The consequences of EMU for the EEA/EFTA countries.
Date: 2003-10-20
Institutions: Directorate-General for Parliamentary Research Services
Subjects: Denmark, Economic and Monetary Union, European Economic Area, Iceland, Liechtenstein, Norway, Sweden, Switzerland, United Kingdom, economic consequence, euro, exchange rate, monetary policy

DIRECTORATE-GENERAL FOR RESEARCH 
Directorate A: Medium and Long Term Research 
Division for Economic, Monetary and Budgetary Affairs 

BRIEFING 
ECON 511 EN rev.1 

THE CONSEQUENCES OF EMU 
FOR THE EEA/EFTA COUNTRIES  

The opinions expressed are those of the authors and do not 
necessarily reflect the European Parliament's position 

Luxembourg, 18 February 2002 

  PE 304.442 rev. 1

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
This document is published in English. 

Summary 

This briefing examines the consequences for Norway, Iceland, Liechtenstein and Switzerland 
of  the  creation  of  the  euro.  It  analyses  each  of  these  countries'  economic  and  monetary 
policies, and also the possible links between the exchange rates of their currencies and that of 
the euro. Finally, it examines the possible effects of EMU and of the policies of the European 
Central  Bank  on  the  conduct  of  monetary,  exchange  rate,  fiscal  and  other  policies  in  third 
countries, and in those of the EFTA in particular. 

Publisher:   European Parliament 
L-2929 Luxembourg 

Author       Aida Liha, Cecilia Andreasson 

Editor:  

Ben Patterson 
Economic, Monetary and Budgetary Affairs Division 
Tel. : (00-352) 4300 24114 
Fax : (00-352) 4300 27721 
E-Mail  : gpatterson@europarl.eu.int 

Reproduction  and  translation  of  this  publication  is  authorised,  except  for  commercial 
purposes,  provided  that  the  source  is  acknowledged  and  that  the  publisher  is  informed  in 
advance and supplied with a copy. 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
EMU and the EFTA 

CONTENTS 

INTRODUCTION.................................................................................................................................................... 5 

1. THE EURO AS AN INTERNATIONAL CURRENCY................................................................................................... 5 
2. THE POSITION OF THE "OUTS" AND THEIR INFLUENCE ON THE EFTA COUNTRIES............................................. 5 
Denmark ........................................................................................................................................................... 6 
Sweden .............................................................................................................................................................. 6 
The United Kingdom ........................................................................................................................................ 7 
3. THE EFTA.......................................................................................................................................................... 8 
4. THE EEA ..........................................................................................................................................................10 

THE IMPLICATIONS OF EMU.........................................................................................................................11 

1. THE "BENIGN NEGLECT" OPTION......................................................................................................................11 
2. GLOBALISATION...............................................................................................................................................12 
3. DEVELOPMENTS IN INTERNAL EURO AREA POLICIES .......................................................................................12 

THE EFTA AND EEA ECONOMIES ................................................................................................................13 

GENERAL..............................................................................................................................................................13 
1. NORWAY ..........................................................................................................................................................13 
Introduction ....................................................................................................................................................13 
Monetary policy..............................................................................................................................................14 
The Government Petroleum Fund and the impact of petroleum revenues on stability ................................15 
The stability of the crown/euro exchange rate ..............................................................................................15 
2. ICELAND ...........................................................................................................................................................17 
Introduction ....................................................................................................................................................17 
Monetary policy..............................................................................................................................................18 
The stability of the crown/euro exchange rate ..............................................................................................18 
Exchange rate policy alternatives..................................................................................................................20 
Other economic policy consequences ............................................................................................................20 
3. SWITZERLAND AND LIECHTENSTEIN................................................................................................................21 
Introduction ....................................................................................................................................................21 
Monetary policy..............................................................................................................................................22 
The stability of the Swiss franc/euro exchange rate ......................................................................................24 

SWISS INTEREST RATES, WHICH HAVE BEEN LOWER THAN ANYWHERE ELSE IN EUROPE, 
MIGHT HAVE TO RISE TO THE LEVELS PREVAILING IN THE EURO AREA. ........................................26 

SUMMARY AND CONCLUSIONS....................................................................................................................27 

ECONOMIC AFFAIRS SERIES BRIEFINGS ..............................................................................................................29 
ECONOMIC AFFAIRS SERIES WORKING PAPERS ..................................................................................................29 

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EMU and the EFTA 

Tables and Charts 

Table 1: Results of the Danish Referendum on € area membership, September 2000..............6 
Table 2: The UK's five economic tests participation in the EMU .............................................8 
Table 3: Economic indicators for the EFTA countries (2000) ..................................................9 
Table 4: GNP per Capita of Major Regional Groupings ( 1999).............................................10 
Table 5: US and Euro Area Trade as a Proportion of GDP .....................................................11 
Chart 1 : Petroleum production on the Norwegian continental shelf.......................................13 
Chart 2 : The Krone exchange rate against ECU/euro.............................................................14 
Chart 3 : The Krone's effective exchange rate against euro ....................................................16 
Chart 4 : Daily variation in the krone exchange rate against ECU/EURO..............................16 
Chart 5 : The Icelandic Krona exchange rate against the ECU/Euro ......................................19 
Chart 6 : Swiss franc exchange rate against euro ....................................................................24 
Chart 7 : Dollar/euro exchange rate .........................................................................................25 

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EMU and the EFTA 

Introduction 

This briefing examines the consequences for Norway, Iceland, Liechtenstein and Switzerland 
of  the  creation  of  the  euro.  The  first  three,  together  with  the  fifteen  members  of  the  EU, 
constitute  the  European  Economic  Area  (EEA).  Switzerland,  though  it  has  rejected  EEA 
membership, nevertheless belongs, with the other three countries, to the European Free Trade 
Area  (EFTA);  and  also  forms  a  single  currency  area  with  Liechtenstein.  It  is  therefore 
sensible to consider the impact of the euro not just on the three EEA countries, but on all four 
members of the EFTA. 

The briefing analyses each of these countries' economic and monetary policies; but these are 
not necessarily presented and assessed in the same way, since the specific factors determining 
each vary considerably.  

1. The euro as an international currency 

The  euro  is  emerging  as  a  major  international  currency,  entailing  implications  for  other 
countries as well as for the monetary policy of the euro zone itself. Before the D-Mark was 
the  only  internationally  significant  European  currency;  but  its  importance  was  still  minor 
compared to the dollar, which has dominated since the end of World War II. 

The use of currency internationally depends on a number of factors. These include:  
•  a large domestic market;  
•  a high exposure to trade;  
•  a large weighting in total global trade;  
•  exporter and importer preferences favouring the currency as a unit of account;  
• 

the  existence  of  a  large  and  competitive  financial  market  in  which  the  currency 
denominated assets are actively traded;  

•  economic  and  political  stability  of  the  currency  area,  thereby  favouring  it  is  a  "safe 

haven" currency; and  

•  competitive pricing of cross-border payment systems. 

Though  the  euro  has  not  yet  fulfilled  the  early  predictions  of  some  that  it  would  rival  the 
dollar  as  an  international  unit  of  accounting,  or  as  a  reserve  currency,  it  has  done  so  in  a 
number of other ways. Most notably, the merging of the former national bond markets into a 
single euro-denominated market has resulted in issues of both sovereign and corporate bonds 
being as often made in euros as in dollars.  

2. The position of the "outs" and their influence on the EFTA countries 

For  different  reasons,  Denmark,  the  United  Kingdom  and  Sweden  have  chosen  to  stand 
outside the EMU and have the status of EU "Member States with a derogation" under Article 
122  of  the  Treaty.  All  three  qualify  on  the  formal  Maastricht  criteria  concerning  inflation, 
interest rates and fiscal position, although Sweden and the UK have declined to join ERM2. 
Their  exclusion  is  mainly  a  matter  of  political  choice,  resulting  from  a  powerful  domestic 
hostility towards the EMU, which led Britain and Denmark to negotiate their Maastricht opt-
outs. Sweden has no formal opt-out. 

Since all three countries are closely related with the three EEA countries and Switzerland –
notably through their former EFTA links – and have an important share of their foreign trade, 
a decision on their part to enter EMU would have significant consequences for the latter. The 

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EMU and the EFTA 

deeper  integration  of  Denmark  and  Sweden  into  the  EU,  which  a  decision  to  join  the  euro 
would imply, is likely to have an especial impact on Norway. 

How  likely,  then,  are  these  "out"  countries  to become "ins"? In all  three  countries  business 
opinion is more favourable than that of the public at large; and if EMU appears to be working 
well the decision to stand aside is likely to be reconsidered at an early date. Indeed, following 
the  successful  introduction  of  €-denominated  notes  and  coins  at  the  beginning  of  2002, 
opinion  polls  recorded  majorities  for  euro  area  membership  in  both  Denmark  and  Sweden, 
and a similar swing (though not to a majority) in the UK (see below). 

Denmark 

Of  the  "out"  countries,  Denmark  is  most  integrated  into  the  European  Union.  As  a  small, 
open economy, some 66% of its trade is intra-European. For this reason the case for Denmark 
adopting the single currency appears strong and the Danish decision to peg the crown against 
the euro within the narrow ERM2 bands has been prudent, almost essential.  

Table 1: Results of the Danish Referendum on € area membership, September 2000 

For 
Against 

46.9% 
53.1% 

However, after an intense campaign, the Denish referendum of September 28th 2000 rejected 
€-area  membership.  Had  the  vote  been  only  about  the  economics  of  joining,  the  "Yes" 
campaign probably would have won. But political doubts – in particular, fears about loss of 
sovereignty – tipped the balance1.   

Recently, however, Danish opinion has been changing. The Eurobarometer in Autumn 2001 
already  recorded  a  7%  rise  in  support  of  the  €  over  the  previous  year,  and  an  8%  drop  in 
opposition, to bring an almost equal division of opinion (47:48). A poll carried out only one 
week after the turn of the year then found 57% in favour of the European currency, with 34% 
opposed.  The  question  of  having  another  referendum  as  early  as  in  2003  is  now  rapidly 
emerging in the political debate.  

At  the  same  time,  the  arrival  of  €-denominated  notes  and  coins  has  resulted  in  the  euro 
already  being  widely  accepted  as  a  means  of  exchange.  A  recent  survey  by  Danish 
Commerce and Services, an employer's organisation, found that 10% of shops plan to mark 
prices in euros as well as in crowns.  

Sweden  

Although  Sweden's  economy  is  in  line  with  the  Maastricht  criteria  for  entry  into  the  euro 
area, the Swedish crown has yet to join the ERM2. Moreover, the hostility of public opinion 
towards EMU membership has been strong for a number of years.  

However, Swedish opinion is also undergoing a sea change. The Autumn Eurobarometer, as 
in the case of Denmark, recorded an extraordinary growth of support: 51% were in favour of 
the euro, an improvement of 22 percentage points since the spring! Opposition had decreased 
by  20  percentage  points  during  the  same  period  to  42%.  A  poll  released  on  8th  January 
reinforced the findings of this survey. Again it showed 51% for the euro and 43% against it.  

1  "The  Eurozone  in  action  -  changes  and  challenges",  Research  Report  by  the  Economist  Intelligence  Unit, 

London 2000. 

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EMU and the EFTA 

The volatility and depreciation of the crown against external currencies during the past few 
years are likely to be influential factors behind the change. Nevertheless it remains to be seen 
whether  the  opinion  shift  is  stable  or  mainly  a  result  of  the  recent  "euro-phoria".  The 
introduction of euro cash has had a psychological, familiarising effect rather than any lasting 
economic ones. During the 1990s the Riksbank managed to maintain relatively stable prices 
and even the Swedish Trade Union Confederation, LO, now considers it "the wage earners' 
best friend". Letting go of national monetary policy could hence be an obstacle for entering 
the EMU. 

Just  a  few  days  after  the  launch  of  €-denominated  notes  and  coins  the  Swedish  Prime 
Minister,  Göran  Persson,  criticised  for  his  passivity,  spoke  out,  presenting  a  possible 
timetable  for  joining  the  EMU.  Whether  this  will  be  acceptable  to  the  other  member  states 
depends on the interpretation of the Maastricht treaty. Mr. Persson suggests a referendum in 
March 2003 and an introduction of the euro in Sweden already in 2006.  

According to the plan, the crown would enter ERM2 for only one year. This contrasts with 
the text of the Treaty which requires observing 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.  

There  are  however  indications  of  flexibility.  Pedro  Solbes,  monetary  affairs  Commissioner, 
has  stated  that  there  may  be  "margin  for  manoeuvre".  Exchange  rate  stability  during  the 
period  before  joining  the  ERM2  will  be  taken  into  account.  Furthermore,  ERM2  is  not 
specifically  mentioned  in  the  Treaty  and  the  criterion  has  already  caused  problems  of 
interpretation concerning band-width (currently the  margin is 15% either side of the central 
rate) and time-frame (neither Italy nor Finland fulfilled the prerequisite of two-years within 
ERM1 before the decision on euro area membership). 

As  in  the  case  of  Denmark,  the  €-denominated  notes  and  coins  are  likely  to  be  widely 
accepted.  Though,  historically, Swedish  people  have  strongly supported the  maintenance  of 
neutrality, a clear focus on the economic benefits of joining the currency union, as opposed to 
political unification, is likely to boost public opinion even more in favour of the euro. 

The United Kingdom 

The UK was granted  leave to opt out of the single currency by the  terms of the Maastricht 
Treaty. Like the Swedish crown, Sterling is not in ERM2, and the problem of maintaining a 
stable    exchange  rate  to  the  euro  is  even  more  acute  than  in  the  case  of  Sweden.  Sterling 
appreciated  by  about  20%  against  the  D-mark  in  1997,  and  is  now  widely  reckoned  to  be 
overvalued  by  up  to  30%;  but  a  significant  devaluation  is  considered  one  of  the  most 
substantial  barriers  to  euro  area  entry.  Moreover,  despite  the  large  percentage  of  total  UK 
trade that takes place with the rest of the EU, the pound has often in the past tended to move 
in step with the US dollar rather than with the euro.  

There are several other economic obstacles to an early British entry. One is the fact that the 
British economic cycle does not yet appear to be entirely synchronised with the continental 
cycle, causing doubts about the applicability of the ECB's "one-size-fits-all" monetary policy. 
Another arises from differences in the transmission mechanisms of monetary policy, mainly 
resulting from the prevalence in the UK of variable-rate mortgages. The UK Government has 
accordingly laid down five additional economic tests (see Table 2 for assessing whether the 
UK should adopt the euro: 

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EMU and the EFTA 

Table 2: The UK's five economic tests participation in the EMU 

1.  Business and economic cycles must be compatible so that Britain can live with European 

interest rates. 

2.  There must be sufficient flexibility to deal with problems. 
3.  Joining the euro area must create better conditions for firms investing in Britain. 
4.  Joining the euro area must not harm the financial services industry. 
5.  Joining the euro area must promote higher growth, stability and job creation. 

The UK Treasury is to evaluate the criteria by June 2003 at the latest.  

The  principal  obstacle  to  UK  membership,  however,  is  the  fact  that  the  public  opinion  has 
been deeply hostile. The memory of "Black Wednesday" in September 1992, when the Pound 
was  forced  out  of  the  ERM1,  still  persists  in  British  minds,  widely  shaping  the  negative 
attitude towards the euro. In contrast to the situation in Denmark and Sweden, and despite the 
successful  introduction  of  €-denominated  notes  and  coins,  opposition  remains  strong.  Two 
opinion  polls  of  January  2002  reported  73%  against  the  currency  area.  In  the  latest 
Eurobarometer  58%  were  against  while  only  27%  approved.  However,  some  confusion  has 
emerged. One recent figure of only 56% against the EMU and another poll showing 52% in 
favour may indicate a slight softening of attitude.  

The opposition Conservative Party made "Saving the £" a main plank of its policy at the last 
UK  elections,  and  remains  opposed  to  €  area  membership  during  the  current  parliamentary 
term, and probably beyond. Since 1997 the UK Prime Minister, Tony Blair, has been able to 
postpone  the  question  by  giving  an  undertaking  to  hold  an  early  referendum  on  euro  area 
membership once a new parliament was elected in 2001. Since the introduction of euro notes 
and coins the government is opening up, taking a stronger position on joining. The autumn of 
2003  is  often  mentioned  as  a  possible  time  for  a  British  referendum,  assuming  that  the 
economic criteria are met.  

3. The EFTA 

The European Free Trade Association is an international organisation comprising four states: 
Iceland,  Liechtenstein,  Norway  and  Switzerland.  The  per-capita  income  in  the  EFTA 
countries is among the highest in the world, and their trade relations are extremely outward 
oriented: the total trade of the EFTA countries, worth some $243 billion, represents 58% of 
the EFTA combined GDP and 2.2% of world trade. The background for this is that EFTA has 
created and further develops the world's second largest network of free trade agreements after 
the EU, comprising 16 Free Trade Agreements and 10 declarations on co-operation.  

The main trading partner of EFTA is the EU while EFTA is the EU's second largest trading 
partner after the US. The EU absorbs more than 66 % of EFTA's external trade, while around 
12%  of  the  EU's  trade  is  done  with  the  EFTA  States.  The  EFTA  countries  are  closely 
integrated with the EU. But all have decided to stay out of the European Union for a variety 
of reasons2. 

2 

For  example  Iceland  has  problems  with  the  EU  common  fisheries  policy,  Norway  turned  down  EU-
membership in a referendum and Switzerland did the same earlier with membership of the EEA. 

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Table 3: Economic indicators for the EFTA countries (2000) 

ICELAND 

LIECHTENSTEIN  NORWAY 

SWITZERLAND 

EMU and the EFTA 

GDP at market 
prices;  
billion euro  
Per capita 
GDP, current 
prices (1999)   
GDP yearly 
growth in % 
Inflation rate 
in % 
Export of 
goods in 
billion euro 
(1999) 

Import of 
goods in 
billion euro 
(1999) 

Government 
gross debt  
(% of GDP) 
Government 
financial 
balance  
(% of GDP)  

9.3 

2.2 

175.5 

279.4 

25.287 

36.969 

26.644 

26.880 

4.9 

5.2 

1.8 
(seafood 67.4%, 
aluminium 
15.6%, ferro-
silicon 2.2%, 
agricultural 
products 1.5%) 
2.23 
(industrial 
supplies 24.7%, 
capital goods 
24.0%, transport 
equipment 
17.2%, food and 
beverages 9.6%, 
fuels and 
lubricant 5.3%) 

33 

2.3 

n.a. 

1.5 

n.a. 

n.a. 

n.a. 

n.a. 

2.3 

3.1 

42.7 
(oil/gas products 
49.7, fish 
products 8.0) 

32.1 
(machinery/tran
sport equipment  
42.5%, road 
vehicles 8.6%, 
electrical 
machinery 
5.2%) 

3.0 

1.5 

71.5 

(machinery/elect. 
equipment 28.5%, 
chemical industry 
29.7%, watches/ 
jewellery 15.4%, metal 
industry 8.2%) 

70.8 

(machinery/elect. 
equipment 23.7%, 
chemical industry 
17.0%, vehicles 12.7%, 
watches/jewellery 
6.0% ) 

24.8 

49.8 

14.3 

1.5 

Sources:   Norwegian Ministry of Finance: 

http://www.odin.dep.no/archive/finbilder/01/05/table057.pdf 

Icelandic Ministry of Finance:  

Swiss Ministry of Finance: http://www.efd.admin.ch/d/dok/sdds/oeffhh.htm 

http://government.is/interpro/fjr/fjr.nsf/Files/newsletter11012002/$file/Newsletter11012002.pdfN 

New Cronos DataBase 

OECD Economic Outlook; December 2001, vol 2001, no.2, pp 119-120 

IMF: http://www.imf.org/external/np/sec/pn/2001/pn0110.htm 

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EMU and the EFTA 

Table 4: GNP per Capita of Major Regional Groupings ( 1999) 

Regional Grouping 

GNP per Capita  (USD) 

EFTA 

EU (15) 

NAFTA 

APEC (21) 

MERCOSUR (4) 

CEFTA (7) 

ASEAN (10) 

SADC (14) 

33 503 

23 133 

18 107 

11 819 

4 875 

4 293 

7 729 

1 245 

        Source: Fortieth  Annual Report of the European Free Trade Association, 2000. 

4. The EEA 

The  purpose  of  the  Agreement  on  the  European  Economic  Area (EEA), which entered into 
force on January 1, 1994, is to create a comprehensive economic partnership that extends the 
internal market of the EU to the participating EFTA states. The total market so created is one of 
some  380  million  people.  The  EEA  Agreement  provides  for  the  free  movement  of  goods, 
persons,  services  and  capital  among  the  signatory  countries.  It  does  not  provide  for  the 
participation by the relevant EFTA countries in certain areas of co-operation among the EU 
member  states,  such  as  taxation,  agricultural  and  fishing  policies,  economic  and  monetary 
policies and the EU customs union.  

Since  the  introduction  of  the  EEA,  three  of  the  original  EFTA  countries  –  Austria,  Finland  and 
Sweden – have become full Members of the European Union. The Agreement now therefore applies 
to the 15 EU Member States and 3 EFTA countries – though not to Switzerland, which nevertheless 
remains a member of EFTA. 

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EMU and the EFTA 

The Implications of EMU 

The  creation  of  a  single  currency  to  replace  the  eleven3  previously  existing  national 
currencies of twelve EU Member States has several general consequences for third countries. 

1. The "benign neglect" option 

An  advantage  enjoyed  by  the  United  States  economy  in  a  global  context  is  its  ability  to 
conduct domestic monetary, fiscal and economic policy without having to pay much attention 
to  external  consequences.  The  Federal  Reserve  Bank  has  been  able  to  adopt  an  attitude  of 
"benign neglect" towards the exchange rate of the Dollar against other currencies. Monetary 
authorities  managing  these  currencies  have  been  "takers",  obliged  to  adapt  their  policies  to 
the exchange rate consequences of decisions made by the Fed for US domestic reasons alone. 

This "lead currency" model is not necessarily an unsatisfactory way to run the international 
monetary  system  (in  game  theory  it  is  called  the  Stackelberg  Strategy).  It  corresponds  in 
many ways to the way in which the European Monetary System operated during the 1980s, 
where the D-Mark occupied the lead position. The EMS analogy, however, also provides an 
example  of  why  the  model  can  prove  unsatisfactory  when  the  system  experiences  an 
unforeseen shock with asymmetric effects – in this case, German re-unification. Among the 
reasons for creating the euro area were precisely the need to escape from this deficiency of 
the EMS, and also from dollar dominance in the international economy as a whole. 

Table 5: US and Euro Area Trade as a Proportion of GDP 

€ area (%)  US (%) 

Exports 

Imports 

16.9 

15.4 

10.8 

13.5 

                  Source: ECB July Bulletin 1999 

The  euro  area  now  enjoys  the  same  important  advantage  as  the  dollar  area:  namely,  a  low 
proportion of GDP accounted for by external trade, and a consequently lowered vulnerability 
to external shocks (see Table 5). This compares to figures of around 30% of GDP for the EU 
Member Countries as independent currency areas. The area thus has a freedom similar to that 
of  the  US  in  the  conduct  of  monetary  policy  -  a  position  which  is  indeed  reflected  in  the 
mandate of the ECB itself, which is required by the Treaty to give primary importance only 
to internal price stability. 

One  consequence  is  that  countries  with  close  economic  and  trade  links  with  the  euro  area, 
like  the  EU  "outs"  and  the  EFTA  countries,  will  increasingly  become  "takers"  of  euro  area 
monetary policy. This is currently most clearly the case with Denmark, but is also likely to 
become true of all European economies (with the possible exception of the UK). 

3  Belgium and Luxembourg already formed a currency union.  

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EMU and the EFTA 

2. Globalisation 

The  second  consequence  of  the  euro's  creation  has  operated,  paradoxically,  in  the  opposite 
direction: a  re-enforcement of global financial and economic integration. Although in trade 
terms the euro area is relatively autarkic, the opening up of national capital markets has led to 
higher capital mobility both within and outside the area.  

One result has been the dominant influence of such flows on the euro/dollar exchange rate. 
Though  the  euro  area  has  overall  enjoyed  a  small  current  account  surplus,  and  the  US  a 
massive  deficit,  this  has  not  had  the  conventional  effect  of  a  euro  appreciation  against  the 
dollar.  Instead,  large  net  outflows  of  direct  and  portfolio  investment  from  the  euro  to  the 
dollar area have overwhelmed trade effects. The creation of a large, liquid euro-denominated 
bond market has played a critical role. As the Bank for International Settlements has put it, 
“the newly created euro may have proved too successful”. 

“Larger and more liquid markets, along with relatively low interest rates, encouraged 
the  issue  of  euro-denominated  bonds  whose  proceeds  could  then  be  exchanged  and 
used  to  finance  investment  elsewhere.”  (Bank  for  International  Settlements,  Basle, 
2000) 

At  the  same  time,  the  creation  of  the  euro  area  has  in  some  respects  simplified  the 
international monetary system, by creating a "tri-polar" (Dollar, Euro and Yen) or even "bi-
polar"  (Dollar  and  Euro)  world.  Whether  Europe  can  take  over  from  the  US  as  the  main 
"motor" of economic growth in the coming years, whether this will result in an appreciation 
of  the  euro  against  the  dollar,  etc.  are  two  of  the  big  questions  of  international  economics. 
Third country currencies are, in this context too, "takers". 

The  overvaluation  of  the  UK  Pound  Sterling  against  the  euro,  for  example,  does  not  arise 
directly from events within the EU, but from the euro/dollar situation. Yet the effect has been 
to  reduce  competitiveness  within  the  UK's  single  most  important  market.  This  reflects  the 
events of 1992, when Sterling was forced out of the EMS Exchange Rate Mechanism, in part  
as a result of capital flows out of  the Dollar into the D-Mark. 

3. Developments in internal euro area policies 

The creation of a single currency, linked to the continuing completion of the Single Market 
and the integration of capital markets, is leading to pressures for the development of common 
policies  in  other  area.  The  freedom  of  Member  States  to  conduct  fiscal  policy  has  already 
been  severely  circumscribed  by  the  Treaty,  the  Stability  and  Growth  Pact  and  the 
development of Broad Economic Guidelines. The pressure is now affecting certain areas of 
tax policy. 

One  of  the  most  contentious  proposals  in  this  field,  for  example,  has  been  that  to  charge  a 
Withholding  Tax  in  all  Member  States  on  the  savings  income  of  non-residents.  After  long 
negotiations, agreement has been reached on a system of information-exchange between tax 
authorities  instead.  In  order  to  prevent  an  outflow  of  funds  from  the  EU,  however,  this 
agreement  is  conditional  upon  similar  arrangements  being  introduced  in  certain  non-EU 
countries: notably Liechtenstein and Switzerland.  

Switzerland has so far firmly resisted abandoning its provisions for banking secrecy. Pressure 
from the EU, however, is likely to grow, linked to similar developments at global level in the 
fields of combating money laundering and eliminating "tax havens". 

12 

PE 304.442 rev.1. 

EMU and the EFTA 

The EFTA and EEA Economies 

General 

In  principle,  EFTA  countries  could  take  their  monetary  policy  frameworks  in  one  of  two 
directions:  towards  direct  inflation  targeting  and  floating  exchange  rates;  or  towards  much 
closer pegs to the euro4. 

Switzerland  and  Liechtenstein  have  a  floating  exchange  rate,  and  use  base  money  as  an 
intermediate  target.  The  inflation  rate  should  not  exceed  2%.  The  Swiss  franc  has  had  a 
reserve  currency  status  and  in  the  past,  its  interest  rates  were  persistently  lower  than  in 
Germany. One immediate possible danger for the Swiss economy from the implementation of 
EMU has been an appreciation of the Swiss franc.  

In 2001 the Central Banks of Norway and Iceland adopted new guidelines for their monetary 
policy. Earlier the exchange rate was the intermediate target for monetary policy. Pursuant to 
its existing mandate, Norges Bank has oriented its monetary policy instruments with a view 
to bringing price and cost inflation down towards the inflation objectives of the ECB, with an 
inflation target of 2.5%. The Icelandic monetary authorities have abolished formal fluctuation 
bands for the exchange rate, and instead have adopted a direct inflation target of 2.5% as the 
basis of monetary policy. 

1. Norway 

Introduction 

Norway is part of the EEA; but by virtue of the referendum of 1994, is not a member of the 
EU  and  consequently  not  currently  a  possible  member  of  the  euro  area.  However,  the 
Norwegian economy is closely integrated into the other economies of Europe. It is open and 
commodity-based,  with  external  trade  per  capita  among  the  highest  in  the  world.  The  oil 
economy and capital exports through the Government Petroleum Fund are specific features. 

Natural conditions such as an abundant supply of hydroelectric power, forestry, fisheries and 
petroleum  are  reflected  in  the  structure  of  the  industry.  The  development  of  the  petroleum 
sector after the discovery of oil at the end of the 1960s has played a significant role. Norway 
is now the seventh largest oil-producing country in the world.  

Chart 1 : Petroleum production on the Norwegian continental shelf 

                                            Source: Norges Bank 

4  Gudmundsson, M., "The implications of EMU for EFTA countries", Sedlabanki Islands, October 1997. 

13 

PE 304.442 rev.1. 

 
                                                 
EMU and the EFTA 

Since  the  recession  in  the  early  1990s,  Norway's  economic  performance  was  very  good  in 
most respects. Economic growth was the strongest in the OECD area and Norway was one of 
the few  countries  that  enjoyed  full  employment.  At the  same  time,  a  major share  of  the  oil 
revenues was saved for future generations and government outlays have been insulated from 
the swings in petroleum revenues5.  

Despite  the  strong rise in expected  household disposable income, due  to tax  cuts,  mainland 
growth  is  predicted  to  be  moderate,  around  1.25%  in  2002.  However,  the  Norwegian 
economy is still characterised by high capacity utilisation, labour shortages in many sectors 
and relatively high cost inflation. The weak global growth since the events of 11 September is 
likely  to  bring  about  a  slowdown  in  the  export  sector,  thus  causing  an  unbalanced  labour 
market with job losses in the exposed sector combined with continued labour shortages in the 
service industries. Unemployment is projected at 3.4% in 2002. 

Following the introduction of €-denominated notes and coins there is scope for the euro as a 
parallel currency to the Norwegian crown, as in the case of Denmark and Sweden. Norway's 
geographical position as an outlier, however, will probably limit the immediate extent of such 
a development, though to attract European tourism, acceptance is likely to emerge.  

Monetary policy 

Throughout  the  post-war  period  Norwegian  monetary  policy  has  been  based  on  a  fixed  or 
stable exchange rate. Over time it became apparent that a system with a defined central rate 
and  a  narrow  fluctuation  margin  around  this  rate  exposed  the  crown  to  speculative  attacks, 
and developments in the foreign exchange market compelled Norway to abandon this system 
on 10 December 1992.  The  crown was left  to float. Emphasis was placed on  maintaining  a 
stable  crown  exchange  rate  against  European  currencies  in  the  implementation  of  monetary 
policy.  In  this  context  it  is  important  to  note  that  a  very  small  and  very  open  Norwegian 
economy is highly vulnerable to fluctuations in the international economy. 

Chart 2 : The Krone exchange rate against ECU/euro 

The Krone exchange rate 
against ECU/euro

K
O
N

9,00
8,50
8,00
7,50
7,00
6,50
6,00

1
0
Q
2
8
9
1

4
0
Q
3
8
9
1

3
0
Q
5
8
9
1

2
0
Q
7
8
9
1

1
0
Q
9
8
9
1

4
0
Q
0
9
9
1

3
0
Q
2
9
9
1

2
0
Q
4
9
9
1

1
0
Q
6
9
9
1

4
0
Q
7
9
9
1

3
0
Q
9
9
9
1

2
0
Q
1
0
0
2

Year

                            Source: New Cronos database  

5 

"Norway - Assessment and recommendations", OECD 2000. 

14 

PE 304.442 rev.1. 

                                                 
EMU and the EFTA 

In  March  2001,  the  Norwegian  Government  presented  a  new  Long-Term  Programme.  The 
guidelines  stipulate  that  monetary  policy  shall  aim  at  stability  in  the  internal  and  external 
value  of  the  crown,  contributing  to  the  stable  exchange  rate.  Hence  Norges  Bank's 
implementation  of  monetary  policy  is  aimed  at  maintaining  low  and  stable  inflation.  The 
operational target is defined as an annual increase in consumer prices of approximately 2.5% 
over  time.  Monetary policy  is  to be  forward-looking,  and  direct  effects on  consumer prices 
stemming  from  changes  in  interest  rates,  taxes,  excise  duties  and  extraordinary,  temporary 
disturbances, are in general not be taken into account6. 

The Government Petroleum Fund and the impact of petroleum revenues on stability 

The  Norwegian  Government  Petroleum  Fund,  established  in  1990,  has  two  objectives.  It 
serves  as  a  buffer  for  the  mainland  economy  against  fluctuations  in  oil  revenues,  and  it 
manages a considerable portion of the government's financial wealth. Its income is defined as 
the government's net cash flow from oil activities and the return on the Fund's investments. 

The Petroleum Fund acts as a buffer against short-term variations in petroleum revenues by 
separating the cash flow from oil extraction from current expenditure. Since a large share of 
revenues  from  petroleum  activities  accrues  to  the  state,  any  fluctuations  in  oil  prices  will 
primarily  result  in  changes  in  allocations  to  the  Fund.  Since  all  of  the  Fund's  capital  is 
invested abroad, such changes will in principle not influence economic activity. This makes 
the  Norwegian  economy  more  robust  to  oil  price  fluctuations,  thereby  reducing  oil 
dependence in the short-term7.  

The Fund also serves as a tool in the management of fiscal policy, by making the spending of 
petroleum  income  more  visible.  The  allocation  of  capital  to  the  Fund  must  form  part  of  a 
coherent budgetary process. Hence no net allocations are made to the Fund unless the Fiscal 
Budget is in surplus. Income is used to increase net imports or saved by accumulating assets 
abroad, so as to redistribute the increased income and thus consumption between generations.  

The stability of the crown/euro exchange rate  

The main objective of the ECB is the maintenance of price stability; and the ECB has defined 
this as an inflation rate of less than 2% p.a.. The main objective of the Norges Bank monetary 
policy  is  the  stability  of  the  crown's  national  and  international  value.  Inflation  in  Norway 
cannot remain higher than inflation in the euro area without this having consequences for the 
exchange rate of the Norwegian krone against the euro.  

As  established  by  the  Royal  Decree  of  29  March  2001,  the  operational  target  of  monetary 
policy  shall  be  annual  consumer  price  inflation  of  approximately  2.5%  over  time.  This 
inflation  target  is  slightly  higher  than  similar  objectives  for  Sweden,  Canada  and  the  euro 
zone,  but  corresponds  roughly  to  targets  in  the  United  Kingdom  and  Australia.  It  is  also 
approximately  in  line  with  the  average  inflation  rate  in  Norway  in  the  1990s.  However,  if 
price and cost inflation remains higher than the rate of increase aimed at by the ECB over a 
long period, the crown will depreciate against the euro. Norges Bank must therefore counter 
such a development.  

In  this  situation,  Norges  Bank  makes  an  evaluation  of  the  reasons  for  exchange  rate 
movements.  The  most  important  factor  is  confidence  in  the  authorities  pursuing  nominal 
stability.  If  such  confidence  exists,  short-term  fluctuations  in  the  krone  exchange  rate  may 

6 

7 

Press Release on New Guidelines for Norwegian economic policy, Royal Ministry of Finance, March 29, 
2001. 
Ibid. 

15 

PE 304.442 rev.1. 

                                                 
EMU and the EFTA 

take  place  without  consequences  for  the  long-term  exchange  rate.  The  krone  exchange  rate 
will  also  be  influenced  by  factors  that  are  not  under  the  control  of  Norges  Bank,  like 
fluctuations  in  international  financial  markets,  uncertainty  in  the  global  economy,  the 
evolution of the price of oil, fiscal policy, and developments in domestic prices and costs.  

Chart 3 : The Krone's effective exchange rate against euro 

Earlier,  the  authorities  aimed  at  bringing  inflation  down  to  the  euro-area  target  range  in  a 
sustained, but cautious manner. However, in 2000 Norges Bank officials noted that inflation 
pressures were gathering pace and acted to tighten monetary conditions. The rise in oil prices, 
apart  from  its  usual  direct  and  second  round  effects  on  prices,  also  seemed  to  influence 
aggregate  demand  through  strong  "Ricardian"  effects  on  consumption  related  to  higher 
national wealth and public saving, and compounded the impact of the wage round. The 150 
basis  point  increase  in  interest  rates  in  2000  was  expected  to  ease  demand  and  price 
pressures8.  However,  the  crown  exchange  rate  has  fluctuated  in  recent  years  in  spite  of 
Norges  Bank's  active  use  of  instruments,  indicating  that  Norges  Bank  cannot  fine-tune 
movements in the crown exchange rate. 

Chart 4 : Daily variation in the krone exchange rate against ECU/EURO 

8 

Ibid. 

16 

PE 304.442 rev.1. 

 
                                                 
EMU and the EFTA 

In  the  Revised  National  Budget  for  1998,  the  Government  decided  that  the  Exchange  Rate 
Regulation would continue to apply without any changes, with the euro replacing the ECU as 
the indicator of the crown's value against European currencies. Thus, the consequences of the 
introduction of the euro for the orientation of Norwegian monetary policy might not appear 
particularly great at the outset 9.  

The  launching  of  the  EMU  has  nevertheless  entailed  changes  in  the  environment  for 
Norwegian monetary policy, for the following reasons.  
•  First, the  ECB  formulates  its  monetary  policy  with  the  primary aim  of  maintaining  low 
inflation  for  the  euro  area  as  a  whole.  This  could  result  in  larger  exchange  rate 
fluctuations between the  major countries than in the past (see earlier under The "benign 
neglect"  option  ).  If  so,  keeping  the  crown  stable  against  the  euro  might  become  more 
challenging.  

•  Second, the launch of the euro has reinforced global financial integration and contributes 

to higher capital mobility. 

Two  monetary  policy  instruments  have  been  used:  exchange-market  interventions  and  the 
interest rate. 

In the experience of the Norges Bank, extensive and persistent exchange-market interventions 
to  influence  the  crown's  exchange  rate  have  yielded  poor  results.  The  foremost  example 
occurred on Friday, 20 November 1992, when Norges Bank made intervention purchases for 
NOK  37  billion  from  the  time  the  market  opened  until  the  market  closed.  Intervention 
purchases  amounting  to  NOK  14  billion  were  also  made  the  previous  day  after  Sweden 
allowed its currency to float. So, Norges Bank used more than NOK 50 billions of its foreign 
exchange reserves in the course of six trading hours over a two-day period10 . 

2. Iceland 

Introduction 

In recent years Icelandic economic growth has been driven mainly by an expansion in gross 
fixed investment and private consumption, while exports and public consumption have been 
growing more slowly. The past decade has also witnessed a substantial strengthening of the 
Icelandic economy, due in large part to major changes in economic policy formulation toward 
an  emphasis  on  stable  and  predictable  macroeconomic  policies,  and  on  structural  reforms. 
The adoption of the exchange rate as a nominal anchor and intermediate target for monetary 
policy was the key to the successful disinflation of the first half of the last decade, which in 
turn set the stage for the economic recovery that began in 1995.  

Iceland's strong economic performance has also benefited from the government's tenacity in 
consolidating  public  finances  and  perseverance  in  enhancing  competition  through  market 
liberalisation  and  privatisation.  Notwithstanding,  the  maturing  cyclical  upswing  has  been 
accompanied in recent years by the emergence of overheating pressures and a large external 
imbalance11.  The  Economist  Intelligence  Unit  estimates  GDP  to  have  grown  by  1.8%  in 
2001,  down  from  4.9  in  2000.  The  deceleration  can  be  attributed  to  a  contraction  in 

9 

"The Impact of the euro on non-member states", Address by Deputy Governor Jarle Bergo to the Scottish 
Norwegian Business Forum, Edinburgh, 3 February 1999. 

10  Gjedrem Svein, op. cit., p. 14. 
11  Concluding  Statement  of  the  2001  Article  IV  Mission  of  the  International  Monetary  Fund  with  Iceland, 

IMF 2001. 

17 

PE 304.442 rev.1. 

                                                 
EMU and the EFTA 

investment  and  private  consumption,  mainly  as  a  result  of  Iceland's  stringent  monetary 
policy. In 2002 domestic demand is expected to continue declining, taking the economy into 
a short-lived recession.  

The  function  of  the  euro  as  a  coexisting  means of payment  is naturally  a  possibility  within 
Icelandic  borders  as  well  as  within  Norway.  However,  the  country's  isolated  position  as  a 
rather remote island limits the extent of such a parallel materialisation of euro cash. 

Monetary policy 

Since a 7.5%-devaluation of 1993, the central rate of the crown remained unchanged and its 
exchange  rate  has  fluctuated  around  this  rate  depending  on  economic  conditions  and  the 
tightness  of  the  Central  Bank's  monetary  stance.  Exchange  rate  policy  since  May  1993  has 
involved  maintaining  the  exchange  rate  of  the  crown  within  announced  target  bands  which 
are decided in consultation between the Central Bank and the government. Initially the zone 
was 2.25% in either direction from the central rate. This was extended to 6% in autumn 1995 
and finally to 9% early in 2000. The currency reference was reformed in autumn 1995 with 
the  introduction  of  a  basket  weighted  against  external  trade  in  goods,  replacing  the  earlier 
basked comprised of the ECU (76%), US dollar (18%) and yen (6%). 

The  overheating  characterising  the  Icelandic  economy  in  recent  years  peaked  in  the  year 
2000,  generating  inflationary  pressures.  Hence  the  Central  Bank  had  to  tighten  its  policy 
stance. A move to a floating exchange rate regime was an obvious extension of the widening 
of  the  fluctuation  bands  over  the  past  decade  and  served  Iceland  better  in  view  of  its 
sensitivity to external and supply shocks. This decision was accompanied by the adoption of 
the inflation targeting as the basis of the monetary policy on 27 March 2001. 

The Icelandic monetary authorities had many factors in favour of adopting inflation targeting, 
which is a logical continuation of the flexible exchange rate policy that has been pursued12. 
Under this new arrangement, specific targets of an annual inflation rate of about 2.5% are set 
and the Central Bank will keep the rate of inflation consistent with them within a specified 
timeframe.  The  inflation  target  of  2.5%  is  to  be  attained  no  later  than  by  the  end  of  2003. 
However,  in  2001  the  average  consumer  price  inflation  was  as  high  as  6.7%.  The  first 
indication of 2002 shows an inflation rate of 9.4% for January. In order to reach the inflation 
target  interest  rates  remain  the  highest  in  Europe  with  the  repo  rate  currently  standing  at 
10.1%. However, the Central Bank has announced that, on the assumption that the currency 
will  not  depreciate  any  further,  a  reduction  in  interest  rates  could  follow  later  in  2002. 
Notwithstanding rising inflation, there is little chance of the economy overheating given the 
decline in domestic consumption. 

The exchange rate is no longer used as an intermediate target and the fluctuation bands have 
been  abolished.  As  the  exchange  rate  always  exerts  a  strong  impact  in  an  open  economy, 
monetary  policy  will  continue  to  take  exchange  rate  developments  into  account.  The  new 
policy will be implemented by producing an inflation forecast, and if it indicates that inflation 
is  heading  beyond  the  target,  the  Bank  is  obliged  to  respond  by  applying  its  monetary 
instruments.  

The stability of the crown/euro exchange rate 

The  12  EMU  member  countries  account  for  a  significant  share  of  Iceland's  foreign  trade, 
albeit  not  an  overwhelming  one.  In  2000  42.5%  of  merchandise  exports  and  33.5%  of 

12  Monetary  policy  based  on  formal  inflation  targeting  enjoys  growing  support  and has been  adopted  by  an 

increasing number of countries, like Australia, New Zealand, Switzerland and Sweden.  

18 

PE 304.442 rev.1. 

                                                 
merchandise  imports  were  traded  with  the  euro  area.  The  Icelandic  economy  is  hence 
vulnerable to external changes and recently the krona has depreciated against the euro.  

Chart 5 : The Icelandic Krona exchange rate against the ECU/Euro 

EMU and the EFTA 

Exchange rate of the Iceland 
Krona

r
K
c
I

95,00
90,00
85,00
80,00
75,00
70,00

1
0
Q
2
9
9
1

1
0
Q
3
9
9
1

1
0
Q
4
9
9
1

1
0
Q
5
9
9
1

1
0
Q
6
9
9
1

1
0
Q
7
9
9
1

1
0
Q
8
9
9
1

1
0
Q
9
9
9
1

1
0
Q
0
0
0
2

1
0
Q
1
0
0
2

Year

                              Source: New Cronos database 

Since  a  change  in  exchange  rate  policy  can  potentially  cause  uncertainty  and  volatility,  the 
Icelandic  monetary  authorities  decided  to  abolish  the  formal  fluctuation  bands  for  the 
exchange rate policy and adopted the inflation target after careful deliberation and after being 
advised  by  international  agencies,  such  as  the  IMF.  A  narrower  exchange  rate  band  would 
expose  the  crown  to speculative  one-way  bets  against  the  crown.  The  scope  for  manoeuvre 
within monetary policy would be severely limited, while domestic businesses would still not 
reap the benefits of a stable exchange rate against the euro (which could potentially serve the 
function of a home market for Icelandic firms if the crown were closely and credibly linked 
to it). 

Instability of the crown could have a very damaging effect on Icelandic businesses, because 
Icelandic  firms  only  have  access  to  a  very  small  home  market  and  are  quite  dependent  on 
export  markets.  Unstable  exchange  rates  can  hurt  their  efforts  to  establish  lasting  business 
relationships  and  maintain  a  sufficient  market  share.  In  order  to  facilitate  the  de  facto 
expansion of the home market of Icelandic businesses, a closer link to the euro area could be 
an  attractive  option,  especially  if  all  the  current  EU  member  countries  join  the  EMU.  The 
success of such a policy, however, would depend on the credibility of such a link13. 

However,  even  if  a  stronger link  to the  euro  were  an  option,  such  a  move  would  hardly  be 
realistic  until  one  or  more  of  the  "outs"  have  joined.  This  particularly  concerns  the  United 
Kingdom,  which  at  present  is  Iceland's  largest  trading  partner  in  terms  of  merchandise 
trade14.  

13 
14 

Ibid. 
Ibid. 

19 

PE 304.442 rev.1. 

                                                 
EMU and the EFTA 

Exchange rate policy alternatives 

Regarding  the  possibility  of  a  closer  link  to  the  euro  area,  the  following  options  were 
considered: 

a) Unilateral peg to the euro 

A unilateral peg to the euro implies that the Icelandic authorities would unilaterally announce 
their intention to fix the exchange rate of the crown against the euro. The exchange rate of the 
crown  with  respect  to  other  currencies  would  then  be  determined  by  their  exchange  rate 
against  the  euro.  The  impact  would  depend  on  the  size  of  the  euro  area.  The  credibility  of 
such  an  arrangement,  however,  would  hardly  exceed  that  of  the  existing  arrangement,  and 
would therefore not result in a sizeable reduction in interest rate differentials against the euro 
area.  Because  this  area  will,  from  the  outset,  only  cover  approximately  1/3  of  Iceland's 
foreign trade, such a peg would, ceteris paribus, lead to exchange rate fluctuations vis-à-vis 
non-euro  countries,  which  could  undermine  the  credibility  of  the  exchange  rate  policy  and 
affect businesses that trade with them. Although a credible fixed exchange rate policy could 
lead  to  a  counterbalancing  change  in  the  mode  of  behaviour  in  the  labour  market,  it  is 
unlikely that a unilateral peg to the euro could enhance credibility in order to facilitate such a 
change. 

b) Bilateral peg to the euro 

A  bilateral  peg  to  the  euro  is  more  advantageous  insofar  as  it  would  entail  some  gains  in 
terms  of  credibility.  Under  a  bilateral  peg,  an  agreement  would  be  made  with  the  ECB  to 
defend  certain parity against the  euro, within  certain limits.  Changes in  the  central rate  and 
the  fluctuation  limits  of  the  exchange  rate  arrangement  would  be  subject  to  an  agreement 
between the Central Bank of Iceland and the ECB. However, the ECB would certainly have 
the option to cease interventions if it considered support to be contradictory to its monetary 
policy goals. 

c) Unilaterally using the euro as a legal tender ("euroisation") 

This is a kind of arrangement that comes closest to the direct EMU membership in terms of 
credibility.  It  would  have  similar  advantages  to  EMU  membership  in  terms  of  lower 
transactions costs and interest rate differentials and enhanced transparency in price formation, 
but  would  give  somewhat  larger  scope  for  using  public  finances  for  counter-cyclical 
purposes.  Interest  rate  differentials  as  a  result  of  foreign  exchange  risk  could  even  almost 
disappear,  because  it  would  be  more  difficult  to  abandon  such  an  arrangement  than  a 
currency  board.  On  the  other  hand,  it  would  lead  to  a  loss  of  the  function  of  lender  of  last 
resort,  as  would  a  currency  board,  while  the  Icelandic  monetary  authorities  would  have  no 
influence  on  ECB  decision-making.  It  is  also  worth  noting  that  both  the  ECB  and  the  EU 
Council of Finance Ministers (ECOFIN), have strongly opposed such "euroisation" by non-
Member States. 

Other economic policy consequences 

It is likely that the financial markets will look at the criteria of the Stability and Growth Pact 
as a benchmark of public finance performance – and also in the case of non-EMU countries – 
penalising  countries  that  do  not  meet  the  criteria  with  a  risk  premium  on  interest  rates.  It 
should be emphasised that the targets of the SGP are minimal.  

20 

PE 304.442 rev.1. 

EMU and the EFTA 

The Icelandic economy is subject to significantly larger fluctuations than the EMU countries 
and  the  Icelandic  business cycle  is  largely  asymmetrical  to  that  of  the EMU  countries. The 
impact that the EMU will have on the financial market will be more swift and direct than on 
other  sectors  of  the  economy.  Foreign  competition,  which  is  already  substantial,  will 
intensify. This will demand enhanced efficiency in Icelandic financial markets especially in 
the  banking  system.  Legislation  to  guarantee  smooth  transition  from  national  currencies  to 
euro denominations in the financial market has already been passed by the Althing. Another 
important  mater  of  concern  for  the  Icelandic  financial  market  is  the  possibility  of  having 
access, via the Central Bank, to TARGET. 

The new exchange rate arrangement means moving from relatively fixed exchange rate peg 
to  a  more  flexible  one.  Despite  the  elimination  of  the  fluctuation  limits  for  the  crown,  the 
Central Bank will intervene in the foreign exchange market if it deems such action necessary 
in order to promote  the inflation objective described  above or if it thinks that the  exchange 
rate fluctuations might undermine the financial stability. 

The experience of recent years, most recently from Argentina, shows that it has become more 
difficult to maintain a stable exchange rate with the liberalisation of capital movements and 
even larger and more active international financial markets. In addition, a flexible approach 
to exchange rate policy would seem to be consistent with the fundamental characteristics of 
the  Icelandic  economy  which  is  subject  to  important  supply  shocks,  as  a  result  of  its 
dependence on fish and energy-intensive products. These shocks are markedly different from 
those  facing  its  trading  partners.  Greater  exchange  rate  flexibility  does  not  only  provide  a 
means for ensuring stabilisation of the domestic economy in the short run, but it also helps 
cope with increased capital mobility in the context of the ongoing financial liberalisation15. 

3. Switzerland and Liechtenstein 

Introduction 

Switzerland  and  Liechtenstein  are  not  a  part  of  the  European  Union,  but  they  are  deeply 
integrated  in  its  European  environment  through  their  geographical  situation  and  strong 
historical, cultural and economic links.  

Switzerland's  economy  is  based  on  high-quality  goods  and  well-trained  workers.  Important 
areas  are  micro-technology,  biotechnology,  banking  and 
insurance,  know-how  and 
pharmaceuticals.  

In  a  referendum  held  in  1992  the  population  of  Liechtenstein  voted  to  join  the  EEA  and  a 
second  referendum  confirmed  Liechtenstein's  definitive  entry.  The  EEA  Agreement  allows 
Liechtenstein  to  participate  in  most  fields  of  the  internal  market  of  the  EU.  An  additional 
protocol allows Liechtenstein to keep at the same time its close ties, especially the customs 
treaty,  with  Switzerland.  The  main  pillars  of  the  economy  are  the  export  industry  and 
financial services. Liechtenstein developed its financial place in a modest way already before 
the  Second  World  War.  There  are  a  few  different  elements  that  make  it  attractive:  solid 
political  and  monetary  stability  (Swiss  franc),  a  highly  skilled  labour  force  and  a  wealthy 
surrounding  region.  Other  indicators  that  confirm  the  story  of  a  healthy  economy  are  well 
developed law with a reliable judicial system, banking secrecy, low taxes, an inflation rate of 
0% in 1999 and an unemployment rate of 2%.  

15 

Ibid. 

21 

PE 304.442 rev.1. 

                                                 
EMU and the EFTA 

Because  of  the  close  institutional  relations  between  these  countries,  the  following  analysis 
refers to the Swiss Franc; but it covers the monetary policy of both countries. 

Switzerland is now surrounded by countries all sharing the same currency. That  means that 
Swiss foreign trade is less diversified by currencies than earlier. At the same time, a common 
monetary  policy for  Europe  is  likely  to  lead  –  over  time  –  to  a  stronger  synchronisation  of 
business  activity  in  the  EMU  member  states16.  This,  in  turn,  means  that  the  impact  of  the 
European  business  cycle  on  the  Swiss  economy  will  become  more  even  and  thus  also 
stronger. More than ever, Switzerland's economic destiny will be linked to that of Europe. As 
the single  currency gains in significance,  the Swiss franc/euro exchange rate will become  a 
major factor for the development of the Swiss economy, and therefore also for the monetary 
policy of the Swiss National Bank (SNB). 

Prior to the introduction of the euro at the beginning of 1999, there were widespread fears in 
Switzerland  and  Liechtenstein  that  the  transition  to  a  common  currency  would  lead  to  an 
undesirable upward pressure on the Swiss franc in the foreign exchange markets. These fears 
have not materialised, however: the exchange rate between the Swiss franc and the euro has 
remained within a narrow fluctuation band. This stable relation between the two currencies is 
largely  a  result  of  the  SNB's  monetary  stance.  By  conducting  an  expansionary  monetary 
policy,  the  SNB  aimed  at  preventing  the  Swiss  franc  from  appreciating  excessively.  It  was 
not a question of keeping the exchange rate stable as such, but the SNB was rather compelled 
to  keep  an  expansionary  course  in  order  to  ward  off  deflationary  trends  in  the  Swiss 
economy.  

Despite  imponderables,  the  high  degree  of  economic  convergence  between  these  two 
countries and the EU is expected to ensure a natural stability between the franc and the euro. 
The transparency of prices will be increased, as well as more developed competition. These 
challenges are not only of a monetary but also economic nature. 

It seems that monetary policy will play a decisive role in defining the strategy of adaptation 
to  EMU.  Given  the  expected  weight  of  the  euro,  it  will  be  much  more  difficult  for  the 
National Bank of Switzerland to  conduct  a fully independent  monetary policy17, although a 
certain margin of manoeuvre will be preserved.  

Generally speaking, the introduction of euro cash will have no influence on the Swiss franc. 
The  latter  will  remain  the  sole  legal  currency  of  payment  in  Switzerland.  However,  in  the 
tourist industry in areas near the Swiss border, the euro can be expected to establish itself as 
the second currency. Hotels, bars and restaurants are displaying prices in francs and euros. In 
an effort to remain open to foreign visitors, two big Swiss banks - Credit Suisse and UBS - 
have  set  up  cash  machines  dispensing  euro  notes  as  well  as  Swiss  francs.  Several  Swiss 
supermarket chains have said they are happy to accept euros from customers.  

Monetary policy 

The  SNB  is  ranged  among  a  small  number  of  central  banks  that  have  opted  for  a  clear 
commitment to price stability. Moreover, it has chosen an operational framework consistent 
with this overriding objective. Monetary targeting was employed until the end of 1999, when 
it was abandoned in favour of an approach based on an inflation forecast.  

16  Over 50% of Switzerland's exports go to euro zone countries, while 70% of its imports originate from the 

17 

EU. 
"La  Suisse  et  l  'Union  économique  et  monétaire  européenne",  Groupe  interdépartemental  "EURO",  Juin 
1998. 

22 

PE 304.442 rev.1. 

                                                 
EMU and the EFTA 

Although multi-year targeting accorded the SNB the required flexibility, it did not solve all 
the problems arising from the earlier approach. Some problems remained: 
•  Demand for the SFr tends to be more stable in the long run than in the short run. For this 
reason,  the  deviations  in  the  monetary  base  from  the  multi-year  target  line  did  not 
necessarily serve as a reliable barometer of the SNB's policy stance. Since high-frequency 
movements in the monetary base were often hard to explain, they could emit misleading 
signals  about  the  monetary  ease  or  tightness  flowing  from  the  SNB's  policy  course18. 
Although the  trend rate  was low,  the SNB  could not prevent  a  temporary resurgence of 
inflation  early  in  the  1980s  and  in  the  1990s.  However,  since  1993,  inflation  has 
consistently stayed at low levels.  

•  Even  in  the  absence  of  signalling  problems,  the  procedures  for  determining  deviations 
from the multi-year target line were not sufficiently consistent and transparent. The SNB 
did  mention  the  exchange  rate  and  the  cyclical  state  of  the  economy  as  the  two  main 
indicators it would follow in order to assess the need for deviations in the monetary base 
from the multi-year target line. However, it could have made greater efforts to explain to 
the public its often complex policy analysis and the decisions based on this analysis. 

These  difficulties,  along  with  instabilities  in  the  base-money  demand  that  had  surfaced  in 
1996, prompted the SNB to reconsider its approach to monetary policy upon the completion 
of the targeting period 1995-1999. At the end of 1999, it announced various modifications to 
its policy concept in three respects.  

First,  it  decided  to  abolish  monetary  targeting,  without  renouncing  the  role  of  money  as  an 
important  policy  indicator.  Instead,  it  placed  inflation  forecasts  at  the  centre  of  its  internal 
monetary policy debate. For this reason, the SNB, at the end of 1999, published a forecast of 
inflation developments over the subsequent three years. The three-year forecasting horizon is 
designed to take account of the long lag in the effects of Swiss monetary policy. 

Secondly, the SNB sets its inflation forecast against its  main objective of maintaining price 
stability. Should the inflation forecast hint at a sustained threat to price stability, the SNB will 
adjust its policy course accordingly.  

Thirdly, the policy conclusions derived from the inflation forecast are framed in terms of an 
operational  target,  expressed  as  a  band  for  the  three-month  Libor  rate  of  interest  for  Swiss 
francs,  with  the  difference  between  the  ceiling  and  floor  of  the  band  amounting  to  one 
percentage point. 

As  a  result  of  these  changes,  the  National  Bank  no  longer  publishes  a  growth  target  for 
monetary aggregate;  the  money stock M3, however, will  continue to play a  major role  as  a 
monetary  policy  indicator.  It  has  adopted  the  ECB's  definition  of  price  stability.  It  is 
considered  that  price  stability  is  achieved  with  an  annual  inflation  rate  of  less  than  2% 
measured by the national consumer price index.  

However, the SNB did not follow the example of the ECB of adopting a two-pillar strategy of 
monetary  policy,  because  it  was  concerned  that  the  public  would  be  confused  by  such  an 
approach  and  would  be  at  a  loss  to  understand  which  pillar  determined  monetary  policy  in 
practice. To chart its policy course, the ECB relies both on inflation forecasts and a reference 
value for the growth in the money stock M3. For this reason, the SNB made it clear that the 

18  The  SNB  (1990,  p.  273)  was  aware  of  this  problem  when  it  announced  the  multi-year  targeting  strategy: 
"Although  this  aggregate  (the  money  base)  often  leaves  much  to  be  desired  as  a  short-term  indicator,  it 
fulfils  a  useful  function  as  a  leading  indicator,  i.e.,  it  anticipates  the  development  of  inflation  over  the 
following three years". 

23 

PE 304.442 rev.1. 

                                                 
EMU and the EFTA 

inflation forecast would act as its main policy compass, while the money stock would serve 
as an important input into that forecast. 

For  all  practical  purposes,  there  is  often  a  significant  correspondence  between  Swiss  and 
European  monetary  policies.  The  SNB  and  ECB  not  only  follow  similar  monetary  policy 
objectives  and  strategies,  but  they  also  operate  in  a  similar  environment.  Even  so,  the 
similarities are not large enough to obviate the need for an autonomous monetary policy. 

The stability of the Swiss franc/euro exchange rate 

The position of the Swiss franc can be described by means of three indicators.  

First, by the SFR's share in the global turnover in foreign exchange trading. 

Secondly,  and  economically  more  important,  is  the  position  of  a  currency  held  in 
international  portfolios.  Relative  to  the  size  of  Switzerland,  the  SFr  occupies  an  unusually 
prominent  position  in  international  institutional  and  private  portfolios.  It  is  the  combined 
result of an efficient financial centre and the commitment to an independent monetary policy 
which lends the SFr special diversification characteristics in global portfolios. This certainly 
is a sign of strength and a sound basis for the value creation. 

Thirdly, due to relatively low interest rates, the Swiss franc – like the yen – periodically plays 
an  important  role  in  the  short-term  financing  of  trading  positions.  Currency  and  securities 
traders take short positions in the Swiss money  market to finance long positions elsewhere. 
This is a rather volatile game, often reinforced by herd effects, which comes and goes with 
short-term exchange rate expectations. In the recent past, however, such strategies have lost 
their  appeal,  probably  as  a  consequence  of  the  appreciation  of  the  Swiss  franc  in  the  year 
2000.  

Trade relations with the euro area have always been strong, on the export as well as on the 
import side. It is clear that the Swiss economy is highly susceptible to shocks in the SFr/euro 
exchange  rate.  This  marked  dependence  is  the  strongest  economic  argument  of  all  those 
wishing to substitute the euro for the Swiss franc as soon as possible.  

Chart 6 : Swiss franc exchange rate against euro 

Exchange rate of the Swiss 
franc

F
H
C

1,95
1,85
1,75
1,65
1,55
1,45

1
0
Q
2
9
9
1

1
0
Q
3
9
9
1

1
0
Q
4
9
9
1

1
0
Q
5
9
9
1

1
0
Q
6
9
9
1

1
0
Q
7
9
9
1

1
0
Q
8
9
9
1

1
0
Q
9
9
9
1

1
0
Q
0
0
0
2

1
0
Q
1
0
0
2

Year

                                Source: New Cronos Database 

24 

PE 304.442 rev.1. 

EMU and the EFTA 

Given  certain  conditions,  EMU  could  increase  the  demand  for  Swiss  franc  assets.  The 
increase in demand would then lead to an increase in the demand for francs, occasioning an 
appreciation of franc.  Such an  increase  in  the demand  for  franc assets  would  possibly arise 
from  differences  between  the  monetary  policies  of  the  euro  zone  and  those  of  Switzerland. 
Any anticipated monetary instability in the euro countries might be expected to increase the 
demand for  franc  assets. In  September  2001  the  SNB eased  its  monetary policy  in order  to 
support activity and limit the appreciation of the Swiss franc after the uncertainties created by 
the 11 September attacks.   

So  far,  the  relation  between  the  two  currencies  has  been  remarkably  stable.  Since  the 
introduction  of  the single  currency, the  Swiss  franc/euro  exchange  rate  has  fluctuated  in  an 
extremely narrow band of only 2%. Thus, exchange rate volatility has until now been even 
lower than the 8% volatility between the Swiss franc and the D-Mark during the three years 
preceding the monetary unification. The extreme stability in the exchange rate has surprised 
many observers, including the SNB itself. It has led to the notion of "sister currencies", the 
euro being the big sister and Swiss franc following her everywhere like a shadow19. 

If one examines the reasons for the extraordinary stability in the exchange rate, one quickly 
finds  that  convergence  in  fundamentals  has  played  a  central  role.  Both  Europe  and 
Switzerland  have  suffered  from  slow  growth  in  the  1990s  and  from  deflation  fears  in  the 
aftermath  of  the  international  financial  crisis  of  1998.  Rising  unemployment  and  weak 
economic activity led the ECB and the SNB to adopt an expansive monetary stance and to cut 
interest rates. Broad similitude in business cycle and monetary stance has created conditions 
leading to an almost fixed exchange rate between the euro and the Swiss franc. At the same 
time, converging fundamentals explain why both currencies have been equally weak against 
the  US  dollar;  the  American  business  cycle  is  well  in  advance  of  the  European  and  Swiss 
business cycles, requiring a different policy response from the Fed. 

Chart 7 : Dollar/euro exchange rate 

Dollar/euro exchange rate 

D
S
U

1,50
1,40
1,30
1,20
1,10
1,00
0,90
0,80

1992Q01

1993Q01

1994Q01

1995Q01

1996Q01

1997Q01

1998Q01

1999Q01

2000Q01

2001Q01

                                    Source: New Cronos Database 

Year

19 

"Euro and Swiss franc: Two sister currencies?", Address given by Roth Jean-Pierre, Swiss National Bank, 
Singapore, February 24, 2000. 

25 

PE 304.442 rev.1. 

                                                 
EMU and the EFTA 

One  further  factor  which  might  influence  the  SFr  exchange  rate  against  the  euro  is 
uncertainty  about  the  future  policy  of  these  two  countries  –  particularly  Switzerland  – 
towards  European  Union.  The  Swiss  population  rejected  membership  in  the  EEA  in 
December 1992; and this vote was regarded as an anti-EU signal by the government, which 
has since then shelved its plans for adhesion to the EU. In March 2001 a privately sponsored 
referendum  advocating  the  opening  of  membership  negotiations  was  heavily  defeated  (it  is 
worth noting that the Government itself advised a "No" vote). As an alternative, Switzerland 
has  negotiated  Bilateral  Agreements  with  the  EU  in  order  to  gain  free  access  to  the  EU 
internal  market  for  goods  and  services.  In  conclusion,  some  analyses  point  to  a  number  of 
possible dangers:  
•  The  fluctuations  of  the  SFr  vis-à-vis  the  euro  might  return  to,  or  even  exceed,  those 

observed in the past for the SFr/DM exchange rate. 

•  A  loss  of  confidence  in  the  euro  might  trigger  an  excessive  appreciation  of  the  Swiss 

franc. 

Swiss interest rates, which have been lower than anywhere else in Europe, might have to rise 
to the levels prevailing in the euro area.  

26 

PE 304.442 rev.1. 

EMU and the EFTA 

Summary and Conclusions 

  It  is  not  yet  entirely  certain  that  the  EMU  will  lead  to  permanent  long-term  benefits  in 
terms of growth and stability, and how these potential benefits weigh against the risk of 
disruption in the event of, for example, asymmetric shocks. But assuming that EMU will 
be fully successful, it should contribute to growth and stability, not only within the euro 
area  itself,  but  also  in  third  countries.  For  the  EFTA  countries,  which  have  a  very  high 
percentage of their trade with the EU, the benefits are likely to be strong. 

  The  Maastricht  criteria  have  become  the  standard  for  economic  policy,  not  only  within 
the euro area and among prospective members of it, but among outsiders too. In view of 
this,  and  also  the  possibility  that  one  or  more  EFTA  countries  might  some  day  join  the 
EU and EMU, these criteria are likely to be a permanent factor in the formulation of their 
economic  and  fiscal  policies,  irrespective  of  the  exchange  rate  arrangements  or 
relationship to the euro that are chosen. 

  The ECB is required by the Treaty to formulate its monetary policy with the overriding 
primary aim of maintaining low inflation for the euro area as a whole. External effects –
for example, on the exchange rate – are only taken into account in so far as they might 
affect the inflationary outlook. In these circumstances, non-euro-area European currencies 
will  to  a  greater  or  lesser  extent  become  "takers"  of  euro  area  monetary  policy,  and 
maintaining  stable  exchange  rates  against  the  euro  might  become  more  challenging.  It 
might  be  necessary,  for  example,  for  interest  rates  in  non-euro-area  countries  to  be 
maintained at permanently higher levels than those set by the ECB for the area itself. 

  The creation of the euro has also reinforced global financial integration and contributed to 
higher capital mobility, both within and outside the euro area. Large movements of funds 
between, for example, the euro and the US dollar can have damaging "spin-off" effects on 
other  currencies  (e.g.  the  £  in  1992).  It  might  become  more  difficult  to  maintain  stable 
exchange rate policies with free capital movements for small countries at the margin of a 
big currency area. 

  The  competitive  position  of  financial  institutions  based  in  non-area  countries  may  be 
adversely affected – although this has so far not been the case with the City of London. 
  It  is  also  possible  that  investment  by  European  firms,  and  also  inward  investment  from 
outside Europe, will be diverted from non-euro-area countries to within the euro area in 
order to avoid exchange costs. There has, however, again been little sign of such an effect 
so far in the case of the United Kingdom. 

  The creation of the Single Currency area with a single monetary policy for the euro area 
has already led to further integration in other fields, notably fiscal policy. This trend may 
be expected to continue – for example into certain areas of taxation – with consequences 
for  the  EFTA/EEA  countries.  The  so-called  "Withholding  Tax"  proposals,  for  example, 
have  already  led  to  negotiations  with  Switzerland  and  Liechtenstein,  aimed  at  requiring 
them  to  abandon  their  policies  of  banking  secrecy.  Recently  strengthened  international 
action against money laundering and the financing of terrorism may well be extended into 
the field of taxation. 

  Since the introduction of euro notes and coins in January 2002 there is a potential for the 
€ to become a "parallel currency" in EFTA/EEA currencies, as in the current EU "outs" 
and  the  candidate  countries  of  Central  and  Eastern  Europe.  Such  an  expansion  of  the 
EMU  sphere  is  particularly  likely  in  Switzerland  and  Liechtenstein  due  to  their 

27 

PE 304.442 rev.1. 

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EMU and the EFTA 

geographical location, being completely surrounded by "Euro-land". Wide acceptance of 
€-denominated notes and coins in Sweden and Denmark, however, might in time spread 
to Norway. 

  If  recent  movements  of  public  opinion  towards  euro  area  membership  in  Denmark  and 
Sweden  prove  durable,  and  result  in  favourable  referendum  votes,  the  influence  of  the 
euro  system  on  Norway  –  and  also  perhaps  Iceland  –  is  likely  to  increase.  This  will  be 
even more the case if the UK, too, opts for membership.  

  In the longer term the euro is almost certain to become the currency of virtually the whole 
of Europe, as the current Central and Eastern European candidate countries join first the 
EU,  and  then  the  euro  area;  and  as  "euroisation"  takes  place  in  other  regions  (as  it  has 
already,  for  example,  in  Kosovo  and  Montenegro).  This  is  likely  to  put  pressure  on 
residual  national  currencies  like  the  Swiss Franc to  fully join  the  area,  or  to  firmly  link 
their rates to the €.  

28 

PE 304.442 rev.1. 

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Economic Affairs Series Briefings 

To obtain paper copies of the following publications, please contact: G.B. Patterson, Economic, Monetary and 
Budgetary Affairs Division, European Parliament, L-2929 Luxembourg. Tel.: (00352) 4300 24114. 

EMU and the EFTA 

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The Taxation of Pensions 
The Finnish Economy 
Die deutsche Wirtschaft 
The Euro and the Blind 
Tobacco Tax 
The Euro: Counterfeiting and Fraud 
The Consequences of EMU for the EEA/EFTA countries 

Title 

Date 

Background to the € 
The Belgian Economy 

Number 
ECON 520  Sept. 2001 
ECON 519  Feb. 2002 
ECON 518  August 2001  Enlargement and Monetary Union 
July 2001 
ECON 517 
ECON 516 
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Stability and Convergence Programmes: the 2000/2001 Updates  EN, FR, DE 
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The Swedish Economy 
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The Economy of the Netherlands 
EN 
The Portuguese Economy 
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The “Third Way” 
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Economic Affairs Series Working Papers 

The following publications are available on line on the Intranet at: http://www.dg4.ep.ec. They are also available 
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Date 
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ECON 114 

Title 
Broad Economic Policy Guidelines 2002 
Tax co-ordination in the EU – the latest position 
The Reform of Taxation in EU Member States 
A Single Market in Financial Services 
The Economic Situation of the European Union and the Outlook for 2001/2 
Tax Co-ordination in the European Union 
Improving cross-border payments in the euro area 
Exchange Rates and Monetary Policy 
Strategies for the EU Economy 
The Functioning and Supervision of International Financial Institutions 
EMU and Enlargement: a review of policy issues 
The Determination of Interest Rates 
Consumer protection aspects of the UCITS amending directives of 1998 
Options for the Exchange Rate Management of the ECB 
The Euro as 'Parallel Currency', 1999-2002 

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29 

PE 304.442 rev.1.