EXCHANGE RATE MECHANISM II - ERM II

By Bianca GIANNINI

The exchange rate mechanism II replaced the old European monetary system (EMS) after the introduction of the euro in the third stage of economic and monetary union (begun on 1 January 1999). The purpose of the ERM II is to maintain stable exchange rates between the euro and the participating national currencies so as to avoid excessive exchange rate fluctuations on the internal market. The currencies of the Member States included in the ERM II and the respectively central parities against the euro and the fluctuation bands observed are:
Denmark: the Danish kroner joined the ERM II on 1 January 1999. The central rate (1 EUR) observed is 7.46038 with a narrow fluctuation band of ±2.25%;
Greece: the Greek drachma joined the ERM II on 1 January 1999. The central rate (1 EUR) observed is 353.109 with a standard fluctuation band of ±15%. On 17 January 2000, the central rate was revalued to 340.750. Greece adopted the euro on 1 January 2001 and left the ERM II;
Estonia: the Estonian kroon joined the ERM II on 28 June 2004, and observes a central rate of 15.6466 to the euro with a standard fluctuation band of ±15%;
Lithuania: the Lithuanian litas joined the ERM II on 28 June 2004, and observes a central rate of 3.45280 to the euro with a standard fluctuation band of ±15%.
Slovenia: the Slovenian tolar joined the ERM II on 28 June 2004, and observed a central rate of 239.640 to the euro with a fluctuation band of ±15%. Slovenia adopted the euro on 1 January 2007 2001 and left the ERM II;
Cyprus: the Cyprus pound joined the ERM II on 2 May 2005, and observed a central rate of 0.585274 to the euro with a fluctuation band of ±15%. Cyprus left the ERM II when the country adopted the euro on 1 January 2008;
Latvia: the Latvian lats joined the ERM II on 2 May 2005, and observes a central rate of 0.702804 to the euro with a fluctuation band of ±15%. Latvia unilaterally maintains a 1% fluctuation band around the central rate;
Malta: the Maltese lira joined the ERM II on 2 May 2005, and observed a central rate of 0.429300 to the euro with a fluctuation band of ±15%. Malta unilaterally maintained the exchange rate of the lira at the central rate without fluctuation. Malta left the ERM II when the country adopted the euro on 1 January 2008;
Slovakia: the Slovak koruna joined the ERM II on 28 November 2005, and observed a central rate of 38.4550 to the euro. The central rate was revalued to 35.4424 on 19 March 2007 and to 30.1260 on 29 May 2008. Slovakia left the ERM II when the country adopted the euro on 1 January 2009.

The deliberations on the establishment of a new Exchange rate mechanism (ERM) in the third stage of the European Monetary Union (EMU) began in autumn 1995. The ECOFIN Council first discussed the new exchange rate arrangement at its informal meeting of 12/13 April 1996 in Verona and progress reports were provided to the Florence European Council on 21/22 June 1996 by the ECOFIN Council, the EMU and the European Commission (EC). The main elements of a new Exchange rate mechanism - based on the existing exchange rate mechanism - had been previously set by the ECOFIN Council at its informal meeting in Dublin on 20 - 21 September 1996. Given the absence of treaty provisions indicating institutional arrangements regarding internal exchange rate regimes, there was uncertainty about a specific authority and legal basis in the treaty, on how to regulate the new ERM. Hence, the new framework was developed gradually through further deliberations based also on the opinion of the EC monetary committee, as well as in other important informal ECOFIN meetings1 between central bank governors and finance ministers until 1997. The basic legal basis of the ERM II is the Treaty on European Union, in its provisions on the exchange-rate convergence criterion and the Resolution of the European council of 16 June 1997, which, by building on the agreements reached at its meetings in Florence and Dublin, laid down the guidelines for the establishment of the ERM II. The following agreement of 1 September 1998 between the European Central Bank (ECB) and the National Central Banks of the member states outside the euro area (OJ C 345 of 13 November 1998) laid down the operating procedures for the exchange rate mechanism. The agreement of 1 September 1998 was last amended by the agreement of 16 March 2006 (2006/C 73/08). As regards the participation in the ERM II, the European Council in its Resolution declared: "Participation in the exchange-rate mechanism will be voluntary for the Member States outside the euro area. Nevertheless, Member States with a derogation can be expected to join the mechanism. A Member State which does not participate from the outset in the exchange-rate mechanism may participate at a later date". Therefore, the participation was in principle voluntary but expected2. More precisely, the voluntary participation in the ERM II is in practice mandatory in that it is a pre-condition for the participation in the eurozone imposed to new member states.

Consequently, the voluntary participation in the exchange rate mechanism must be interpreted as the freedom for each member state to decide the optimal timing for this interim exchange rate arrangement with a duration of at least two years, and not as the freedom to decide whether to apply or maintain a different exchange rate arrangement. In summary, the exchange rate convergence criterion to meet in order to adopt the euro comprises the participation in the ERM II and the maintenance of exchange-rate stability3. Thus, the maintenance of exchange-rate stability is closely linked to the ERM II, but the two terms are not interchangeable, as it is possible for a country to participate in the ERM II and yet not to fulfill the exchange-rate convergence criterion. Before the introduction of the ERM II, the main issue debated regarded the fundamental arrangement of the system. In line with the original ERM, one proposal was to create a similar system of parity grid with the fixing of central parities and fluctuation bands between all participating currencies. In such a system, the fluctuations of each currency against the other currencies would be limited. The second option, that ultimately prevailed, was to define central parities for the non-euro currencies vis-à-vis the euro by fixing only the allowed fluctuations bands relative to the euro. The euro would thus be the hub of the system, while the non-euro currencies would constitute the spokes4. The latest period in the ERM with relatively broad bands of ±15%, that replaced the ±2, 5% fluctuation margins around the central parities, secured a certain degree of stability. For this reason, new accession countries opted for this greater flexibility. Hence, their currencies were allowed to fluctuate considerably more against each other’s, thus making interventions at the margins probably less frequent. Furthermore, many advocates of gretaer flexibility argued that narrower bands could have led to speculative attacks against the currencies involved in the system, invoking the risk of reminiscence of the ERM currency crisis in 1992. The possibility to commit to a narrower band, however, was not completely dismissed in order to best meet the convergence need of accession countries, considering that the participation in the ERM II should have been the shortest possible and uniquely aimed at adopting the euro. The agreement on narrower fluctuations bands, made on request of an accession country, was allowed on one condition, that is to say, not to influence the interpretation of the exchange rate criterion creating discriminations among member states5. According to the European Council Resolution of Amsterdam (16 June 1997), decisions on central parities and the band are taken by mutual accord of the ministers of the eurozone, the European Central Bank (ECB) and the minister and central bank governor of the accession country intending to participate in the ERM II, while the European Commission and Economic and Financial Committee are only consulted. The issue of interventions on the margins was treated similarly to the original ERM, by providing mandatory unlimited intervention from both sides, the ECB and the central bank of the country in question, in order to keep the market exchange rate within the selected fluctuation margins. It must be noted, however, that the Resolution of Amsterdam (1997) poses the price stability objective of central banks as explicitly superior to the obligations on intervention. As a result, the ECB has some discretion in deciding the appropriateness of the intervention. There is also the possibility of intra-marginal interventions on the basis of mutual agreement.
The main difference with the previous ERM is the possibility for all parties to initiate a confidential procedure if central rates are deemed to need realignment. Ideally, this procedure enables to reconsider central rates before they deviate too much from real equilibrium exchange rates and currency crises become inevitable. The multilateral approach in this crucial aspect of the strategies toward the euro adoption provoked some concerns in that it created uncertainty about the effective adoption of all necessary measures to ensure the exchange rate stability. In defence of this architecture, as the ECB Board Member Padoa Schioppa (2003) noted, the multilateral character of the ERM II was instead found to provide further credibility to the framework. Indeed, the ERM II, by entailing coordinated actions, including the activation of foreign exchange interventions or the call of realignment and the ultimate exit into the euro area, escaped the criticism usually attributed to the so-called intermediate regimes. In his opinion, the ERM II can be labelled as an intermediate exchange rate regime only in the sense that it is intermediate to the adoption of the euro. In summary, the main features of this new exchange rate arrangement were the multilateral procedure to commit to central rates and fluctuation bands (involving Finance Ministers, the ECB, national central bank governors and the European Commission); the broad fluctuation band set at 15% while giving the chance to opt for narrower margins; marginal interventions, in principle unlimited and automatic, with the support of the ECB to the national central banks (NCBs), and finally discretionary and intra-marginal interventions supported by the ECB - according to the priority of maintaining the price stability objective. The realignments of central parity are made by the common procedure, which both the ECB and the Member States have the right to initiate. Even if some questions about the regulative framework of the ERM II remained unsolved, as the use of the discretionary power by the ECB in according realignments and the actual limit to the intervention at the margins, the main issues faced by new member states in the ERM participation were centred on the choice of the central parity against the euro and the exchange rate arrangement to be chosen before joining the EMU. The implications of the accession process upon the exchange rate arrangements in the candidate countries were treated in details by the European Council Statements of 2000/2003 on Exchange Rate Policy and the ERM II. In particular, the Report by the ECOFIN Council to the European Council in Nice on the Exchange rate Aspects of Enlargement (2000) presented an overview on exchange rate strategies for the new accession countries. Accordingly, the choice of an exchange rate regime on the path from pre-accession to accession was extremely important for the success of the economic transformation process.

The main economic goals to be achieved were macroeconomic stability, and a facilitated transition, growth and real convergence preparing for the integration into the EU and the participation in the single market, by adjusting to real shocks, maintaining external balance, and dealing with capital flows. Furthermore, the individual responsibility of each Member State with respect to the exchange rate management was stressed. The EU played an important role in monitoring the economic situation and the characteristics of the country concerned, and the state of transition. Moreover, in accordance with Article 124.2 of the Treaty, exchange-rate policy was dealt with as a matter of common interest, so different incentive structures of alternative exchange-rate regimes became a crucial issue from an EMU prospective. In other terms, the existence of some successful experiences with fixed exchange rate regimes, including Currency Board arrangements (CBAs) prior to the EU accession needed to be revisited, even if compatible with the ERM II, in order to assess their sustainability in the medium-long term, also taking into account the evolution of the macroeconomic environment following the EU membership. The general economic theory on fixed exchange rate regimes provided suggestions also on the sustainability of currency board arrangements in small and open economies with sufficient wage and price flexibility, strict fiscal discipline and sound financial systems. Instead, concerns arose if considering the high speed of the catching–up process linked to the EU accession that, by fostering economic activity, could have led to a real exchange rate appreciation. With a limited action of the monetary policy, this could have directly resulted in an uncontrolled increase in the price level, creating serious obstacles to the nominal convergence. In addition, increasing capital inflow boosted by the capital movement liberalization would have also entailed the need for some exchange rate flexibility, in order to avoid the creation of excessive external imbalances.

For these reasons, the decision on the compatibility of a Currency Board arrangement with the participation in the ERM II was taken on the basis of a careful assessment of its sustainability in the country in question. In any case, the ECB refrained from considering currency board arrangements to be a substitute for the participation in the ERM II. Instead they could form, in specific cases, a unilateral commitment within the ERM II, thus placing no additional obligations on the ECB.
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1Communication from the Commission to the Council "Reinforced convergence procedures and a new exchange rate mechanism in stage three of EMU", 16/10/96
2 See the Common Statement on Acceding Countries and ERM II adopted by ECOFIN, ECB President, NCBs Governors and European Commissioners, in Athens, on 5 April 2003.
3With regard to exchange rate stability, the criterion refers to the participation in the ERM II for a period of at least two years prior to the convergence assessment without severe tensions, in particular without devaluation against the euro. The assessment of exchange rate stability against the euro will focus on the exchange rate being close to the central rate while also taking into account factors that may have led to an appreciation, which is in line with what was done in the past. In this respect, the width of the fluctuation band within the ERM II shall not prejudice the assessment of the exchange rate stability criterion. Moreover, the issue of the absence of "severe tensions" is generally addressed by examining the degree of deviation of exchange rates from the ERM II central rates against the euro; by using indicators such as short-term interest rate differentials vis-à-vis the euro area and their evolution; and by considering the role played by foreign exchange interventions.
4This solution resembled that of the Bretton Woods system, in which the dollar acted as the hub.
5 In practice, this principle implies that competitive devaluations should be avoided, as they are harmful for the overall EMU stability.

Bibliography
Padoa Schioppa T. (2003), "Trajectories Towards the Euro and the Role of ERM II", International Finance, Volume 6, Issue 1, pp. 129 – 144
ECB International Relations Committee, Task Force Enlargement (2006), Macroeconomic and financial stability challenges for accession and candidate countries, Occasional Paper No. 48
JulyAdam Bennett (1994), "Currency Boards: Issues and Experiences", IMF Policy Discussion Papers No. 94/18, International Monetary Fund
Backé P. (1999), "Exchange Rate Regimes in Central and Eastern Europe: A Brief Review of Recent Changes, Current Issues and Future Challenges", Focus in Transition, No. 2, pp. 47-67

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