European Exchange Rate Mechanism

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• Their inclusion marks a milestone towards future enlargement of the euro area, given the important role that ERM II plays as a preparatory phase for euro adoption.
• Participation in ERM II may lead to a regime shift in the country concerned, i.e.
• We provide evidence that a regime shift indeed occurred in the central and eastern European countries (CEECs) that joined the mechanism in 2004 and 2005.
• If supported by sound economic policies, this shift may have positive consequences, such as accelerating the convergence process.

1 Introduction

• The inclusion of the Bulgarian lev and the Croatian kuna in ERM II is a milestone towards further enlargement of the euro area.
• [3] For Bulgaria and Croatia, ERM II will therefore serve not only as an exchange rate arrangement, but also as a preparatory phase for euro adoption.
• Specifically, Section 2 briefly reviews the history, main features and procedures of ERM II.
• Section 3 argues on the basis of quantitative evidence that ERM II may lead to a regime shift in participating countries on the path to euro adoption.
• Section 4 explains the roadmap towards ERM II participation that was established and implemented for Bulgaria and Croatia.
• Finally, Section 5 concludes by highlighting the way ahead and the key challenges faced by Bulgaria and Croatia on the path towards euro adoption.

2 The history, main features and procedures of ERM II

2.1 History

• [5] The original ERM, a core element of the EMS, was aimed at reducing exchange rate variability and fostering monetary stability among the currencies of an initial eight Member States.
• With the introduction of the euro, the Danish krone and the Greek drachma were included in the new mechanism, ERM II.
• Chart 1 Exchange rate regimes of EU Member States since the start of the European Monetary System
• On 1 May 2004 ten new Member States joined the European Union and their national central banks (NCBs) became part of the ERM II Central Bank Agreement.
• On 28 June 2004, soon after EU enlargement, the Estonian kroon, the Lithuanian litas and the Slovenian tolar were added to ERM II.
• On 2 May 2005 the Cyprus pound, the Latvian lats and the Maltese lira joined the mechanism, followed by the Slovak koruna on 28 November 2005.

2.2 Main features

• ERM II was established by the European Council Resolution of 16 June 1997[6], which stipulated that The euro will be the centre of the new mechanism.
• The main features of ERM II are (i) a central rate against the euro, (ii) a fluctuation band with a standard width of 15% around the central rate, (iii) interventions at the margins of the agreed fluctuation band, and (iv) the availability of very short-term financing from the participating central banks.
• During ERM II participation, realignments of the central rate or adjustments to the width of the fluctuation band may occur, for example if equilibrium exchange rates change over time.

2.3 Main procedures

• While ERM II is referred to in the Treaty as an integral part of the Maastricht exchange rate convergence criteria, the ERM II procedures and agreements are not based on the Treaty, since they are intergovernmental in nature.
• The decisions are taken at the end of a process involving consultation of the EWG.
• The European Commission is also involved in this process; it participates in the relevant meetings, can be mandated particular tasks and is kept informed by the ERM II parties.
• all non-euro area Member States except Denmark, are expected to join the mechanism at some stage.
• All parties take part in the search for consensus in a positive spirit, and negotiations continue until there is an agreement acceptable to all.

3 The “regime shift” effect of ERM II on investor and policymaker behaviour

3.1 Motivation

• The full benefits of euro adoption can only be enjoyed if adequate policy measures are in place, including at the national level.
• [9] Attaining a high degree of sustainable convergence (Article 140 of the TFEU) is the most important precondition for the successful adoption of the euro.
• To this end, sound policies and an adequate level of institutional quality are of the essence.
• They are therefore given due consideration when assessing the readiness of a non-euro area EU Member State to participate in ERM II.
• The analysis focuses on the CEECs that joined ERM II in 2004 and 2005 and subsequently adopted the euro: Estonia, Latvia, Lithuania, Slovenia and Slovakia.

3.2 Evidence

• Gross financial inflows as a share of GDP accelerated ahead of EU accession, which for some countries also coincided with the start of their participation in ERM II.
• [11] However, countries that joined ERM II experienced a much stronger surge (see Charts 2 and 3).
• Gross financial inflows in ERM II countries peaked about three years after they joined ERM II, at an average of around 30% of GDP (see Chart 2).
• [12] Supporting the quantitative evidence, internal econometric analysis on a sample of emerging market and (former) transition economies shows that the degree of flexibility of the exchange rate regime does not affect financial inflows to these countries, whereas ERM II participation is found to increase the magnitude of gross financial inflows.


Chart 3 Gross international financial inflows of CEECs not participating in ERM II before and after joining the European Union (as a percentage share of GDP; unweighted averages)

• The largest share of financial flows to ERM II CEECs took the form of other investment, consisting mainly of bank lending to firms and households and flows within banking groups.
• While this may reflect the strong presence of foreign (mostly EU-based) banks in ERM II CEECs during that period, it was a common feature across the whole region.
• At the same time, ERM II countries experienced negative average short-term real interest rates in the three to four-year period after joining ERM II.
• In addition, the drop in long-term real interest rates was much stronger in ERM II countries than in non-ERM II countries (see Chart 5).
• Chart 4 Domestic credit to the private sector in ERM II and non-ERM II CEECs (as a percentage share of GDP; unweighted averages)


Chart 5 Real interest rates in ERM II and non-ERM II CEECs (percentages)

3.3 Policy implications

• ERM II participants may benefit from increased availability of capital, but they may also face an increased risk of a build-up of macroeconomic imbalances.
• Resilient economic structures create the preconditions for allocating capital to productive firms, thus supporting the catching-up process rather than the formation of bubbles.
• However, if institutions are weak, such financial inflows are more likely to eventually become a disadvantage more than a benefit.
• The smooth participation of a given currency in ERM II therefore requires the proper framework conditions to be in place at the national level.
• If these improvements do not take place, excessive ease of financing after joining ERM II and later after adopting the euro risks reducing the incentives to make necessary reforms.

4 The Bulgarian lev and the Croatian kuna in ERM II

• In the summers of 2018 and 2019 respectively, following discussions with the ERM II parties, the Bulgarian and Croatian authorities made a number of policy commitments in areas of high relevance for a smooth transition process and subsequent participation in ERM II.
• After fulfilment of these so-called prior policy commitments, as well as the announcement of post-entry policy commitments to be completed after joining ERM II, the two countries entered ERM II and European banking union simultaneously on 10 July 2020.
• This section explains the rationale for ERM II participation and the roadmap towards it that was implemented for these two EU Member States.
• When Bulgaria and Croatia first expressed their interest in joining the mechanism, ERM II parties took account of three fundamental considerations.
• First, it would be the first time a country had joined ERM II since the financial crisis, from which important lessons had been learned.
• In particular, the experiences of former ERM II participants had confirmed that these features needed to be in place to ensure smooth participation in the mechanism.
• Second, it would also be the first time a Member State had joined ERM II since the start of Europeanbanking union.
• Given that ERM II is a preparatory phase for euro adoption, joining ERM II today also means preparing for banking union.
• During the informal phase of the roadmap towards ERM II participation, a dialogue was held between the ERM II parties and the Bulgarian and Croatian authorities on the risks that had been identified and how they could be mitigated.
• Once this phase was completed, the last step in the roadmap was marked by the formal requests for the inclusion of the Bulgarian lev and the Croatian kuna in ERM II, which were sent the day before the decision was taken.
• those in the banking supervision and macroprudential fields), which were completed by the time the two countries joined ERM II.
• After the completion of their prior commitments, Bulgaria and Croatia joined ERM II and banking union.
• Box 2 Completion of ERM II prior policy commitments related to structural policies In their letters to the exchange rate mechanism (ERM II) parties, Bulgaria[31] and Croatia[32] committed themselves to implementing a number of policy measures related to structural policies before joining ERM II.
• The European Commission was mandated by the ERM II parties to monitor the implementation of these prior policy commitments, in line with its remit.
• The monitoring was facilitated by regular technical exchanges between the Commission and the Bulgarian and Croatian authorities.
• The European Commission provided regular progress updates to the ERM II parties.

Post-entry commitments made by Bulgaria and Croatia on joining ERM II

• The central rate of the Croatian kuna against the euro within ERM II was set at the prevailing market rate at the time of its inclusion.
• In line with past practice, the central rate was equal to the official ECB reference rate published daily on the ECBs website of the Friday prior to the currencys inclusion in ERM II.
• The inclusion of the Croatian kuna in ERM II is also subject to the standard fluctuation margins of 15%.
• Box 3 Assessing the central rates of the Bulgarian lev and the Croatian kuna within ERM II Bulgaria and Croatia have both maintained nominal exchange rate stability for more than two decades (see Chart A).
• Chart A Exchange rates of the Bulgarian lev and the Croatian kuna against the euro (4 January 1999 to 14 October 2020; national currency units per euro)
• Thus, the issuance of Bulgarian levs is not discretionary, but directly linked to the availability of international reserves.
• As a result, BNB does not need to undertake traditional foreign exchange interventions in order to maintain the exchange rate peg.
• Instead, it issues or absorbs national currency solely against reserve currency in transactions with the banking sector, referred to as type II interventions, such that the national currency supply automatically equates to the demand.
• As a result of their credible commitments to maintaining exchange rate stability, both national central banks have accumulated comfortable buffers of foreign exchange reserves.
• Since the global financial crisis of 2007-08, BNB and HNB have significantly expanded their holdings of foreign exchange reserves.
• In the case of the Bulgarian lev, this was equal to its fixed exchange rate under the currency board arrangement.
• Thus, the Bulgarian lev was included with its central rate set as its fixed exchange rate of 1.95583 levs per euro.

5 Conclusion: the way ahead and related challenges

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• PRESS RELEASE

  Euro central and compulsory intervention rates for Bulgarian lev and Croatian kuna in ERM II

  13 July 2020

  Further to the decisions taken on 13 July 2020 (see communiqus of the European Union of the same date) on the euro central rates in ERM II for the Bulgarian lev and the Croatian kuna, the compulsory intervention rates for these currencies have been established with effect from 13 July 2020 and are set out in the table below.

• The compulsory intervention rates have been agreed by common accord between the European Central Bank (ECB) and (Bulgarian National Bank) and Hrvatska narodna banka, (Croatian National Bank) in line with Article 1.2 of the Agreement of 16 March 2006 between the European Central Bank and the national central banks of the Member States outside the euro area laying down the operating procedures for an exchange rate mechanism in stage three of Economic and Monetary Union (OJ C 73, 25.3.2006, p. 21).
• The euro central rates and compulsory intervention rates for the Danish krone remain unchanged.
• For media queries, please contact William Lelieveldt, tel.