wider band. on the other hand, malta ’ s dependence on foreign trade and investment, the country ’ s track record with a fixed peg as well as the central bank ’ s commitment to price stability would seem to justify the adoption of a narrow band. as real convergence is progressively achieved and as structural reforms proceed, the case for a narrow band would also become stronger. should this latter path be followed, the burden of adjustment to external shocks would, of course, have to be borne by the real economy. in the first instance, this means pursuing a prudent fiscal policy. the current aim of fiscal policy is indeed to reduce the deficit to gdp ratio to around 2. 5 % by 2004, from 5. 3 % last year and over 10 % in the late 1990s. by restraining domestic absorption, tighter fiscal policy should enhance the credibility of the exchange rate peg. moreover, a smaller borrowing requirement also frees up resources for the private sector and helps to contain upward pressure on interest rates, thereby stimulating economic growth. finally, bringing the budget deficit closer to balance will then give fiscal policy the leeway to respond in the event of adverse shocks or cyclical downturns. the response to shocks will also depend on the degree of flexibility in the economy as a whole. unlike most accession countries, malta has a long experience of a functioning market economy, driven by private ownership of productive assets and with much of it exposed to international competition. in general, therefore, the private sector has already proved that it can cope with adverse shocks. in this regard, the flexibility of the labour market has been especially important. this flexibility must, however, be enhanced in order to safeguard competitiveness. as is the case with any exchange rate strategy, the sustainability of the central rate and, with that, the fulfilment of the maastricht criteria, will hinge on whether that rate is compatible with economic fundamentals. fulfilling this criterion requires an unconditional willingness to defend the external value of the currency. for policy makers that means a commitment to abstain from practices that could be in conflict with the objectives of exchange rate policy. for participants in foreign exchange markets, including the central bank, it implies the need to intervene in the market without hesitation. within this context, the importance which the acquis assigns to the independence of central banks is understandable. whereas the central bank of malta has been formulating monetary policy independently since 1994, there is no doubt that the recent amendments to

##m ii is thus of particular interest to central bankers. against this background, i will now review some issues which eventual participation in erm ii, and later in emu, raises for policy makers in malta. no significant change in the parameters governing monetary and exchange rate policy emu entails the adoption of the euro and the surrender of autonomy in the area of monetary policy to the european central bank ( ecb ). at this point, however, it is relevant to mention that the additional loss of independence which emu would represent for the formulation of monetary policy in malta is minimal. this is so because the central bank of malta already has limited freedom of action since it operates a fixed exchange rate regime and exchange controls have been almost entirely removed. this means that the bank must adjust domestic interest rates in response to movements in capital flows in a way which is consistent with the peg. too low an interest rate would encourage investors to move out of domestic assets, creating downward pressures on the currency, whereas too high a rate could attract interest - sensitive capital flows which could create upward pressures on the exchange rate. to a large extent, these conditions already govern monetary policy and reserves management in malta. while the monetary policy advisory council does take domestic economic conditions into account, decisions on official interest rates are, in fact, primarily conditioned by trends in the official reserves and in the interest rates on the currencies which make up the basket to which the maltese lira is pegged. malta ’ s eventual participation in emu, therefore, would not involve any significant departure from the current situation in terms of the degree of autonomy enjoyed by the central bank of malta in setting interest rates. in view of the incompatibility of monetary policy autonomy, full capital account liberalisation and a fixed exchange rate, emu participants have given up independent national monetary polices in favour of the free movement of capital and the adoption of a single currency. the main driving force behind this decision was the desire to overcome the obstacles to the completion of the single market and to progress towards monetary and, eventually, economic union. a single currency was a logical step in this regard. given the constraints which the adoption of the single currency entails, the emphasis which the treaty puts on containing fiscal deficits and on labour mobility is understandable. in this set - up, in fact, the adjustment to asymmetric shocks has to take place through fiscal policy and the labour market. since labour mobility within the union is still weak, however