the Central Bank Act of Ireland 

"Tlie Bank shall  be conducted  and managed in accordance  with this Act  by a Board 
of Directors  consisting  of  (a)  a  Governor and  (b)  such  number  of  other  Directors 
(not exceeding  nine  and  not  including at any  time  more than  two service  Directors) 
as the Minister shall from  time to time determine.... Every sendee Director  shall  hold 
office  at  the pleasure  of  the  Minister  and  may  be  removed  by  the  Minister  at  any 
time. " 

e.  A right to be consulted  before a NCB takes a decision 

Article  107  of  the  Treaty  does  not,  of  course,  preclude  cooperation  and  dialogue 
between  NCBs  and  government,  parliament  or  other  state bodies.  In  fact  the  Treaty 
provides  for  such  contacts  and  reporting  in  a  number  of  provisions.  The  point  is 
whether the government  avails itself of any formal  mechanism  of which the  purpose 
is  to  influence  the  final  decision  of  the NCB.  An  explicit  duty  to  consult  political 
bodies  prior  to  the  decision  provides  for  such  a  mechanism  and  appears  not  to  be 
compatible with the second sentence of Article 107. 

Article 42 ofSveriges  RiksbankAct 

" Prior to the Riksbank  making  a monetary policy  decision  of major importance,  the 
Cabinet  Minister  appointed  by  the  Government  shall  be  consulted.  If  such 
consultation is not possible  and  there  is exceptional  cause,  the Riksbank  may  make 
such a decision without  consultation. " 

f.  A right to control ex ante the central bank's budget 

As for the previous point, the borderline between constraints to which NCBs must be 
subjected  and  attempts  to  influence  the members  of their decision-making  bodies  in 
the  performance  of  their  tasks  is  not  easy  to  draw  in  each  case.  A  NCB  must,  of 
course,  be  financially  accountable.  On  the  other  hand,  a  requirement  to  have  its 
budget approved beforehand  may  create a situation  where  a NCB  is unable  to  avail 
itself autonomously of the appropriate means to fulfil  its mandate. 

15 

Article  4.2 of  the Law of Autonomy  of the Banco de Espana 

"The Bank's  draft  budget for  operating expenses and  investments, once  approved  by 
its  Governing  Council  according  to  Article  21. lg),  shall  be  submitted  to  the 
Government,  which  will send  it  to  the Spanish parliament for  approval.  The  Bank's 
budget shall  be  estimative  in nature,  and shall  not  be consolidated  with  other  state 
public  sector  budgets. " 

g.  Membership  of members of decision-making bodies in bodies outside the ESCB 

Membership in external bodies may entail conflicts  of interests between the duties vis-
à-vis a NCB (for  Governors additionally vis-à-vis the ECB)  and the external  function. 
However,  it  appears  to  be  difficult  to  establish  a  general  rule  with  respect  to 
compliance  or  non-compliance  of  such  membership  with  Article  107.  The  point  in 
question  is whether  the  member  of  the NCB  body  executes  other  tasks  which  might 
jeopardise his personal independence. 

Article  22 of the Osterreichische Nationalbank Act 

"(3)  Only persons  holding  Austrian  citizenship  who  are  not  debarred from  being 
elected  to  the  National  Council  (Nationalrat)  may  be  members  of  the  General 
Council.  The members  of  the  General Covncil shall  be persons prominent  in  some 
include 
branch  of  economic  activity  or  jurists  or  economists.  They  shall 
representatives  of: 
1. banks; 
2. industry; 
3. trade and small  businesses; 
4. agriculture;  and 
5. salaried employees  and wage-earners. 

(4) No person  who  is in the active service of the Federal Republic  or a Land  or  who 
is  a  member  of  the  Nationalrat,  the  Federal  Government  or  the  government  of  a 
Land  may  be  a  member  of  the  General  Council.  The  restriction  with  regard  to 
persons  in  the  active  service  of  the  Federal  Republic  shall  not  apply  to  university 
professors  in  law  and  economics.  Not  more  than four  members  of  the  General 
Council  may  in  their  main  occupation  be a  member  of  the  management  of  banks; 
such persons  may  not be a  President or Vice President  of the Bank. " 

Compliance with Article  14.2 of the ESCB  Statute 

In Article  14.2 of the  Statute, the security of tenure for Governors is addressed  under  the 
aspect of their term of office  and the grounds for their dismissal. 

16 

a.  Term of office  for  Governors 

Article  14.2 of the Statute requires a minimum term of office  for  Governors, i.e.  five 
years. Consequently, statutes with a shorter term of office  need to be revised. 

Statutes  which  do  not  explicitly  provide  for  a  minimum  term  of  office  meet  the 
minimum term requirement, provided that the grounds for dismissal  are limited to the 
cases specified  in the second sub-paragraph of Article  14.2 of the Statute (see below). 

Article  29 of the statutes  of the Bank of Greece 

"The Governor  and  the Deputy  Governors (...) shall  be appointed  (...)  by  an Act  of 
the  Cabinet, for  a period  of four  years  on proposal  of  the Board  of Directors  of  the 
Bank  (...)." 

The statute of the Banca dTtalia is silent about the term of office  of the Governor and 
about grounds for dismissal. 

Article  19 of the Statute of the Banca  d'ltalia 

"The  Board  of  Directors  may  appoint  and  dismiss  the  Governor,  the  General 
Manager  and the two Deputy  General Managers. " 

Article  7(3) of the Bundesbank  Act 

"The President,  the  Vice-President  and  the  other  members  of  the  Directorate  are 
nominated  by  the  Federal  Cabinet  and  appointed  by  the  President  of  the  Federal 
Republic.  Before  making  such  nominations,  the  Federal  Cabinet  shall  consult  the 
Central Bank  Council. Members  of the Directorate are appointed for  eight years,  or 
in exceptional cases for  a shorter  term of office, but not less than two years. " 

b.  Grounds for dismissal of a Governor 

Article  14.2 of the  Statute  seeks to  avoid the arbitrary  dismissal  of the  Governor  by 
the  authorities  involved  in  the  appointment  procedure.  As  in  this  case  the  Statute 
contains  an  explicit  requirement  on  the  content  of  national 
legislation,  any 
contradictory provision would have to be amended. 

17 

Article  12(3)  of 
Luxembourgeois 

the  Act  on 

the  establishment  of 

the  Institut  Monétaire 

there 

is  a  fundamental  disagreement  between  the  Government  and 

"The Government may propose  to the  Grand-Duke  the dismissal  of the  Management 
if 
the 
Management  over  the policy  of  the Institut  and  the performance  of  its tasks. In  this 
event,  the  proposal  of  dismissal  shall  relate  to  the  Management  collectively. 
Likewise,  the  Government  may  propose  to  the  Grand-Duke  the  dismissal  of  a 
member  of the Management  who becomes permanently  unable  to perform  his duties. 
Before  transmitting a proposal  to the  Grand-Duke,  the Government shall  consult the 
Council of the Institut. " 

Article  44 of the Statutes of the National Bank of Belgium 

"The governor  is appointed and can be dismissed or suspended  by the King. " 

Compliance with Article  105 of the Treaty 

The  requirement  that  the  objectives  of  all  members  of  the  ESCB  must  coincide  with 
Article  105(1)  does  not  imply  the  need  to  copy  in  all  instances  the  wording  of  this 
paragraph into national statutes. In fact,  the formulation  of a central bank's  objectives  is 
quite  disparate  among Member  States.  This to  some  extent reflects  the fact  that  central 
bank  statutes  date from different  decades. However,  any formulation  must  avoid  casting 
doubt as to whether the bank in question is bound by the primary objective  as laid  down 
in the Treaty. 

Article  1 Act  n. 116 on Danmarks  Nationalbank3 

"Danmarks  Nationalbank  shall  have  the  object  to  maintain  a  safe  and  secure 
currency  system  in  this  country,  and  to facilitate  and  regulate  the  traffic  in  money 
and  the extension of credit. " 

Since  Denmark  has  notified  the  Council  that  it  will  not  participate  in  the  third  stage,  there  is  no 
need to adapt the statute of Danmarks Nationalbank in this respect. 

18 

Further statutory requirements to be fulfilled  for NCBs to become an integral part of the 
ESCB 

According to Article 14.3 of the Statute, national central banks are an integral part of the 
ESCB and shall act in accordance with the guidelines and instructions  of the ECB. The 
scope of necessary adaptations of national law - either in central bank statutes or in other 
parts  of law - which this  principle implies will emerge more  clearly  in the  process  of 
preparatory  work  for  the  ECB's  regulatory  framework.  It  is  obvious  that  national 
peculiarities may continue to  exist to the extent that the effectiveness  and uniformity  of 
the single monetary policy are not  affected. 

An example where national  statutory  provisions  do not  respect  the prerogatives  of the 
ECB are rules which provide for  competencies  of government  bodies in the process of 
issuing banknotes. 

19 

3.  PRICE  STABILITY 

3.1 Treaty  provisions 

The price stability criterion  is defined  in the first indent of Article  109j(l)  of the Treaty:  "The 
achievement  of a  high  degree  of price  stability  [...] will  be apparent from  a  rate  of  inflation 
which  is close  to  that  of,  at  most,  the  three  best performing  Member  States  in  terms  of  price 
stability. " 

Protocol No 6 on the convergence  criteria develops Article  109j(l), by stipulating  in Article 1 
that  a Member  State is convergent  in terms of inflation  if it  "has a price performance  that  is 
sustainable  and  an  average  rate  of  inflation,  observed over a period  of  one year  before  the 
examination,  that  does  not  exceed  by  more  than  1'A percentage  points  that  of,  at  most,  the 
three  best performing  Member  States  in  terms of price  stability.  Inflation  shall  be  measured 
by means  of the consumer price  index on a comparable basis, taking into account  differences 
in national definitions. " 

National  consumer  price  indices  (CPIs)  diverge  substantially  in terms  of  concepts,  methods 
and practices. Thus, to meet the requirement of Protocol No 6 that inflation must be measured 
on  a  comparable  basis,  the  Council  adopted  on  23 October  1995  a  framework  Regulation 
(No 2494/95) which provides for a harmonisation of national CPIs in two steps. 

The  first  step  required  for  the  purpose  of  the  report  referred  to  in  Article  109j(l),  i.e.  the 
present document, was the production by March  1996 of a set of so-called "interim  indices  of 
consumer  prices"  (IICPs),  adjusted  to  reduce  differences  in  coverage  of  goods  and  services 
observed between existing national indices. 

The monthly IICPs have been published as from January  1996 with the time series going back 
to  January  1994. As  a  first  step  in the harmonisation  process, IICPs  exclude those  categories 
of  the  national  indices  for  which  existing  practices  differ  most  markedly  across  Member 
States.  As  such,  IICPs  do  not  include  imputed  rents  of  owner-occupied  housing,  health  and 
educational  services,  and  various  other  items  like  mortgage  interest  payments,  financial 
services,  insurance, package  holidays  and  certain  local  authority  services. On the other  hand, 
IICPs  incorporate  some  components,  such  as  prices  of  alcohol  and  tobacco,  which  are 
excluded  from  the  national  CPIs  in  some  Member  States.  Though  not  strictly  comparable, 
IICPs  are  for  the  time  being  considered  to  constitute  a  more  comparable  basis  for  the 
assessment  of inflation  convergence among Member States than the national CPIs. 

The  second  step,  scheduled  for  January  1997, will  be  the  launch  of  comparable  harmonised 
indices  (HICPs)  based  on  common  definitions  and  methods  such  as  the  use  of  a  common 
coverage  of  goods  and  services  for  all  Member  States  and  harmonisation  of  the  reference 
period, standards for sampling, frequency of updating weights, demographic and  geographical 
coverage, etc. 

20 

3.2 Price stability as assessed  by the IICPs 

3.2.1 Recent  trends 

The time series for the IICPs are available only from  January  1994. As a result,  the analysis  of 
the inflation  trend  based  on  this  index  cannot  start  before  January  1995.  Since  early  1995,  a 
general  tendency  towards  lower  and  more  convergent  inflation  has  prevailed.  Inflation  in  the 
Community  as a whole as measured  by the IICP (percentage change on a year  earlier)  stood  at 
2.8%  in January  1995 and  declined  to  2.4% in September  1996. This  figure  is historically  low 
and not far from what could  be called price stability. 

In the  seven Member  States  where  the  annual  inflation  rate was  below  2.5% in January  1995 
(Belgium, Denmark,  Germany, France, Luxembourg, the Netherlands and Finland), the pace  of 
price increases either eased further  or stabilised at a low level during the subsequent  20 months 
(see Graph  3.1).  In three  of the  four  countries where the annual  inflation  rate  ranged  between 
2.5%» and  3% at the beginning  of  1995  (Ireland,  Austria  and  Sweden,  the  exception  being  the 
United Kingdom),  it  edged  down  to  below  2%  in  mid-1996.  The  deceleration  was  most 
noticeable  in  Sweden  where  the  annual inflation  rate  eased  to  below  1%  since  August  of  this 
year.  In  the  United  Kingdom,  progress  towards  price  stability  has  proved  to  be  gradual  and 
somewhat  erratic,  but  the  downward  trend  has  been  confirmed  during  the  course  of  1996, 
despite the context of a sustained recovery and earlier downward pressure on sterling. 

In the remaining Member States, visible progress has been achieved with inflation  performance, 
but the  degree  of price  stability  and  price  convergence is not  yet  satisfactory.  Spain  and  Italy 
experienced  a worrying upward  movement in inflation  during the first half of  1995  due to  both 
the  surge  in import  prices following  the  marked  depreciation  of their  currencies  in the  spring 
and increases in indirect taxation. However,  in both countries inflation  peaked  in the middle  of 
1995  and  since then  a  steady  downward  trend  has  been  clearly  discernible.  Inflation  stood  at 
3.5%o in Italy  and  at  3.6%  in  Spain  in  September  of this year.But  in  Spain  the  deceleration  in 
inflation  has  stalled  in  recent  months,  although  underlying  inflation  (excluding  prices  of 
unprocessed  food  and  energy)  has  continued  to  edge  down.  An upward  blip  in  inflation  also 
took place in Portugal in the spring of last year, but the upturn was much smaller  and  reversed 
more  quickly than in the previous two  countries. However,  after  having  eased  to  close  to  2% 
in March  of this year,  inflation  has accelerated  in recent  months,  reaching  3.2%  in  September. 
In Greece, inflation  has declined  from  10.9% in January  1995 to  8.1% in September  1996, but 
it is still well above the Community average. 

21 

22 

3.2.2 Price convergence  measured against a reference value 

In  this  report,  the  following  operational  definitions  have  been  used  (for  a  discussion  of  the 
issues involved  see the box on the "Calculation  of the inflation  reference  value"). A  Member 
State's  inflation  is measured by the percentage  change 
I  Table  3.1 
in  the  arithmetic  average  of  twelve  monthly  indices 
relative  to  the  arithmetic  average  of  the  twelve 

I 

Inflation  convergence 
(inflation  measured  by the  percentage  change 
in the IICP) 

monthly indices of the previous period*. The  reference 
value  is  calculated  as  the  arithmetic  average  of  the 
inflation  rates  of  the  three  best  performing  Member 
States plus 1.5 percentage points. 

2.7% 

Over  the  period  for  which  a  reference  value  can  be 
calculated2,  the  reference  value  declined  marginally 
in 
in  December  1995 
from 
September  1996  (see  Table 3.1).  Over  the  period 
concerned,  the  composition  of  the  reference  group  of 
the  three  best  performers  shows  little  change.  The 
Netherlands  and  Finland have  invariably  been  part  of 
the group whereas Germany replaced Belgium  as  from 
June 1996. 

2.6% 

to 

two 

other 

countries 

In September  1996, ten Member States had an average 
inflation  rate  below  the  reference  value  (Belgium, 
Denmark,  Germany,  France,  Ireland3,  Luxembourg, 
the Netherlands, Austria,  Finland  and  Sweden),  while 
in 
the 
United Kingdom),  the  average  inflation  rate  was 
0.4 percentage  points  above  the  reference  value.  In 
Spain and Italy, the average inflation rate exceeded the 
reference  value  by  1.2 percentage  points 
and 
2.1 percentage  points,  respectively.  In  the  case  of 
Greece, the  gap from, the reference  value  amounted  to 
5.8 percentage points (see Table 3.2) 

(Portugal 

and 

Interim  indices of 
c o n s u m er  prices 

Three  best 
performers 

"i 

December 
1995 

n 

D 
NL 
FIN 
Reference 
valued) 

1.1 
KO 
2.7 

September 
1996 
-
1.3 
1.2 
0.9 
2.6 

Member States respecting the reference 
value 

I 

9 
15 

ÏÂ 
2.3 
1.5 
1.7 
2.4 
1.9 
1.1 
2.0 
1.0 
- 

10 
Number: 
15 
out of: 
ÏT 
~B 
2.2 
DK 
1.3 
D 
2.1 
F 
2.1 
IRL<3) 
1.3 
L 
1.2 
NL' 
1.7 
A 
0.9 
FIN 
J3 
I  1.6 
(1)  Measured  by the  percentage  change in 
the  arithmetic  average  of  twelve 
monthly  indices  relative to the 
arithmetic  average  of the  twelve 
monthly  indices  of the  previous  period. 

J 

(2)  Definition  adopted  in this  report: 

arithmetic  average  of the  three  best 
performers  in terms  of inflation  plus 
1.5 percentage'points. 

(3) Measured on the basis of quarterly data 
Source: Commission services. 

It should be noted that this measure is different  from  that usually referred  to as the inflation  rate  (calculated 
as the  percentage  change  in  an  index  in  the  latest  month  over  the  index  of  12 months  before),  which  has 
been used in Section 3.2.1. and Graph 3.1. 
The time series  for  the IICP are available  only  from  January  1994. As a result, the earliest  reference  value 
which can be calculated  is for December 1995. 
For Ireland the IICP and national CPI are only available  quarterly. 

23 

better 

convergence 

situation  was 

The 
in 
September  1996  than  in December  1995, when  nine 
countries  enjoyed  average  inflation  rates  below  the 
reference  value,  and  when  the  distance  from  the 
reference  value  in  the  other  countries  was 
larger 
than is currently the case. 

Table 3.2 

The average rate of  inflation 
(measured by IICP; percentage change) 

Interim indices of consumer 
p_rices 

(i) 

December 
1995 
1-4 
2.3 
1.5 
9.0 
4.7 
1.7 
2.4 
5.4 
1.9 
1.1 
2.0 
3.8 
1.0 
2.9 
3.1 

September 
1996(1) 
1.6 
2.2 
1.3 
8.4 
3.8 
2.1 
2.1 
4.7 
1.3 
1.2 
1.7 
3.0 
0.9 
1.6 
3.0 

B 
DK 
D 
EL 
E 
F 
IRL(2) 
I 
L 
NL 
A 
P 
FIN 
S 
UK 

EUR 
(1) Measured by the percentage change in the 

3.0 

2.7 

arithmetic average of twelve monthly indices 
relative to  the arithmetic average of the 
twelve monthly indices of the previous 
period. 

(2) Measured on the basis of quarterly data 
Source: Commission services. 

Graph 3.2 

Interim indices of consumer prices (IICP) 

(Arithme&c average of twelve monthly indices relative to tfee ari&metic average of the 
twelve monâîly indices of the preceding j>erM) 

Percentage change 

li 

HHDec.  1995 
S3 Sep.  1996 

B  DK 

P 

S& 

B 

F  ML 

I 

Ht,  A 

P 

FîN 

S  OK 

* Average of 3 best performers^ 1,5 percentage points. 
Commission services, 
Source: 

24 

3.3 Inflation  performance  during  the second  stage of EMU 

The  limited  time-span  covered  by  the  IICPs  does  not  allow  more  recent 
inflation 
developments to be seen in perspective. To ensure a comprehensive and balanced  examination 
of the degree of price stability and the sustainability  of the inflation  performance,  some  other 
inflation  indicators  must  be  considered,  including  private  consumption  deflators  and  CPIs. 
The box on the "Differences  between IICPs and CPIs" examines the scale of such  differences. 

Developments with regard to private consumption deflators  and CPIs confirm  that  substantial 
progress in inflation  convergence has been achieved in the Community since the start of Stage 
Two  of EMU on  1  January  1994. Between  1993 and  1995, inflation  for  the  Community  as  a 
whole, fell  from  4% to 3%, as measured by the private consumption  deflator,  and  from  VA% 
to 3%, as measured by the CPI. This downward trend has continued  in  1996, with inflation  in 
the  Community  on  average  expected  to  be just  over  IViVo  on  both  measures  this  year  (see 
Table 3.3). 

At the country  level, the picture painted by the evolution of the private consumption  deflator 
and the CPI is similar to that outlined by the IICPs. The decline in inflation  is observed in  all 
the  Community  countries,  although  to  varying  degrees.  During  Stage  Two,  Member  States 
which  have  long  participated  in  the  exchange-rate  mechanism  (ERM)  (Belgium,  Denmark, 
Germany,  France, Ireland,  Luxembourg  and the Netherlands) have consolidated  their  already 
good initial inflation  performances, while the three new Member States (Austria, Finland  and 
Sweden) have converged in terms of price stability towards this first group. 

In the United Kingdom,  the CPI evolution  is strongly influenced  by movements  in  mortgage 
rates. The latter largely explains the drop to  1.6%  in  1993 and the subsequent rise to 3.5% up 
to  1995. Again, most of the slowdown in the CPI inflation  during the first half of  1996 is  due 
to the fall  in mortgage rates. However,  the private consumption deflator  showed an easing  in 
inflation from 3.5% in  1993 to 2.6% in 1995, and it is expected to be slightly lower in 1996. 

25 

Table  3.3 

Private  consumption  deflator  and  consumer  price  index 
(national currency, percentage  change) 

Private consumption 
deflator 

Consumer price index 

1993 

1994 

1995 

3.0 
0.3 
3.9 
13.7 
5.5 
2.2 
1.9 
5.4 
7.0 
2.1 
3.4 
7.1 
4.2 
5.7 
3.5 

3.2 
1.7 
2.7 
10.8 
4.9 
2.1 
2.6 
4.6 
2.4 
2.7 
3.0 
4.8 
1.4 
3.1 
2.5 

1.6 
2.1 
2.0 
9.3 
4.7 
1.7 
2.0 
5.8 
2.0 
0.9 
2.3 
4.2 
0.2 
2.7 
2.6 

4.1 
0.73 
0.62 

3.3 
0.63 
0.35 

3.0 
0.75 
0.48 

1996 
0) 
2.0 
2.0 
1.8 
8.5 
3.6 
1.9 
2.0 
3.9 
1.7 
1.9 
2.0 
3.3 
0.9 
1.7 
2.5 

2.6 
0.66 
0.34 

1993 

1994 

1995 

Sep. 96 
(2) 

2.8 
1.3 
3.6 
14.4 
4.6 
2.1 
1.4 
4.5 
3.6 
2.6 
3.6 
6.4 
2.2 
4.6 
1.6 

3.4 
0.85 
0.49 

2.4 
2.0 
2.7 
10.9 
4.7 
1.7 
2.3 
4.0 
2.2 
2.8 
3.0 
5.2 
1.1 
2.2 
2.5 

1.5 
2.1 
1.8 
9.3 
4.7 
1.8 
2.6 
5.2 
1.9 
1.9 
2.2 
4.1 
1.0 
2.5 
3.4 

1.8 
2.0 
1.6 
8.6 
3.8 
2.1 
1.8 
4.6 
1.3 
1.9 
1.8 
3.3 
0.5 
1.2 
2.6 

3.1 
0.68 
0.40 

3.1 
0.66 
0.41 

2.7 
0.74 
0.43 

0.59 

0.59 

0.76 

0.63 

0.81 

0.63 

0.67 

0.66 

B 
DK 
D 
EL 
E 
F 

BRL 
I 
L 

NL 
A 
P 

FIN 
S 
UK 

EUR 

CV 
CVERM 
CV 
Non-ERM 

(1) Autumn 1< 
(2)  Measured 
twelve mo 
monthly ir 
CV =  Coeffici 
of the data). 
CV  ERM is  t 
P for  1993  an< 
1996. 
The Non-ERN 
included  in th 
Source: Comn 

?96 economic forecasts. 
by the percentage change in the arithmetic average of 
nthly indices relative to arithmetic average of the twelve 
idices of the previous period. 
ent of variation (ratio of the standard deviation to the mean 

le coefficient  of variation for ; B, DK, D, E, F, IRL, L, NL, 
i  1994. A is included in 1995 and 1996. FIN is included in 

1 includes EL, I, UK for 1993 and 1994. FIN and S are 
e CV Non-ERM for 1995 and S also for 1996. 
lission services. 

the 

Portugal), 

a 
has 

In 
remaining  Member 
States  (Spain,  Greece,  Italy 
clear 
and 
improvement 
been 
observed  since  1993,  but  in 
Spain 
the 
and  Portugal 
downward  trend  in  inflation 
was  interrupted  in  the  spring 
of 1996. 

inflation 

measure 

throughout 
has 

The  generalised  reduction  in 
the 
inflation 
been 
Community 
accompanied  by  a  narrowing 
in 
differentials 
between  Member  States.  One 
indication  of  how  inflation  in 
the Member  States has tended 
to  converge is provided by the 
coefficient  of  variation4 
,  a 
statistical 
of 
dispersion.  The  coefficient  of 
inflation, 
variation 
for 
the  private 
measured  by 
consumption 
deflator, 
declined  from  0.73  in  1993  to 
the 
1996 
0.66 
Community  as  a  whole.  The 
convergence  process has  been 
even  greater  within  the  ERM 
group,  with  the  coefficient  of 
variation  declining  from  0.62 
in  1993  to  0.34  in  1996.  On 
the  other  hand,  substantially 
greater variability continues  to 
characterise 
inflation  within 
the non-ERM group. 

for 

in 

The coefficient  of variation shows the dispersion of individual Member State's inflation around the average 
rate of inflation for each year; the higher the value, the greater the dispersion of inflation in any given year. 

3.4 The sustainability of price convergence 

26 

The process of inflation  convergence which has been evident in the Community for more than 
a decade results in large part from fundamental  changes in the attitude of all  economic  actors 
towards  inflation. 

The most important structural change has undoubtedly been the determined implementation  of 
monetary  policies  targeted  at  price  stability.  Several  Member  States  have  adopted  explicit 
inflation targets, or indirect objectives  (like a money growth target or an exchange rate target), 
and accordingly they have conducted their monetary policies credibly. 

Institutional  changes  such  as the prohibition  of  central bank financing of budget  deficits  and 
the prohibition of privileged access of the public sector to financial  institutions (which  entered 
into  force  with  the  start  of  Stage  Two)  as  well  as  the  granting  of  independence  to  central 
banks  (as  required  by  the  Treaty  by  the  end  of  Stage  Two,  see  Chapter 2)  have  helped  to 
strengthen  the  effectiveness  and  credibility  of  a  stability-oriented  monetary  policy  in  the 
Member States. 

Besides  its  direct  effect  on  inflation,  monetary  policy  also  exerts  a curbing  impact  on  price 
increases through its influence  on economic agents' behaviour. By remaining firm on an anti-
inflation  policy,  monetary  authorities  raise  the  credibility  of  price  stability  objectives  and 
strongly  contribute  to  reduce  inflation  expectations.  Nominal  wage  moderation  has  been 
progressively achieved over the past ten years (see section 7.4.1). This trend suggests that  the 
Social  Partners  have  increasingly  internalised  the  price-stability  objective  in  their  wage 
settlements. 

But other key structural factors  have contributed  importantly to the low inflation  environment 
currently prevailing in the Community. The completion of the single market has exerted - and 
will  continue  to  do  so -  downward  pressure  on  price  inflation  at  the  firm  and  sectoral  level 
mainly  through  two  channels.  Firstly,  the  removal  of  national  trade  barriers  has  increased 
competition  in  many  markets  for  goods  and  services,  with  a  subsequent  squeeze  of  rents 
which  resulted  from  imperfect  market  situations.  Secondly,  greater  competition  has  also 
induced  a  more  efficient  allocation  of  resources  within  the  Community,  fostering  the 
efficiency  of  the  supply  side.  Production  costs  have  thus  been  curbed,  with  an  obvious 
downward impact on prices. 

Since the  1980s,  most  Member  States  have  re-oriented  their  budgetary  policy.  The  use  of 
discretionary  budgetary  instruments  for  regulating  economic  activity  has  been  increasingly 
regarded  as  inefficient  and  even  damaging,  as  persistent  excessive  deficits  and  the 
accumulation  of  public  debt  have  been  accompanied  by  serious  adverse  supply-side  and 
inflation  effects.  Initially, the success of  budgetary consolidation policies was mixed, but,  in 
recent years,  efforts  to  reduce  budget  deficits  have  intensified  and  have proved  to  be  more 
credible,  as  examined  in  Chapter 4.  The  shift  towards  greater budgetary  discipline,  aimed  at 
balanced positions in the medium term, has  fostered  low and stable inflationary  expectations, 
thereby  facilitating  the  task  of  monetary  policy  to  achieve  and  maintain  price  stability  with 
lower interest rates. 

27 

Beside structural factors, cyclical forces have also helped to bring about the current  favourable 
inflation  performance  in the Community.  The persistence of output levels below  full  capacity 
has  exerted  a  strong  disincentive  for  companies  to  raise  prices  or  to  allow  significant  wage 
increases. 

28 

CALCULATION  OF THE INFLATION REFERENCE  VALUE 

Protocol No 6 states that the inflation  reference value should be calculated  on the basis of  "an 
average  rate  of  inflation,  observed  over  a period  of  one  year  of,  at  most,  the  three  best 
performing  States ' '. 

As to the question of the average, in this report preference  is given to  an arithmetic average  as 
opposed  to  a  geometric  one  as  it  is  the  most  commonly  used  method.  Furthermore,  the 
difference  between the arithmetic and geometric  average is very  small,  especially if inflation  is 
low. 

Regarding  the period  of one year,  two main approaches  are possible:  either using the  year-on-
year  change  of  a monthly  indicator  (for  instance,  September  1996/September  1995),  or  using 
the  average  change  of  the  last  twelve  months  over  the  preceding  twelve  months.  The 
advantage  of  the  first  approach  is  that  it  is  straightforward  and  easy  understandable.  But 
disadvantages  outweigh  this  advantage.  Indeed,  results  may  vary  importantly  from  month  to 
month,  because  of  possible  base  effects  due  for  instance  to  changes  in  indirect  taxes. 
Furthermore,  and  more  importantly,  as  the  criterion  should  assess  the  sustainability  of  price 
stability  and  of  inflation  convergence,  taking  into  account  a  longer  period  seems  more 
appropriate. 

Concerning  the  number  of  countries  to  be  included  in  the  calculation  of  the  reference  value, 
different  approaches  are  conceivable.  A  first  group  takes  one  country  to  calculaate  the 
reference value: 

Method  1: the best performing  country  +1.5 percentage  points. 

Method  2:  the second best performing  country +1.5 percentage  points. 

Method  3: the third best performing  country +1.5 percentage  points. 

A second group of interpretations would take an average of two or three countries: 

Method  4:  an  unweighted  average  of  the  two  best performing  countries  +1.5 percentage 

points. 

Method  5: 

the unweighted average  of  the three  best performing  countries  +1.5 percentage 
points. 

Method  6:  a  weighted  average  of  the  three  best  performing  countries  +1.5 percentage 

points. 

29 

Table  3.4 

Inflation  convergence  according  to alternative  methods  for  the calculation  of the  reference  value, 
ncp 

December  1995  0) 

September  1996(I) 

Reference 
value 

Number  of 
member  states 
respecting  the 
reference  value 
(?) 

Reference 
value 

Number  of 
member  states 
respecting  the 
reference  value 
(3) 

1. The best performing  country 
+1.5 percentage points. 

2. The second  best performing  country 

+1.5 percentage points. 

3.  The third  best performing  country 

+ 1.5  percentage  points. 

4. The two best performing  countries, 

unweighted  average 
+1.5 percentage points. 

5. The three best performing  countries, 

unweighted  average 
+1.5 percentage points. 

6. The three best performing  countries, 
weighted® average +1.5 percentage 
points. 

2.5 

2.6 

2.9 

2.5 

2.7 

2.7 

9 

9 

9 

9 

9 

9 

2.4 

2.7 

2.8 

2.6 

2.6 

2.8 

10 

10 

10 

10 

10 

10 

(1) Measured  by the percentage change in the arithmetic average of twelve monthly indices relative to the 

arithmetic average of the twelve monthly indices of the previous period. 

(2) Weighted  according to shares of  private consumption in  1995 at current prices, PPS. 
(3)  9 countries respecting the reference  value in December  1995: B, DK, D, F, KL, L, NL, A, FIN. 

10 countries respecting the reference  value in September  1996: B, DK, D, F, ERL, L, NL, A,-FIN, S. 

Source:  Commission  services. 

A reference  value has been calculated  according to these six methods both for  December  1995 
and  for  September  1996.  For  the  purpose  of  this  report,  the  Commission  has  adopted 
method  5.  Table 3.4  shows  that  the  number  of  countries  with  inflation  below  the  reference 
value is the same, both in December  1995 and in September  1996, whatever the method used. 

These  results  may be  explained  by two  factors.  First,  there is an important  group  of  countries 
which  has  achieved  low  and  convergent  inflation  in  a  sustained  way.  As  a  result,  neither  the 
number of countries taken into account nor the composition of the reference  group has a major 
effect  on  the  magnitude  of  the  reference  value.  Secondly,  the  inflation  performance  of  the 
remaining  Member  States  is  still  too  distant  from  the  low  inflation  group  such  that  small 
variations in the reference  value do not a1low these countries to be below the reference value. 

30 

DIFFERENCES  BETWEEN IICPS AND CPIS 

The  differences  between  IICPs  and  CPIs  depend  very  much  on  the  existing  structure  of 
national CPIs. 

For  countries  where  the  CPIs  incorporate  items  like  health  care  or  imputed  rents  on  owner-
occupied  housing,  the  IICPs  will  tend  to  be  lower  than  the  CPIs  as  the  prices  of  these  items 
tend  to rise faster  than those  of internationally  traded  goods.  On the  other  hand,  for  countries 
where  alcohol  and  tobacco  prices  are  excluded  from  the  CPIs,  the  difference  with  the  IICPs 
will be positive as price increases  on these goods  are typically  higher  than  average.  Countries 
where  mortgages  are  included  in  the  national  CPIs  will  see  erratic  differentials.  At  the 
Community level and for  a number  of countries,  differences  between the CPI  and the IICP  are 
minor, with the discrepancy in the range of ±0.1 percentage point to ±0.3 percentage point  (see 
Table 3.5).  But  for  some  countries,  differences  vary  from  ±XA percentage  point  to  nearly 
1 percentage point (Ireland, the Netherlands, Finland,  Sweden and the United Kingdom). 

Table 3.5 

. 

B 
DK 
D 
EL 
"E 
F 
IRL(3) 
I 
L 
NL 
A 
P 
FIN 
S 
UK 

EUR 

Difference between IICPs and CPIs 
( percentage change) 

1995(1) 
CPI 

IICP 

1.4 
2.3 
1.5 
9.0 
4.7 
1.7 
2.4 
5.4 
1.9 
1.1 
2.0 
3!8 
1.0 
2.9 
3.1 

3.0 

1.5 
2.1 
1.8 
9.3 
4.7 
1.8 
2.6 
5.2 
1.9 
1.9 
2.2 
4.1 
1.0 
2.5 
3.4 

3.1 

Difference 
ncp-cpi 
-0.1 
0.2 
-0.3 
-0.3 
0.0 
-0.1 
-0.2 
0.2 
0.0 
-0.8 
-0.2 
-0.3 
0.0 
0.4 
-0.3 

-0.1 

ncp 

1.7 
2.3 
1.4 
8.9 
3.4 
2.5 
2.1 
4.4 
1.3 
1.5 
1.8 
2.1 

1.1 
1.5 
3.0 

2.7 

March 1996(2) 
CPI 

September 1996(2) 
CPI 

ncp 

Difference 
n cp  - CPI 
-0.3 
0.2 
-0.3 
-0.2 
0.0 
0.2 
0.1 
-0.1 
0.1 
-0.6 
0.0 
-0.3 
0.5 
0.0 
0.3 

0.0 

2.0 
2.1 
1.7 
9.1 
3.4 
2.3 
2.0 
4.5 
1.2 
2.1 
1.8 
2.4 
0.6 
1-5. 
2.7 

2.7 

Difference 
HCP - CPI 
0.2 
0.2 
-0.1 
-0.4 
0.0 
0.0 
0.8 
0.1 
0.1 
-0.6 
0.2 
-0.2 
0.6 
0.7 
0.8 

0.1 

2.1 
2.5 
1.3 
8.1 
3.6 
1.6 
2.2 
3.5 
1-5 
1.4 
2.2 
3.2 
1.2 
0.6 
2.9 

2.4 

1.9 
2.3 
1.4 
8.5 
3.6 
1.6 
1.4 
3.4 
1.4 
2.0 
2.0 
3.4 
0.6 
-0.1 
2.1 

2.3 

(1) Annual percentage change. 
(2) Percentage on a year earlier, T/T-l2. 
(3) Measured on the basis of quarterly data. 
Source: Commission services. 

the 

influence 

Furthermore, 
inflation 
since 
criterion  is  defined  in  relative  and  not 
in absolute terms, the use of the  IICPs 
does  not  significantly 
the 
results.  As  indicated  in  Table 3.6,  the 
the 
number  of  countries  respecting 
reference  value  does  not  differ  if  the 
CPI 
instead  of  the  IICP. 
However,  the  group  of  the  three  best 
performing  countries is  different. 

is  used 

31 

Table  3.6 

Inflation  convergence  using  IICPs  and  CPIs 
(percentage  change) 

Interim  indices  of 

consumer  prices  ( ') 

Consumer  Price  Index 
(1) 

Three  best 
performers 

B 
D 
F 
NL 
L 
FIN 
S 
Reference 
valued) 

Dec. 
1995(1) 
1.4 

Sep. 
(i) 

1996 

1.3 

1.2 

0.9 

2.6 

1.1 

1.0 

2.7 

Dec. 
1995(I) 
1.5 

1.8 

1.0 

2.9 

Member  States  respecting  the reference  value 

9 
15 

1.4 
2.3 
1.5. 
1.7 
2.4 
1.9 
1.1 
2.0 
1.0 

10 
15 

1.6 
2.2 
1.3 
2.1 
2.1 
1.3 
1.2 
1.7 
0.9 
1.6 

10 
15 
1.5 
2.1 
1.8 
1.8 
2.6 
1.9 
1.9 
2.2 
1.0 
2.5 

Number: 
Out  of: 
B 
DK 
D 
F 
ERL(3) 
L 
NL 
A 
FIN 
S 
(1)  Measured  t 
of twelve n 
twelve mor 
(2)  Defmition 
three best ] 
points. 
(3)  Measured < 

y the percentage change in the arithmetic average 
lonthly indices relative to arithmetic average of the 
ithly indices of the previous period, 
adapted in this report: arithmetic average of the 
jerformers  in terms of inflation  plus  1.5 percentage 

an the basis of quarterly data. 

Source:  Commi. 

ssion services. 

Sep. 
(i) 

1996 

1.3 
0.5 
1.2 
2.5 

10 
15 

1.8 
2.0 
1.6 
2.1 
1.8 
1.3 
1.9 
1.8 
0.5 
1.2 

32 

4. GOVERNMENT  BUDGETARY  POSITION 

4.1  Existence of an excessive  deficit 

Fulfilment  of  the  criterion  on  the  sustainability  of  the  government  financial  position 
depends,  as  the  second  indent  of  Article  109j(l)  makes  clear,  on  a  Member  State 
having achieved  a government budgetary  position without  a deficit  that is excessive  as 
determined  in  accordance  with  Article  104c(6).  Protocol  No 6  on  the  convergence 
criteria further  states, in Article 2, that: 

"The criterion on the government  budgetary position  referred to in the second  indent 
of Article  109j(l)  of  this  Treaty shall  mean  that  at  the  time  of  the  examination  the 
Member  State  is  not  the  subject  of  a  Council decision  under Article  104c(6)  of  this 
Treaty that an excessive deficit  exists". 

The  role  of  this 
report,  therefore,  is  not  to  make  an  independent  assessment  of 
whether  or  not  Member  States  currently  fulfil  the  criterion  on  the  government 
budgetary  position.  This  is  already  determined  by  the  Council  decisions  on  the 
existence  of  an  excessive  deficit.  The  first  section  of  this  chapter  describes  the 
application of the excessive deficit  procedure during the second  stage of EMU  and  the 
decisions  on the  existence  of  an  excessive  deficit  which  are  currently  in force.  In  the 
remaining  sections  of  this  chapter  recent  budgetary  developments  in  the  Member 
States are reviewed. 

The provisions  of the  excessive  deficit  procedure  (Article  104c with the  exception  of 
paragraphs  1,9,  11 and  14, together with the associated Protocol (No 5)) have applied 
since the beginning  of the  second  stage  of EMU  in January  1994.  The  practice  since 
then  has  been  for  the  Commission  and  Council  to  implement  the  procedure  on  an 
.annual basis. Each year the various steps of the procedure have been applied  following 
the  March  reporting  of  budgetary  data  by  Member  States  (as  required  by  Council 
Regulation (EC) No 3605/93). The box on the "Excessive deficit  procedure"  describes 
the main features of the procedure during the second stage. 

In the  first  application  of  the  procedure  in  1994  the  Council  decided1  in  accordance 
with Article  104c(6)  on the  existence  of  an excessive  deficit  in ten  of the  then  twelve 
Member  States. Only Ireland  and Luxembourg were not the subject  of such a decision: 
in Ireland the government  deficit was below the reference value of 3%  of GDP  and the 
government  debt  ratio,  while  above  the  reference  value  of  60%  of  GDP,  had  been 
declining  significantly;  in Luxembourg  the government  balance was  in  surplus  and  the 
debt  ratio  was  far  below  the  reference  value.  All the  other  ten  Member  States  were 
judged not to satisfy  one or both of the criteria for government deficit  and debt. 

In  1995 the  procedure  was  applied  for  the first time to  the three  new Member  States 
(Austria,  Finland  and  Sweden)  and  the  Council  decided2  that  an  excessive  deficit 

Council  decisions  of  26  September  1994.  None  of  the  documents  for  the  application  of  the 
procedure has been published in the Official  Journal. 
Council decisions of  10 July 1995. 

33 

existed  in  each  of  them.  At  the  same  time  the  Council  decided3  in  accordance  with 
Article  104c(12)  to  abrogate  the  decision  on  Germany:  the  government  deficit  in 
Germany  had  fallen  below  the  reference  value  in  1994  and  was  expected  then  to 
remain  below  in  1995,  and  the  government  debt  ratio  remained  below  the  reference 
value. 

In the application of the procedure in  1996 the Council adopted  a new decision4  on the 
existence  of  an  excessive  deficit  in  Germany:  as  it  had  turned  out,  the  government 
deficit  in Germany rose above the reference  value in  1995 and was  expected  to  remain 
above  in  1996.  The  Council  also decided5  to  abrogate  the  decision  on  Denmark:  the 
government  deficit  in  Denmark  fell  well  below  the  reference  value  in  1995  and  was 
expected  to  remain  at  a  low  level  in  1996,  and  the  government  debt  ratio,  while  still 
above the reference value, declined  significantly in  1994 and  1995. 

Thus  twelve  Member  States  are  currently  the  subject  of  a  Council  decision  that  an 
excessive  deficit  exists.  At  present,  only  three  Member  States  (Denmark,  Ireland  and 
Luxembourg)  are  not  the  subject  of  such  a  decision  and  so  fulfil  the  criterion  on  the 
government budgetary position. 

Graph 4.1 

General government deficit 
(%o£GDF) 

B  DK  D 

EL 

E 

F 

rci, 

Î 

t  w,  A 

? 

if 

s 

ii 

Source iC<imm$$i0û servfcç& 

4.2 Budgetary  developments  in 1996 

Efforts  at  budgetary  consolidation  in  1996  have  been  made  within  the  context  of  a 
pause  in  economic  growth.  The  Commission  services  forecast  real  GDP  growth  of 
1.6%  this  year  for  the  European  Union  as  a  whole,  and  growth  rates  below  this 

3  Council decision of  10 July 1995. 
4  Council decision of 27 June  1996. 
5  Council decision of 27 June  1996. 

34 

average  are  expected  for  Belgium,  Germany,  France,  Italy  and  Austria.  Despite  the 
unfavourable  economic  climate  almost  all  Member  States  are  expected  to  make 
further  progress  in  reducing  government  deficits  in  1996.  According  to  the  latest 
forecasts  of the  Commission  services  (see Table 4.1  and  Graph 4.1),  only  Germany  is 
likely to see a widening of its deficit  in  1996. In all the other Member States and in the 
European  Union  as  a  whole  the  deficit  is  expected  to  decline  (in  Luxembourg,  the 
surplus is likely to be smaller). Particularly large reductions in the deficit  of  more than 
1%  of  GDP  are  likely  in  Greece,  Spain,  the  Netherlands,  Austria,  Portugal,  Finland, 
Sweden and the United Kingdom. 

Table 4.1 

General government  deficit 
(%ofGDP) 

1993 

1994 

1995 

1996(1) 

B 
DK 
D 

EL 
E 
F 

IRL 
I 
L(2) 

NL 
A 
P 

FIN 
S 
UK 

EUR 

7.5 
3.9 
3.5 

14.2 
6.8 
5.6 

2.4 
9.6 
-1.7 

3.2 
4.2 
6.9 

8.0 
12.3 
7.8 

6.2 

5.1 
3.5 
2.4 

12.1 
6.3 
5.6 

1.7 
9.0 
-2.6 

3.4 
4.4 
5.8 

6.2 
10.8 
6.8 

5.4 

4.1 
1.6 
3.5 

9.1 
6.6 
4.8 

2.0 
7.1 
-1.5 

4.0 
5.9 
-  5.1 

5.2 
8.1 
5.8 

5.0 

3.3 
1.4 
4.0 

7.9 
4.4 
4.0 

1.6 
6.6 
-0.9 

2.6 
4.3 
4.0 

3.3 
3.9 
4.6 

4.4 

State 

achieved 

On present estimates, it seems 
likely  that  in  1996  one  more 
Member 
(the 
Netherlands)  will  succeed  in 
reducing  its  deficit  to  below 
the  3%  of  GDP  reference 
value,  thus  joining  the  three 
Member  States  which  have 
this 
already 
- Denmark, 
and 
surplus). 
Luxembourg 
Two Member States (Belgium 
and  Finland)  are 
to 
achieve  a  deficit  of  between 
3%  and  VA%  of  GDP  this 
year 
six 
a 
(Germany,  Spain,  France, 
and 
Austria, 
Sweden) are expected to  have 
a deficit below 41/2% of GDP. 

Ireland 
(in 

Portugal 

further 

likely 

and 

(1 ) Autumn 1996 economic forecasts. 
(2) Negative sign indicates a surplus 
Source: Commission services. 

Persisting government  deficits 
and  relatively  low  growth  of 
nominal  GDP  (due  to  both 
poor  real  growth  and  a  good  or  improving  inflation  performance)  imply  that  the 
government gross  debt ratio, all other things being equal, is likely to  continue rising in 
several Member  States in  1996 and  in the European  Union  as a whole  (see Table  4.2 
and  Graph  4.2).  However, 
the 
Netherlands, Portugal and Sweden the debt ratio is expected to decline this year. 

in  Belgium,  Denmark,  Greece,  Ireland,  Italy, 

35 

Table 4.2 

General government gross debt 
(%ofGDP) 

Level 

B 
DK(2) 
D(3) 

EL 
E 
F 

IRL 
I 
L 

NL 
A 
P 

FIN 
S 
UK 

1993 
137.0 
80.1 
48.2 

111.8 
60.5 
45.6 

94.5 
119.3 
6.2 

80.8 
62.8 
68.2 

57.3 
76.0 
48.5 

1994 
135.0 
76.0 
50.4 

110.4 
63.1 
48.4 

87.9 
125.5 
5.7 

77.4 
65.1 
69.6 

59.5 
79.3 
50.4 

1995 
133.7 
71.9 
58.1 

111.8 
65.7 
52.8 

81.6 
124.9 
6.0 
79.7 
69.0 
71.7 

59.2 
78.7 
54.1 

1996(1) 
130.6 
70.2 
60.8 

94/93 
-2.0 
-4.1 
2.2 

Change 

95/94 
-1.3 
-4.1 
7.7 

110.6 
67.8 
56.4 

74.7 
123.4 
7.8 

78.7 
71.7 
71.1 

61.3 
78.1 
56.3 

-1.4 
2.6 
2.8 

-6.6 
6.2 
-0.5 

-3.4 
2.3 
1.4 

2.2 
3.3 
1.9 

1.4 
2.6 
4.4 

-6.3 
-0.6 
0.3 
2.3 
3.9 
2.1 

-0.3 
-0.6 
3.7 

96/95 
-3.1 
-1.7 
2.7 

-1.2 
2.1 
3.6 

-6.9 
-1.5 
1.8 

-1.0 
2.7 
-0.6 

2.1 
-0.6 
2.2 

66.1 

71.3 
EUR 
(1) Autumn 1996 economic forecasts. 
(2)  Government deposits with the central bank, government holdings of non 

68.1 

3.2 

73.5 

2.0 

2.2 

governmental bonds and public enterprises related debt amounted to some 
18  percent of GDP in 1995. 

(3)  The sharp increase in the German debt ratio in 1995 is mainly caused by 

the take-over by the government of off-budget  unification-related 
liabilities, the most important of which is the debt of the 
'Treuhandanstalt". 

Source: Commission services. 

level 

ratio 
by 

At  the  end  of  1996 
is 
the  debt 
expected 
the 
Commission 
services to be below 
the  60%  of  GDP 
reference  value 
in 
Member 
three 
-  France, 
States 
Luxembourg 
and 
the 
United 
Kingdom.  The  debt 
ratio  is likely  to  rise 
the 
to  just  above 
60% 
in 
and 
Germany 
Finland  and  to  be  in 
the  range  between 
60 and 70% of GDP 
also 
In 
in  Spain. 
Ireland, 
Denmark, 
Netherlands, 
the 
Portugal 
Austria, 
and  Sweden 
the 
debt  ratio  is  likely 
to  be  in  the 
between 
70 
80% 
Finally, 
Member 

range 
and 
GDP. 
three 
States 

of 

in 

(Belgium, Greece and Italy) the debt ratio will remain higher than  110% of GDP. 

Graph  4.2 

General government gross debt 

& » K D £ L fc 

? 

StCL 

ï 

L 

XL 

A 

1?  m 

"$ 

V& 

jfouror; 

ûomnu $KK>8 services 

' • " " • •f 

11 

36 

4.3 Progress with budgetary consolidation  during the second stage of EMU 

At  the  beginning  of  the  second  stage  of  EMU  budgetary  positions  in  most  Member 
States were in very serious imbalance; deficits  had risen in many cases to record  levels 
in  1993  as a result of the  sharp recession  and  debt  ratios  were  on  an upward  trend  in 
all Member  States except Ireland and Luxembourg. 

During  the  last  three  years  efforts  by  Member  State  governments  at  budgetary 
consolidation have been intensified  on a broad  front.  There has been a rising  awareness 
of  the  risks  for  inflation,  interest  rates  and  economic  growth  from  uncorrected 
budgetary imbalances generating debt trends which are very difficult  to reverse. During 
this  period  financial  markets  have  tended  more  clearly  to  attach  a  risk  premium  to 
countries with untackled budgetary problems. In addition,  policy in the Member  States 
has  drawn  support  from  the  need  for  a  high  degree  of  convergence  in  view  of  the 
single currency. 

All  the  Member  States  with  high  levels  of  deficits #have  adopted  ambitious  medium-
term  programmes  for  budgetary  consolidation.  Reducing  budgetary  imbalances  is  at 
the  core  of the  convergence  programmes  presented  by Member  States  at  Community 
level. 

Although  in  several  cases  progress  has  not  been  as  rapid  as  originally  planned  and 
there have been a few  setbacks, the experience since  1993 in most  Member  States  has 
been  one  of  steady  narrowing  of government  deficits  (see  Table 4.1  and  Graph 4.3). 
The  only exceptions are Germany, where after  the  deficit  declined  in  1994  it has risen 
again  in  both  1995  and  1996,  Spain,  where  the  deficit  increased  in  1995  before 
declining  again in  1996, the Netherlands, where the  deficit  widened  in  1994 and  1995 
before  declining  in  1996,  and  Austria,  which  also  saw  its  deficit  continue  to  rise  in 
1994 and  1995 before  a reduction in  1996. The  surplus  in Luxembourg  has  fluctuated 
from year to year. 

Especially  large  deficit  reductions  of  over  4%  of  GDP  have  been  achieved  between 
1993 and  1996 in Belgium,  Greece, Finland and  Sweden, while reductions  of between 
2% and 4% of GDP have been seen in Denmark,  Spain,  Italy, Portugal  and the United 
Kingdom.  Nonetheless  many  of  these  countries  started  from  very  high  deficits  and 
have  not  yet  reached  satisfactory  deficit  levels.  Although  the  short-term  focus  is  on 
bringing  deficits  down  to  3% of  GDP,  this  has  to  be  seen  as  only  a  step  on  the  way 
towards re-establishing  sound budgetary positions. As shown by the recent  discussions 
about  a  stability  pact  on  which  proposals  were  adopted  by  the  Commission  on 
16 October  1996, the  3% of  GDP  deficit  reference  value  is  to  be  considered  not  as a 
target but as a ceiling; it would be appropriate for Member States to aim in the medium 
term for  budgetary  positions  close to  balance or in surplus  so  as to  foster  growth  and 
employment. 

Graph  4.3 

Government deficit and debt ratios - 1993-96 
(%ofGDP) 

&^ - - < - - °B 

#' 

01993 
*1994 
•1995 
#1996 

soi 

GR 

. .* — -«--€> 

IRLl 

V 

i  DK 

-^r 

#' 

#-  — 

^ —Q 

* * © *L 

A 

* > ©D 

^  %F 

Debt 

SIB 

120 

110 

100 

90 

80 

70 

60 

50 

40 

-1 

0 

1 

2 

3 

4 

5 

6 

7 

8 

9 

10 

11 . 

12 

13 

14 

15 

Deficit 

-B-

- * ~- ^ ~.  O 

#-<£t 

."f-JÈl-^-OP 

#•  _l<f 

# - « --

- -©  FIN 

* ^ 0 UK 

01993 
*1994 
D1995 
#1996 

Debt 

100 

90 

80 

70 

60 

50  h 

40 

30  h 

20 

10 I-

0 

-3 

-

2

-

10 

1 

Source:  Commission services. 

5 

Deficit 

10 

11 

12 

: 13 

38 

4.3.1 Influence  of  the economic cycle 

Just  as  deficits  in  1993  were  swollen  by  the  impact  of  recession,  so  part  of  the 
improvement  in  deficits  since then  can be ascribed  to  the  effects  on  spending  and  tax 
revenues of the recovery in economic activity. In  1994 and  1995 more than half of the 

f| Graph 4.4 

Actual and cyclically adjusted government deficit - EUR 

(%ofGDP) 

—Actual deficit 
•••Cyclically adjusted  deficit 

mm-

I9«0 

©82 

39S4 

WM 

mm  mmm 

®&m 

MM 

mm 

jj  Saurce^Commts^on. $emce$ 

deficit  reduction  in  the  EU  as  a  whole  can  be  ascribed  to  these  cyclical  influences, 
according to  the prudent  cyclical adjustment  method used by the  Commission  services 
(see Table 4.3  and  Graph 4.4). Between mid-1995  and mid-1996 there was  a pause in 
growth  which  has  generally  depressed  GDP  growth  rates  for  1996  and  in  several 
countries has had  an adverse impact on budget balances. According to latest estimates, 
while for  the EU  as a whole a reduction  of 0.6%  of GDP in the government  deficit  is 
expected in 1996, cyclical influences  have had a negative impact on this figure of 0.2% 
of GDP, and the decline in the cyclically adjusted  deficit  is estimated  at 0.8% of GDP. 

39 

Table  4.3 

Table 4.4 

Changes from  previous year in the actual  and 
cyclically  adjusted  general  government  deficit 
(%  of GDP) 

Change in  deficit 

1994 

1995 

1996 

-2.3 
-0.4 
-1.0 

-2.1 
-0.4 
0.0 

-0.7 
-0.5 
-1.0 

0.2 
0.2 
-1.1 

-1.8 
-1.5 
-1.0 

-0.7 

-1.0 
-1.8 
1.1 

-3.0 
0.3 
•  -0.8 

0.3 
-1.9 
1.1 

0.7 
1.5 
-0.7 

-1.0 
-2.7 
-1.0 

-0.4 

-0.8 
-0.2 
0.5 

-1.2 
-2.2 
-0.8 

-0.4 
-0.5 
0.6 

-1.4 
-1.6 
-1.1 

-1.9 
-4.1 
-1.1 

-0.6 

B 
DK 
D 

EL 
E 
F 

IRL 
I 
L ( l) 

NL 
A 
P 

FIN 
S 
UK 

EUR 

Cyclical adjustment  of government deficit  in 
1996 
(% of GDP) 

Government 

Cyclical 

deficit 

component 

Cyclically 
adjusted 
deficit 

Change  in  cyclically-
adjusted  deficit 
1995 

1996 

1994 

-2.0 
1.1 
-0.8 

-2.2 
-0.6 
0.5 

0.1 
-0.2 
n.a. 

0.7 
0.7 
-1.7 

0.1 
-0.4 
-0.1 

-1.0 
-1.3 
0.9 

-2.9 
0.6 
-0.6 

2.8 
-1.2 
1.5 

0.4 
1.2 
-0.7 

1.0 
-1.3 
-0.7 

-0.2 

-0.2 

-1.0 
-0.3 
0.0 

-0.9 
-2.3 
-1.2 

0.4 
-0.9 
0.3 

-1.4 
-2.0 
-1.0 

-1-7 
-3.8 
-1.1 

-0.8 

B 
DK 
D 
EL 
E 
F 

IRL 
I 
L 

NL 
A 
P 

FIN 
S 
UK 

EUR 

3.3 
1.4 
4.0 
7.9 
4.4 
4.0 

1.6 
6.6 
-0.9 

2.6 
4.3 
4.0 

3.3 
3.9 
4.6 

4.4 

0.6 
0.2 
0.5 
0.4 
0.9 
0.6 

-2.0 
0.4 
0.4 

0.3 
0.2 
0.8 

1.1 
0.9 
0.6 

0.5 

2.7 
1.2 
3.5 
7.5 
3.5 
3.4 

3.6 
6.2 
-1.3 

2.3 
4.1 
3.2 

2.2 
3.0 
4.0 

3.9 

A negative (positive) sign indicates a reduction 
(increase) in the  deficit; 
(1 ) Luxembourg has a surplus, thus a negative  (positive) 
sign indicates an increase (a reduction) in its surplus. 

Source:  Commission  services; figures for  1996 from 
Autumn  1996 economic  forecasts. 

Source: Commission services, Autumn 1996 

economic forecasts. 

Because of the recession in the early  1990s and the hesitant recovery  since then,  levels 
of  GDP  in  1996  still  remain  below  their  trend  in  all  Member  States  except  Ireland. 
Such  a negative  output  gap  implies  that  the  deficit  adjusted  for  cyclical  influences  is 
not  as  high  as  the  recorded  deficit.  Using  the  cyclical  adjustment  method  of  the 
Commission  services, three Member  States (Belgium, Finland  and  Sweden)  which  are 
likely  to  record  deficits  over  3%  of  GDP  this  year  are  estimated  to  have  cyclically 
adjusted  deficits  equal to or below 3% of GDP (see Table 4.4).6 

This  method  is,  however,  rather  prudent:  according  to  figures  from  the  IMF  published  in  the 
World Economic  Outlook  of October  1996  for  instance,  of the  Member  States  with  deficits  over 
3% of GDP this year, the structural  deficit  was estimated to be below or equal to 3% in  Belgium, 
Germany,  Spain, France, the Netherlands, Portugal, and the United  Kingdom. 

40 

4.3.2 Trends in the debt ratio 

Although  there has been widespread  progress in reducing budget  deficits,  this has  only 
been sufficient  in a few  cases to  clearly reverse the upward  trend  in the  debt  ratio  (see 
Table 4.2 and Graph 4.3). In Belgium the debt ratio has fallen each year from  the very 

Table 4.5 

Factors, other than the  deficit, 
adding to the debt stock 
(stock/flow  adjustment) 
(%ofGDP) 

1989-93 
annual 
average 
1.0 
3.7 
2.1 
8.1 
2.8 
0.9 

1.7 
1.8 
2.5 

0.1 
1.4 
3.4 

7.6 
5.1 
-0.4 

0.9 

1994-96 
annual 
average 
-1.4 
-2.0 
2.9 
1.7 
0.6 
0.5 

-0.3 
1.3 
2.6 

-0.7 
0.8 
0.6 

-0.5 
-2.9 
-0.6 

0.6 

B 
DK 
D 
EL 
E 
F 

IRL 
I 
L 
NL 
A 
P 

FIN 
S 
UK 

EUR 

high level of  137.0% of GDP reached  in  1993  and  is 
expected  to  decline  to  130.6% in  1996.  In  Denmark, 
similarly,  the ratio  peaked  at  80.1% of  GDP  in  1993 
and  is  likely  to  be  at  70.2%  in  1996.  The  earlier 
decline in the debt ratio in Ireland  has continued  since 
1993,  from  94.5%  of  GDP  in  that  year  to  an 
estimated 74.7% in 1996. 

In Greece the debt  ratio  expected  in  1996  at  110.6% 
of GDP is below its level in  1993. In the  Netherlands 
the debt ratio in  1996 is also expected  to  be below its 
level of 1993. 

Elsewhere debt ratios have risen significantly  over the 
last three years; by  at  least  5%  of  GDP  in  Germany, 
Spain,  France,  Austria  and  the  United Kingdom.  In 
Italy,  after  a  sharp  rise  in  1994  the  debt  ratio  fell 
marginally  in  1995  and  is expected  to  do  so  again  in 
1996.  A  decline in the  debt  ratio  is  also  expected  in 
Portugal  in  1996.  In Finland,  after  a  small  decline  in 
1995, the debt ratio is likely to rise again this year.  In 
Sweden  the  debt  ratio  will  have  fallen  in  both  1995 
and  1996 but remains above the level in 1993 

Source: Commission services. 

The  change  in  the  absolute  level  of  the  government 
gross  debt  is,  according  to  Treaty  definitions,  affected  not  only  by the  borrowing  to 
finance the government  deficit  each year,  but  also by a variety  of  other  factors  which 
are  reflected  in  the  liabilities  in  the  government  balance  sheet.  Thus,  the  value  in 
national  currency  of  debt  denominated  in  foreign  currency  may  change  because  of 
exchange rate movements; liabilities may be added to  in order to finance  on-lending  to 
other  sectors  of the  economy; the proceeds  of privatisation  sales or the running  down 
of stocks of financial assets may be used to reduce the level of gross debt,  etc. In most 
Member  States these factors  taken together have in the past tended to  add  regularly  to 
the  level  of  the  debt  stock.  Indeed,  in  the  period  1989-93,  they  added  more  than 
2 percentage points  of GDP  per year on average to the level of the debt  stock  in eight 
Member  States and had an appreciable upward  effect  in all but the Netherlands  and the 
United Kingdom  (see  Table  4.5).  On  average  in  the  three  years  1994-96  the  annual 
impact  on  the  debt  stock  has  been  reduced  compared  with  the  previous  period  in 
almost  all  Member  States,  with  the  notable  exception  of  Germany  where  there  have 
been  large  unification-related  debt  assumptions.  Indeed  the  average  annual  effect  has 
been  negative  (i.e.  reducing  the  debt  stock)  in  seven  Member  States  in  this  recent 
period  and has only exceeded  a positive effect  of  1% of GDP per year in four  Member 
States. There are a number of explanations for this change, including reduced  exchange 
rate  turbulence  after  1993  and  less  need  for  the  emergency  financing  of  banking  and 

41 

other  sectors which had occurred  in several countries. However,  there is also  evidence 
that,  since the gross  debt  ratio  has become more  closely  monitored  during  the  second 
stage, governments have been managing their balance sheets more  carefully. 

4.3.3  The sources of budgetary adjustment 

For the European Union, as a whole the reduction in the government  deficit  of  1.8%  of 
GDP  between  1993  and  1996  has  been  achieved  through  a  reduction  in  the  share  in 
GDP  of non-interest  government  expenditure.  Between  these  two  years  the  shares  of 
current  revenues  and  of  interest  payments  have  remained  almost  unchanged  (see 
Table 4.6). 

Table  4.6 

Revenue  and  expenditure  shares,  1993 and  1996 
(% of GDP) 

Current  revenues 

Non-interest  expenditure 

Interest  payments 

1993 

1996(1) 

Change 

1993 

1996(1) 

Change 

1993 

1996 (1) 

Change 

B 
DK 
D 

EL 
E 
F 

IRL 
I 
L 

NL 
A 
P 

FIN 
S 
UK 

EUR 

49.2 
58.3 
46.4 

34.4 
42.8 
49.5 

37.8 
47.4 
44.7 

52.9 
49.4 
37.7 

53.8 
60.3 
35.9 

46.2 

96/93 

+1.3 
+0.5 
-0.7N 

+3.6 
-2.5 
+1.1 

-3.1 
-1.1 
-3.0 

-4.6 
-1.2 
+3.8 

*  +1.5 
+2.7 
+1.8 

+0.0 

50.5 
58.8 
45.7 

38.0 
40.3 
50.6 

34.7 
4 6 . 3. 
41.7 

48.3 
48.2 
41.5 

55.3 
63.0 
37.7 

46.2 

45.9 
54.5 
46.6 

35.7 
44.4 
51.7 

33.8 
44.9 
42.5 

49.9 
49.4 
38.1 

57.2 
66.4 
40.8 

47.1 

(1) Autumn  1996 economic forecasts. 

Source:  Commission services. 

96/93 

-0.6 
-0.7 
-0.7 

-1.6 
-5.0 
-0.8 

-2.0 
-2.5 
-2.1 

-4.6 
-1.4 
+2.9 

-4.4 
-7.0 
-2.2 

-1.9 

45.3 
53.8 
45.9 

34.1 
39.4 
50.9 

31.8 
42.4 
40.4 

45.3 
48.0 
41.0 

52.8 
59.4 
38.6 

45.2 

10.8 
7.8 
3.3 

12.8 
5.2 
3.4 

6.5 
12.1 
0.4 

6.2 
4.3 
6.8 

4.6 
6.2 
2.9 

5.4 

8.5 
6.4 
3.8 

11.9 
5.4 
3.8 

4.5 
10.5 
0.3 

5.6 
4.5 
4.9 

5.9 
7.5 
3.8 

5.4 

96/93 

-2.3 
-1.4 
+0.5 

-0.9 
+0.2 
+0.4 

-2.0 
-1.6 
-0.1 

-0.6 
+0.2 
-1.9 

+1.3 
+1.3 
+0.9 

+0.0 

The  pattern  at  the  level  of  individual  Member  States  is  more  varied.  Most  Member 
States  have  benefited  from  lower  interest  rates.  Those  Member  States  with  steadily 
declining  debt  ratios  have  enjoyed  a  marked  decline  in  their  interest  payments 
(Belgium,  Denmark,  Ireland)  and  some  others  have  benefited  from  declining  nominal 
interest  rates to  an extent  that  has  also  cut their  interest  payments  (Greece,  Italy,  the 
Netherlands  and  Portugal).  In  most  of  the  remaining  Member  States  the  rising  debt 
ratio  has outweighed  any favourable  impact from lower  nominal interest  rates  ai;d the 
siiare of interest payments has risen - particularly sharply in Finland and  Sweden. 

Non-interest  government  expenditure  has  been  reduced  as  a  share  of  GDP  between 
1993 and  1996 in all Member  States except Portugal. Especially large declines of more 
than 4% of GDP have been achieved in Spain, the Netherlands, Finland and Sweden. 

42 

Several  of  the  Member  States  have  increased  taxation  to  achieve  part  of  their 
budgetary  adjustment.  The  share  in  GDP  of  current  government  revenues  has  risen 
between  1993  and  1996  in  Belgium,  Denmark,  Greece,  France,  Portugal,  Finland, 
Sweden  and  the  United Kingdom.  Elsewhere  this  share  has  declined;there  have  been 
in  Ireland,  Luxembourg  and  the 
particularly  sharp  declines  in  this  revenue  ratio 
Netherlands. 

In  most  Member  States,  however,  the  major  part  of  budgetary  adjustment  has  come 
from  a reduction in the total  expenditure ratio.  Some Member States have used part  or 
almost all of the reduction  in expenditure to finance lower taxation. By contrast,  other 
Member  States  have  supplemented  their  expenditure-cutting  efforts  by  also  raising 
taxation.  The reduction in the  deficit  between  1993 and  1996 achieved  through  higher 
revenues  has  been  at  least  as  important  as  the  reduction  due  to  a  lower  total 
expenditure ratio in Greece, France and the United Kingdom. Portugal  stands out  from 
the  other  Member  States  during  this  period,  in  that  it  has  used  a  sharp  rise  in  tax 
revenues,  albeit  starting  from  a  relatively  low  level,  to  finance  both  a  rise  in  the 
expenditure ratio and deficit  reduction. 

4.3.4. Deficits and  fixed  investment 

In  its  monitoring  of  budgetary  developments  for  the  excessive  deficit  procedure  the 
Commission, as well as examining compliance with  the government deficit  and debt 

Table 4.7 

Government investment and  deficit 
(% of GDP) 

Government  fixed 
investment 

Government  deficit 

B 
DK 
D 
EL 
E 
F 

IRL 
I 
L(2) 
NL 
A 
P 

FIN 
S 
UK 

EUR 

1995 
1.3 
2.0 
2.5 
2.9 
3.6 
3.0 

2.3 
2.3 
4.6 

2.7 
3.1 
4.0 

2.7 
3.3 
1.8 

2.6 

1996 
1.2 
2.0 
2.3 
2.9 
3.2 
3.1 

2.3 
n.a. 
4.8 
2.7 
3.1 
4.3 

2.7 
3.2 
1.5 

2.5 (3) 

1995 
4.1 
1.6 
3.5 
9.1 
6.6 
4.8 

2.0 
7.1 
-1.5 

4.0 
5.9 
5.1 

5.2 
8.1 
5.8 

5.0 

(1) Autumn 1996 economic forecasts. 
(2) Negative figure indicates a surplus. 
(3) Excluding Italy 
Source: Commission services; 

1996  (1) 
3.3 
1.4 
4.0 
7.9 
4.4 
4.0 

1.6 
6.6 
-0.9 

2.6 
4.3 
4.0 

3.3 
3.9 
4.6 

4.4 

whether 

criteria,  has  also  to  take  into 
account 
the 
government  deficit  exceeds 
investment 
government 
expenditure.  Table 4.7  shows 
figures for  gross  fixed  capital 
formation 
general 
by 
government in 1995 and latest 
estimates  for  1996  in  each  of 
and 
the.  Member  States 
the 
these  with 
compares 
corresponding 
government 
deficits. 

is 

larger 

those  Member  States 
In 
where  the  government  deficit 
remains  above  the  3%  of 
the 
GDP  reference  value, 
deficit 
than 
government  expenditure  on 
the 
fixed  investment 
(with 
in 
exception  of  Portugal 
1996).  Apart 
the 
Member  States  already  with 
low 
(Denmark, 
Ireland  and  Luxembourg), 

deficits 

from 

43 

current government  expenditure elsewhere is in part being financed through  borrowing 
(i.e. government  saving in most Member States is negative). 

4.4 Sustainability  of budgetary  convergence 

Table  4.8 

Budgetary  consolidation  efforts  have  been  strengthened  during  the  course  of  1996. 
Most Member  States, including all of those with deficits  currently still above the 3% of 
GDP  reference  value,  are  aiming  for  a  further  reduction  in  their  deficits  in  1997. 
Budget plans presented  so far  during  the 
autumn  of  1996  have  made  clearer  how 
governments intend to  achieve this.Table 
4.8  shows  the  objectives  for  the  general 
government  deficit  in  1997  announced 
by  Member  State  governments  in  their 
latest  convergence  programmes  or  in 
more recent budget  statements. 

Objectives for the general  government 
deficit  in  1997 
(%ofGDP) 

B 
DK 
D 

2.9 
0.6 
2.5 

EL 
E 
F 

IRL 
I 
L 

NL 
A 
P 

FIN 
S 
UK(1) 

4.2 
3.0 
3.0 

<3 

3.0 
n.a. 

2.2 
3.0 
2.9 

1.4 
2.6 
3 

Several  Member  States  expect  to  be 
clearly  below  the  3%  level  in  1997. 
Another group is aiming at a deficit  next 
year  in  line  with  the  reference  value. 
Only Greece is targeting a deficit in  1997 
higher  than  3%  of  GDP;  in  its  revised 
convergence  programme  Greece  set  the 
objective  of  bringing  the  deficit  below 
the reference value in  1998. 

more recent budget statements. 

(1) Financial year 1997/98. 
Source:  National convergence programmes or 

Beyond  1997  many  Member  States  are 
already  aiming  for  further  reductions  in 
their  budget  deficits,  often  with  balance 
or  surplus  as  a  medium-term  goal. 
Achieving  sound  and  sustainable  budgetary  positions,  leading  to  declining  debt  ratios 
where  they  are  too  high,  is  an  essential  condition  for  maintaining  stability,  keeping 
interest  rates  low  and  fostering 
the  growth  of  output  and  employment.  The 
Commission's  proposals  for  a  stability  pact  involve  a firm implementation  of  Treaty 
provisions so as to ensure budgetary discipline in the third stage. 

44 

EXCESSIVE  DEFICIT  PROCEDURE 

The excessive deficit  procedure set out in Article  104c of the Treaty and the associated 
Protocol No  5 determines  the steps to be followed  to reach a decision by the  Council 
that an excessive deficit  exists. 

The  Commission  is  required  (in  paragraph  2  of  Article  104c)  to  monitor  the 
development  of  the  budgetary  situation  and  of  the  stock  of  government  debt  in  the 
Member  States  with  a view to  identifying  gross  errors.  In particular,  compliance  with 
budgetary discipline is to be examined  by the Commission on the basis of the  following 
two  criteria: 

"(a)  whether  the  ratio  of  the  planned  or  actual  government  deficit  to  gi'oss 
domestic product  exceeds a reference value (specified in the Protocol as  3%), 
unless: 

-  either  the ratio has  declined  substantially  and  continuously  and reached  a 

level that comes close to the reference value; 

-  or,  alternatively,  the  excess of  the reference  value  is only  exceptional  and 

temporary and the ratio remains close to the reference value; 

(b)  whether  the  ratio  of  government  debt  to  gross  domestic  product  exceeds  a 
reference  value  (specified  in  the  Protocol  as  60%),  unless  the  ratio  is 
sufficiently  diminishing  and approaching  the reference value at a  satisfactory 
pace. " 

The Commission  is required  to  prepare  a report  if a Member  State  does not  fulfil  the 
requirements  under  one  or  both  of  these  criteria.  The  report  shall  also  take  into 
account  whether  the  government  deficit  exceeds  government  investment  expenditure 
and  all  other  relevant  factors,  including  the  medium-term  economic  and  budgetary 
position of the Member State (paragraph 3). 

Subsequent steps in the procedure include the formulation  by the Monetary Committee 
of  an  opinion  on  the  report  of  the  Commission  (paragraph  4);  the  addressing  of  an 
opinion  to  the  Council  by  the  Commission,  if  it  considers  that  an  excessive  deficit 
exists  (paragraph 5);  and  then  a  decision  by  the  Council  after  an  overall  assessment 
whether  an  excessive  deficit  exists  (paragraph  6).  Finally,  the  Council  makes  non 
public recommendations  to  the Member  State for  which the  existence  of  an  excessive 
deficit  has been decided with a view to bringing that  situation to  an end within a given 
period  (paragraph  7).  The  Council  may  subsequently  make  its  recommendations 
public,  where  it  establishes  that  there  has  been  no  effective  action  in  response  to  its 
recommendations within the period  laid down (paragraph  8). When, in the view of the 
Council, the excessive deficit  in the Member  States  concerned  has been corrected,  the 
Council  abrogates  its  decision  (paragraph  12).  The  provisions  of  Article  104c  in 
paragraphs 9 and  1 \  are not applicable during the second stage of EMU 

45 

5. EXCHANGE  RATES 

5.1 Treaty  provisions 

The exchange rate criterion, as set out in the third indent of Article  109j(l)  of the  Treaty, 
is  defined  as  "the  observance  of  the  normal fluctuation  margins  provided  for  by  the 
exchange-rate  mechanism  of  the  European  Monetary  System for  at  least  two  years, 
without devaluing  against  the currency of any other Member  State ".  The fourth  indent  of 
the  same Article  refers  to  "the durability  of  convergence achieved  by  the Member  State 
and  of  its  participation  in  the  exchange-rate  mechanism  of  the  European  Monetary 
System  being  reflected  in the long-term  interest-rate  levels".  In addition,  Article 3 of the 
Protocol  (No 6) on the convergence criteria specifies that:  "The criterion on  participation 
in  the  exchange-rate  mechanism  of  the  European  Monetary  System  referred  to  in  the 
third  indent  of  Article  109j(l)  of  this  Treaty  shall  mean  that  a  Member  State  has 
respected  the  normal fluctuation  margins provided for  by the  exchange-rate  mechanism 
of  the  European  Monetaiy  System  without severe  tensions for  at  least  the  last  two  years 
before  the  examination.  In  particular,  the  Member  State  shall  not  have  devalued  its 
currency's  bilateral  central  rate  against  any  other Member  State's  currency  on  its  own 
initiative for  the same period". 

Eleven currencies  are currently participating in the ERM. The Austrian schilling joined  the 
ERM  at  the  beginning  of  1995  and  has  continued  to  trade  in its traditional,  very  narrow 
range  against  the  DM.  The  Finnish  markka joined  the  ERM  on  14 October  1996.  The 
drachma  and  the  Swedish  krona  have  remained  outside  the  ERM,  while  the  lira  and 
sterling have not re-joined  since leaving the mechanism in September  1992. 

|  Graph 5.1 

ERM grid spread 

I  £s!2£g£oTOmj$SK>n serviced 

-

m 

,W6 

46 

Graph  5.2 

Movements within the ERM band 
(% deviation torn ECU central rate) 

\A 

Hi 

Hill 

III! 

mm 

MM 

Hi! 

FMK 

Whurce: Commission services 

J994 

H!i 

iiii 

47 

In  the  first  half  of  1995,  exchange  rate  tensions  emerged  at  the  international  level, 
reflecting  mainly the financial  crisis in Mexico and US-Japan trade tensions; these caused  a 
pronounced  weakening  of the  US  dollar which,  combined  with  country-specific  problems 
in Europe,  contributed  to  a strengthening  of the DM against many of the ERM  currencies 
and  to  the  increase  in  the  volatility  of  these  currencies.  As  a  result,  tensions  emerged 
within the ERM that led to  a realignment  on 6 March  1995: at the request  of the  Spanish 
authorities,  the  Ministers  and  Central  Bank  Governors  decided  the  devaluation  of  the 
peseta by 7%; by the same decision, the escudo was devalued by 3.5%. 

Tensions  in the  ERM  are  reflected  in  the  spread  between  the  strongest  and  the  weakest 
currencies in the mechanism,  as shown in Graph 5.1. The spread widened to  about  12% in 
February  1995. As international financial markets stabilised the spread  declined  to just 4% 
in  late  Summer  1995.  After  a  temporary  increase  in  September,  mainly  caused  by  a 
weakness of the US dollar, the spread resumed  its downward trend by the end  of  1995. By 
June  1996  the  spread  had  narrowed  to  below  2%.  This  rather  promising  performance 
continued  until  the  autumn.  In  general,  although  temporary  tensions  occurred,  the  ERM 
has been characterised  by a high degree of stability during most cf 1996. 

Within the ERM band  (see Graph 5.2),  the DM, the guilder,  the schilling and  the Belgian 
franc  have  been  strong  throughout  the  two-year  period.  In  1995,  the  peseta  recovered 
sharply  in  the  two  months  after  its  devaluation,  and  it  has  remained  strong  in  1996.  By 
contrast,  the  Irish  punt,  affected  by  the  course  of  the  dollar  and  sterling,  weakened 
considerably in the first quarter of  1995 and, though it strengthened thereafter,  it remained 
below its central rate until May  1996, but it has since recovered strongly. The French  franc 
traded  in  the  lower  part  of  the  band  for  most  of  the  two  years,  but  more  recently  the 
French  franc  recovered  closer  to  its  central  rate.  The  escudo  and  the  Danish  krone 
generally remained  close to their central rates. 

In  sum,  currently  nine  currencies  have  been  members  of  the  ERM  for  over  two  years: 
DKR,  BFR,  DM,  PTA,  FF,  IRL,  LFR,  HFL  and  ESC.  The  Austrian  schilling  will  have 
completed  two  years  of membership  by the  end  of  1996. With the exception  of the  PTA 
and the ESC, these  currencies  have not  modified  their  central ERM parities  over the past 
two  years  and,  while  large  fluctuations  have  taken  place in the band,  none  of these  eight 
currencies  can be  said  to  have undergone  severe  tensions.  The  central  rate  of the  peseta 
was devalued,  in March  1995, at the request  of the  Spanish authorities. The central rate of 
the Portuguese  escudo was also adjusted  downwards  following  the decision to  change the 
central  rate  of  the  Spanish  currency1.  Since  the  middle  of  October  1996  the  Finnish 
markka has also been a member of the ERM. 

5.2 Further analysis  of exchange rate stability 

Similar indications  are obtained  if stability  of exchange  rates is considered  in terms  of the 
coefficient  of  variation2  ,  which  enables  cross-currency  comparisons.  Graph 5.3  depicts 
variability against the DM. 

1  EU Communique, 6 March 1995 
2  Defined as the standard deviation divided by the mean 

48 

It  can  be  seen  that,  after  the  turbulence  of  the  first  half  of  1995,  the  variability  of  most 
currencies  returned  to  previously  prevailing  levels.  Also,  ERM  currencies  varied  by  less 
than  those  outside:  in  the  two-year  period,  on  average,  the  five  currencies  outside  the 
ERM  are  also  the  ones  that  displayed  the  greatest  variability;  among  these,  the  Finnish 
markka has fluctuated  the  least  and  has been  comparatively  stable in  1995  and  1996.  The 
lira  and  the  Swedish  krona  were  the  most  volatile.  Inside  the  ERM,  the  guilder,  the 
schilling  and  the  Belgian  franc  have  displayed  minimal  variability  and  the  Danish  krone 
joined  that  group  from  November  1995. The variability  of the  other  ERM  currencies  has 
also tended to be lower in  1996 than in earlier years. 

Domestic causes of foreign  exchange unrest include concern over the capacity of  countries 
or the willingness  of governments  to  achieve the high degree  of  convergence  required  for 
a  single currency.  In addition, the development  of fundamentals,  mainly public finance and 
inflation  but  also unemployment,  exerted  direct  influence  on exchange  rate  developments. 
Some  influence,  mostly  towards  appreciation  and  stability,  was  exerted  on  the  Finnish 
markka and the Italian lira, as a result of expectations for joining the ERM. 

In  1996,  a  number  of  factors  contributed  to  the  easing  of  tensions  in  foreign  exchange 
markets.  Firstly,  the recovery  of the US  dollar  played  a most  important  role:  from  below 
1.40  DM  in late  1995, the  dollar  rose  to  about  1.54 DM  in  June  1996; the  dollar  pulled 
upwards  mainly  sterling  and  the  punt  and  generally  reinforced  the  weaker  European 
currencies  against  the  stronger  group.  This  also  had  a  considerable  bearing  on  the 
functioning  of  the  ERM  by  reducing  the  spread  between  the  weakest  and  the  strongest 
currencies.  Subsequently,  a temporary  weakening  of the  dollar,  which  fell  to  1.48 DM  in 
July  1996,  did  not  have  a  substantial  effect  on the ERM  spread;  renewed  strength  in  the 
dollar  in  September  and  October  1996  was  accompanied  by  a  slight  widening  of  the 
spread as the punt appreciated  further  and became the strongest currency in the ERM. 

Secondly,  a  more  synchronised  cycle  in  the  European  economies  and  prospects  for 
disinflation  in  the  higher  inflation  countries  allowed  parallel  monetary  policy  moves  and 
reduced the scope for  speculative behaviour. 

Finally, trading in relation to convergence prospects was a very important factor.  From  the 
second  half  of  1995,  governments  increasingly  took  conspicuous  measures  to  improve 
their  convergence  situation.  At  the  same  time,  the  European  authorities  demonstrated 
repeatedly their determination to proceed to Monetary Union; particularly after  the Madrid 
European  Council,  where  the  realisation  of  EMU  in  1999  became  a  certainty.  These 
prospects  contributed  to the calming  of exchange rates  and to the substantial reduction  of 
. interest rate  differentials. 

49 

50 

6. LONG-TERM INTEREST RATES 

6.1 Interest rate convergence 

The criterion  addressed  here,  as defined  by the  fourth  indent  of  Article 109j(l)  of the 
Treaty,  is  "the durability of  convergence  achieved by  the  Member State and  of  its 
participation in the exchange  rate mechanism  of the European Monetary  System being 
reflected in  the  long-term interest rate levels".  This  criterion  on  the  convergence  of 
interest  rates  is  developed  further  in  the  Protocol  No 6  on  the  convergence  criteria, 
Article 4 of which states that the criterion  "shall mean that, observed over a period of 
one year before the examination,  a Member State has had an average long-term interest 
rate that does not exceed by more than 2 percentage points that of, at most, the three 
best performing  Member States in  terms of price  stability ".  It  goes  on  to  say  that 
"Interest rates  shall  be  measured on  the  basis  of  long-term  government bonds or 
comparable securities, taking into account differences in national definitions. " 

The unweighted  arithmetic  average  of  the  12-month average of  the long-term  interest 
rate of the three best performers  in terms of  inflation  has been used  in this  report  for 
the  calculation  of  the  reference  value  (see  also  analysis  of  Chapter 3).  For  most 
Member  States,  the  yield  on  the  ten-year  benchmark  bond  is  the  one  used  in  the 
calculations.  Efforts  have  been  made  to  make  these  data  as  comparable  as  possible. 
Further  details  on  the  interest  rates  used  for  each  Member  State  are  contained  in the 
box  on  "Data  and  reference  value  for  the  interest  rate  convergence  criterion".  All 
references  to  the  long-term  interest  rate  in  this  section  refer  to  the  average  over  the 
latest  12 months of the nominal long-term interest rate. 

The three best performing  Member  States with respect  to consumer  price  inflation1  in 
September  1996  were:  Germany,  the  Netherlands  and  Finland.  The  average  nominal 
long-term  interest  rates  for  these  countries  in  September  were,  respectively:  6.3%, 
6.3%  and  7.4%,  producing  a reference  value  of  8.7%  (see Table 6.1).  Two  of these 
three  countries  also  had  the  lowest  average  interest  rates,  namely,  Germany  and  the 
Netherlands.  In  all,  eleven  Member  States  had  average  interest  rates  below  the 
reference  value in September  1996. These were: Belgium, Denmark, Germany, France, 
Ireland, Luxembourg, Netherlands, Austria, Finland, Sweden and the United Kingdom. 
Four  Member  States  (Greece,  Spain,  Italy,  and  Portugal)  had  average  interest  rates 
above the reference  value. Sweden's average interest rate was above the reference value 
at  the  end  of  1995  but,  having  declined  during  1996,  it  moved  below  the  reference 
value in August 1996. 

1  The  price  index  used  to  establish  the  three  best  performers  is  the  interim  index  of  consumer  prices 

(IICP) from  December  1995 and the consumer price index (CPI) before then (see Chapter 3). 

51 

7.7 

8.7 

7.5 

7.3 

6.3 

7.5 

7.7 

9.5 

7.2 

7.9 

9.7 

9.6 

to 

1993 

1994 

1995 

1.6 

(see 

1996(1) 

6.3 
7.4 

6.9 
8.8 

Table  6.1 

12-month  average 

this  general 

is  considered 

Three best price  performers 

Member States respecting the reference  value 

is  confirmed  when 
situation  of 

Long-term  interest  rate  convergence  in  the 
Member  States 

B 
DK 
D 
F 
IRL 
L 
NL 
FIN 
UK 
Reference 
value 2 

This  impression  of  an  improvement  in 
the convergence  situation  since  the  end 
the 
of  1995 
individual 
underlying 
Member  States 
(see 
Graph 6.1  and  Table 6.2).  During  this 
period,  the. reference  value  gradually 
declined,  and the dispersion around this 
reference  value diminished  from  2.0  at 
by 
1995 
end  of 
the 
Table 6.2). 
September  1996 
trend  are 
Underlying 
somewhat  different  developments 
in 
Member  States  satisfying  the  criterion 
and those not  satisfying  the criterion  at 
the end of  1995. Although all countries 
experienced  falling  average  rates,  the 
pace  of  the  fall  was  considerably  less 
among  those  Member  States  in  the 
former  group  than  those  in  the  latter 
in  the 
group.  Finland,  with  a  fall 
average  rate  of  1.4 percentage  points 
between the end of  1995 and September 
1996,  provided  an  exception  to  this 
latter  observation.  Indeed,  the  fall  in 
Finnish  rates  accounts  for  the  major 
part  of  the  fall  in  the  reference  value, 
while  the  falls  in  the  five  Member 
States not respecting the reference value 
at  the  end  of  1995 help  to  explain  the 
reduction in dispersion.  Compared with 
rate 
December  1995, 
convergence 
difference 
gap 
between  the  average  domestic  interest 
rate  and  the  reference  value)  fell  for 
Greece,  Italy,  Spain 
and  Portugal, 
respectively  to  6.4 percentage  points 
(-1.3),  1.6 percentage  points  (-0.9), 
0.8 percentage  points 
and 
0.7 percentage  points  (-1.1).  Greece 
remains the least convergent Member State, while Sweden moved from a divergence of 
0.5 percentage  points  at  the  end  of  1995  to  being  0.2 percentage  points  below  the 
reference value in September 1996. 

(1) Oct.  1995 to Sep.  1996 
(2) Definition  adopted in this report: arithmetic average of 
the  12-month average of interest rates of the three best 
performing  Member States in terms of price stability 
plus 2 percentage points. 

B 
DK 
D 
F 
IRL 
L 
NL 
A 
FIN 
S 
UK 

6.7 
7.4 
6.3 
6.6 
7.5 
7.0 
6.3 
6.5 
7.4 
8.5 
8.0 

7.5 
8.3 
6.9 
7.5 
8.3 
7.6 
6.9 
7.1 
8.8 

7.9 
7.9 
7.1 
7.2 
7.9 
7.7 
6.9 

7.2 
7.3 
6.5 
6.8 
7.7 
6.5 
6.3 

Number: 
out  of: 

interest 

Source:  EMI. 

(-0.8), 

(the 

10 
15 

11 
15 

8 
12 

8 
12 

the 

8.3 

8.2 

7.5 

52 

low 

1995(1) 

1994(1) 

1993  (1) 

1996(1) (2) 

7.9 
7.9 
7.1 

6.3 
6.7 
9.7 

NL 
A 
P 

Table 6.2 

IRL 
I 
L 

FIN 
S 
UK 

7.5 
10.3 
7.0 

7.9 
10.5 
7.7 

8.3 
12.2 
7.6 

II  Within 

6.9 
7.1 
11.5 

6.9 
7.0 
10.5 

20.8 
10.0 
7.2 

12-month  average 

B 
DK 
D 
EL 
E 
F 

6.7 
7.4 
6.3 
15.1 
9.5 
6.6 

7.5 
8.3 
6.9 
17.4 
11.3 
7.5 

Development of long-term interest rates 

7.2 
7.3 
6.5 
23.3 
10.2 
6.8 
7.7 
11.2 
6.5 

the  group  of 
countries  meeting 
the 
criterion,  the  picture  was 
In 
somewhat  different. 
general,  the  pace  of  the 
decline  in  average  long-
term rates over the review 
period was less than in the 
group  of  countries  not 
satisfying 
the  criterion. 
This  was  to  be  expected 
since  long-term  rates  in 
countries  were 
these 
(see 
already 
Graph 6.1). 
Finland 
provides  an  exception  to 
the  general 
trend.  The 
strong  decline  in  Finnish 
long-term  rates,  together 
with  the  levelling  off  of 
the 
in 
rates 
United Kingdom,  saw  the 
latter replacing  Finland  as 
the  Member  State  in  this 
the  highest 
group  with 
rates.2  The 
long-term 
dispersion  within 
the 
declined. 
itself 
group 
Excluding  Sweden, 
the 
spread between  the lowest 
(Germany: 
rate 
interest 
the  highest 
6.9%)  and 
interest 
(Finland: 
rate 
8.8%)  was  1.9  percentage 
points  at  the  end  of  1995.  This  fell  to  1.7 percentage  points  (=8.0%  for  the 
United Kingdom less 6.3%  for  the Netherlands) in September  1996. Including  Sweden, 
the spread in September  1996 was higher at 2.2 percentage points. 

(2) Average of October  1995 to September 1996. 
(3) Measured by the standard deviation around the average of the 3 best price 
performers (Greece omitted from calculations in all years; Luxembourg 
omitted from calculations in 1993). 

(1) For 1993, data are non-comparable for Luxembourg (January -September) and 

Dispersion 
from average 
of 3 best price 
performers (3) 

Portugal (January-June). For Greece data are non-comparable. 

Average of 3 
best price 
performers 

8.8 
10.2 
8.3 

pro memona 

Source: EMI. 

7.4 
8.5 
8.0 

8.8 
8.5 
7.5 

6.3 
6.5 
9.4 

9.1 
9.7 
8.2 

1.5 

2.0 

7.7 

7.5 

7.6 

6.7 

1.6 

1.6 

Uiitil Sweden became a member of this group in August  1996. 

53 

54 

6.2 Recent developments in long-term interest rates 

In  this  section,  the  recent  evolution  of  long-term  interest  rates  is  analysed  by  a 
consideration  of  the  paths  followed  by  monthly  nominal  long-term  interest  rates  (as 
opposed to the  12-month averages of the previous section) in the Member States and at 
the level of the Union as a whole.  The sharp upward movement in nominal  long-term 
rates  in  the  European  Union  in  1994,  was  followed  by  a  steady  downward  trend  in 
1995.  After  a brief  interruption  at the beginning  of the year,  this downward  path has 
continued  in  1996  (see  Graph 6.3).  Falling  long-term  interest  rates  in  1995  were 
generally  seen as an  international  phenomenon  stemming from a slowdown of  growth 
in  the  USA,  deflationary  pressures  in  Japan,  and  perceptions  of  lower  inflationary 
pressures in Europe. 

Revisions  in market  expectations  about  the  likelihood  of  official  interest  rates  cuts  in 
Germany and the US were widely cited as the reason for the upward spike in long-term 
interest rates at the beginning of  1996. Expectations that a policy of monetary easing in 
Germany  had reached  a turning  point  surfaced  towards  the end  of January.  This  was 
compounded  in  February  by  expectations  of  a  tightening  of  monetary  policy  in  the 
USA,  the  effect  of  which  spilled  over  from  US  to  European  bond  markets.  This 
international  trend  was  driven  partly  by  market  fears  of  excess  global  liquidity 
following  the  sustained  reduction  in  interest  rates  in  the  major  economies  throughout 
1995. 

55 

The resumption of downward trend in average nominal long-term rates in the EU since 
April  1996 may  be explained  by  a number  of  factors.  These  include:  a decoupling  of 
trends  in the  USA  and  some  European  bond  markets  in  the  second  quarter  of  1996; 
and,  in  the  third  quarter,  another  shift  in  market  expectations  concerning  US  and 
Japanese monetary policy,  this time away from a near-term  tightening,  which resulted 
in internationally  falling  long-term rates. In September  1996, the average level of bond 
yields  in  the  EU  recorded  a  level  of  7.2%,  1 percentage  point  lower  than  in 
September  1995 and below the level of 7.3% recorded in January 1996. 

A number of features  in the evolution of long-term interest rates across Member States 
may be highlighted.  First,  although  long-term  rates  fell  in  all  EU  countries  over  the 
period  between September  1995 and September  1996, the size of the  fall  varied  across 
countries  (see Table 6.3).  In  general,  those  countries  with  the highest  long-term  rates 
experienced the largest  falls:  Italy,  Portugal,  Spain and Sweden recorded  reductions  in 
the range of 1.8-2.9 percentage points. 

56 

Table  6.3 

Recent  evolution  of  long-term  interest  rates 

Monthly  average  of  daily  data 

September 
1995 
7.0 
7.8 
6.6 

15.8 
10.8 
7.4 

8.0 
11.5 
.7.4 

6.6 
6.9 
11.2 

September 
1996 
6.5 
7.2 
6.2 

14.8  (Feb) 
8.4 
6.2 

7.2 
9.2 
6.8 

6.1 
6.3 
8.3 

Change(pps) 

-0.5 
-0.6 
-0.4 

-1.0 
-2.4 
-1.2 

-0.8 
-2.3 
-0.6 

-0.5 
-0.6 
-2.9 

B 
DK 
D 

EL 
E 
F 

IRL 
I 
L 

NL 
A 
P 

FIN 
S 
UK 

8.0 
9.6 
8.1 

6.9 
7.8 
8.0 

-1.1 
-1.8 
-0.1 

the 

from 

benefiting 

In Greece the decline was  less,  so 
that  long-term  rates  remain  high3 
.  Among  the  countries  already 
with lower  interest  rates,  Finland, 
lower 
also 
inflation  expectations,  recorded  a 
substantial 
reduction 
(1.1 percentage  points).  Given 
rate 
largest 
that 
reductions,  over 
to 
September  1996,  were  realised  by 
the 
those  Member  States  with 
highest  nominal  long-term  rates, 
rate  differentials  over 
interest 
corresponding  German 
bonds 
narrowed4  during  the  year,  with 
Spain,  Italy,  Portugal  and  Sweden 
experiencing 
largest 
reductions. 

interest 
the  year 

the 

8.2 

7.2 

-1.0 

Source:  EMI. 

EUR (1) 
(1)  : weighted  average  using  1995 GDP  weights 

Second,  while  all  EU  countries 
shared  common trends  in  nominal 
between 
rates 
long-term 
August  1995  and  March  1996, 
there  has  been  some  divergence 
of experience  among  Member  States  since then.  Following  the brief upward  blip  in  the 
first  quarter,  all  countries  except  the  United Kingdom  recorded  reductions  once  again 
during  April.  For  Belgium,  Denmark,  Germany,  Luxembourg  and  Austria,  long-term 
rates  rose  over  the  period  May-June,  before  dropping  once  again  in  July-August.  On 
the  other  hand,  the  downward  trend  persisted  in  the  high-yield  countries,  namely, 
Spain,  Italy  and  Portugal. 

6.3  Explanatory  factors  and  assessment 

Progress  was  made  over  the  last  year  in  terms  of  interest  rate  convergence,  with 
Sweden  satisfying  this  convergence  criterion  from  August  1996 and  the  remaining  four 
countries  (Greece,  Spain,  Italy  and  Portugal)  moving  nearer  the  reference  value. 
Spain,  Italy  and  Portugal  also  recorded  considerable  narrowing  of  their  interest  rate 
convergence  gaps.  Indeed,  if  the  current  levels  of  interest  rates  were  to be  maintained, 
the  average  long-term  rates  for  Spain  and  Portugal  would  very  shortly  come  under  the 

3 

4 

It  should  be  noted  that  the  data  for  Greece  are  not  comparable  to  the data  for  other  Member  States. 
In  the  absence  of  a  long-term  capital  market  a bond  with  an  original  maturity  of  5  years  is  used.  In 
addition,  the existence of  a reporting  lag  in the receipt of  the data hampers up-to-date  comparisons. 
For all countries except the United  Kingdom. 

57 

reference  value.  This  favourable  development  may  be  attributed  to  a  number  of 
underlying  factors.  One  important  factor  is  the  declining  inflation  rates  in  these 
countries, which in turn helped to reduce inflation expectations. This is particularly  the 
case  for  Spain,  Portugal  and  Sweden,  which  recorded  sizeable  reductions  in  average 
inflation  rates between December  1995 and September  1996. Compared to the previous 
year,  the  rapid  reduction  in  inflation  in  Portugal  appears  to  have  affected  long-term 
interest  rates.  Greece's  less  spectacular  progress  in terms  of  inflation,  given  the  high 
starting  point,  may  help  explain  the  slower  progress  in terms  of  reducing  the  interest 
rate gap in this country. 

A second  important explanatory  factor  was the efforts  made in these countries  in terms 
of  reducing  government  deficits.  Such  progress  in  government  deficit  consolidation 
contributed  to  a  more  balanced  policy  mix  and  thus  to  reducing  the  credit  risk 
premium.  The  progressive  calming  of  exchange  rate  markets  during  the  1996  created 
conditions for a stabilising of bond markets. 

58 

DATA AND REFERENCE VALUE FOR THE INTEREST  RATE 
CONVERGENCE  CRITERION 

Data 

According to Article 4 of the Protocol on the convergence criteria: 

"Interest  rates  shall  be  measured  on  the  basis  of  long-term  government  bonds  or 
comparable securities,  taking into account differences  in national  definitions. " 

According  to Article 5 of the same Protocol, the Commission  shall provide the  statistical 
data  for  the application  of the interest rate convergence  criterion.  In  agreement  with  the 
European  Monetary  Institute,  which  has  a  comparative  advantage  in  the  analysis  of 
financial  statistics  and  has  advised  the  Commission  on  the  issue,  interest  rates  with  the 
following  characteristics  have been  deemed  the most  appropriate  for  the  examination  of 
the interest rate criterion: 

issuer: central government (in Germany including  Treuhandanstalt) 

-  maturity: residual maturity close to  10 years (9 to  10.5 years) 
- 
-  choice  of bonds:  liquidity  is the main  selection  criterion;  the choice between  a  single 
benchmark  or  the  average  of  a  sample  should  be  based  on  this  requirement;  most 
(eleven)  Member  States  choose  a  benchmark  (Belgium,  Denmark,  France,  Ireland, 
Italy,  Luxembourg,  Netherlands,  Austria,  Finland,  Sweden,  United  Kingdom),  while 
three Member States choose an average (Germany, Spain, Portugal) 

-  aggregation:  simple  average  should  be  used  if  there  is  more  than  one  bond  in  the 

sample 
-  gross of tax 
-  yield calculation: ISMA-formula for yield to maturity 
-  coupon: fixed 

In Greece, in the absence of a long-term  capital market  a bond with  an original  maturity 
of 5 years was selected.  Its coupon is indexed to the  12-month treasury bill and  adjusted 
yearly. Contrary to the other Member States where daily quotations are available, an end-
of-month figure is used. 

The  present  evaluation  of  the  long-term  interest  rate  criterion  is  based  on  harmonised 
long-term interest rates, incorporating the above characteristics. 

Reference  value 

According  to  Article  4  of  the  Protocol  on  the  convergence  criteria,  the  criterion  on  the 
convergence of interest rates  "shall mean that, observed  over a period  of one year  before 
this  examination,  a Member  State  has  had  an  average  nominal  long  term  interest  rate 
that  does  not  exceed  by  more  than  2 percentage  points  that  of,  at  most,  the  three  best 
performing  Member States in terms of price stability. " 

The  unweighted  arithmetic  average  interest  rate  of the  three best  performers  in terms  of 
price  stability  is used  in this  examination  of the interest  rate criterion  for  the  calculation 
of the reference value. 

59 

7.  SUPPLEMENTARY  INFORMATION 

This  chapter  reviews  developments  is  several  other  areas  which  are  required  by 
Article  109j(l)  to be taken  account  of by the  Commission  (and the EMI) in their reports. 
The  following  sections  examine  the  developments  of  the  ECU,  the  results  of  the 
integration  of  markets,  the  situation  and  development  of  the  balances  of  payments  on 
current account and the development of unit labour costs and other price indices. 

7.1 Development  of the  ECU 

The  ECU  markets  encountered  difficult  conditions  in  1995  and  much  of  1996.  Primary 
bond  market  activity  contracted  to  historically  low  levels,  though  secondary  market 
turnover  proved  to  be  more  robust.  A  degree  of  stability  was  provided  by  sovereign 
issuers  through  the  continuation  of  regular  debt  programmes  in  ECU  but,  with  private 
issuers  largely  ignoring  the  ECU,  liquidity  in  the  market  was  much  reduced.  From  the 
start of the second half of  1996 interest  in the ECU began to recover as confidence  in the 
EMU  process  developed  and  perceived  uncertainties,  like  the  start  date  of  monetary 
union,  the  1:1  substitution  of  the  euro  for  the  ECU  and  continuity  of  ECU  contracts, 
began to crumble. With the release of the regulations on the legal framework  for the euro 
positive  market  sentiment  towards  the  ECU  has  firmed,  and  market  analysts  now 
anticipate a return to growth in the ECU markets  in the run up to  1 January  1999 and the 
start of monetary union. 

One manifestation  of the ECU's  difficulties  was the emergence  from  the middle  of  1994 
of  a  persistent  spread,  in  excess  of  50  basis  points,  between  the  market  exchange  rate 
value of the ECU and  its theoretical  value.  In an historical context, ±20 basis points had 
been  considered  to  be  the  normal  trading  range  of  the  spread;  moreover,  on  those 
occasions when the spread exceeded its normal range, in particular during the ERM crises 
in  1992 and  1993, it had done so  for  only  a short period of time before  arbitrage  activity 
by the so-called  "basket makers" brought the spread rapidly down to more normal levels. 
Towards  the  end  of  1994,  the  spread  -though  still  volatile-  had  contracted,  reaching 
around  20 basis  points. However,  with  the  subsequent  re-emergence of ERM tensions  in 
early  1995 the spread rapidly  increased  reaching  a high of  152 basis points by the end of 
March  1995.  Though  it  subsequently  fell  to  under  100 basis  points  this  was  only  a 
temporary  respite.  The  spread  reached  over  300 basis  points  at  the  end  of  1995.  During 
the  first  half  of  1996  confidence  began  to  return  to  the  ECU  markets  and  the  spread 
tended  to  fluctuate  between  150  and  250 basis  points,  with  a  slow  fall  commencing  in 
May.  During  the  second  half  of  1996  the  spread  stabilised  at  approximately  100 basis 
points  during  July  and  August,  and  then  fell  to  below  60 basis  points  by  the  end  of 
September.  Subsequently  the  spread  has  contracted  further  to  between  30  to  20 basis 
points. 

The underlying reasons, and their relative importance,  for the behaviour of the spread are 
difficult  to determine precisely, but a number of factors  have demonstrably played  a role. 
First,  exchange  rate  tensions  in  the  ERM  have  had  a  negative  impact  on  the  ECU. 
Second,  there  has  been  an  increase  in  the  perceived  risk  of  running  open  positions  in 

60 

ECU, which has been reflected  in the switch by the basket maker banks from a long-term 
strategy,  in  which  they  were  willing  to  hold  open  positions  in  ECU  for  considerable 
periods  of  time,  to  a  short-term  strategy  in  which  profits  are  taken  as  soon  as  possible 
even though greater profits would potentially have been generated by holding the position 
for longer. 

In  part  also,  the  increase  in  perceived  risk  stems  from  a  growing  awareness  that  since 
1987  there  has  been  no  institutionalised  link  between  the  market  ECU  and  the  basket 
apart  from  the  conversion  of  ECU  into  euro  at  1:1 upon  the  start  of  Stage  Three,  on 
1 January  19991.  For  many  market  operators  the  level  of  uncertainty,  over  the  EMU 
timetable and legal issues, was such that they took little comfort from the  1:1 provision in 
the Treaty.  Thus  uncertainty  over EMU  fed  through  to  concerns  over the  future  value  of 
the  ECU.  However,  since  the  European  Council  in  Madrid  in  December  1995,  market 
confidence  has been growing as the high level of political commitment to monetary union 
has  been  repeatedly  demonstrated  and  the  uncertainties  over  legal  issues,  such  as  the 
continuity  of  contracts  and  the  1:1  conversion  of  ECU  into  euro,  have  largely  been 
removed by the regulations proposed by the Commission. 

The exchange rate value of the ECU may also have been damaged by the high level of net 
redemptions  of  ECU  denominated  bonds  in  1995  and  1996.  Given  a  contraction  in  the 
stock of outstanding  ECU denominated bonds, the proceeds from repayments, funded  by 
the  drawing  down  of  existing  ECU  deposits,  have  tended  to  be  exchanged  for  other 
currencies  for reinvestment.  This has put downward  pressure on the exchange rate  value 
of  the  ECU;  however,  as  confidence  in EMU  has  grown  so  too  confidence  in  the  ECU 
markets has slowly been returning and the spread has reduced. 

During  1995, the  amount  of  bond  issues  denominated  in  ECU  was  significantly  lower 
than  the  amount  of  maturing  paper  with  the  result  that  the  stock  of  outstanding  debt  in 
ECU  declined  by  6%  to  ECU  127 billion  (excluding  Greek  ECU-linked  bonds).  This 
compares  to  a  historic  peak  of  ECU  140 billion  stock  outstanding  in  1993. During  the 
first  nine  months  of  1996,  demand  for  ECU  from  institutional  investors  remained 
subdued  and  private  issuers  were  few  in number  and  wary.  Issue  activity  was  therefore 
low, with  periods  of no  issuing. The total amount  issued  during  the first nine  months  of 
1996  amounted  to  ECU  10.9 billion  compared  with  ECU  13.5  billion  over  the  same 
period  in  1995. Thus  with  ECU  18.9 billion  of  maturing  paper  the  stock  of  outstanding 
ECU denominated debt fell to ECU  119 billion by the end of September 1996. 

In  the  secondary  market,  average  turnover  in  ECU  bonds  rose  in  value  terms  by  8%  in 
1995,  its  highest  level  since  1992.  In the first nine  months  of  1996 there  was  a  further 
rise of 4%. As  a percentage  of the total  secondary market  the share of the ECU  declined 
from 5.6% in  1993 to 5.2% in  1994 and  1995, but rose slightly to 5.3% in  1996 (up to the 
end of September). 

Until  1987  the  institutionalised  link  was  also  provided  by  the  acceptance  by  the  ECU  Banking 
Association of delivery of the basket in the settlement of ECU positions in the clearing 

61 

In contrast  to the  steady  contraction  of  the  ECU  bond  markets  other  ECU  markets  have 
performed  better  but  have nevertheless  registered  decreases  in activity.  The  approximate 
measure  of  commercial  and  financial  activity  provided  by  the  daily  average  turnover  in 
the  EBA  ECU  Clearing  System  has  experience  a  modest  fall  in  activity,  from 
ECU 50.0 billion  during  1994 to  ECU 46.8 billion  during  1995, a year  on  year  decrease 
of 6.5%. For the first nine months thé average daily turnover in  1996 is some 2.1%  lower 
than for  1995 at ECU 45.8 billion. 

Studies  of  ECU  flows  related  to  commercial  transactions  (i.e.  purchase  of  goods  and 
services)  as  opposed  to  purely  financial  transactions  suggest  that  commercial  payments 
account  for  a small portion of total payments  (1996 results: 7.1% in volume terms,  0.7% 
value),  but  that  nevertheless  commercial  ECU  payments  can  be  estimated  to  be  in  the 
region of ECU 50 billion to ECU 75 billion. 

7.2 Results  of the integration  of  markets 

With  an  average  of  about  93% of  Single  Market  legislation  transposed  into  domestic 
legislation  by  all  Member  States,  the  Single  Market  is  becoming  reality.  It  is  not  yet 
complete, but the  achievement  so  far  should not be underestimated.  It has  already  made 
the  European  Union  the  most  economically  integrated  collection  of  nation  states  in  the 
world. Evidence of this deepening integration is accumulating. 

7.2.1 Market integration  through  trade 

By removing trade barriers between countries, the Single Market was expected to  expand 
trade among  EU Member  States. In  fact,  between  1985  and  1995, the  share of  intra-EU 
imports in total manufacturing  imports has indeed increased on average by 6.7 percentage 
points  from  61.2%  in  1985  to  67.9%  in  1995. Furthermore,  intra-EU  penetration  ratios 
increased much more in fifteen manufacturing  industries identified  ex ante  as particularly 
sensitive to the Single Market project  (SMP) than in all other manufacturing  sectors. For 
services during the same period  1985-1995, the share of intra-EU exports in total services 
exports has increased  on average by  3.1 percentage points from 46.9% in  1985 to 50.0% 
in  1995.  Direct  and  pro-competitive  effects  of  the  SMP  on  trade  almost  fully  explain 
these changes in the market share of intra-EU imports. 

Increasing economic integration may lead to greater country specialisation on the basis of 
their  respective  comparative  advantages  (inter-industry  trade)  or  it  may  favour  intra-
industry  trade,  the  simultaneous  import  and  export  of  similar  product  lines  between 
Member States. 

Inter-industry trade between different  countries carries efficiency  gains, with each country 
specialising' in  those  activities  in  which  it  is  relatively  more  efficient,  and  consumers 
gaining lower prices as a consequence. However, this would imply a deeper  specialisation 
between  the  less  developed  Member  States  and  the  more  advanced,  each  country 
experiencing  a  contraction  of  some  sectors  and  expansion  of  others,  which  may  imply 
significant  adjustment  Costs. 

62 

By contrast, intra-industry trade benefits  the consumer by leading to a much wider  variety 
of products, whilst  producers  face  lower adjustment  costs. Here, adjustments  would  take 
place amongst firms inside industries rather than amongst industries. 

At  the beginning  of  the  1980s, most  trade within  the Community  could  be  classified  as 
inter-industry2  (around  45%). However,  the preparation  phase  of the  Single  Market  was 
accompanied  by  a  decrease  in  the  share  of  inter-industry  trade  in  Europe  and  a  rise  in 
intra-industry  trade  - which  itself  could be further  subdifferentiated:  either  intra-industry 
trade in similar products  in terms of prices and quality or intra-industry  trade in  products 
differentiated  by  price  and  quality  (for  example,  one  country  expoiting  brand-name 
expensive  shirts  and  the  other  inexpensive  low  quality  shirts). The  rise  in  intra-industry 
trade  has  predominantly  been  the  latter  type  (from  less  than  35% in  1985  to  more  than 
42%  in  1994),  whilst  intra-industry  trade  in  similar  products3  remained  rather  stable 
(around  20%  of  total  intra-EU  trade).  The  SMP  has  therefore  increased  the  range  of 
products  available  to  consumers  in terms of prices and quality, and encouraged  differing 
business strategies: either emphasising design, research and development, and  advertising 
in some cases (high price-quality) or production cost-minimising in others (low price). 

In  the  period  1985-94,  all  EU  countries  have  experienced  a  decrease  in  inter-industry 
trade, but  especially  Spain,  the United Kingdom, France and Germany.  Nevertheless,  in 
1994, inter-industry trade still accounted for over 58% of the total manufacturing  trade  of 
Greece, Portugal, Ireland and Denmark. At the same time, conversely, intra-industry  trade 
in  price  and  quality-differentiated  products  represented  over  42%  of  total  trade  for  the 
United Kingdom,  Germany,  France, Belgium, Luxembourg and the Netherlands,  a  share 
which  grew  between  1987  and  1994  for  all  this  group  of  countries  plus  Spain  and 
Portugal. 

Analysis  of  price  and  quality-differentiated 
intra-industry  trade  shows  a  striking 
difference  between  northern  and  southern  countries.  Scrutiny  of  the  contribution  to  the 
trade balance  of  low,  medium  and  high price quality product ranges  spotlights  different 
country  groupings.  Germany  has  a  comparative  advantage  in  high  price  and  quality 
product ranges, France in medium to high price and quality ranges, the United  Kingdom, 
the Netherlands, Belgium,  Luxembourg  and Denmark  only  in medium  price  and  quality 
ranges, Spain in medium to low price and quality ranges, and Greece and Portugal only in 
low  price  and  quality  ranges.  These  specialisations  have  been  unaffected  by  monetary 
fluctuations. 

In the period  1985-94, the share of medium price and quality products in overall  intra-EU 
trade  has  declined  (by  some  10 percentage  points)  to  the  benefit  of  high  price  quality 

Ihere  is inter-industry  trade between two countries when one country's trade flow (imports or  exports) 
with the other in a sector represents less than  10% of the other country's trade flow (imports or exports) 
with it in the same sector. 
There is intra-industry  trade in similar products when export and import unit values differ  by less  than 
15% and  there  is  intra-*industry  trade  in  differentiated  products when unit  values  differ  by  more  man 
15%. 

63 

products  (plus 7 percentage points)  and low price and quality products. This is  especially 
so  for  the  most  advanced  European  economies, but  even in the  southern  Member  States, 
specialisation  has  changed  and  the share of  low price  and quality products  has  generally 
fallen whilst the share of high price and quality products has increased. 

Growing  intra-industry  trade  with  price  differentiation  implies  that  Member  States  are 
more and more  specialised  inside industries on products with differing  price level ranges. 
For most advanced countries such an evolution involves growing intangible investment in 
R&D,  training,  innovations  to  compete  in  traditional  mature  industries,  and  for  less 
advanced countries, the possibility of entering high tech and high value added sectors and 
competing on price. 

7.2.2 Market  integration through foreign  direct investment 

Trade is not the only mechanism by which markets can become more integrated.  Foreign 
direct  investment  (FDI) is an alternative to trade as a way of  supplying  foreign  markets. 
Multinational companies are the main source of FDI flows,  and the sales of multinational 
foreign  affiliates  are now by some estimates worth double the value of world exports. 

In fact,  impact on FDI of the SMP seems to have been even more positive than its impact 
on trade.  The European Union absorbed 44.4% of FDI inflows  from  all countries  in  the 
world  at  the  beginning  of  the  1990s,  compared  to  28.2%  in  the  period  1982-87. 
Moreover,  intra-EU  FDI  (i.e., FDI  flows  between  Member  States)  increased  four  times 
faster  than intra-EU trade in the period  1984-92.  Altogether, between  1984-85 and  1992-
93,  EU  FDI  inflows  from  all  sources  increased  five  times  (seven  times  for  intra-EU 
inflows). 

The  impact  on  the  domestic  economy  of  FDI  (FDI  inflows  relative  to  GDP)  differs 
widely  amongst  Member  States. At the beginning  of the  1990s, annual Irish FDI  inflows 
were  worth  over  9%  of  GDP.  In Belgium  and  Luxembourg,  the  ratio  was  4.7%  a  year. 
The  Netherlands  (2.7%)  came  next,  then  Portugal  (2.6%),  the  UK  (1.8%)  and  Spain 
(nearly  1.8%). By contrast, in Germany (less than 0.4%), Italy  (0.4%)  and Greece  (0.6%) 
these  figures  were very  low. Over the period  1986-93, two Member  States  (Belgium  and 
Ireland)  have  gained  considerable ground  in terms  of  attractiveness  as  locations  for  FDI. 
In general, Ireland, Portugal, Spain  and the Benelux  countries  are among  the ones  which 
have benefited  most from the Single Market in terms of FDI. 

7.2.3 Market  integration and competition conditions inside the EU 

Cost  reductions  related  to  size  achieved  over  the  period  1985-93  have  been  mostly  the 
result  of  exploiting  scale  advaixtages  linked  to  fixed  investments  in  marketing,  brand 
development,  R&D  spending  and  development  of  new  production  processes.  Few 
improvements  have  been  the  consequence  of  exploiting  purely  technical 
efficiency 
efficiency  gains related to the size of establishments. 

64 

Nevertheless,  sectors  such  as  distribution  and  road  freight  transport  do  show  remarkable 
productivity  gains.  Productivity  and  efficiency  gains  in  the  more  regulated  sectors 
(telecommunications,  banking,  airlines)  have  been  less  pronounced  and,  in  general,  it  is 
very  uncertain  the  extent  to  which  observed  changes  can  be  linked  to  the  SMP.  Large 
gains have been observed only in liberalised telecommunication  services. 

Evidence  on  price  cost  margins  and  business  perceptions  seems  to  indicate  that  the 
efficiency  gains  associated  with  large  size  have  been  passed  on  to  consumers  and  users 
thanks  to  increased  competition  associated  with  the  SMP.  Over  the  period  1980-1992, 
European  manufacturing  industry  registered  a trend  recovery  of price-cost  margins,  at  a 
yearly  rate  of  about  2%,  controlling  for  the  evolution  of  the  economic  cycle  and  the 
diverging  industrial  structures  of  the  EU  Member  States.  Within  this  overall  trend, 
imposed 
that 
however,  statistical  analysis  confirms 
increasing  pressure  on  price-cost  margins,  thus  ensuring  that  cost  reductions  have  been 
passed  on to consumers  and  downstream  users. It  is  estimated  that  the  SMP  has  led  to  a 
yearly  1%  reduction  in  margins  since  1986/87.  That  is,  in  the  absence  of  the  SMP, 
margins would have grown faster over the period. 

implementation  of  the  SMP 

Competitive  conditions  in  services  have  also  been  significantly  altered  by  the  SMP.  A 
significant  increase  in  competition  is  noticeable  in  sectors  such  as  telecommunication 
services or retail banking, but also in airlines, where implementation  of the SMP has only 
been partial so far.  Overall, however, the increase  in competition  seems to be less  strong 
than  in  manufacturing  sectors,  reflecting  that  many  regulations  are  still  maintained  on 
services  and  that  the  SMP  has  not  been  fully  implemented  in  several  domains.  This 
increased competition has resulted  in substantial  and quite general reductions  in prices  in 
sectors such as telecommunications,  and a more selective decline of prices in segments of 
the airline and banking industries. 

In road freight transport,  the  margins  for  cross-border  traffic  have  declined  sharply  over 
the period  1986-94.  The result has  been  a reduction  in real transportation  prices  which, 
together  with  efficiency  gains  in the distribution  sectors, have  led to  substantial  changes 
in the sourcing patterns of manufacturing  and retailing  firms.  A wider range of  sourcing 
possibilities has contributed to declines in input costs. 

The changes  in  structures  and  the  degree  of competition  of  European  markets  prompted 
by  the  implementation  of  the  SMP  have  also  resulted  in  increased  price  convergence 
across  the  EU  for  many  goods.  Between  1990  and  1993  the  variation  between  Member 
States in prices (including  taxes) has decreased  from  22.8% to  19.6% in consumer  goods 
and from 31.8% to 28.6% in services, but increased 28% to 31.7% in energy. 

65 

7.3  Situation  and development  of balances  of payments on current  account 

1993 

1995 

1994 

financial 

B 
DK 
D 

3.8 
2.9 
-1.1 

4.5 
0.6 
-1.2 

4.0 
1.6 
-1.4 

1996 
(D 
4.1 
1.0 
-0.9 

Current  account  balance 
(national accounts definition,  % of 
GDP) 

Following  deficits  in  both  1991  and  1992, the  current  account  of  the Union  as  a  whole 
has recorded either a zero balance, in  1993 and  1994, or a small surplus, in  1995; a larger 
surplus  is  expected  in  1996.  These  balances,  apart 
Table  7.1 
from  being  indicators  of  the  amount  of  national 
savings,  have  in  recent  years  become  signals  of  the 
state  of  domestic  absorption  relative  to  domestic 
liberalization  of  capital 
output.  With  complete 
movements,  and  the  removal  of  residual  exchange 
controls  by  some  Member  States  in  the  past  two 
to 
years, 
progress,  and  the Union's  financial  markets  are  now 
closely  integrated  with  international  financial  and 
capital  markets.  Consequently,  the  international 
allocation  process  of  excess  domestic  savings  or 
excess  domestic  spending  is  facilitated.  Several 
Member  States have systematically  recorded  current 
account  surpluses  since  the  beginning  of  the  1990s 
(Belgium,  Denmark,  France,  Ireland,  Luxembourg 
and the Netherlands), while in others current  account 
deficits  of  earlier  years  have  become  surpluses 
(Spain,  Italy, Finland  and Sweden); in  five  Member 
States  (Germany,  Greece,  Austria,  Portugal  and  the 
United Kingdom)  the  current  account  has  remained 
in  deficit  since  the  beginning  of  the  decade  (see 
Table 7.1). 

integration  has  continued 

3.4 
1.5 
15.9 
5.2 
-1.0 
-1.8 

4.3 
2.4 
17.9 
5.2 
-2.3 
-0.2 

IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 

4.9  , 
-1,9. 
-1.0 

3.7 
3.6 
16.3 

5.3 
1.0 
15.2 

4.0 
1.2 
-1.8 

-1.0 
-1.2 
1.0 

-1.7 
-1.0 
1.0 

-2.7 
0.9 
1.6 

4.9 
-0.4 
-2.1 

-1.3 
-1.4 
-2.5 

-3.0 
0.9 
1.7 

1.3 
-0.7 
-2.1 

4.5 
0.6 
-1.8 

EL 
E 
F 

1) Autumn 1996 economic forecasts. 
Source: Commission services. 

EUR 

0.0 

0.2 

0.0 

1.0 

In a majority  of Member  States the current  account balance has been improving,  despite 
the recovery  of  economic  growth,  since the end of the recession  of the  early  1990s.  An 
important  factor  in  this  has  been  the  reduction  of  fiscal  imbalances  and  the  consequent 
increase  in national  savings. Balance  of payments  positions relative to  GDP  in  1996  are 
not  estimated  to  change  markedly  compared  to the previous  year;  latest  estimates  by  the 
Commission  services  show  reductions  in  the  surplus  in  Belgium,  Ireland,  Luxembourg, 
the Netherlands  and  Finland,  and  a widening of the  deficit  in  Greece  and  Portugal.  The 
surplus  is likely to  rise  in  1996 in Denmark,  France, Italy and Sweden,  and the deficit  is 
expected to narrow in Germany and Austria. The current account surplus in Spain and the 
deficit  in  the  United Kingdom  are  likely  to  be  similar  in  scale  in  1996  to  the  previous 
year. 

7.4 Examination  of development of unit labour costs and other price indices 

Developments  in  various  consumer  price  indices  (IICP,  CPI,  private  consumption 
deflator)  contain  important,  albeit  incomplete,  information  on  the  inflation  environment 
prevailing  in  an  economy  (see  Chapter  3).  To  ensure  a  comprehensive  and  balanced 
examination  of  the  degree  of  price  stability  and  the  sustainability  of  the  inflation 

66 

performance,  the  Treaty  (Article  109j  (1))  also  requires  that  "the  development  of  unit 
labour costs and other price  indices " should be considered. 

7.4.1  Unit labour costs 

Developments in unit labour costs take on a particular importance in the inflation  process. 
They  reflect  trends  in  labour  productivity  and  nominal  compensation  of  employees  per 
head.  The  latter  not  only play  a key  role  in  the determination  of  input  costs  and  thus  of 
consumer  prices,  but  also  reflect  private  agents'  inflation  expectations.  They  therefore 
serve as an important  indicator,  amongst  others, of the credibility  of the  anti-inflationary 
policy stance pursued by the monetary authorities. 

At  the  Community  level,  growth  in  nominal  compensation  per  employee  has  slowed 
down steadily from 4.2% in  1993 to 3.4% in  1996, thereby reaching a level never  attained 
over  the  past  35 years.  This  deceleration  was  common  to  most  Community  countries, 
though  to a varying  extent (see Table 7.2). The salient  exceptions  are Italy, Sweden,  and, 
to a lesser extent, Denmark.  Over the same period, the increase in nominal  compensation 
per employee accelerated from 3.7% to 6.2% in Italy, and from 4.4% to 6.6%.in Sweden. 
This  means  that  wage  growth  is  now  above  the  inflation  rate,  which  could  generate 
wage/price tensions when economic activity speeds up. 

Three major  factors seem to explain the generally observed moderation in nominal wages. 
Firstly,  as  already  noted,  wage  settlements  appear  to  increasingly  incorporate  inflation 
expectations  consistent with the price objectives  announced by the monetary  authorities. 
Secondly, wage negotiations  seem to have increasingly taken  into account  developments 
in  the  real  side  of  the  economy  (output  growth,  labour  market  situation,  profitability 
concerns). Thirdly, actions to  improve  labour market  flexibility  have been undertaken  in 
several Member States, including among others incentives for unemployed people to  look 
for  a job  more  actively,  reforms  of  the  educational  and  training  system,  measures  to 
increase  flexibility  of working  time  and  of rules  governing  employment  conditions,  and 
measures  to  improve  the  efficiency  of  employment  services.  This  set  of  structural 
measures should help to avoid excessive upward pressure on wages when activity  speeds 
up, allowing unemployment to come down. 

The  second  element  which  influences  unit  labour  costs  is labour productivity.  The  latter 
has shown  the usual  cyclical  pattern  over the past  few  years. After  slowing down  during 
the  recession  of  1993,  gains  in  labour  productivity  picked  up  in  1994,  along  with  the 
rebound  in  economic  activity.  However,  the  growth  slowdown  experienced  in  the 
Community from mid-1995 again drove down apparent  labour productivity  growth, both 
in 1995 and in 1996. 

As  a  result,  growth  in  nominal  unit  labour  costs  was  very  modest  over  the  1994-1995 
period.  In  1994, eight  countries  showed  an  actual  decline  in  unit  labour  costs, while  in 
1995,  growth  in  unit  labour  costs  was  at  or  below  2XA% in  all  Member  States,  with  the 
exception  of Greece. Thus, apart  from  Greece, growth  in unit labour costs was below  the 
inflation  rate in  all  the  Community  countries  over  this  two  year  period.  This  favourable 

67 

evolution  is  mainly  the  result  of  moderate  wage  increases  but  is  helped  by  the  cyclical 
rebound in labour productivity  growth. 

The  moderate  trend  in unit  labour  costs  has  continued  in  1996. While  an  acceleration  is 
noticeable, the increase in unit  labour costs remains consistent with continued  favourable 
inflation  trends  in  the  Community  and  in  most  Member  States.  An  acceleration  in  unit 
labour  costs  is  expected  in  Spain,  Italy  and  Sweden,  and  to  a  lesser  extent  in  Denmark, 
Portugal,  Finland,  and  the  UK.  For  most  of  these  countries,  this  acceleration  remains 
moderate  and  leaves the increase in labour costs below or close to the inflation  rate, with 
the  exception  of  Italy.  In  addition,  this  strengthening  could  be  short-lived  as  it  partly 
reflects  cyclical  factors. 

Table  7.2 

Labour  costs 
(percentage  change, total economy) 
Labour productivity growth 

Nominal compensation  per 
employee 

Nominal unit labour costs 

1993 

1994 

1995 

B 
DK 
D 
EL 
E 
F 

IRL 
I 
L 
NL 
A 
P 

FIN 
S 
UK 

EUR 

3.5 
1.6 
4.3 
10.1 
6.5 
2.8 
6.7 
3.7 
5.2 

3.3 
4.6 
9.1 

1.0 
4.4 
4.3 

4.2 

4.4 
3.6 
3.2 

11.9 
3.1 
2.2 

2.3 
3.0 
3.7 

2.4 
3.1 
8.2 

3.5. 
5.4 
3.5 

3.3 

2.5 
3.6 
3.8 

12.7 
3.0 
2.3 

1.1 
5.2 
3.8 

2.0 
3.8 
5.3 
4.7 
3.1 
2.9 

3.5 

1996 
(1) 

1.6 
4.1 
2.6 
11.1 
3.9 
2.2 

4.0 
6.2 
3.4 

1.0 
2.9 
5.8 

4.0 
6.6 
3.3 

3.4 

1993 

1994 

1995 

1996 
(1) 

1993 

1994 

1995 

0.0 
2.5 
0.6 
-3.2 
2.6 
-0.2 

3.0 
1.8 
-1.7 

0.9 
0.8 
0.7 

5.7 
3.2 
3.7 

1.4 

2.9 
5.0 
3.6 
-0.4 
2.7 
2.9 

4.1 
3.7 
1.0 

3.3 
2.9 
0.9 

5.6 
3.6 
3.8 

3.3 

1.5 
1.1 
2.2 

1.1 
1.1 
1.0 

6.1 
3.4 
0.9 
0.2 
2.1 
2.9 
3.1 
1.4 
1.8 

1.9 

1.5 
1.5 
2.2 

1.2 
0.8 
1.3 

4.3 
0.5 
1.1 
1.0 
1.7 
2.0 

1.0 
2.3 
1.9 

1.5 

3.5 
-0.8 
3.6 

13.7 
3.7 
2.9 

3.6 
1.9 
7.0 

2.5 
3.7 
8.3 

-4.4 
1.2 
0.5 

2.7 

1.4 
-1.4 
-0.4 

12.3 
0.4 
-0.7 

-1.7 
-0.7 
2.7 

-0.8 
0.2 
7.2 

-2.0 
1.7 
-0.3 

0.0 

1.0 
2.5 
1.5 

11.5 
1.9 
1.4 

-4.6 
1.7 
2.8 

1.8 
1.6 
2.3 

1.5 
1.7 
1.2 

1,5 

1996 
0) 
0.1 
2.6 
0.4 

9.8 
3.1 
0.9 

-0.2 
5.7 
2.2 

0.0 
1.2 
3.8 
2.9 
4.1 
1.4 

1.9 

1) Autun 
Source: 

in  1996 economic  forecasts. 
Commission services. 

7.4.2 Import  prices 

Given  the  increased  degree  of  international  openness  of  the  Community  economy,  the 
evolution  of  import  prices  plays  an  important  role  in  domestic  price  formation.  Import 
prices  in domestic currency are the synthesis of the evolution  of several differenc  factors: 
the  value  of  the  exchange  rate,  international  prices*  the  geographical  composition  of 
imports and the price-setting behaviour of foreign  suppliers. 

68 

Several elements had helped in keeping the growth in 
import prices very moderate between  1990 and  1992: 
low  oil  prices,  a  weak  US  dollar,  progress  in  trade 
liberalisation,  coupled  with  the  completion  of  the 
internal  market.  As  a  result,  contributions  of  import 
prices to final demand inflation  were negative in most 
Member  States  (and  to  varying  degree)  over  this 
period. 

However,  the  effects  of  some  of  these  factors  were 
reversed  or  weakened  during  the  1993-95  period. 
Oil  prices  increased  at  a  relatively  fast  pace  in  the 
first  half  of  1994  and  again  in  early  1995,  while  the 
dollar  strengthened  somewhat  in  1993  and  1994.  In 
addition,  the  curbing impact  on prices  exerted  by the 
single market gradually  faded. 

Table 7.3 

Import price  inflation 
(percentage change in the deflator of 
imports of goods and services, in national 
currency; national accounts basis) 
1994 

1995 

1993 

B 
DK 
D 

EL 
E 
F 

IRL 
I 
L 

-2.6 
-1.1 
-1.5 

9.1 
6.6 
-2.5 

4.4 
12.1 
5.4 

0.9 
0.4 
0.5 

8.3 
6.0 
1.7 

2.8 
5.0 
0.2 

NL 
A 
P 

-2.3 
0.8 
8.9 

0.6 
0.7 
4.5 

1996 
0) 
1.6 
2.1 
0.7 

4.0 
0.9 
1.8 

0.5 
1.3 
0.7 

7.1 
4.2 
1.3 

4.2 
11.7 
0.5 

*  0.5 
-0.6 
3.1 

0.2 
0.9 
1.5 

2.0 
1.2 
1.2 

1.1 

3.8 

2.2 

3.1 

EUR 

0.4 
5.1 
7.3 

FIN 
S 
UK 

-0.3 
3.3 
1.9 

2.3 
-3.1 
2.0 

8.7 
14.5 
8.4 

(1) Autumn 1996 economic forecasts. 
Source:  Commission services. 

The upward  impact  of these  factors  on import  prices 
varied  strongly  country  by  country,  depending  on 
the  exchange 
developments  on 
In 
strong 
countries  whose 
currencies 
(Belgium,  Denmark,  Germany, 
the 
Netherlands  and  Austria),  increases  in  import  prices 
remained  subdued 
their 
contributions  to  final  demand  inflation  were  still 
negative  in  1993  and  marginally  positive  in  1994-95 
(see  Table 7.4).  On  the  other  hand,  in  those  countries  which  experienced  marked 
depreciation  between  1993  and  1995  (Spain,  Italy,  Sweden  and  the  United Kingdom), 
import  prices  increased  strongly  over  the  period.  However,  the  knock-on  effects  on 
domestic  inflation  were  relatively  limited,  particularly  owing  to  the  appropriate  economic 
policy response, but also to the weak growth environment prevailing in these countries. 

(see  Table  7.3),  and 

rate 
remained 

France, 

front. 

Most commodity prices have experienced  another fall  since mid-1996 (see Graph 7.1).  On 
the  other  hand,  the  dollar  has  recovered  somewhat  since  mid-1995.  European  currencies 
which  depreciated  significantly  in early  1995  also  strengthened  during  the  course  of  1995 
and  1996. Consequently,  the rise in import  prices  should  remain moderate  throughout  the 
Community  in  1996.  Their  contributions  to  overall  inflation  are thus  expected  to  narrow 
in Member  States  whose  currencies  have  appreciated  recently,  and  to  remain  moderate in 
other Member  States (around  0.5%). 

Table 7.4 

Contribution of import prices to the 
change of the final uses deflator. 
(percentage change) 

1993 

1994 

1995 

-1.0 
-0.3 
-0.2 
1.9 
1.1 
-0.4 

1.5 
2.0 

2.6 

-0.7 
0.2 
2.4 

1.8 
3.0 
1.7 

0.4 
0.1 
0.1 
1.7 
1.0 
0.3 

1.0 
0.8 

0.1 

0.2 
0.2 
1.2 

-0.1 
0.8 
0.4 

0.2 
0.3 
0.1 
1.5 
0.8 
0.2 

1.5 
2.0 

0.2 

0.1 
0.2 
0.4 

0.1 
1.2 
1.6 

1996 
0) 
0.6 
0.5 
0.1 
0.9 
0.2 
0.3 

0.2 
-0.1 

1.4 

0.6 
0.3 
0.4 

0.5 
-0.8 
0.4 

B 
DK 
D 
EL 
E 
F 

IRL 
I 

L 

NL 
A 
P 
rasr 
s 
UK 

(1) Autumn 1996 economic forecasts. 
Source: Commission services. 

69 

Table 7.5 

Nominal effective exchange rate changes 
relative to 23 industrial countries; 
(annual percentage changes) 

1993 

1994 

1995 

B/L 
DK 
D 
EL 
E 
F 

IRL 
I 

NL 
A 
P 

FIN 
S 
UK 

1.4 
3.1 
4.1 
-7.0 
•11.5 
3.0 

-5.3 
-15.8 

3.7 
3.3 
-6.3 

•13.0 
•18.5 
-7.9 

2.6 
0.8 
2.0 
-4.8 
-5.3 
2.0 

0.7 
-2.5 

1.5 
1.2 
-3.7 

9.0 
-0.3 
1.5 

EUR (2) 

-10.5 

3.4 

5.4 
5.1 
6.8 
-1.5 
1.2 
4.7 

0.6 
-8.0 

4.8 
4.2 
2.3 

11.4 
0.4 
-3.4 

7.9 

1996 
O) 
-1.4 
-0.4 
-1.6 
-0.8 
1.7 
0.8 

1.9 
9.7 

-1.4 
-1.3 
-0.2 

-2.5 
10.1 
0.6 

4.7 

(1) Based on the geometric average of monthly 
exchange rates until 23 October 1996. 
(2) Relative to 9 non-member countries. USA, 

Japan, Mexico, Canada, Switzerland, Norway, 
Australia, New Zealand and Turkey. 

Source: Commission services. 

70 

7.4.3. Effects  of indirect  tax changes  on inflation 

Table 7.6. 

Although  during  Stage  Two  the  progress  in budgetary  consolidation  has  been  achieved 
predominantly  through  a  reduction  in  the  share  of  government  expenditure  relative  to 
GDP,  all Member  States  have  also  made use of increases in indirect  taxes  to  this  end  but 
to  varying  degree.  In  several  countries,  increases  in 
indirect taxes have contributed  importantly to increases in 
inflation,  as  is  suggested  in  Table  7.6  which  shows 
estimates  of  the  direct  mechanical  impact  under  the 
assumption  of  a full  pass-through  of  changes  in  indirect 
taxes to consumer prices. 

Effects  of indirect  tax  changes 
on consumer  price  inflation 
(percentage  points) 

1994 

1995 

1996 

B 
DK 
D 

GR 
E 
F 

IRL 
I 
L 

NL 
A 
P 

FIN 
S 
UK 

0.7 
0.4 
0.4 

0.8 
0.3 
0.1 

0.3 
0.3 
0.1 

0.2 
0.2 
0.2 

0.7 
0.3 
0.7 

0.1 
0.4 
0.0 

0.6 
1.0 
1.1 

0.1 
0.8 
0.1 

0.1 
0.5 
0.5 

1.1 
0.4 
0.6 

0.2 
0.4 
-0.2 

0.8 
0.2 
0.1 

0.2 
0.0 
0.0 

0.4 
0.2 
-0.2 

0.7 
0.3 
0.4 

Source: Commission services. 

indirect 

tax 
important  contributions  of 
The  most 
increases  to  inflation  have  been  observed  in  Belgium 
(1994), France (1995), Italy (1995), Finland  (1995-1996) 
and  the  United Kingdom  (1994-95).  However,  more 
than the direct impact - which is, by  definition,  a  one-off 
effect  -  what matters is the risk that  increases in  indirect 
taxes  raise  inflation  expectations  and  thus  trigger  a 
wage/price spiral.  This does not  appear to  have been  the 
case  in  any  of  these  countries.  After  showing  a  blip 
during  the  year  in  which  increases  in  indirect 
tax 
occurred,  inflation  came  down  swiftly  to  its  previous 
pattern within a short delay. 

71 

72 

8. CONCLUDING  SUMMARY 

8.1  General  assessment 

This report  has been prepared  in accordance with the procedure  and timetable  set  out 
in Article  109j of the Treaty. 

Substantial  progress  towards  the  achievement  of  a  high  degree  of  sustainable 
convergence  has  been  made  in  all  Member  States  since  the  beginning  of  the  second 
stage  of EMU.  This  progress  gathered  greater  momentum  during  1996, when  efforts 
to  achieve  convergence  (especially  in  the  budgetary  field)  were  intensified  in  many 
Member  States. Other necessary preparations  for  the third  stage are also advancing  at 
the  national  level  and  at  Community  level,  where  during  the  past  year  agreement  has 
been  reached  on  the  scenario  for  the  introduction  of  the  single  currency,  the 
Commission has recently presented  proposals for  the legal status of the euro  and for  a 
stability  pact to  ensure budgetary  discipline in the third  stage, a consensus is emerging 
on  the  design  of  the  so-called  "ERM II"  and  a  communication  campaign  has  been 
launched. 

The  examination  in  Chapter 2  of  this  report  of  the  compatibility  between  national 
legislation and Articles  107 and  108 of the Treaty  and the Statute of the ESCB first of 
all set out  the requirements  that will have to  be satisfied  by the start  of stage three.  It 
then  identified  types  of  existing  provisions,  mainly  in  the  statutes  of  national  central 
banks, which do not yet conform. In virtually all Member States there continue to  exist 
provisions that will need to be amended.  Several Member  States are preparing or have 
already brought forward  proposals for changes in their legislation. 

Li  the  next  four  chapters  progress  by  each  Member  State  in  relation  to  each  of  the 
convergence criteria has been examined. 

The  steady  progress  made  in  the  European  Union  as  a  whole  and  by  individual 
Member  States in moving towards  or  maintaining  a high degree  of  price  stability  has 
continued  in  1996.  The  assessment  of  price  convergence  has  been  made  using  the 
recently  available  interim  indices  of  consumer  prices  (IICPs),  which  are  more 
comparable  than  national  indices  but  not  yet  fully  harmonised.  The  average  rate  of 
inflation  for  each Member  State  has  been  calculated  as the  percentage  change  in  the 
average  IICP  in  the  latest  12 months  relative  to  the  average  index  in  the  preceding 
12 months.  The  reference  value  has been  calculated  for  the  purpose  of  this  report  as 
the simple arithmetic average of the average inflation  rates in the three best  performing 
Member  States plus  1.5 percentage points.  Calculated in this way and according to  the 
latest  available  information  (September  1996),  the  three  best  price  performers  were 
Finland,  the  Netherlands  and  Germany,  and  the  reference  value  was  2.6%  (see 
Table 8,1).  Ten  Member  States  (Belgium,  Denmark,  Germany,  France,  Ireland, 
Luxembourg,  the  Netherlands,  Austria,  Finland  and  Sweden)  had  average  inflation 
rates below this reference value. A box in Chapter 3 shows that the number of Member 
States  respecting the price  stability  criterion  is not  at  present  sensitive to  the  method 
chosen to calculate the reference value. Five Member  States still have average  inflation 
rates  above  the  reference  value  in  September  (Greece,  Spain,  Italy,  Portugal  and  the 
United Kingdom), but the differentials  have tended  to narrow in recent years and again 

73 

in  1996. Portugal  and the United Kingdom are less than  V2 percentage point  above  the 
reference value. 

Only three  Member  States  (Denmark,  Ireland  and  Luxembourg)  are currently  not  the 
subject  of a Council  Decision  on the existence  of an excessive government  deficit  and 
so  respect  the  criterion  on  the  government  budgetary  position.  The  most  recent 
decisions under the excessive deficit  procedure (Article  104c) were made in June  1996. 
Chapter 4  also  reviewed  budgetary  developments  in  the  Member  States  during  the 
second  stage  and  presented  estimates  of  likely  outturns  in  1996.  Significant  progress 
has been made  since  1993 by most  Member  States  in reducing  government  deficits;  in 
1996  four  countries  (Denmark,  Ireland,  Luxembourg  and  the  Netherlands)  are 
expected  to  achieve a government  balance better than the 3% of GDP deficit  reference 

Table  8.1 

P e r f o r m a n ce  of  the  M e m b er  States  in  relation  to  convergence  in  1996 

Inflation 

General  government  budgetary  position 

Exchange 
rates 

Long-term 
interest  rates 

Interim 
index of 
consumer 
prices 
0) 

Oct.  1995 

Sep.  1996 

2.6  (3) 

1.6 
2.2 
1.3 

8.4 
3.8 
2.1 

2.1  (5) 
4.7 
1.3 

1.2 
1.7 
3.0 

0.9 
1.6 
3.0 

2.7 

Reference 
value 
B 
DK 
D 

EL 
E 
F 

IRL 
I 
L 

NL 
A 
P 

FIN 
S 
UK 

EUR 

Existence 
of 
an excessive 
deficit 

Deficit 
(% of 
GDP) 
(2) 

Debt 
(%ofGDP) 
(2) 

ERM 
participation 

Council 
decisions, 
26.9.1994, 
10.7.1995  and 
27.6.1996 

1996 

1996 

Change 

October 
1996 

94/93 

95/94 

96/95 

yes  .. 
no 
yes 

yes 
yes, 
yes 

no 
yes 
no 

yes 
yes 
yes 

yes 
yes 
yes 

3.0 

3.3 
1.4 
4.0 

7.9 
4.4 
4.0 

1.6 
6.6 
-0.9 

2.6 
4.3 
4.0 

3.3 
3.9 
4.6 

4.4 

60 

130.6 
70.2 
60.8 

110.6 
67.8 
56.4 

74.7 
123.4 
7.8 

78.7 
71.7 
71.1 

61.3 
78.1 
56.3 

73.5 

-2.0 
-4.1 
2.2 

-1.4 
2.6 
2.8 

-6.6 
6.2 
-0.5 

-3.4 
2.3 
1.4 

2.2 
3.3 
1.9 

2.0 

-1.3 
-4.1 
7.7 

1.4 
2.6 
4.4 

-6.3 
-0.6 
0.3 

2.3 
3.9 
2.1 

-0.3 
-0.6 
3.7 

3.2 

-3.1 
-1.7 
2.7 

-1.2 
2.1 
3.6 

-6.9 
-1.5 
1.8 

-1.0 
2.7 
-0.6 

2.1 
-0.6 
2.2 

2.2 

yes 
yes 
yes 

no 
yes 
yes 

yes 
no 
yes 

yes 
yes 
yes 

yes 
no 
no 

Oct.  1995 

Sep.  1996 

8.7(4) 

6.7 
7.4 
6.3 

15.1 
9.5 
6.6 

7.5 
10.3 
7.0 

6.3 
6.5 
9.4 

7.4 
8.5 
8.0 

7.6 

(1 ) Percentage change in average level of index in latest  12 months over average in previous  12 month period 
(2) Estimates from Commission services' Autumn  1996 Economic Forecasts. 
(3) Definition  adopted  in this report:  arithmetic average of the three best performers  in terms of inflation  plus 

1.5 percentage points. 

(4) Defmition  adopted  in this report: arithmetic average of the  12-month average of interest rates of the three best 

performing  Member  States in terms of price stability plus 2 percentage points. 

(5) Measured on the basis of quarterly  data. 
Source:  Commission  services. 

74 

value; Belgium  and  Finland  are  likely  to  have  deficits  smaller  than  31/2% of  GDP.  By 
the end of  1996  three Member  States (France, Luxembourg  and the United  Kingdom) 
are expected  to  have a government  gross  debt  ratio  below  the 60% of GDP  reference 
value. In Germany  and Finland,  the debt ratio is likely to  exceed the reference  value  of 
60%  by  the  end  of  1996,  after  having  been  consistently  below  that  value.  Several 
Member  States have succeeded  in reversing  the earlier upward  trend  in the debt ratio, 
with  a  steady  reduction  since  1993  in  Belgium,  Denmark  and  Ireland  and  declines 
expected in  1996 also in Greece, Italy, the Netherlands, Portugal and  Sweden. 

Since the turbulence  in foreign  exchange  markets  that led  to  the realignment  in March 
1995  within  the  ERM  of  the  Spanish  peseta,  followed  by  the  Portuguese  escudo, 
exchange rate conditions have not  been subject to  severe tensions and the gap between 
the  strongest  and  weakest  currencies  within  the  ERM  band  has  tended  to  narrow  (as 
described  in  Chapter  5).  There  are  currently  eleven  currencies  participating  in  the 
ERM.  Nine  of  these  (the  currencies  of  Belgium,  Denmark,  Germany,  Spain,  France, 
Ireland,  Luxembourg,  the Netherlands  and  Portugal)  have  been  members  of the  ERM 
for  well over two  years. Austria joined  the ERM  at the beginning  of  1995 and  Finland 
in the  middle  of  October  1996.  Four  Member  States  (Greece,  Italy,  Sweden  and  the 
United Kingdom)  are  not  currently  participating  in  the  ERM;  the  last  three  of  these 
countries  have  seen  a  significant  appreciation  of  their  currencies  during  1996, 
following the weakness of earlier years. 

The fourth  criterion, on the durability of convergence as reflected  in long-term  interest 
rates, has been examined in Chapter 6. The assessment is based on the interest rates on 
comparable  10-year  benchmark  bonds  (not  fully  comparable  for  Greece)  ,  using  an 
average rate over the latest  12 months.  The reference  value has been  calculated  as the 
simple  arithmetic  average  of the  long-term  interest  rates  of the  three  best  performing 
Member  States in terms  of price stability plus 2 percentage  points.  In  September  1996 
the reference  value  was  8.7%.  Eleven Member  States  (Belgium,  Denmark,  Germany, 
France,  Ireland,  Luxembourg,  the  Netherlands,  Austria,  Finland,  Sweden  and  the 
United Kingdom) have average interest rates below the reference  value. Developments 
in  bond  markets  during  1996,  and  especially  in  September,  have  resulted  in  a 
significant  narrowing in interest  rate  differentials,  especially  among the  higher-yielding 
countries where the criterion is not yet  respected. 

The Treaty also requires that this report  should  examine developments in several  other 
areas  relevant  to  economic  integration  and  convergence.  These  are  dealt  with  in 
Chapter 7.  Financial  markets  in  ECU  have  tended  to  decline  in  importance  since  the 
severe  currency  turbulence  of  1992  and  1993, but  significant  amounts  of  commercial 
transactions  are  settled  in  ECU.  The  spread  between  the  private  and  public  ECU  is 
reducing as the certainty of the  1 for  1 convertibility between the ECU  and the euro is 
incorporated  by the  markets.  The  Single Market  project  has been  having  a  significant 
impact on economic integration,  particularly on the structure of trade between Member 
States,  on  foreign  direct  investment  flows,  on  competition  conditions  and  on  price 
convergence  for  certain  categories  of  goods  and  services.  The  current  account  of  the 
balance of payments reflects  the national  savings in each Member  State; the  European 
Union  as  a  whole  and  ten  Member  States  are  expected  to  be  in  surplus  in  1996. 
Additional  indicators for  unit  labour  costs  and  import  prices confirm  the picture given 

75 

in  Chapter 3  of  a  satisfactory  and  soundly  based  price  performance  in  most  Member 
States. 

Mainly as a consequence  of the persistence of budgetary imbalances (although they  are 
being  reduced)  and  as illustrated  by the  existence  of  excessive  government  deficits  in 
twelve  Member  States,  it  is  clear  that  currently  a majority  of Member  States  has  not 
yet  made  sufficient  progress  in  the  achievement  of  a  high  degree  of  sustainable 
convergence. 

8.2  Summary  by Member  States 

In this final section  of the report  performance  in relation to the convergence  criteria  is 
presented  on  a  country-by-country  basis  in  accordance  with  Article  109j(l)  which 
requires  an  examination  of  the  achievement  of  a  high  degree  of  sustainable 
convergence  by reference  to  the  fulfilment  by each Member  State of the  criteria.  The 
criteria  on  inflation  and  long-term  interest  rates  have  been  examined  using  data 
covering  the  period  up  to  September  1996.  The  reference  value  has,  in  both  cases, 
been calculated  using the average of the three best performing  Member  States in terms 
of  inflation.  As  regards  the  criterion  on  the  government  budgetary  position,  where 
relevant,  Commission estimates of budgetary data for  1996 as a whole are presented. 

In  Belgium  the  average  inflation  rate  in the year  ending  in  September  1996  stood  at 
1.6%  which  is  below  the  reference  value;  during  the  same  period  nominal  long-term 
interest  rates  were,  on  average,  6.7%  which  is  also  below  the  reference  value.  The 
Council  has not  yet  abrogated  its Decision  of 26 September  1994 according  to  which 
an  excessive  government  deficit  exists  in  Belgium.  In  1996  the  general  government 
deficit  is  expected  to  be  reduced  by  0.8 percentage  points  to  3.3%  of  GDP;  the 
government gross debt ratio is likely to  decline from 133.7% of GDP in  1995  to  130.6 
%  in  1996. Belgium  has been  a member  of the ERM  since its inception;  in  the  latest 
two years the BFR has respected the fluctuation  margins of the ERM and has not been 
subject to severe tensions and the BFR bilateral central rate has not been devalued. 

In Denmark  the  average  inflation  rate in the year  ending  in  September  1996  stood  at 
2.2%  which  is  below  the  reference  value;  during  the  same  period  nominal  long-term 
interest  rates  were,  on  average,  7.4%  which  is  also  below  the  reference  value.  The 
Council  decided  on  27 June  1996  to  abrogate  its  Decision  of  26 September  1994  on 
the  existence  of  an  excessive  government  deficit  in  Denmark.  In  1996  the  general 
government  deficit  is  expected  to  be  reduced  by  0.2 percentage  points  to  1.4%  of 
GDP;  the  government  gross  debt  ratio  is  likely  to  decline  further  to  70.2%  in  1996 
from  71.9%  of  GDP  in  1995.  Denmark  has  been  a  member  of  the  ERM  since  its 
inception; in the latest two years the DKR has respected  the fluctuation  margins of the 
ERM  and  has  not  been  subject  to  severe tensions  and  the  DKR  bilateral  central  rate 
has not been devalued. 

In  Germany  the  average  inflation  rate in the year- ending  in  September  1996  stood  at 
1.3%  which  is  the  third  best  performance  in  the  EU  and  is  therefore  below  the 
reference  value;  during  the  same  period  nominal  long-term  interest  rates  were,  on 
average,  6.3%  which  is  also  below  the  reference  value.  The  Council  decided  on 
27 June  1996  that  an  excessive  government  deficit  exists  in  Germany.  In  1996  the 

76 

general government deficit is expected to increase to 4.0% of GDP from 3.5% in 1995; 
the  government  gross  debt  ratio  which  has  been  below  60%  of  GDP  is  likely  to 
increase  in  1996  reaching  60.8% of  GDP.  Germany  has been  a  member  of  the  ERM 
since its inception; in the latest two years the DM has respected the fluctuation  margins 
of the  ERM  and  has not  been  subject  to  severe  tensions  and  the  DM  bilateral  central 
rate has not been devalued. 

In  Greece  the  average  inflation  rate  in  the  year  ending  in  September  1996  stood  at 
8.4%) which is significantly  above the reference  value; during the  same period  nominal 
long-term  interest  rates  were,  on  average,  15.1%,  also  clearly  above  the  reference 
value. The Council has not yet abrogated  its Decision of 26 September  1994  according 
to  which  an  excessive  government  deficit  exists  in  Greece.  In  1996  the  general 
government  deficit  is  expected  to  be  reduced  by  1.2 percentage  points  to  7.9%  of 
GDP;  the  government  gross  debt  ratio  is  likely  to  decline  from  111.8%  of  GDP  in 
1995 to  110.6% in  1996. The DR does not participate in the ERM. 

In Spain  the average inflation rate in the year ending in September  1996 stood  at 3.8% 
which is above the reference value; during the same period  nominal long-term  interest 
rates were,  on average, 9.5% which is also above the reference value. The  Council has 
not yet abrogated  its Decision  of 26 September  1994 according to  which  an  excessive 
government  deficit  exists in Spain. In  1996 the general government  deficit  is  expected 
to  be  reduced  by  2.2 percentage  points  to  4.4%  of  GDP; the  government  gross  debt 
ratio  is  likely  to  increase  from  65.7%  of  GDP  in  1995  to  67.8% in  1996.  Spain  has 
been a member of the ERM since June 1989; in March  1995 the bilateral central rate of 
the  peseta  was  devalued  by  7%,  at  the  initiative  of  Spain;  since  then  the  PTA  has 
respected  the  fluctuation  margins  of  the  ERM  and  has  not  been  subject  to  severe 
tensions. 

In  France  the  average  inflation  rate  in  the  year  ending  in  September  1996  stood  at 
2.1%) which  is  below  the  reference  value;  during  the  same  period  nominal  long-term 
interest  rates  were,  on  average,  6.6%  which  is  also  below  the  reference  value.  The 
Council has not  yet  abrogated  its Decision of 26 September  1994  according  to  which 
an  excessive  government  deficit  exists  in  France.  In  1996  the  general  government 
deficit  is  expected  to  be  reduced  by  0.8 percentage  points  to  4.0%  of  GDP;  the 
government  gross  debt ratio  continues to  be below  60% of GDP  in  1996.  France  has 
been  a  member  of  the  ERM  since  its  inception;  in  the  latest  two  years  the  FF  has 
respected  the  fluctuation  margins  of  the  ERM  and  has  not  been  subject  to  severe 
tensions and the FF bilateral central rate has not been devalued. 

In  Ireland  the  average  inflation  rate  in  the  year  ending  in  September  1996  stood  at 
2.1%  which  is  below  the  reference  value;  during  the  same period  nominal  long-term 
interest  rates were,  on average,  7.5% which is also below the reference  value.  Ireland 
is not  the  subject  of  a  Council  decision  on the  existence  of  an  excessive  government 
deficit.  The general  government  deficit  has been below  3% of GDP  since  1989  and  is 
expected  to  be reduced  further  by 0.4 percentage points to  1.6%  of GDP  in  1996; the 
government  gross  debt  ratio  is likely to  decline further  to  74.7% in  1996  from  81.6% 
of  GDP  in  1995.  Ireland  has  been  a  member  of  the  ERM  since  its  inception;  in  the 
latest two years the ERL has respected  the fluctuation  margins of the ERM  and  has not 

77 

been  subject  to  severe  tensions  and  the  IRL  bilateral  central  rate  has  not  been 
devalued. 

In Italy the average inflation  rate in the year ending in  September  1996 stood  at 4.7% 
which is clearly  above  the reference  value; during  the  same period  nominal  long-term 
interest  rates  were,  on  average,  10.3% which  is  also  above  the  reference  value.  The 
Council  has not yet  abrogated  its Decision  of 26  September  1994  according  to  which 
an excessive government  deficit  exists in Italy. In  1996 the  general government  deficit 
is expected  to  be  reduced  by  0.5 percentage  points  to  6.6%  of  GDP; the  government 
gross debt ratio  is likely to  decline from  124.9% of GDP  in  1995 to  123.4 % in  1996. 
Italy  was  a  member  of  the  ERM  from  its  inception  until  September  1992  when  the 
intervention  obligations  for  the  LIT  were  suspended;  since  then  the  LIT  has  not  re 
entered the ERM. 

In Luxembourg  the average inflation  rate in the year  ending in September  1996  stood 
at  1.3% which is below the reference  value; during the  same period  nominal  long-term 
interest  rates  were,  on  average,  7.0%  which  is  also  below  the  reference  value. 
Luxembourg  is not  the  subject  of  a  Council  decision  on  the  existence  of  an  excessive 
government  deficit.  The general government financial position has traditionally been in 
a  surplus,  expected  to  amount  to  0.9%  of  GDP  in  1996.  The  government  gross  debt 
ratio  continues  to  remain  significantly  below  60%  of  GDP.  Luxembourg  has  been  a 
member  of the ERM  since its inception; in the latest  two  years the LFR has  respected 
the fluctuation  margins of the ERM and has not been subject to severe tensions and the 
LFR bilateral central rate has not been devalued. 

In  the  Netherlands  the  average  inflation  rate  in  the  year  ending  in  September  1996 
stood  at  1.2%  which is the second  best performance  in the EU  and  is therefore  below 
the reference  value; during the  same period  nominal  long-term  interest  rates were,  on 
average,  6.3%  which  is  also  below  the  reference  value.  The  Council  has  not  yet 
abrogated  its  Decision  of  26 September  1994  according  to  which  an  excessive 
government deficit  exists in the Netherlands. In  1996 the general government  deficit  is 
expected  to  be  reduced  by  1.4 percentage  points  to  2.6%  of  GDP;  the  government 
gross  debt  ratio  is  likely  to  decline  from  19.1%  of  GDP  in  1995  to  78.7  %  in  1996. 
The Netherlands have been a member  of the ERM  since its inception; in the latest  two 
years  the  HFL  has  respected  the  fluctuation  margins  of  the  ERM  and  has  not  been 
subject to severe tensions and the HFL bilateral central rate has not been devalued. 

In  Austria  the  average  inflation  rate  in  the  year  ending  in  September  1996  stood  at 
1.7%  which  is below  the  reference  value;  during  the  same  period  nominal  long-term 
interest  rates  were,  on  average,  6.5%  which  is  also  below  the  reference  value.  The 
Council  has  not  yet  abrogated  its  Decision  of  10 July  1995  according  to  which  an 
excessive government  deficit  exists in Austria. In  1996 the  general  government  deficit 
is expected  to  be reduced  by  1.6  percentage  points  to  4.3% of  GDP; the  government 
gross  debt  ratio  is likely  to  increase  from  69.0%  of  GDP  in  1995  to  71.7  %  in  1996. 
Austria  has been  a  member  of  the  ERM  since  early  January  1995; since  then  the  OS 
has respected  the  fluctuation  margins  of  the ERM  and  has  not  been  subject  to  severe 
tensions and the OS bilateral central rate has not been  devalued. 

78 

In Portugal  the  average  inflation  rate  in the  year  ending  in  September  1996  stood  at 
3.0%  which  is  above  the  reference  value;  during  the  same  period  nominal  long-term 
interest  rates  were,  on  average,  9.4%  which  is. also  above  the  reference  value.  The 
Council has not  yet  abrogated  its Decision  of 26  September  1994  according  to  which 
an  excessive  government  deficit  exists  in Portugal.  In  1996  the  general  government 
deficit  is  expected  to  be  reduced  by  1.1 percentage  points  to  4.0%  of  GDP;  the 
government gross debt ratio  is likely to decline from  71.7.% of GDP in  1995 to 71.1% 
in  1996. Portugal  has been  a member  of the ERM  since April  1992.  In March  1995, 
following  the  devaluation  of  the  Spanish  peseta,  the  bilateral  central  rate  of  the 
Portuguese  escudo  was  devalued  by  3.5%.  Since  then  the  ESC  has  respected  the 
fluctuation  margins of the ERM and has not been subject to severe tensions. 

In  Finland  the  average  inflation  rate  in the  year  ending  in  September  1996  stood  at 
0.9%  which  is  the  best  performance  in  the  EU  and  is  therefore  below  the  reference 
value; during the same period  nominal long-term interest  rates were,  on average,  7.4% 
which is also below the reference  value. The Council has not yet abrogated  its Decision 
of  10 July  1995  according  to  which  an  excessive  government  deficit  exists  in Finland. 
In  1996  the  general  government  deficit  is  expected  to  be  reduced  by  1.9  percentage 
points to 3.3% of GDP; the government gross debt ratio which has been below 60% of 
GDP is likely to increase in  1996, reaching 61.3%  of GDP. Finland has been a member 
of the ERM since mid-October  1996. 

In  Sweden  the  average  inflation  rate  in  the  year  ending  in  September  1996  stood  at 
1.6%  which  is  below  the  reference  value;  during  the  same  period  nominal  long-term 
interest  rates were,  on average,  8.5% which is below the reference  value. The  Council 
has  not  yet  abrogated  its  Decision  of  10 July  1995  according  to  which  an  excessive 
government  deficit  exists  in  Sweden.  In  1996  the  general  government  deficit  is 
expected  to  be  reduced  by  4.2 percentage  points  to  3.9%  of  GDP;  the  government 
gross debt ratio is likely to decline from 78.7% of GDP in  1995 ta 78.1% in  1996. The 
SKR does not participate in the ERM. 

the  average 

inflation  rate 

in  the  year  ending 

in 
In  the  United  Kingdom 
September  1996  stood  at  3.0%  which  is  above  the  reference  value;  during  the  same 
period  nominal  long-term  interest  rates  were,  on  average,  8.0%  which  is  below  the 
reference  value. The Council has not yet abrogated  its Decision  of 26 September  1994 
according  to  which  an  excessive  government  deficit  exists  in the  United Kingdom.  In 
1996  the  general  government  deficit  is  expected  to  be  reduced  by  1.2  percentage 
points to 4.6% of GDP; the government gross debt ratio continues to be below 60% of 
GDP in  1996. The currency of the United Kingdom entered the ERM in October  1990; 
the  participation  of  the  UKL  in the  ERM  was  suspended  in  September  1992  and  has 
not been resumed. 

ISSN 0254-1475 

COM(96) 560  final 

DOCUMENTS 

EN 

09  10 

Catalogue  number  :  CB-CO-96-569-EN-C 

ISBN  92-78-11424-3 

Office  for  Official  Publications  of the European  Communities 

L-2985 Luxembourg