Special Topics in Economics Special Topics in Economics Econ. 491Econ. 491

Chapter 5:Chapter 5:

Convergence CriteriaConvergence Criteria

I. Maastricht Criteria I. Maastricht Criteria

The Maastricht criteria (also known as the convergence criteria) The Maastricht criteria (also known as the convergence criteria) are the criteria for European Union member states to enter the are the criteria for European Union member states to enter the third stage of European Economic and Monetary Union (EMU) third stage of European Economic and Monetary Union (EMU) and adopt the euro as their currency.and adopt the euro as their currency.

The Maastricht criteria stress three main policies:The Maastricht criteria stress three main policies:

1- Attain exchange rate stability defined by ERM (before Euro).1- Attain exchange rate stability defined by ERM (before Euro).

2- Attain price stability2- Attain price stability

3- Maintain a restrictive fiscal policy3- Maintain a restrictive fiscal policy

II. Maastricht Convergence Indicators II. Maastricht Convergence Indicators

Courtiers must conform to rules regarding exchange Courtiers must conform to rules regarding exchange rate stability, inflation, interest rates, government rate stability, inflation, interest rates, government budget deficits, and government debt.budget deficits, and government debt.

These are called convergence indicators or These are called convergence indicators or convergence criteria. convergence criteria.

They measure whether the economies follow policies They measure whether the economies follow policies similar-or convergent- enough to make a common similar-or convergent- enough to make a common currency viable.currency viable.

All countries that satisfied the criteria were to embark All countries that satisfied the criteria were to embark on currency on currency unification as of January 1on currency on currency unification as of January 1stst, , 1999. Other EU members could join later as they met 1999. Other EU members could join later as they met the convergence criteria.the convergence criteria.

The Maastricht treaty requires each EU country The Maastricht treaty requires each EU country to meet five convergence criteria to participate in to meet five convergence criteria to participate in monetary unification:monetary unification:

1.1. Currency must have remained within its ERM trading Currency must have remained within its ERM trading band for at least two years with no realignment.band for at least two years with no realignment.

2.2. Inflation rate for the preceding year must have been no Inflation rate for the preceding year must have been no more than 1.5% above the average inflation rate of the more than 1.5% above the average inflation rate of the three lowest –inflation EU members.three lowest –inflation EU members.

3.3. Long term interest rate on government bonds during Long term interest rate on government bonds during the preceding year must have been no more 2% above the preceding year must have been no more 2% above the average interest rate of the three lowest inflation the average interest rate of the three lowest inflation EU members.EU members.

4.4. Budget deficit must not exceed 3% of GDP.Budget deficit must not exceed 3% of GDP.

5.5. Government debt must not exceed 60% of GDP.Government debt must not exceed 60% of GDP.

1.1. Currency must have remained within its ERM Currency must have remained within its ERM trading band for at least two years with no trading band for at least two years with no realignment:realignment:

Joined the exchange rate mechanism of the EMS and Joined the exchange rate mechanism of the EMS and did not experience a devaluation during the two years did not experience a devaluation during the two years preceding the entrance into EMUpreceding the entrance into EMU

2.2. Inflation rate for the preceding year must have Inflation rate for the preceding year must have been no more than 1.5% above the average been no more than 1.5% above the average inflation rate of the three lowest –inflation EU inflation rate of the three lowest –inflation EU members:members:

Inflation rate Inflation rate average of three lowest inflation rates average of three lowest inflation rates in the group of candidate countries + 1.5%in the group of candidate countries + 1.5%

3.3. Long term interest rate on government bonds Long term interest rate on government bonds during the preceding year must have been no more during the preceding year must have been no more 2% above the average interest rate of the three 2% above the average interest rate of the three lowest inflation EU members:lowest inflation EU members:

Long-term interest rate Long-term interest rate average observed in the average observed in the three low-inflation countries + 2%three low-inflation countries + 2%

4.4. Budget deficit must not exceed 3% of GDP:Budget deficit must not exceed 3% of GDP:

Government budget deficit Government budget deficit 3% of its GDP; 3% of its GDP;

If this condition is not satisfiedIf this condition is not satisfied:: budget budget deficit should deficit should be declining continuously and be declining continuously and substantially and come substantially and come close to the 3% norm close to the 3% norm oror the deviation from the the deviation from the reference value (3%) reference value (3%) 'should be exceptional and 'should be exceptional and temporary and remain temporary and remain close to the reference value', close to the reference value', art. 104c(a))art. 104c(a))

5.5. Government debt must not exceed 60% of GDP:Government debt must not exceed 60% of GDP:

Government debt Government debt 60%of GDP; 60%of GDP;

If this condition is not satisfied:If this condition is not satisfied:

government debt should diminish sufficiently and government debt should diminish sufficiently and approach the reference value (60%) at a satisfactory approach the reference value (60%) at a satisfactory pace', art. 104c(b))pace', art. 104c(b))

III. Why Convergence RequirementsIII. Why Convergence Requirements

The OCA theory stresses The OCA theory stresses micromicro-economic conditions for a -economic conditions for a successful monetary unionsuccessful monetary union Symmetry of shocksSymmetry of shocks Labour market flexibility Labour market flexibility Labour mobility Labour mobility

The Treaty stresses The Treaty stresses macromacro-economic convergence -economic convergence InflationInflation Interest ratesInterest rates Budgetary policiesBudgetary policies

Exchange rate convergence (no-devaluation requirement)Exchange rate convergence (no-devaluation requirement) ; ;

It prevents countries from manipulating their exchange It prevents countries from manipulating their exchange rates. rates.

So as to have more favorable (depreciated) exchange rate So as to have more favorable (depreciated) exchange rate in the union.in the union.

According to the Treaty, countries should maintain their According to the Treaty, countries should maintain their exchange rates within the 'normal' band of fluctuation exchange rates within the 'normal' band of fluctuation (without changing that band) during the two years (without changing that band) during the two years preceding their entry into the EMU.preceding their entry into the EMU.

Deficit and debt criteria can be rationalized in a similar way;Deficit and debt criteria can be rationalized in a similar way;

A country with a high debt-to-GDP ratio has an incentive A country with a high debt-to-GDP ratio has an incentive to create surprise inflation to create surprise inflation

The low debt country stands to lose and will insist that the The low debt country stands to lose and will insist that the debt-to-GDP ratio of the highly indebted country be debt-to-GDP ratio of the highly indebted country be reduced prior to entry into the monetary union reduced prior to entry into the monetary union

The high debt country must also reduce its government The high debt country must also reduce its government budget deficitbudget deficit

Countries with a large debt face a higher default risk;Countries with a large debt face a higher default risk;

Once in the union, this will increase the pressure for a Once in the union, this will increase the pressure for a bailout in the event of a default crisis.bailout in the event of a default crisis.

No-bailoutNo-bailout clause was incorporated into the Maastricht clause was incorporated into the Maastricht Treaty.Treaty.

But is this clause credible?But is this clause credible?

Interest rate convergence;Interest rate convergence;

Excessively large differences in the interest rates prior to Excessively large differences in the interest rates prior to entry could lead to large capital gains and losses at the entry could lead to large capital gains and losses at the moment of entry into EMU moment of entry into EMU

However, these gains and losses are likely to occur prior However, these gains and losses are likely to occur prior to entry because the market will automatically lead to a to entry because the market will automatically lead to a convergence of long term interest rates as soon as the convergence of long term interest rates as soon as the political decision is made to allow entry of the candidate political decision is made to allow entry of the candidate member countrymember country

IV. How to fix the conversion rates during the transition

Madrid Council of 1995 implied that on 1 January 1999 one Madrid Council of 1995 implied that on 1 January 1999 one ECU would be converted into one EuroECU would be converted into one Euro

At the same time the conversion rates of the national At the same time the conversion rates of the national currencies into the Euro had to be equal to the market rates of currencies into the Euro had to be equal to the market rates of these currencies against the ECU at the close of the market on these currencies against the ECU at the close of the market on 31 December 199831 December 1998

This created potential for self-fulfilling speculative This created potential for self-fulfilling speculative movements of the exchange rates prior to 31 December 1998.movements of the exchange rates prior to 31 December 1998.

The effect of such speculative movements could be to The effect of such speculative movements could be to permanently fix the wrong values of the exchange rates.permanently fix the wrong values of the exchange rates.

In order to avoid this, the fixed rates at which the currencies In order to avoid this, the fixed rates at which the currencies would be converted into each other at the start of EMU were would be converted into each other at the start of EMU were announced in advance;announced in advance; If these announcements were credible, the market would If these announcements were credible, the market would

smoothly drive the market rates towards the announced smoothly drive the market rates towards the announced fixed conversion ratesfixed conversion rates

This is exactly what happened. The authorities announced the This is exactly what happened. The authorities announced the fixed bilateral conversion rates in May 1998 fixed bilateral conversion rates in May 1998

Transition was very smooth with minimal turbulenceTransition was very smooth with minimal turbulence

Table 6.1 Conversion rates of EMU currencies into the euro.

Belgian franc 40,339900Spanish peseta 166,386000Irish punt 0,787564Luxembourgish franc 40,339900Austrian schilling 13,760300Finnish marka 5,945730Geraman mark 1,955830French franc 6,559570Italian lire 1936,270000Dutch guilder 2,203710Portuguese escudo 200,482000

V. Calculating the Common Currency (Unified Currency)

It is possible to define the par value of the unified currency.It is possible to define the par value of the unified currency.

One method to calculate the par value of the unified currency One method to calculate the par value of the unified currency is based on the weighted GDP.is based on the weighted GDP.

The other method to calculate the par value of the unified The other method to calculate the par value of the unified currency is based on the weighted bilateral trade.currency is based on the weighted bilateral trade.

According to both methods, the exchange rate of the unified According to both methods, the exchange rate of the unified currency currency versusversus other external currencies is determined. other external currencies is determined.

The exchange rate of the national currencies ( for the The exchange rate of the national currencies ( for the Monetary Union Members) Monetary Union Members) versusversus the unified currency can the unified currency can also be determined .also be determined .

Calculating the par value of the unified currency based on the Calculating the par value of the unified currency based on the weighted GDP.weighted GDP.

(1)Exchange Rate of US Dollar v.s

National Currency ($/x)

(2)Nominal

GDP (in million

US Dollar)

(3)The

Weight ( # 2/ total)

(3 X 1)Par Value

Country A 0.2666 348 673 51.16% 0.13641

Country B 0.2747 52 723 7.74% 0.02125

Country C 0.2722 163 167 23.94% 0.06518

Country D 3.4630 101 905 14.95% 0.51776

Country E 2.6595 15 121 2.22% 0.0590

Total 681 589 0.79961

Calculating the Conversion Rates of the National Currencies Calculating the Conversion Rates of the National Currencies versus the Unified Currency based on the weighted GDP.versus the Unified Currency based on the weighted GDP.

Conversion Rates of national Currencies v.s Unified Currency

(National Currency /Unified Currency)

Country A 2.99857

Country B 2.91061

Country C 2.93660

Country D 0.23089

Country E 0.30065