European Monetary System

a moderation in the pace of growth and further developments in these

indicators will continue to be monitored closely. Area-wide growth should,

however, be supported by a number of domestic factors. One factor

supporting continued growth, particularly in private consumption, is the

gradual improvement in labour market conditions. Moreover, the lowest short-

term interest rates in the euro area currently stand at 3.3%, and several

countries have cut interest rates towards this level recently as part of

the process towards interest rate convergence. The process of convergence

towards this level has been gradual, but should imply a reduction in the

average short-term interest rate in the euro area of about 0.5 percentage

point since July. Long-term rates also stand at low levels. And, there has

been a marked degree of exchange rate stability among countries

participating in the euro. This is undoubtedly a welcome development from

the standpoint of encouraging trade and investment. Thus, our assessment is

similar to that of other international organisations, that - unless the

international environment deteriorates further, which is not currently

expected - growth will be somewhat weaker in 1999. Growth should, however,

remain high enough to support continued employment creation and, assuming a

recovery in the international environment, there should be a pick-up in

growth in the year 2000. At the meetings in December the ECB Governing

Council will again assess the outlook for economic and price developments.

Although the economic outlook may be less favourable than expected -

let us say - half a year ago, I believe that the conditions for a

successful launch of the euro are in place. You can be sure that the ESCB

will do its utmost to make the euro a stable currency.

The euro: pushing the boundaries

Presentation by Ms Sirkka Hдmдlдinen,

Member of the Executive Board of the European Central Bank,

at the symposium arranged by the European Private Equity and

Venture Capital Association

on 11 June 1999 in Prague

It is a great honour for me to be invited here today to this

symposium arranged by the European Private Equity and Venture Capital

Association to speak about the new European currency - the euro. Indeed,

the theme of this symposium - "Pushing the boundaries" - is very

appropriate when speaking about the euro. To my mind, the establishment of

Economic and Monetary Union can be characterised as pushing the boundaries

in several ways, such as:

* pushing the boundaries in the process of European

integration;

* pushing the boundaries of stability-oriented policies in

Europe; and

* pushing the boundaries of market integration in Europe.

In today's presentation, I shall give an overview of these three

aspects of Economic and Monetary Union. Thereafter, I shall discuss more

thoroughly the implications of the single currency for the development of

the European financial markets, focusing on the capital markets. Finally, I

shall reflect briefly on the importance of equity prices, and other asset

prices, in the formulation of monetary policy.

1. Pushing the boundaries of the process of European integration

I shall start with a few comments on the role of the euro in the

overall European integration process: I think there is little doubt that in

future books on European history the start of the third stage of European

Economic and Monetary Union on 1 January 1999 will be marked as a

significant and unique event in the long process of European integration.

On that day, the national currencies of 11 EU countries became

denominations of the euro. At the same time, the "Eurosystem" (which is

composed of the European Central Bank (ECB) and the 11 national central

banks (NCBs) of the participating Member States) assumed responsibility for

the monetary policy of the euro area.

In order to put this event into a historical context, I should like

to note that the establishment of an Economic and Monetary Union in Europe

was, in fact, originally motivated more by general political arguments than

by economic arguments. In the current debate, these overall political

arguments have almost disappeared. Instead, the media and economic analysts

are increasingly focusing their assessment of the new currency on the

recent short-term economic and financial developments in the euro area.

The process of European integration started shortly after the end of

the Second World War and gained momentum in the 1950s. At the time, the

striving for integration was mainly driven by the aim of eliminating the

risk that wars and crises would once more plague the continent. Through the

establishment of common institutions, political conflicts could be avoided

or at least resolved through discussion and compromise.

The idea of establishing a monetary union and a common monetary

policy was raised at an early stage of this process. It was argued that the

full economic effects from integration in Europe could only be gained if

the transaction costs of exchanging different currencies were eliminated.

Other benefits of a monetary union in Europe were emphasised less in the

early stages of the discussion, partly due to the fact that at that time

the Bretton Woods system was already providing a high degree of exchange

rate stability.

The first concrete proposal for an economic and monetary union in

Europe was presented in 1970 in the so-called Werner Report, named after

the then Prime Minister of Luxembourg, Pierre Werner. However, this

proposal was never implemented. In the aftermath of the break-up of the

Bretton Woods system and the shock of the first oil crisis in 1973, the

European economies entered a period of stagnation with high inflation,

persisting unemployment and instability in exchange rates and interest

rates. The European countries applied very different policy responses to

the unfavourable economic developments, and policy co-ordination

deteriorated. In this environment, it was not realistic to establish a

monetary union.

The experience of this volatile period showed that large exchange

rate fluctuations between the European currencies led to a disruption of

trade flows and an unfavourable investment climate, thereby hampering the

aims of achieving growth, employment, economic stability and enhanced

integration. Therefore, the benefits of eliminating intra-EU exchange rate

volatility became an increasingly powerful argument when the issue of

establishing an economic and monetary union was revisited in the so-called

Delors Report in 1989.

The Delors Report contained a detailed plan for the establishment of

Economic and Monetary Union and eventually became the basis for the

drafting of the Maastricht Treaty. This time, the time schedule for

establishing the Economic and Monetary Union took into account the need to

first achieve a high degree of nominal convergence for the participating

countries.

The fact that the plan for the introduction of the single currency

was then pursued and implemented in such a determined and consistent manner

implied, in itself, a boost for the overall process of integration. The

momentum of the process of integration is no longer crucially dependent on

political decisions. By contrast, the integration of the European economies

has become an irreversible and self-sustained process, which is proceeding

automatically in all areas of political, economic, social and cultural

life. The euro can thus be seen as a catalyst for further co-ordination and

integration in other policy areas. This is one way in which the

introduction of the euro has definitely helped to push the boundaries in

the process of European integration.

Another way to push the boundaries in the European integration

process relates to the geographical extent of the euro area and the

European Union. Here, I sincerely hope that the four EU countries which

have not yet adopted the euro will soon be able to join the Monetary Union.

At the same time, I hope the process to enlarge the European Union with the

applicant countries will progress successfully. An enlargement of the euro

area and of the European Union would further strengthen the role of Europe

in a global perspective and should be for the benefit of all participating

countries. However, it is clear that countries aiming to join the Economic

Monetary Union would have to fulfil the same degree of nominal convergence

as was required from the participating countries when the Economic and

Monetary Union was established. This is essential in order to avoid

tensions to emerge in the euro area, which could eventually compromise

macro-economic stability.

2. Pushing the boundaries of stability-oriented economic policies

Economic and Monetary Union in Europe also provides an opportunity to

push the boundaries in areas of economic policy. The convergence process

prior to the establishment of Economic and Monetary Union was helpful in

order to achieve a broad consensus among policy makers on the virtues of

stability-oriented policies, i.e. policies directed towards price

stability, fiscal discipline and structural reform geared at promoting

growth and employment. The convergence process also helped policy makers to

focus their efforts on the formulation of stability-oriented economic

policies in the participating countries and it also facilitated the

acceptance of these policies among the general public.

In the new environment of Economic and Monetary Union, monetary

policy can no longer be applied as a means of accommodating economic

developments in an individual Member State. Such nation-specific

developments would have to be countered by fiscal and structural policies,

while the best way in which the single monetary policy can contribute to

improved conditions for growth and employment is by ensuring price

stability in the euro area as a whole. In this respect, the formulation of

the Maastricht Treaty is instrumental, since it guarantees the Eurosystem's

firm commitment to price stability; it clearly specifies that price

stability is the primary objective of the single monetary policy.

The Eurosystem has put a lot of effort into establishing a monetary

policy framework that will ensure that it can fulfil its primary objective

of price stability as efficiently as possible. There are several aspects to

this framework.

First, the Eurosystem has adopted a quantitative definition of the

primary objective - the Governing Council of the ECB has defined price

stability as a year-on-year increase of the Harmonised Index of Consumer

Prices (HICP) for the euro area of below 2%. This is a medium-term

objective. In the short run, many factors beyond the scope of monetary

policy also affect price movements.

Second, the Eurosystem has made public the strategy to be used for

the implementation of the single monetary policy. This strategy is based on

two key elements, whereby money has been assigned a prominent role, as

signalled by the announcement of a Z- -#"+ !-+

1999\SEATSCASE.DOCh[?]€б@[?]Rreference rate of 4Ѕ% for the 12-month growth

of the euro area monetary aggregate M3. The other element consists of a

broadly based assessment of the outlook for price developments and the

risks to price stability in the euro area on the basis of a wide range of

economic and financial indicators.

Third, the Eurosystem puts significant emphasis on the need to

carefully explain its policy actions in terms of its monetary policy

strategy. Therefore, the Eurosystem has established various channels for

the communication with market participants and the general public. The most

important communication channels are the ECB's Monthly Bulletin, its press

releases and the press conferences following the meetings of the Governing

Council, the President's appearances in the European Parliament and the

speeches given by the members of the Governing Council.

Fourth, the Eurosystem's monetary policy is implemented in a marketed-

oriented manner. The Eurosystem's key policy instrument is its weekly

tender for two-week repo operations, the so-called main refinancing

operations. The features of the monetary policy operations are decided by

the decision-making bodies of the ECB, but the operations are conducted in

a decentralised manner by the NCBs.

The experience gained from the first five months of operations has

shown that the Eurosystem's procedures for decision-making and operational

implementation works very well. There are therefore no operational reasons

to call into question the ability of the Eurosystem to fulfil its mandate

to ensure price stability in the euro area. However, stable macroeconomic

policies cannot be achieved by monetary policy alone. It is also necessary

for governments to pursue fiscal and structural policies consistent with

such macroeconomic stability.

In order to ensure fiscal discipline in the participating countries,

the EU Council agreed in June 1997 to establish the so-called Stability and

Growth Pact. This Pact sets an upper limit of 3% of GDP for the fiscal

deficits of the countries participating in the euro area. Furthermore, the

Pact specifies as an objective that Member States are to bring government

budgets close to balance or even into surplus in the medium term. Only if

this objective is met will sufficient room for manoeuvre be created to

enable fiscal policy to react to cyclical developments without risking a

loss of credibility.

As regards structural policies, the policy framework is, so far, less

well developed. This is worrying given that the need for structural reform

is urgent in many areas in order to be able to effectively promote greater

growth potential and higher employment. I appreciate that these problems

are generally acknowledged, and some action has been taken in recent years.

For example, it is encouraging that the European Employment Pact adopted at

the EU Summit in Cologne last weekend explicitly recognises the need to

pursue comprehensive structural labour market reform.

Nevertheless, experience from several countries shows that it usually

takes a long time for the full effects of structural reforms to be seen.

Therefore, it is worrisome that structural reforms, in particular as

regards labour markets as well as those to limit expenditure on social

security and pension systems, are long overdue in several Member States.

Clearly, the establishment of Economic and Monetary Union does not

mean that the efforts undertaken during the convergence process can be

relaxed. On the contrary, the need for policy co-ordination among the

participating countries is now even more pressing. We have already seen

examples of negative market reactions to any perceived slippage in fiscal

discipline or postponement of structural reform. Personally, I think that

these swift market reactions, although sometimes exaggerated, may be

helpful in promoting a continued stability-oriented policy thinking in

Europe. Any move towards less responsible policies would come up against

intense peer pressure from other countries.

In this context, I would once more like to underline how important it

is that a consensus has emerged among European policy-makers on the virtues

of price stability, fiscal discipline and market-oriented structural

reform. In this way, we have already pushed the boundary significantly

towards a macroeconomic environment conducive to growth and employment,

although much still needs to be done in the years to come.

4. Pushing the boundaries in the development of financial markets

However, the success of the euro is not only in the hands of central

bankers and policy-makers. An important area in which the private sector

has an instrumental role in meeting the challenge of pushing the boundaries

is in the development of the European financial markets. In order for the

euro to be a success, it is important for the euro area financial markets

to become wider, deeper and more diversified. The introduction of the euro

has provided further input into this process; the elimination of exchange

rate risks has removed one of the main barriers to financial market

integration in Europe.

In most European countries, the financial markets have,

traditionally, been rather shallow, with few participants and a narrow

range of financial instruments on offer. A high degree of segmentation and

a lack of cross-border competition have implied relatively low trading

volumes, high transaction costs and a reluctance to implement innovative

financial instruments. This segmentation has been a function of exchange

rate borders, tradition, differing practices and, of course, national

regulations and tax regimes.

Following the elimination of the barriers implied by different

currencies, it is now up to the European Commission and the relevant

national authorities to further the integration process in the areas of

regulation and taxation. Meanwhile, it is up to market participants to take

advantage of the business opportunities implied by the increased scope for

market integration.

The introduction of the euro brought about an almost immediate

integration of the national money markets into a euro area-wide money

market. This was made possible thanks to the establishment of pan-European

payment systems, such as the TARGET system set up by the Eurosystem, which

enables banks to access liquidity throughout the euro area in real time.

The cross-border integration of bond markets in the euro area is

progressing at a slower pace, as is also true of equities and derivatives

markets. This notwithstanding, we are also experiencing important

developments in these segments of the financial markets. These developments

are partly due to the general trends towards globalisation and

technological refinement and partly related to the introduction of the

euro. As a result of the introduction of the euro, market participants

increasingly perceive similar instruments traded in the different national

markets to be close substitutes. This holds true, in particular, for bonds

issued by the euro area governments, where the establishment of common

benchmarks, the narrowing of yield spreads and increased market liquidity

seem to indicate that a high degree of cross-border substitutability has

already been achieved.

The fact that euro area financial instruments are increasingly

considered to be close substitutes increases the competitive pressures on

national markets to attract issuers and investors wishing to benefit from

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