Life outside the Euro—Monetary and financial issues for the EU periphery and beyond

Conference of the European Political Economy Project (In association with SEESOX)

St Antony’s College, 23 January, 2020

European countries that have not adopted the Euro face a complex set of issues regarding their interactions with those countries that have adopted it, and ultimately have to decide whether and when to join the Euro and the banking union (BU). Similarly, EU member states that have adopted the Euro face complex issues in their relationships with the non-Euro member states. The eight member states outside the Euro are economically and politically important. They have a total population of 105 million people, a significant number and more than any individual member state that has adopted the Euro. They range from among the richest to the poorest EU members.

On 23 January 2020 the European Political Economy Project (EuPEP) of the St. Antony’s European Studies Centre (ESC) hosted a conference that looked instead at monetary and financial issues for those countries that are not at the core, i.e. have not (yet) adopted the Euro—defined as the EU “periphery” in this context. Much research on EU integration looks at the “core” EU member states, defined here as those that have adopted the Euro as their currency, and focuses on them in analysing the speed and priorities for taking forward the European project. This conference sought instead to look at the policy choices and experiences of the countries at present not in the core.

The conference took as a starting point that “one size does not fit all” as regards countries’ monetary and financial management within the EU, and that seeking to fit all member states prematurely within the same shoe may undermine the stability not only of that member state but also the EU as a whole. Early inclusion of Italy and Greece, for example, has likely worsened the economic performance of both countries over the past decade, with adverse knock-on effects on the rest of the EU.
Evidence suggests that there are tradeoffs for member states as to when and if they join the Euro, and whilst they are outside the Euro whether or not to join the BU. The conference thus examined how the various member states addressed these choices. Given the thesis that overall EU governance is improved when the non-core member states are directly involved in setting European priorities and driving policy implementation, the conference also looked at two such areas: the Vienna Initiative and the implementation of macroprudential policy. The issues are relevant not only for these countries, but also for the “near EU”, including EEA countries, accession countries, and the departed country.

Speakers from all but two of the EU periphery member states participated in the conference, as well as from the core—three at central bank governor level, and others at senior central bank level, as well as from the international institutions and academia. There were differing views as to how tightly the formal rules of the EU—in particular the stipulations of the Maastricht Treaty--need to be followed. Govenor Radev of Bulgaria and Professor Baker of the University of Sheffield, for instance, posited the sanctity of the rules, while Aleš Michl of the Czech National Bank highlighted the role of the real exchange rate in restoring the competitiveness of an economy in recession and suggested that the country should adopt the euro only once a nominal depreciation in recessions does not lead to a significant real depreciation of the exchange rate. On the other side, National Michael Faulend of the Croatian National Bank reported that Croatia’s cost benefit analysis found clearly in favour of early entry.

One theme of the conference was the extent of informal arrangements that have developed within the EU framework. Governor Ingves of the Swedish Riksbank spoke about the regular cooperation amongst the Nordic and Baltic states, notwithstanding that these range from member states that have adopted the Euro, through EU member states outside the Euro—both with and without a derogation--to countries not in the EU. That cooperation is effected and reinforced for example by holding regular “drills” amongst the countries on the handling of financial crises. The Vienna initiative too involves close cooperation amongst EU member states at differing degrees of integration, as well as their banks, and countries not in the EU, at various stages of the EU accession process. Finally, in this regard, macroprudential policy discussions at the European Systemic Risk Board (ESRB) equally involve core and periphery countries, and have evolved to include also non-EU EEA members, who now participate in everything but voting.

What are the implications for the EU for the future? The length of time since the most recent EU Treaty, the Lisbon Treaty, is now greater than that between any previous EU Treaties—not because there would be nothing to discuss in a new Treaty but because of the difficulties that emerged in implementing the Lisbon Treaty, and the fear that—given the opportunity—a number of member states would raise their own anti-integrationist issues, providing a Pandora’s box that might leave the overall situation even less coherent than hitherto. We are likely therefore to continue with second-best and pragmatism for some time[1]—a challenge for those wishing to accelerate the integration process, but an opportunity for those (including those not currently in the EU) that might be concerned if the integration process is pursued too fast.[2]

The discussion below covers briefly the four panels of the conference.

Joining the banking union?
The BU was put forward in 2012 as a response to the ongoing Euro crisis. With the Single Supervisory Mechanism (SSM) of the BU located at the ECB, joining the BU is mandatory for member states using the Euro, and optional for the other EU member states, although increasingly seen as a pre-requisite for joining ERM2, i.e. the transition phase towards joining the Euro. Remarkably, at this point only two of the members states outside the Euro (Bulgaria and Croatia) have opted to join, although several are actively considering it.

The benefits to an individual member state from joining the BU are seen to include enhancing the quality of supervision of the country’s banks, reducing the possibility of regulatory capture and arbitrage and the protection of national champions, and facilitating the resolution of cross-border banks. Patrick Amis (ECB) noted the importance of being “at the table” for the central/south/south east Europe (CSSEE) member states when banks from elsewhere in the EU that are major players in their own country are discussed. Cristian Popa, former Deputy Governor of the National Bank of Romania, pointed out that in Romania, for instance, 75% of the banking sector (in terms of assets) is foreign-owned, re-iterating the importance of host country opinions being officially heard. For Nordic countries the benefit lies in seeing what their own banks do elsewhere in the EU. Daniel Hardy (St. Antony’s College) stressed the benefit of having access to resolution support. This has not yet become apparent, but access to the Single Resolution Fund could be very important during the next crisis.

On the other side are a government’s desire to “keep control”, to set priorities in supervision and resolution, and a fear that—notwithstanding the achievements made in the new regulatory institutions--the structure of the BU at this point is incomplete, with significant gaps remaining to make the union properly functional: the absence of Euro swap lines coming into play under well-defined conditions of severe financial instability was mentioned by Cristian Popa as important for domestic banks in host countries . The need to complete the BU through establishing a common deposit insurance scheme was also identified in this regard, but its importance was challenged. Amongst the banks themselves, there is reportedly arbitrage in some cases as banks in countries within the BU work amongst themselves to fall below the ECB’s minimum size threshold for direct ECB supervision, but other banks prefer to be subject to the harmonized, coherent supervision of the SSM—the latter preference seems to be growing in importance.

Vienna Initiative: where now?
Boris Vujcic (Governor of the Croatian National Bank, Chair of the Vienna Initiative), reviewed the past work of the Initiative in mitigating the effects of the rapid withdrawal of credit from CSSEE countries at the height of the global financial crisis (GFC). He stressed that much of the success of the Initiative was due to the emphasis on voluntarism, trust, and inclusivity across regulators of host and home countries, both from member states of the EU and those outside, together with the international financial institutions.

While it could be argued that the Initiative’s work is complete, participants find its structure helpful, and wish to continue. Panelists identified several areas for further work: non-performing loans; helping non-EU countries who do not have the same access to information on regulations as EU member states; increasing capacity in non-EU countries; and the transition to the green economy. It could also be possible to retain its function in the event of a future crisis. Declan Vasiljev (EBRD) noted that some of the countries of the region have opted for the multiple point of entry framework for bank resolution; this requires them to raise bail-inable debt in the countries where they operate—an issue so far little studied. In this regard too, Doris Ritzberger-Gruenwald (Austrian National Bank) drew attention to the dramatic rise in debt in a number of CSSEE countries.

Joining the Euro?
All EU member states, with the exception of Denmark, which has a derogation, are formally required to join the single currency, i.e. adopt the Euro, as soon as they have satisfied the three Maastricht criteria, on inflation, the level of debt, and the independence of the central bank. In practice, affected countries have assumed discretion on the issue. While there was a clear political advantage to joining the Euro in its early days, the issue now is not as clear-cut. The main benefit of staying out is that a country in difficulty would likely see its exchange rate depreciate, so would be able to improve competitiveness in a less disruptive way than if competitiveness has to be restored entirely through internal adjustment. However, such perceived benefit might be less than thought: if a country has a high degree of Euroization there is limited scope to improve competitiveness by depreciation, so the benefit of “being at the table” in monetary discussions might be more relevant. Similarly, the postulated ability to take control of domestic interest rates may be exaggerated, especially for small countries, since rates would likely move closely with those of the Euro, whether or not the member state has actually adopted the Euro.

Nadeem Ilahi (IMF) reported IMF studies analysing the impact of joining the Euro. The main initial objective was that the fixed exchange rate would bring down inflation and stimulate balanced growth. While this was achieved, countries that had fixed their rates showed higher volatility in growth. The countries most supportive of joining the Euro were those that had a legacy of hyper-inflation. Aleš Mishl (Czech National Bank (CNB)) reported a CNB study showing Czech economic performance outside the Euro was superior to the counterfactual if it had adopted the Euro.

There was discussion of the Maastricht criteria, now about 30 years old. They may still be relevant, although the debt ratio in particular is hugely exceeded by many member states with the Euro, but they are not deemed sufficient. Experience since the establishment of the currency union has shown the importance also of a sound banking system. It is now considered that a member state will not be ready to join the Euro if its banking system is not sound.

Dmitar Radev (Governor, Bulgarian National Bank) explained Bulgaria’s political and economic arguments underpinning a strategic decision to move ahead to ERM2 and join the Euro as a way of furthering the country’s EU integration. In this process the Maastricht criteria assessing nominal convergence remain appropriate, but their strict enforcement is essential in order to align institutional rules with political discretion. This also points to the need to further strengthen the sustainability of the entire EU framework by ever deeper integration instead of national “cherry picking” and divergences. Michael Faulend (Vice Governor, Croatian National Bank) considered that joining the Euro for the countries at present in the EU periphery would be largely a political decision, but that economic factors are also relevant. The Croatian National Bank has conducted a detailed cost-benefit study, and has concluded that Croatia should enter, the sooner the better.

Macroprudential frameworks
Macroprudential policies are new, barely 20 years old, so frameworks have less legacy encumbrance than other areas of policy. Macroprudential policies can sit between the pan-territorial requirements of monetary policy and the national perspectives of fiscal policy. Even more than other areas of policy, macroprudential policies need international focus, given that they seek to manage the actions of major financial institutions, which themselves are international.

Stefan Ingves (Governor, Swedish Riksbank) described the close interactions of the Nordic/Baltic countries, notwithstanding their very different positions as regards the EU and the Euro. Notably, all participate fully in the ESRB, with non-EU members able to do everything but vote. His own election as Vice-President of the Board, following the Bank of England’s Mark Carney, is a further sign of the embrace of the ESRB beyond the Euro countries. A key issue for the effectiveness of policy is reciprocity if a country adopts a macroprudential measure; otherwise there is no level playing field.

Francesco Mazzaferro (ESRB) noted that the establishment of responsibility for EU macroprudential policies at the ESRB, co-located with the ECB, reflected a pragmatic response to ongoing constraints. Its reliance on largely acting through warnings, public and private, in contrast to the implementation power of the SSM, was limiting in some regards, but has enhanced its potential for innovation. He stressed that at the ESRB non-Euro member states have as much of a say as those that have adopted the Euro, and he therefore questioned the use of the “periphery” term in these discussions. The departure of the UK from the EU was problematic as the UK had been playing an outsize role at the ESRB, and as the UK is the leading financial centre for the EU.

Andrew Baker (Sheffield University) argued that macroprudential policies require more international cooperation than, say, monetary policies. It is a key contemporary example of the tragedy of the commons: with uncoordinated policies the externalities will deplete the common resource of financial stability. He noted that the literature on macroprudential policies so far is limited; most strategic objectives remain aspirational.

Cristian Popa recalled that Romania had introduced macroprudential policies, such as loan-to-value ratios, debt to income ratios, and limits on unhedged borrowers, before they were known as such. Evidence suggested that they were effective for one to two years, before they became porous and institutions were gaming them, requiring further innovation from the macroprudential authorities, as well as careful cost benefit analysis of their impact. There was some stigma at the outset, since such measures were likened to capital controls, but this was much less of an issue now.

Panellists noted that major issues remain, reflecting the infancy of the macroprudential frameworks. Practices under stress remain to be tested. Also, the issue as to whether macroprudential policies are separate from, or integral to, inflation targeting is contested, and yet to be resolved.

Next steps
Papers and presentations from the conference will be made available through posting on the EuPEP webpage. A follow-on publication including the presentations is envisaged. The possibility of a complementary conference on “life outside the Euro” looking directly at the near-EU countries is being considered.

[1] There are risks in having this constraint: Wolfgang Schauble commented that situating the banking union within the ECB meant that it was “timber framed’, not “steel plated”, and that time would tell whether it would be able to withstand prospective storms.

[2] Tomas Wieser, in his Max Watson lecture in June 2019, argued for the EU to set up a number of “buckets” that countries could choose to join, or not: he suggested separate buckets for monetary/fiscal management, defence and security, labour, and environment. Other supporters of the European project reject such separation, arguing that it is tantamount to enabling “cherry picking”. 

Charles Enoch (ESC Fellow, St. Antony’s College, University of Oxford)