Why did the EU introduced a phased approach to adopt a single currency ? Why did some countries refuse to join the EMU ?

University Degree Business and Administrative studies

International Trade and Banking 305 EU and Progress of adopting a single currency

TABLE OF CONTENTS

Page

1. Introduction 2

2. Motive of integration to the Euro 3

3. EMU and Progress of adopting the Euro 3

a. EMU and convergence criteria 3

b. Three-phased approach to adopt Euro 4

c. Why three-phased approach ? 4

4. How effective the phased approach ? 5

5. Cases against the adoption of Euro 6

6. Conclusion 7

REFERENCES 8

Introduction

Europe has become one of the largest economy in the world, and EU by itself is considered as the largest domestic single market, especially after implementing the adoption of single currency (Euro) since 1999 (European Commission 2011). Although there was scepticism about viability of Euro by the time of its introduction, it now creates a stronger presence for the EU in the world arena. Euro is currently being used by over 330 million European and nearly 200 million people of countries have currency pegged to the Euro (Eurunion 2011). The creation of the world’s second-largest currency transformed the European economy from the individually economic governance to the united governance with well integration.

On the progress of adopting a single currency, EU employed three-phased approach, which is the monetary integration process composed of three steps in their run-up to the euro adoption. The entire process ranges from the preparation for entry to the institution of Exchange Rate Mechanism (ERM) to ensure all candidates’ legislations and monetary issues compatible with the EU monetary regime (Vladimir Lavrac 2003). Candidate countries must follow the desgined procedures during their negotiation with the EU and might choose whether to participate or not. Despite the fact of having great potential in competitiveness in the world monetary, EU still has been unsuccessful in inciting some European countries to join the Euro area. This paper will focus on the introduction and reason behind the use of three-phased approach by EU as well as factors affect the determination of countries to use Euro in lieu of their original currency.

Motive of integration to the Euro

In a study published in 1990, Emerson cited four reasons in favour of the adoption of single currency. Firstly, intra-EU trade represents approximately sixty percents of international trade, which makes Europe the world’s largest importer and exporter. As more concerned, the use of single currency will be lodged by 11 prospective members that creates a highly liquid market involved large transactions. This leads to the reduction in transaction costs utilizing international investments. Secondly, the unification of separate currencies will avoid the riskiness arises from the fluctuation in foreign exchange market, enables firms throughout Europe to facilitate optimal business decisions. Thirdly, single denomination allows EU consumers to acquire comprehensive information about price of good Europe-wide. Firms are also encouraged to embark in the more competitive market and increase the quality of products, services as well as new innovations. Finally, as euro becomes more attractive, it will create economies of scale, inducing more foreign companies to use euro denominated currency. This sets up a bipolar financial system which reduces the predominance of US dollar in global arena. Any movement towards the use of euro in trade will affect the desirability of euro reserves in many banks. This is a stepping-stone for further strides in order to achieve international status.

EMU and Progress of adopting the Euro

EMU and convergence criteria

In line with the institution of European Union endorsed by the Maastricht Treaty on 7th February 1992, the introduction of Economic and Monetary Union (EMU) earmarked the evolvement of European monetary union. EMU set a number of criteria which EU members must satisfy in order to adopt a single currency. The true function of EMU is to prepare a monetary institution with strict framework through the use of European Exchange Rate Mechanism (ERM), in which candidate currencies must fulfill the convergence criteria by maintaining the minimal variance ...

This is a preview of the whole essay

EMU and Progress of adopting the Euro

EMU and convergence criteria

Specifically, inflation rates of countries expected to join EMU must not be more than 1.5 percent above the average of the three best-performing members. Long-term rates are subjective to the limitation of less than 2.00 percent above the average of the best-performing members. Budget deficits should not account for more than 3 percent of national GDP, while the public debt ratio should not exceed 60 percent of GDP (Dileep M., H. G. Fung 2007)

Three-phased approach to adopt Euro

The launch of EMU is the first phase of the 3-phased approach to adopt a single currency. The second phase commenced on January 1st 1999 involved the irrevocable fixing of the conversion rates of the 11 countries that qualified for the EMU (AMUE 1994). In this phase, ERM ensures that conversion facilities will translate amounts from euro into national denominated units and vice versa, at the irrevocably fixed conversion rates. This phase would last for 3 years. The third phase was in effective on January 1st 2002, which maintains the dual currency mechanism. At that time, new euro banknotes and coins were introduced and widely used in parallel with the national denominated currencies. This dual currency system would last for 6 months and on July 1st 2002, national currencies of EMU members lost their legal tender and euro became the sole currency.

Why three-phased approach ?

Changing over to another currency is a radical operation requiring prudent arrangements in order to ensure a smooth transition (Euro Commission 2011). The three-phased approach is the framework from which EU Member States follow in steps through their progress of shifting to the Euro. The first step is the foundation of EMU responsible for observation of the convergence in all aspects mentioned. A salient criterion required by EMU is the member’s ability of catching up in terms of GDP per capita and price level convergence (Szapáry, G. 2000). Second phased approach allows EU Member States to have more time to outline key strategy and assign national steering structure.The fact shows that there was a large differences among members. It took time to satisfy the inflation criterion because inflation is the long-term factor. Beside that, the problem caused by decimalisation as the conversion facilities is unlikely to equally round national prices into euro prices in short term (Bolle M. 2002). In another aspect, both private and public sectors must adapt to new administrative, financial and monetary mechanism, and legislation must be amended accordingly. All the massive modifications must be implemented for at least 3 years before all the factors fully converged. The completion of second phase paved the way for the introduction of the last phase. The final phase was the agreement to apply a dual-currency process to avoid the market shock in which all denomination, payment systems and means of exchanges would be converted to euro in a very short period. The dual circulation also helps consumers mentally adapt to new currency and price quotation in gradual manner.

How effective the phased approach ?

As mentioned, three phases approach put up stages for a smooth transition to a single currency. However, for new candidates the procedures are prescribed by the EU side, which means candidates must follow in steps in the strict-time manner in order to adopt euro. Some mandatory charters gave insufficient time for some candidates to manoeuvre. According to Begg’s analysis in 2002, accession countries have another option to boost up the speed of their participating progress to the euro area. These countries might choose to by-pass procedures required by the EU through unilateral adoption of euro, or euroisation in more specific term. This is an example of Czech Republic, Hungary, Bulgarie, Romanie and Poland trying to abandon their currency for euro before joining the EMU, which allows them hurdle some criteria stipulated by EMU (Maurizio M. H. 2000). Obviously, the EU side would not allow for unilateral euroisation, and trying to prevent this becomes material with hostility. As a result, euroisation would not be employed by many accession countries, as they choose decent way for their joining in the euro area. Although this would not be a matter of concern afterwards, this event proves that not all prospective candidates have the same viewpoint on how long for the entire process can be done.

Cases against the adoption of Euro

Until now, there has been 17 member states commit to use euro as their denominated currency (European Commission 2011). One of the typical example is the refusion of United Kingdom (UK) to completely replace their sterling. Giving up sterling means UK has to sacrifice the national monetary autonomy, giving up flexibility on short-term interest rates. All the monetary policies will now be imposed by European Central Bank. Sometimes the needs of domestic UK market is inconsistent with the monetary policies pursued by European Central Bank. In the extreme case when monetary union appears to be in problem, countries members will cancel their membership and recover an independent currency. This also leads to high cost to re-establish new monetary policy. Even though union still operates in an effective manner, any shocks occured in the domestic market such as unexpected disasters will immediately affect the domestic economy. Because the domestic monetary policy would no longer be able to respond in harmony with rise in commodity price, domestic economy will tolerate the slow respond from the monetary union.

EMU is structurized in a state of convergence, which means EMU must maintain the balance among members. In reality, there is potential of crisis occurs in one country might cause an imbalance in the monetary mechanism. It is hard for EMU to moderate by satisfying simultaneously all the problems arise from each members. There has a minor chance that EMU will not be sustainable. Some currency unions have collapsed in the past. However, it is the precious learn that helps EMU avoid the difficulties.

Adopting euro involves in substantial costs incurred by local firms and banks. It also takes time to fully convergence to the stipulated level. Even with relatively steady convergence, there is no guarantee that euro will be optimal utilized in every corner of the continent. Moreover, European Commission tax revenue only accounts for 1.5 percent of GDP, which sometimes mismatches with the inflationary policy pursued by local countries. Countries are likely to be more vulnerable after being a member of EMU. These are some of plausible reasons make countries reluctant to joining the EMU.

Conclusion

The objective of this paper is to identify the progress of adopting euro and difficulties facing by its prospect members. Since the first time of its introduction, value of the euro has soared to high level over US dollar, which implies a general good condition of EU against US. By adding more members to the union, EU has created a powerful financial system in terms of quantity and quality. EU also becomes the largest single domestic market compared to US. All the recent figures shows the appropriate strategy employed by EU in the path of strengthening its influential in the global financial system. There still have some challenges facing by EU in order to fully accomplish the absolute integration into one economic entity. These obstacles arise from the lack of comprehensiveness in legislation to induce more EU countries to join the EMU. However, because every countries commiting to the use of euro emphatically concern about price stability and budegetary discipline, this eventually creates a strong union economy and becomes a sturdy foundation to forge the new regulatory framework in the future.

REFERENCES

Association for the Monetary Union of Europe (AMUE). 1994. Preparing the Transitionto the Single Currency.

Begg D., Eichengreen B., Halpern L., Von Hagen J. and Wyplosz C. 2002, Sustainable regimes of capital movements in accession countries. CEPR Policy Paper No.10.

Bolle M. 2002. Eurozone enlargement: Exchange rate choices and adjusting markets. Ezoneplus summary report. Berlin : Berliner Wissenschafts-Verlag

Business Times. nd. Why the euro will quickly rival dollar as world coinage. http://www.btimes.co.za/98/0517/world/world.htm (accessed August 19 2011)

Dileep, M., H. G. Fung. 2007.International Bank Management. 2nd ed. Blackwell Publishing Ltd. 2007.

Emerson, M. 1990. One Market, One Money. European Economy. October.

European Commission. nd. The euro. Economic and Financial Affairs. http://ec.europa.eu/economy_finance/euro/index_en.htm (accessed August 14, 2011)

European Central Bank. 2000. The Eurosystem and the EU enlargement process. ECB Monthly bulletin. Frankfurt : ECB

European Monetary Institute. 1995. The Changeover to the Single Currency. Frankfurt November.

European Union External Action. 2011. Panel Discussion: Estonia Joins the Euro - A Safe Bet. http://www.eurunion.org/eu/2011/Panel-Discussion-Estonia-Joins-the-Euro-A-Safe-Bet.html (accessed August 19, 2011)

Lavrač V. and Zumer T. 2003. Accession of CEE countries to EMU: Nominal convergence, real convergence and optimum currency area criteria. Bank of Valetta Review, Spring 2003, No.27

Maurizio M. H. 2000. The Case for Euroisation in Central and Eastern European Countries. London.

Szapáry, G. 2000. Maastricht and the Choice of Exchange Rate Regime in TransitionCountries During the Run-Up to EMU. National Bank of Hungary Working Paper, No. 7.

Thimann, C. 2005. Real Convergence, Economic Dynamics, and Adoption of the Euro in the New European Union Members States. S. Schadler ed., Euro Adoption in Central and Eastern Europe: Opportunities and Challenges. IMF.

Page