10 Years of the Euro: A Perspective from the IMF, by Sean Hagan at the European Central Bank in Frankfurt
January 29, 2009by Sean Hagan, General Counsel and Director of the Legal Department
at the European Central Bank in Frankfurt
January 29, 2009
A number of metrics can be used to measure the success of the euro. One can cite, for example, the value of euro banknotes in circulation—which now exceeds the U.S. dollar—or, alternatively, the increasing share of the euro as an international reserve currency. For the lawyers among us today, however, it may be useful to consider another benchmark of success: the fact that the euro represents an important breakthrough in the development of public international law. The success of the euro is, in no small part, attributable to the legal and institutional framework that has supported it, a framework that, when viewed from a broader perspective, confirms the continued validity of the principle that a country’s decision to transfer national sovereignty in the conduct of its economic and financial policies can indeed be in its long-term interest. As a lawyer working in an international organization, I am particularly cognizant of the significance of this achievement and would like to take the opportunity to congratulate all of those here today who have helped translate the broad vision of the euro into an operational success.
I have been asked to provide a retrospective of the euro from the viewpoint of the Fund. I will take some liberty in the scope of my assignment in two respects. First, I intend to cover issues that are also of particular relevance to EU members that have not yet adopted the euro. Second, while an historical perspective is essential, I will also identify several issues that are of current interest. It goes without saying that the views that I am expressing are my own and do not necessarily reflect those of the Fund.
From a purely legal perspective, it may be said that the adoption of the euro had no impact on the nature of euro area members’ relationship with the Fund, since neither the adoption of the Maastricht Treat nor the adoption of the euro modified members’ rights and obligations under the Fund’s Articles of Agreement.
On a broader level, however, the adoption of the euro has had a profound impact on this relationship. In particular, while members’ rights and obligations under the Articles have not changed, the transfer of competence with respect to the conduct of both exchange rate and monetary policy has had an important impact on how these members exercise these rights and fulfill these obligations.
An understanding of the nature of this impact on member’s obligations requires some analysis of the Fund’s existing responsibilities. While the Fund is best known as a financial institution, it is also a regulatory institution, in that it oversees members’ obligations under the Articles of Agreement. These obligations have changed since the Fund was established over 60 years ago. Originally, a member was required to maintain the value of its currencies relative to other currencies of members and the Fund was charged with ensuring that members adhered to this obligation.
With the collapse of this fixed exchange rate system in the 1970s—referred to as the Bretton Woods system—the Articles were amended to give members more latitude in the conduct of their exchange rate policies. This latitude is not unlimited, however. While members currently have the freedom to choose whatever exchange arrangements they wish, they may not exercise this freedom in a manner that undermines the stability of the overall system. As specified in the Articles, members are required to “collaborate with the Fund to promote a stable system of exchange rates.” The Fund, for its part, is charged with conducting periodic consultations with members to ensure that they are adhering to this obligation, a process that is referred to as Fund surveillance.
As a general matter, the Fund takes the position that a member fulfills its obligation to promote the stability of the overall system of exchange rates when it pursues policies that promote its own external stability. Importantly, the policies examined by the Fund for this purpose include not only exchange rate policies but also domestic policies that may have an effect on a member’s exchange rate and, in particular, monetary, fiscal, and financial sector policies.
Applying this approach to monetary unions and, more specifically, European Monetary Union (EMU), the Fund takes the position that euro area members are still accountable to the Fund for the performance of their obligations relating to both exchange rate policies and monetary policies, consistent with the general principle that their obligations under the obligations have not been modified. Nevertheless, the Fund recognizes that euro area members have effectively delegated to the Community institutions performance of these obligations. Consistent with the above, Fund surveillance of euro members’ exchange rate and monetary policies involves discussions with the relevant European institutions, in particular the European Central Bank (ECB). In contrast, surveillance over domestic policies that largely continue to be within the competence of individual euro members involves discussions with the members themselves.
In that context, an issue that has become particularly important in Fund surveillance of euro members is whether the existing financial stability framework in the euro area is sufficiently robust given the degree of financial integration that has taken place. The challenges arise, in many respects, from the very success of the euro, which has fostered this integration. Not surprisingly, the result is the existence of large cross-border financial institutions with balance sheets of such magnitude that their own failure could have EU-wide implications.
The existing financial sector regulatory framework applicable to the euro area is currently underpinned by two general principles. On the one hand, the European Parliament and the Council issue directives and establish a relatively structured process that is designed to achieve convergence of financial sector regulation and supervisory practices. On the other hand, financial institutions remain supervised by national authorities, who are accountable to national legislatures only.
This framework is undergoing reform, and it is fair to say that the pace of this reform has been accelerated by the ongoing crisis, which has emphasized the need for greater joint responsibility and accountability in securing EU-wide financial stability. An important step forward was the adoption by the ECOFIN in October 2007 of a set of crisis management principles that effectively call on supervisors to take an EU—and not just a national—perspective in crisis management.
The Fund welcomes the recognition by the EU that further reform is needed in this area and is particularly looking forward to the outcome of the work of the high-level expert group on financial supervision headed by former IMF Managing Director Jacques de Larosière, which has been asked to make recommendations on how to establish a more integrated European system of supervision that would address, as stated in the terms of reference, “the obvious mismatch between European and global financial markets and supervision which remains largely national.”
In that context, some of the approaches to European supervision that are currently being discussed would involve relying upon a supranational structure to fulfill some supervisory functions, notably for cross-border banks. Clearly, such a solution would raise sensitive issues, not least because of the fiscal implications of supervision and intervention. Nevertheless, it is important to recognize that, as part of the ECOFIN crisis management principles noted above, governments have already committed to share the budgetary costs of intervention on the basis of “equitable and balanced criteria, which take into account the economic impact of the crisis in the countries affected.” In essence, what is needed is a system that will assure that these principles are effectively applied in practice.
I would like to discuss issues relating to the exercise of members’ rights under the Articles and, in particular, members’ right to use the Fund’s financial resources.
Allow me to provide a brief overview of the Fund’s role as a financial institution, which has also evolved over the years. Originally, this assistance was designed primarily to support the Fund’s regulatory function: by making its resources available to help members address balance of payments problems—problems that put pressure on exchange rates that members were required to retain—the Fund helped members adhere to their obligations.
With the steady growth of capital markets and collapse of the Bretton Woods system of exchange rates, the Fund’s financing role changed. While the growth of private capital flows to emerging markets is generally beneficial, this growth periodically generates periods of instability when these economies borrow more than they can repay and there is a sudden loss in market confidence. By providing financial support in support of a member’s adjustment program, the Fund facilitates a return of market confidence.
When the Fund provides financial assistance, the Articles require it to make a determination that two related conditions have been met. First, the member must be taking action to actually resolve—rather than delay the resolution of— its balance of payments problems. Second, the necessary adjustment process must take place within a time frame that will enable it to repay the Fund within the relatively short maturity period established for Fund financing, normally three to five years. As a means of satisfying itself that these requirement are being met, the Fund makes its resources conditional upon evidence that a member is implementing an appropriate economic adjustment program, a program that the Fund normally helps the member to design.
It is important to emphasize that the magnitude of the needs faced by these members normally far outstrips the amount of financing that the Fund can provide. However the fact that the Fund has made a judgment that the member’s adjustment policies merit Fund financial support is intended to catalyze financial assistance from other sources, whether official or private.
Applying these general principles to EU members, it is necessary to make a distinction between those members that have adopted the euro and those that have not.
With respect to those members that have not yet adopted the euro, the last several months have seen the Fund provide large amounts of financing to two EU members, Hungary and Latvia, a process that has involved considerable consultations and collaboration with EU institutions.
Some background on the EU legal framework at this point is helpful. Under the EC Treaty, countries that have not yet adopted the euro that are suffering from balance of payments are eligible to receive financial support from the EU upon a decision by the Council. By regulation, the Council has decided that a member experiencing balance of payments difficulties should consult with the Commission first regarding the availability of EU assistance before seeking financial assistance from elsewhere.
In the case of both Latvia and Hungary, it was quickly recognized both by the country and the EU that any EU financial assistance would need to be supplemented by resources from the Fund. This was partly because of the magnitude of the financing needed, and because the Fund was in a position to move more rapidly than the EU in disbursing the initial installments.
In both cases, there has been close cooperation between the EU and the Fund. With respect to financing, there was considerable burden sharing. In the case of Hungary, the Fund provided 12.5 billion euro and the EU provided 6.5 billion. With respect to Latvia, the EU provided 3.1 billion euro and the Fund provided 1.7 billion. Importantly, the Fund notes that the EU has decided to increase the overall amount that it has available to provide assistance to non-euro members, from 12 to 25 billion.
In addition to financial burden sharing, an important objective has been the effective coordination of conditionality, in terms of both the overall design of the adjustment program and the monitoring of policy implementation. This coordination has been new for both the Fund and the EU, and it is very likely, following this experience, more formal coordination procedures will be put in place.
What about a member that has adopted the euro? Under the EC Treaty, balance of payments assistance from the EU is not available for these members. This does not mean, however, that such assistance would not be available from the Fund. Although Fund financial assistance to a euro member is somewhat theoretical, the Fund has provided financial assistance to members in other currency unions in the past. In doing so, the Fund has considered a number of issues. First, from Fund’s perspective, a member of a currency union still has its own balance of payments vis-à-vis other countries, including currency union members. Second, a balance of payments need can exist if the member has an overall balance of payments deficit and a balance of payments deficit can occur if a member is having difficulties financing its international debt obligations, even if these obligation are in the currency of the union. Importantly, what makes the transaction “international”—and therefore relevant for balance of payments purposes—is the fact that it takes place between a resident and a nonresident. Accordingly, in the past the Fund has provided financial assistance to currency union members whose balance of payments difficulties are derived from a fiscal deficit.
The final issue that I would like to discuss relates to EU representation in the Fund, an issue that has been the subject of considerable attention within the Fund, within the EU, and among outside observers.
This question must be considered in the context of the Fund’s own governance framework. When a country becomes a member of the Fund, it receives a quota, the size of a member’s quota being determined by the relative size of the member’s economy in the world economy. A member’s quota is an important key in its relationship with the Fund: it determines the amount of its financial subscription, the amount that it can borrow, and, most importantly for our discussion today, its voting power in the Fund.
Members exercise their voting power most regularly through the Executive Board, which is charged with conducting the business of the Fund and in that capacity takes most of the strategic and operational decisions of the Fund. The Fund’s Executive Board currently consists of 24 Executive Directors. As required under the Fund’s Articles, five of these Executive Directors are appointed by the members with the largest five quotas (currently the United States, Japan, Germany, the United Kingdom, and France). The remaining —currently 19— Executive Directors are elected every two years through a process that involves the remaining members of the Fund forming constituencies. Importantly, when an Executive Director cast the votes of the members who elected him or her, he or she must do so as a block: the votes of a constituency cannot be split by an Executive Director.
When contemplating options for EU representation in the Fund, it is important to recognize that the framework described above imposes two constraints on the nature of such representation.
The first constraint is that membership is only available to individual countries. Unlike the WTO agreement, the Fund’s Articles do not contain a provision that allows for the membership of monetary or custom unions. Of course, membership of EMU would be possible if the Fund were to determine the EMU is a “country” within the meaning of the Articles. Such a determination would be difficult in light of the fact that, notwithstanding the transfer of sovereignty in areas of importance to the Fund, such a transfer has not been regarded as affecting the status of euro area members as independent countries under international law.
Second, it would not be possible—at least under the existing configuration of voting power—for all of the euro members to form a single constituency and elect a single Executive Director. This is because France and Germany, having two of the five largest quotas in the Fund, are each required to appoint their own Executive Director. The appointment of Executive Directors by the members with the five largest quotas is not a right that can be waived but, rather, is an obligation.
Notwithstanding these important constraints, there are a number of opportunities under the current Articles for euro members to bring a European—rather than a purely national—voice to the Fund. First, it would be possible for the euro members other than France and Germany to form a constituency and elect a single Executive Director. These members have chosen not to do so, however.
Second, the various Executive Directors elected or appointed by euro members can coordinate their views with to the aim of combining their voting power. In this area, important progress has been made on a number of different levels.
In Europe, the Economic and Financial Committee created under the EU Treaty has established a subcommittee on IMF matters—“SCIMF”—consisting of representatives of member states and the EU institutions. Importantly, however, SCIMF has a broader membership than euro members alone.
At the IMF in Washington, representatives from all EU Member States have formed a separate group—“EURIMF”—with a view to maximizing coordination in Executive Board proceedings. This group constitutes an important supplement to the SCIMF because it is able to meet frequently, which is essential given the fact the Executive Board itself meets three times a week. Interestingly, the presidency of this group is chosen for 2 years, and therefore does not always reflect the EU presidency, which rotates more frequently.
Finally, the EU institutions—although not members themselves—play an important role in the coordination process. Most tangibly, the ECB has a resident observer in the Fund, who participates in Executive Board discussions that are of direct relevance to EMU. Moreover, both the Commission and the ECB are represented in the SCIMF in Europe and the EURIMF in Washington and, accordingly, their views are taken into account during the coordination process.
On what matters do EU members coordinate most closely? Clearly, when the Executive Board is discussing policies where competence has been transferred to the EU institutions, EU coordination is at its strongest. For example, when discussing exchange rate policies of the euro area, there is a single written statement by the President of the EURIMF, representing all euro members, and the ECB also makes a statement during the Board meeting. In those areas where there are national or shared competencies, there is an attempt to coordinate as closely as possible. In this regard, it should be emphasized that coordination has increased not only with respect to country-specific matters, but also regarding general policy issues confronted by the Fund.
Experience demonstrates, however, that there are limits to the degree to which EU members are able to forge common positions. These limits are perhaps most evident when discussions take place regarding surveillance of—or the provision of financial assistance to—countries outside the EU, where the differing geopolitical priorities of EU members may surface. For example, views differ among euro members as to the scope of the Fund’s role in Africa. While some stress the importance of Fund engagement in these countries, others emphasize the fact that the Fund is a monetary rather than a development institution.
Accordingly, while there are important legal constraints imposed by the Articles of the Articles on the complete consolidation of representation of euro members in the Fund, there is scope under the existing framework for further coordination if these members so wish. I would also emphasize that the existing constraints may not be permanent. Proposals have recently been made to amend the Articles to allow for the election of all Executive Directors, which would facilitate the consolidation of a single euro—and even EU—chair. The question is whether EU members would be ready to support such an amendment.
To conclude, the current upheaval in the global economy is placing stress on all of the actors in the official sector, including the Fund, the EU institutions, and the EU members. Experience demonstrates, however, that these periods can provide opportunities for meaningful reform. Within the Fund, there is momentum for reform in a number of areas—including with respect to our governance structure and the design of our lending instruments—reform that is necessary to enhance the Fund’s legitimacy and effectiveness.
Within the EU, the crisis seems to have catalyzed an acceleration of reform with respect to the establishment of a more robust supervisory framework for cross-border financial institutions. It has also generated closer cooperation between the Fund and the EU, particularly with respect to the provision of financial assistance to EU members that are facing balance of payments difficulties.
It remains to be seen whether the ongoing reform initiatives by both the EU and the Fund will also result in significant consolidation in EU representation in the Fund. As I have tried to indicate in my remarks today, progress in this area will largely depend on the perspectives of individual EU members.