DIRECTORATE-GENERAL FOR RESEARCH Directorate A: Medium and Long Term Research Division for Economic, Monetary and Budgetary Affairs

BRIEFING ECON 511 EN rev.1

THE CONSEQUENCES OF EMU FOR THE EEA/EFTA COUNTRIES

The opinions expressed are those of the authors and do not necessarily reflect the European Parliament's position

Luxembourg, 18 February 2002 PE 304.442 rev. 1 This document is published in English.

Summary

This briefing examines the consequences for Norway, Iceland, Liechtenstein and Switzerland of the creation of the euro. It analyses each of these countries' economic and monetary policies, and also the possible links between the exchange rates of their currencies and that of the euro. Finally, it examines the possible effects of EMU and of the policies of the European Central Bank on the conduct of monetary, exchange rate, fiscal and other policies in third countries, and in those of the EFTA in particular.

Publisher: European Parliament L-2929 Luxembourg

Author Aida Liha, Cecilia Andreasson

Editor: Ben Patterson Economic, Monetary and Budgetary Affairs Division Tel. : (00-352) 4300 24114 Fax : (00-352) 4300 27721 E-Mail : [email protected]

Reproduction and translation of this publication is authorised, except for commercial purposes, provided that the source is acknowledged and that the publisher is informed in advance and supplied with a copy. EMU and the EFTA

CONTENTS

INTRODUCTION...... 5

1. THE EURO AS AN INTERNATIONAL CURRENCY ...... 5 2. THE POSITION OF THE "OUTS " AND THEIR INFLUENCE ON THE EFTA COUNTRIES ...... 5 Denmark ...... 6 Sweden ...... 6 The United Kingdom ...... 7 3. THE EFTA...... 8 4. THE EEA...... 10 THE IMPLICATIONS OF EMU...... 11

1. THE "BENIGN NEGLECT " OPTION ...... 11 2. GLOBALISATION ...... 12 3. DEVELOPMENTS IN INTERNAL EURO AREA POLICIES ...... 12 THE EFTA AND EEA ECONOMIES ...... 13

GENERAL ...... 13 1. NORWAY ...... 13 Introduction ...... 13 Monetary policy...... 14 The Government Petroleum Fund and the impact of petroleum revenues on stability ...... 15 The stability of the crown/euro exchange rate ...... 15 2. ICELAND ...... 17 Introduction ...... 17 Monetary policy...... 18 The stability of the crown/euro exchange rate ...... 18 Exchange rate policy alternatives...... 20 Other economic policy consequences ...... 20 3. SWITZERLAND AND LIECHTENSTEIN ...... 21 Introduction ...... 21 Monetary policy...... 22 The stability of the Swiss franc/euro exchange rate...... 24 SWISS INTEREST RATES, WHICH HAVE BEEN LOWER THAN ANYWHERE ELSE IN EUROPE, MIGHT HAVE TO RISE TO THE LEVELS PREVAILING IN THE EURO AREA...... 26

SUMMARY AND CONCLUSIONS...... 27

ECONOMIC AFFAIRS SERIES BRIEFINGS ...... 29 ECONOMIC AFFAIRS SERIES WORKING PAPERS ...... 29

3 PE 304.442 rev.1. EMU and the EFTA

Tables and Charts Table 1: Results of the Danish Referendum on € area membership, September 2000...... 6 Table 2: The UK's five economic tests participation in the EMU ...... 8 Table 3: Economic indicators for the EFTA countries (2000) ...... 9 Table 4: GNP per Capita of Major Regional Groupings ( 1999)...... 10 Table 5: US and Euro Area Trade as a Proportion of GDP...... 11 Chart 1 : Petroleum production on the Norwegian continental shelf...... 13 Chart 2 : The Krone exchange rate against ECU/euro...... 14 Chart 3 : The Krone's effective exchange rate against euro ...... 16 Chart 4 : Daily variation in the krone exchange rate against ECU/EURO...... 16 Chart 5 : The Icelandic Krona exchange rate against the ECU/Euro ...... 19 Chart 6 : Swiss franc exchange rate against euro ...... 24 Chart 7 : Dollar/euro exchange rate...... 25

4 PE 304.442 rev.1. EMU and the EFTA

Introduction

This briefing examines the consequences for Norway, Iceland, Liechtenstein and Switzerland of the creation of the euro. The first three, together with the fifteen members of the EU, constitute the European Economic Area (EEA). Switzerland, though it has rejected EEA membership, nevertheless belongs, with the other three countries, to the European Free Trade Area (EFTA); and also forms a single currency area with Liechtenstein. It is therefore sensible to consider the impact of the euro not just on the three EEA countries, but on all four members of the EFTA. The briefing analyses each of these countries' economic and monetary policies; but these are not necessarily presented and assessed in the same way, since the specific factors determining each vary considerably.

1. The euro as an international currency

The euro is emerging as a major international currency, entailing implications for other countries as well as for the monetary policy of the euro zone itself. Before the D-Mark was the only internationally significant European currency; but its importance was still minor compared to the dollar, which has dominated since the end of World War II. The use of currency internationally depends on a number of factors. These include: • a large domestic market; • a high exposure to trade; • a large weighting in total global trade; • exporter and importer preferences favouring the currency as a unit of account; • the existence of a large and competitive financial market in which the currency denominated assets are actively traded; • economic and political stability of the currency area, thereby favouring it is a "safe haven" currency; and • competitive pricing of cross-border payment systems. Though the euro has not yet fulfilled the early predictions of some that it would rival the dollar as an international unit of accounting, or as a reserve currency, it has done so in a number of other ways. Most notably, the merging of the former national bond markets into a single euro-denominated market has resulted in issues of both sovereign and corporate bonds being as often made in euros as in dollars.

2. The position of the "outs" and their influence on the EFTA countries

For different reasons, Denmark, the United Kingdom and Sweden have chosen to stand outside the EMU and have the status of EU "Member States with a derogation" under Article 122 of the Treaty. All three qualify on the formal Maastricht criteria concerning inflation, interest rates and fiscal position, although Sweden and the UK have declined to join ERM2. Their exclusion is mainly a matter of political choice, resulting from a powerful domestic hostility towards the EMU, which led Britain and Denmark to negotiate their Maastricht opt- outs. Sweden has no formal opt-out. Since all three countries are closely related with the three EEA countries and Switzerland – notably through their former EFTA links – and have an important share of their foreign trade, a decision on their part to enter EMU would have significant consequences for the latter. The

5 PE 304.442 rev.1. EMU and the EFTA deeper integration of Denmark and Sweden into the EU, which a decision to join the euro would imply, is likely to have an especial impact on Norway. How likely, then, are these "out" countries to become "ins"? In all three countries business opinion is more favourable than that of the public at large; and if EMU appears to be working well the decision to stand aside is likely to be reconsidered at an early date. Indeed, following the successful introduction of €-denominated notes and coins at the beginning of 2002, opinion polls recorded majorities for euro area membership in both Denmark and Sweden, and a similar swing (though not to a majority) in the UK (see below).

Denmark Of the "out" countries, Denmark is most integrated into the European Union. As a small, open economy, some 66% of its trade is intra-European. For this reason the case for Denmark adopting the single currency appears strong and the Danish decision to peg the crown against the euro within the narrow ERM2 bands has been prudent, almost essential.

Table 1: Results of the Danish Referendum on € area membership, September 2000

For 46.9% Against 53.1% However, after an intense campaign, the Denish referendum of September 28th 2000 rejected €-area membership. Had the vote been only about the economics of joining, the "Yes" campaign probably would have won. But political doubts – in particular, fears about loss of sovereignty – tipped the balance 1. Recently, however, Danish opinion has been changing. The Eurobarometer in Autumn 2001 already recorded a 7% rise in support of the € over the previous year, and an 8% drop in opposition, to bring an almost equal division of opinion (47:48). A poll carried out only one week after the turn of the year then found 57% in favour of the European currency, with 34% opposed. The question of having another referendum as early as in 2003 is now rapidly emerging in the political debate. At the same time, the arrival of €-denominated notes and coins has resulted in the euro already being widely accepted as a means of exchange. A recent survey by Danish Commerce and Services, an employer's organisation, found that 10% of shops plan to mark prices in euros as well as in crowns.

Sweden Although Sweden's economy is in line with the Maastricht criteria for entry into the euro area, the Swedish crown has yet to join the ERM2. Moreover, the hostility of public opinion towards EMU membership has been strong for a number of years. However, Swedish opinion is also undergoing a sea change. The Autumn Eurobarometer, as in the case of Denmark, recorded an extraordinary growth of support: 51% were in favour of the euro, an improvement of 22 percentage points since the spring! Opposition had decreased by 20 percentage points during the same period to 42%. A poll released on 8th January reinforced the findings of this survey. Again it showed 51% for the euro and 43% against it.

1 "The Eurozone in action - changes and challenges", Research Report by the Economist Intelligence Unit, London 2000.

6 PE 304.442 rev.1. EMU and the EFTA

The volatility and depreciation of the crown against external currencies during the past few years are likely to be influential factors behind the change. Nevertheless it remains to be seen whether the opinion shift is stable or mainly a result of the recent "euro-phoria". The introduction of euro cash has had a psychological, familiarising effect rather than any lasting economic ones. During the 1990s the Riksbank managed to maintain relatively stable prices and even the Swedish Trade Union Confederation, LO, now considers it "the wage earners' best friend". Letting go of national monetary policy could hence be an obstacle for entering the EMU. Just a few days after the launch of €-denominated notes and coins the Swedish Prime Minister, Göran Persson, criticised for his passivity, spoke out, presenting a possible timetable for joining the EMU. Whether this will be acceptable to the other member states depends on the interpretation of the Maastricht treaty. Mr. Persson suggests a referendum in March 2003 and an introduction of the euro in Sweden already in 2006. According to the plan, the crown would enter ERM2 for only one year. This contrasts with the text of the Treaty which requires observing the normal fluctuation margins provided for by the exchange-rate mechanism of the European Monetary System for at least two years, without devaluing against the currency of any other Member State . There are however indications of flexibility. Pedro Solbes, monetary affairs Commissioner, has stated that there may be "margin for manoeuvre". Exchange rate stability during the period before joining the ERM2 will be taken into account. Furthermore, ERM2 is not specifically mentioned in the Treaty and the criterion has already caused problems of interpretation concerning band-width (currently the margin is 15% either side of the central rate) and time-frame (neither Italy nor Finland fulfilled the prerequisite of two-years within ERM1 before the decision on euro area membership). As in the case of Denmark, the €-denominated notes and coins are likely to be widely accepted. Though, historically, Swedish people have strongly supported the maintenance of neutrality, a clear focus on the economic benefits of joining the currency union, as opposed to political unification, is likely to boost public opinion even more in favour of the euro.

The United Kingdom

The UK was granted leave to opt out of the single currency by the terms of the Maastricht Treaty. Like the Swedish crown, Sterling is not in ERM2, and the problem of maintaining a stable exchange rate to the euro is even more acute than in the case of Sweden. Sterling appreciated by about 20% against the D-mark in 1997, and is now widely reckoned to be overvalued by up to 30%; but a significant devaluation is considered one of the most substantial barriers to euro area entry. Moreover, despite the large percentage of total UK trade that takes place with the rest of the EU, the pound has often in the past tended to move in step with the US dollar rather than with the euro. There are several other economic obstacles to an early British entry. One is the fact that the British economic cycle does not yet appear to be entirely synchronised with the continental cycle, causing doubts about the applicability of the ECB's "one-size-fits-all" monetary policy. Another arises from differences in the transmission mechanisms of monetary policy, mainly resulting from the prevalence in the UK of variable-rate mortgages. The UK Government has accordingly laid down five additional economic tests (see Table 2 for assessing whether the UK should adopt the euro:

7 PE 304.442 rev.1. EMU and the EFTA

Table 2: The UK's five economic tests participation in the EMU

1. Business and economic cycles must be compatible so that Britain can live with European interest rates. 2. There must be sufficient flexibility to deal with problems. 3. Joining the euro area must create better conditions for firms investing in Britain. 4. Joining the euro area must not harm the financial services industry. 5. Joining the euro area must promote higher growth, stability and job creation.

The UK Treasury is to evaluate the criteria by June 2003 at the latest. The principal obstacle to UK membership, however, is the fact that the public opinion has been deeply hostile. The memory of "Black Wednesday" in September 1992, when the Pound was forced out of the ERM1, still persists in British minds, widely shaping the negative attitude towards the euro. In contrast to the situation in Denmark and Sweden, and despite the successful introduction of €-denominated notes and coins, opposition remains strong. Two opinion polls of January 2002 reported 73% against the currency area. In the latest Eurobarometer 58% were against while only 27% approved. However, some confusion has emerged. One recent figure of only 56% against the EMU and another poll showing 52% in favour may indicate a slight softening of attitude. The opposition Conservative Party made "Saving the £" a main plank of its policy at the last UK elections, and remains opposed to € area membership during the current parliamentary term, and probably beyond. Since 1997 the UK Prime Minister, Tony Blair, has been able to postpone the question by giving an undertaking to hold an early referendum on euro area membership once a new parliament was elected in 2001. Since the introduction of euro notes and coins the government is opening up, taking a stronger position on joining. The autumn of 2003 is often mentioned as a possible time for a British referendum, assuming that the economic criteria are met.

3. The EFTA

The European Free Trade Association is an international organisation comprising four states: Iceland, Liechtenstein, Norway and Switzerland. The per-capita income in the EFTA countries is among the highest in the world, and their trade relations are extremely outward oriented: the total trade of the EFTA countries, worth some $243 billion, represents 58% of the EFTA combined GDP and 2.2% of world trade. The background for this is that EFTA has created and further develops the world's second largest network of free trade agreements after the EU, comprising 16 Free Trade Agreements and 10 declarations on co-operation. The main trading partner of EFTA is the EU while EFTA is the EU's second largest trading partner after the US. The EU absorbs more than 66 % of EFTA's external trade, while around 12% of the EU's trade is done with the EFTA States. The EFTA countries are closely integrated with the EU. But all have decided to stay out of the European Union for a variety of reasons 2.

2 For example Iceland has problems with the EU common fisheries policy, Norway turned down EU- membership in a referendum and Switzerland did the same earlier with membership of the EEA.

8 PE 304.442 rev.1. EMU and the EFTA

Table 3: Economic indicators for the EFTA countries (2000)

ICELAND LIECHTENSTEIN NORWAY SWITZERLAND GDP at market prices; 9.3 2.2 175.5 279.4 billion euro Per capita GDP, current 25.287 36.969 26.644 26.880 prices (1999) GDP yearly 4.9 n.a. 2.3 3.0 growth in % Inflation rate 5.2 1.5 3.1 1.5 in % Export of 1.8 n.a. 42.7 71.5 goods in (seafood 67.4%, (oil/gas products (machinery/elect. billion euro aluminium 49.7, fish equipment 28.5%, (1999) 15.6%, ferro- products 8.0) chemical industry silicon 2.2%, 29.7%, watches/ agricultural jewellery 15.4%, metal products 1.5% ) industry 8.2%) Import of 2.23 n.a. 32.1 70.8 goods in (industrial (machinery/tran (machinery/elect. billion euro supplies 24.7%, sport equipment equipment 23.7%, (1999) capital goods 42.5%, road chemical industry 24.0%, transport vehicles 8.6%, 17.0%, vehicles 12.7%, equipment electrical watches/jewellery 17.2%, food and machinery 6.0% ) beverages 9.6%, 5.2% ) fuels and lubricant 5.3%) Government gross debt 33 n.a. 24.8 49.8 (% of GDP) Government financial balance 2.3 n.a. 14.3 1.5 (% of GDP)

Sources: Norwegian Ministry of Finance: http://www.odin.dep.no/archive/finbilder/01/05/table057.pdf Icelandic Ministry of Finance: Swiss Ministry of Finance: http://www.efd.admin.ch/d/dok/sdds/oeffhh.htm http://government.is/interpro/fjr/fjr.nsf/Files/newsletter11012002/$file/Newsletter11012002.pdfN New Cronos DataBase OECD Economic Outlook; December 2001, vol 2001, no.2, pp 119-120 IMF: http://www.imf.org/external/np/sec/pn/2001/pn0110.htm

9 PE 304.442 rev.1. EMU and the EFTA

Table 4: GNP per Capita of Major Regional Groupings ( 1999)

Regional Grouping GNP per Capita (USD) EFTA 33 503 EU (15) 23 133 NAFTA 18 107 APEC (21) 11 819 MERCOSUR (4) 4 875 CEFTA (7) 4 293 ASEAN (10) 7 729 SADC (14) 1 245 Source: Fortieth Annual Report of the European Free Trade Association, 2000.

4. The EEA

The purpose of the Agreement on the European Economic Area (EEA), which entered into force on January 1, 1994, is to create a comprehensive economic partnership that extends the internal market of the EU to the participating EFTA states. The total market so created is one of some 380 million people. The EEA Agreement provides for the free movement of goods, persons, services and capital among the signatory countries. It does not provide for the participation by the relevant EFTA countries in certain areas of co-operation among the EU member states, such as taxation, agricultural and fishing policies, economic and monetary policies and the EU customs union. Since the introduction of the EEA, three of the original EFTA countries – Austria, Finland and Sweden – have become full Members of the European Union. The Agreement now therefore applies to the 15 EU Member States and 3 EFTA countries – though not to Switzerland, which nevertheless remains a member of EFTA.

10 PE 304.442 rev.1. EMU and the EFTA

The Implications of EMU

The creation of a single currency to replace the eleven 3 previously existing national currencies of twelve EU Member States has several general consequences for third countries.

1. The "benign neglect" option

An advantage enjoyed by the United States economy in a global context is its ability to conduct domestic monetary, fiscal and economic policy without having to pay much attention to external consequences. The Federal Reserve Bank has been able to adopt an attitude of "benign neglect" towards the exchange rate of the Dollar against other currencies. Monetary authorities managing these currencies have been "takers", obliged to adapt their policies to the exchange rate consequences of decisions made by the Fed for US domestic reasons alone. This "lead currency" model is not necessarily an unsatisfactory way to run the international monetary system (in game theory it is called the Stackelberg Strategy). It corresponds in many ways to the way in which the European Monetary System operated during the 1980s, where the D-Mark occupied the lead position. The EMS analogy, however, also provides an example of why the model can prove unsatisfactory when the system experiences an unforeseen shock with asymmetric effects – in this case, German re-unification. Among the reasons for creating the euro area were precisely the need to escape from this deficiency of the EMS, and also from dollar dominance in the international economy as a whole.

Table 5: US and Euro Area Trade as a Proportion of GDP

€ area (%) US (%)

Exports 16.9 10.8

Imports 15.4 13.5

Source: ECB July Bulletin 1999

The euro area now enjoys the same important advantage as the dollar area: namely, a low proportion of GDP accounted for by external trade, and a consequently lowered vulnerability to external shocks (see Table 5). This compares to figures of around 30% of GDP for the EU Member Countries as independent currency areas. The area thus has a freedom similar to that of the US in the conduct of monetary policy - a position which is indeed reflected in the mandate of the ECB itself, which is required by the Treaty to give primary importance only to internal price stability. One consequence is that countries with close economic and trade links with the euro area, like the EU "outs" and the EFTA countries, will increasingly become "takers" of euro area monetary policy. This is currently most clearly the case with Denmark, but is also likely to become true of all European economies (with the possible exception of the UK).

3 Belgium and Luxembourg already formed a currency union.

11 PE 304.442 rev.1. EMU and the EFTA

2. Globalisation

The second consequence of the euro's creation has operated, paradoxically, in the opposite direction: a re-enforcement of global financial and economic integration. Although in trade terms the euro area is relatively autarkic, the opening up of national capital markets has led to higher capital mobility both within and outside the area. One result has been the dominant influence of such flows on the euro/dollar exchange rate. Though the euro area has overall enjoyed a small current account surplus, and the US a massive deficit, this has not had the conventional effect of a euro appreciation against the dollar. Instead, large net outflows of direct and portfolio investment from the euro to the dollar area have overwhelmed trade effects. The creation of a large, liquid euro-denominated bond market has played a critical role. As the Bank for International Settlements has put it, “the newly created euro may have proved too successful”. “Larger and more liquid markets, along with relatively low interest rates, encouraged the issue of euro-denominated bonds whose proceeds could then be exchanged and used to finance investment elsewhere.” (Bank for International Settlements , Basle, 2000) At the same time, the creation of the euro area has in some respects simplified the international monetary system, by creating a "tri-polar" (Dollar, Euro and Yen) or even "bi- polar" (Dollar and Euro) world. Whether Europe can take over from the US as the main "motor" of economic growth in the coming years, whether this will result in an appreciation of the euro against the dollar, etc. are two of the big questions of international economics. Third country currencies are, in this context too, "takers". The overvaluation of the UK Pound Sterling against the euro, for example, does not arise directly from events within the EU, but from the euro/dollar situation. Yet the effect has been to reduce competitiveness within the UK's single most important market. This reflects the events of 1992, when Sterling was forced out of the EMS Exchange Rate Mechanism, in part as a result of capital flows out of the Dollar into the D-Mark.

3. Developments in internal euro area policies

The creation of a single currency, linked to the continuing completion of the Single Market and the integration of capital markets, is leading to pressures for the development of common policies in other area. The freedom of Member States to conduct fiscal policy has already been severely circumscribed by the Treaty, the Stability and Growth Pact and the development of Broad Economic Guidelines. The pressure is now affecting certain areas of tax policy. One of the most contentious proposals in this field, for example, has been that to charge a Withholding Tax in all Member States on the savings income of non-residents. After long negotiations, agreement has been reached on a system of information-exchange between tax authorities instead. In order to prevent an outflow of funds from the EU, however, this agreement is conditional upon similar arrangements being introduced in certain non-EU countries: notably Liechtenstein and Switzerland. Switzerland has so far firmly resisted abandoning its provisions for banking secrecy. Pressure from the EU, however, is likely to grow, linked to similar developments at global level in the fields of combating money laundering and eliminating "tax havens".

12 PE 304.442 rev.1. EMU and the EFTA

The EFTA and EEA Economies

General

In principle, EFTA countries could take their monetary policy frameworks in one of two directions: towards direct inflation targeting and floating exchange rates; or towards much closer pegs to the euro 4. Switzerland and Liechtenstein have a floating exchange rate, and use base money as an intermediate target. The inflation rate should not exceed 2%. The Swiss franc has had a reserve currency status and in the past, its interest rates were persistently lower than in Germany. One immediate possible danger for the Swiss economy from the implementation of EMU has been an appreciation of the Swiss franc. In 2001 the Central Banks of Norway and Iceland adopted new guidelines for their monetary policy. Earlier the exchange rate was the intermediate target for monetary policy. Pursuant to its existing mandate, Norges Bank has oriented its monetary policy instruments with a view to bringing price and cost inflation down towards the inflation objectives of the ECB, with an inflation target of 2.5%. The Icelandic monetary authorities have abolished formal fluctuation bands for the exchange rate, and instead have adopted a direct inflation target of 2.5% as the basis of monetary policy.

1. Norway

Introduction Norway is part of the EEA; but by virtue of the referendum of 1994, is not a member of the EU and consequently not currently a possible member of the euro area. However, the Norwegian economy is closely integrated into the other economies of Europe. It is open and commodity-based, with external trade per capita among the highest in the world. The oil economy and capital exports through the Government Petroleum Fund are specific features. Natural conditions such as an abundant supply of hydroelectric power, forestry, fisheries and petroleum are reflected in the structure of the industry. The development of the petroleum sector after the discovery of oil at the end of the 1960s has played a significant role. Norway is now the seventh largest oil-producing country in the world.

Chart 1 : Petroleum production on the Norwegian continental shelf

Source: Norges Bank

4 Gudmundsson, M., "The implications of EMU for EFTA countries", Sedlabanki Islands, October 1997.

13 PE 304.442 rev.1. EMU and the EFTA

Since the recession in the early 1990s, Norway's economic performance was very good in most respects. Economic growth was the strongest in the OECD area and Norway was one of the few countries that enjoyed full employment. At the same time, a major share of the oil revenues was saved for future generations and government outlays have been insulated from the swings in petroleum revenues 5. Despite the strong rise in expected household disposable income, due to tax cuts, mainland growth is predicted to be moderate, around 1.25% in 2002. However, the Norwegian economy is still characterised by high capacity utilisation, labour shortages in many sectors and relatively high cost inflation. The weak global growth since the events of 11 September is likely to bring about a slowdown in the export sector, thus causing an unbalanced labour market with job losses in the exposed sector combined with continued labour shortages in the service industries. Unemployment is projected at 3.4% in 2002. Following the introduction of €-denominated notes and coins there is scope for the euro as a parallel currency to the Norwegian crown, as in the case of Denmark and Sweden. Norway's geographical position as an outlier, however, will probably limit the immediate extent of such a development, though to attract European tourism, acceptance is likely to emerge.

Monetary policy Throughout the post-war period Norwegian monetary policy has been based on a fixed or stable exchange rate. Over time it became apparent that a system with a defined central rate and a narrow fluctuation margin around this rate exposed the crown to speculative attacks, and developments in the foreign exchange market compelled Norway to abandon this system on 10 December 1992. The crown was left to float. Emphasis was placed on maintaining a stable crown exchange rate against European currencies in the implementation of monetary policy. In this context it is important to note that a very small and very open Norwegian economy is highly vulnerable to fluctuations in the international economy.

Chart 2 : The Krone exchange rate against ECU/euro The Krone exchange rate against ECU/euro

9,00 8,50 8,00 7,50

NOK 7,00 6,50 6,00 1982Q01 1983Q04 1985Q03 1987Q02 1989Q01 1990Q04 1992Q03 1994Q02 1996Q01 1997Q04 1999Q03 2001Q02 Year

Source: New Cronos database

5 "Norway - Assessment and recommendations", OECD 2000.

14 PE 304.442 rev.1. EMU and the EFTA

In March 2001, the Norwegian Government presented a new Long-Term Programme. The guidelines stipulate that monetary policy shall aim at stability in the internal and external value of the crown, contributing to the stable exchange rate. Hence Norges Bank's implementation of monetary policy is aimed at maintaining low and stable inflation. The operational target is defined as an annual increase in consumer prices of approximately 2.5% over time. Monetary policy is to be forward-looking, and direct effects on consumer prices stemming from changes in interest rates, taxes, excise duties and extraordinary, temporary disturbances, are in general not be taken into account 6.

The Government Petroleum Fund and the impact of petroleum revenues on stability The Norwegian Government Petroleum Fund, established in 1990, has two objectives. It serves as a buffer for the mainland economy against fluctuations in oil revenues, and it manages a considerable portion of the government's financial wealth. Its income is defined as the government's net cash flow from oil activities and the return on the Fund's investments. The Petroleum Fund acts as a buffer against short-term variations in petroleum revenues by separating the cash flow from oil extraction from current expenditure. Since a large share of revenues from petroleum activities accrues to the state, any fluctuations in oil prices will primarily result in changes in allocations to the Fund. Since all of the Fund's capital is invested abroad, such changes will in principle not influence economic activity. This makes the Norwegian economy more robust to oil price fluctuations, thereby reducing oil dependence in the short-term 7. The Fund also serves as a tool in the management of fiscal policy, by making the spending of petroleum income more visible. The allocation of capital to the Fund must form part of a coherent budgetary process. Hence no net allocations are made to the Fund unless the Fiscal Budget is in surplus. Income is used to increase net imports or saved by accumulating assets abroad, so as to redistribute the increased income and thus consumption between generations.

The stability of the crown/euro exchange rate The main objective of the ECB is the maintenance of price stability; and the ECB has defined this as an inflation rate of less than 2% p.a.. The main objective of the Norges Bank monetary policy is the stability of the crown's national and international value. Inflation in Norway cannot remain higher than inflation in the euro area without this having consequences for the exchange rate of the Norwegian krone against the euro. As established by the Royal Decree of 29 March 2001, the operational target of monetary policy shall be annual consumer price inflation of approximately 2.5% over time. This inflation target is slightly higher than similar objectives for Sweden, Canada and the euro zone, but corresponds roughly to targets in the United Kingdom and Australia. It is also approximately in line with the average inflation rate in Norway in the 1990s. However, if price and cost inflation remains higher than the rate of increase aimed at by the ECB over a long period, the crown will depreciate against the euro. Norges Bank must therefore counter such a development. In this situation, Norges Bank makes an evaluation of the reasons for exchange rate movements. The most important factor is confidence in the authorities pursuing nominal stability. If such confidence exists, short-term fluctuations in the krone exchange rate may

6 Press Release on New Guidelines for Norwegian economic policy, Royal Ministry of Finance, March 29, 2001. 7 Ibid.

15 PE 304.442 rev.1. EMU and the EFTA take place without consequences for the long-term exchange rate. The krone exchange rate will also be influenced by factors that are not under the control of Norges Bank, like fluctuations in international financial markets, uncertainty in the global economy, the evolution of the price of oil, fiscal policy, and developments in domestic prices and costs.

Chart 3 : The Krone's effective exchange rate against euro

Earlier, the authorities aimed at bringing inflation down to the euro-area target range in a sustained, but cautious manner. However, in 2000 Norges Bank officials noted that inflation pressures were gathering pace and acted to tighten monetary conditions. The rise in oil prices, apart from its usual direct and second round effects on prices, also seemed to influence aggregate demand through strong "Ricardian" effects on consumption related to higher national wealth and public saving, and compounded the impact of the wage round. The 150 basis point increase in interest rates in 2000 was expected to ease demand and price pressures 8. However, the crown exchange rate has fluctuated in recent years in spite of Norges Bank's active use of instruments, indicating that Norges Bank cannot fine-tune movements in the crown exchange rate.

Chart 4 : Daily variation in the krone exchange rate against ECU/EURO

8 Ibid.

16 PE 304.442 rev.1. EMU and the EFTA

In the Revised National Budget for 1998, the Government decided that the Exchange Rate Regulation would continue to apply without any changes, with the euro replacing the ECU as the indicator of the crown's value against European currencies. Thus, the consequences of the introduction of the euro for the orientation of Norwegian monetary policy might not appear particularly great at the outset 9. The launching of the EMU has nevertheless entailed changes in the environment for Norwegian monetary policy, for the following reasons. • First, the ECB formulates its monetary policy with the primary aim of maintaining low inflation for the euro area as a whole. This could result in larger exchange rate fluctuations between the major countries than in the past (see earlier under The "benign neglect" option ). If so, keeping the crown stable against the euro might become more challenging. • Second, the launch of the euro has reinforced global financial integration and contributes to higher capital mobility. Two monetary policy instruments have been used: exchange-market interventions and the interest rate. In the experience of the Norges Bank, extensive and persistent exchange-market interventions to influence the crown's exchange rate have yielded poor results. The foremost example occurred on Friday, 20 November 1992, when Norges Bank made intervention purchases for NOK 37 billion from the time the market opened until the market closed. Intervention purchases amounting to NOK 14 billion were also made the previous day after Sweden allowed its currency to float. So, Norges Bank used more than NOK 50 billions of its foreign exchange reserves in the course of six trading hours over a two-day period 10 .

2. Iceland

Introduction In recent years Icelandic economic growth has been driven mainly by an expansion in gross fixed investment and private consumption, while exports and public consumption have been growing more slowly. The past decade has also witnessed a substantial strengthening of the Icelandic economy, due in large part to major changes in economic policy formulation toward an emphasis on stable and predictable macroeconomic policies, and on structural reforms. The adoption of the exchange rate as a nominal anchor and intermediate target for monetary policy was the key to the successful disinflation of the first half of the last decade, which in turn set the stage for the economic recovery that began in 1995. Iceland's strong economic performance has also benefited from the government's tenacity in consolidating public finances and perseverance in enhancing competition through market liberalisation and privatisation. Notwithstanding, the maturing cyclical upswing has been accompanied in recent years by the emergence of overheating pressures and a large external imbalance 11 . The Economist Intelligence Unit estimates GDP to have grown by 1.8% in 2001, down from 4.9 in 2000. The deceleration can be attributed to a contraction in

9 "The Impact of the euro on non-member states", Address by Deputy Governor Jarle Bergo to the Scottish Norwegian Business Forum, Edinburgh, 3 February 1999. 10 Gjedrem Svein, op. cit., p. 14. 11 Concluding Statement of the 2001 Article IV Mission of the International Monetary Fund with Iceland, IMF 2001.

17 PE 304.442 rev.1. EMU and the EFTA investment and private consumption, mainly as a result of Iceland's stringent monetary policy. In 2002 domestic demand is expected to continue declining, taking the economy into a short-lived recession. The function of the euro as a coexisting means of payment is naturally a possibility within Icelandic borders as well as within Norway. However, the country's isolated position as a rather remote island limits the extent of such a parallel materialisation of euro cash.

Monetary policy Since a 7.5%-devaluation of 1993, the central rate of the crown remained unchanged and its exchange rate has fluctuated around this rate depending on economic conditions and the tightness of the Central Bank's monetary stance. Exchange rate policy since May 1993 has involved maintaining the exchange rate of the crown within announced target bands which are decided in consultation between the Central Bank and the government. Initially the zone was 2.25% in either direction from the central rate. This was extended to 6% in autumn 1995 and finally to 9% early in 2000. The currency reference was reformed in autumn 1995 with the introduction of a basket weighted against external trade in goods, replacing the earlier basked comprised of the ECU (76%), US dollar (18%) and yen (6%). The overheating characterising the Icelandic economy in recent years peaked in the year 2000, generating inflationary pressures. Hence the Central Bank had to tighten its policy stance. A move to a floating exchange rate regime was an obvious extension of the widening of the fluctuation bands over the past decade and served Iceland better in view of its sensitivity to external and supply shocks. This decision was accompanied by the adoption of the inflation targeting as the basis of the monetary policy on 27 March 2001. The Icelandic monetary authorities had many factors in favour of adopting inflation targeting, which is a logical continuation of the flexible exchange rate policy that has been pursued12 . Under this new arrangement, specific targets of an annual inflation rate of about 2.5% are set and the Central Bank will keep the rate of inflation consistent with them within a specified timeframe. The inflation target of 2.5% is to be attained no later than by the end of 2003. However, in 2001 the average consumer price inflation was as high as 6.7%. The first indication of 2002 shows an inflation rate of 9.4% for January. In order to reach the inflation target interest rates remain the highest in Europe with the repo rate currently standing at 10.1%. However, the Central Bank has announced that, on the assumption that the currency will not depreciate any further, a reduction in interest rates could follow later in 2002. Notwithstanding rising inflation, there is little chance of the economy overheating given the decline in domestic consumption. The exchange rate is no longer used as an intermediate target and the fluctuation bands have been abolished. As the exchange rate always exerts a strong impact in an open economy, monetary policy will continue to take exchange rate developments into account. The new policy will be implemented by producing an inflation forecast, and if it indicates that inflation is heading beyond the target, the Bank is obliged to respond by applying its monetary instruments.

The stability of the crown/euro exchange rate The 12 EMU member countries account for a significant share of Iceland's foreign trade, albeit not an overwhelming one. In 2000 42.5% of merchandise exports and 33.5% of

12 Monetary policy based on formal inflation targeting enjoys growing support and has been adopted by an increasing number of countries, like Australia, New Zealand, Switzerland and Sweden.

18 PE 304.442 rev.1. EMU and the EFTA merchandise imports were traded with the euro area. The Icelandic economy is hence vulnerable to external changes and recently the krona has depreciated against the euro.

Chart 5 : The Icelandic Krona exchange rate against the ECU/Euro

Exchange rate of the Iceland Krona

95,00 90,00 85,00

IcKr 80,00 75,00 70,00 1992Q01 1993Q01 1994Q01 1995Q01 1996Q01 1997Q01 1998Q01 1999Q01 2000Q01 2001Q01 Year

Source: New Cronos database

Since a change in exchange rate policy can potentially cause uncertainty and volatility, the Icelandic monetary authorities decided to abolish the formal fluctuation bands for the exchange rate policy and adopted the inflation target after careful deliberation and after being advised by international agencies, such as the IMF. A narrower exchange rate band would expose the crown to speculative one-way bets against the crown. The scope for manoeuvre within monetary policy would be severely limited, while domestic businesses would still not reap the benefits of a stable exchange rate against the euro (which could potentially serve the function of a home market for Icelandic firms if the crown were closely and credibly linked to it). Instability of the crown could have a very damaging effect on Icelandic businesses, because Icelandic firms only have access to a very small home market and are quite dependent on export markets. Unstable exchange rates can hurt their efforts to establish lasting business relationships and maintain a sufficient market share. In order to facilitate the de facto expansion of the home market of Icelandic businesses, a closer link to the euro area could be an attractive option, especially if all the current EU member countries join the EMU. The success of such a policy, however, would depend on the credibility of such a link 13 . However, even if a stronger link to the euro were an option, such a move would hardly be realistic until one or more of the "outs" have joined. This particularly concerns the United Kingdom, which at present is Iceland's largest trading partner in terms of merchandise trade 14 .

13 Ibid. 14 Ibid.

19 PE 304.442 rev.1. EMU and the EFTA

Exchange rate policy alternatives Regarding the possibility of a closer link to the euro area, the following options were considered: a) Unilateral peg to the euro A unilateral peg to the euro implies that the Icelandic authorities would unilaterally announce their intention to fix the exchange rate of the crown against the euro. The exchange rate of the crown with respect to other currencies would then be determined by their exchange rate against the euro. The impact would depend on the size of the euro area. The credibility of such an arrangement, however, would hardly exceed that of the existing arrangement, and would therefore not result in a sizeable reduction in interest rate differentials against the euro area. Because this area will, from the outset, only cover approximately 1/3 of Iceland's foreign trade, such a peg would, ceteris paribus , lead to exchange rate fluctuations vis-à-vis non-euro countries, which could undermine the credibility of the exchange rate policy and affect businesses that trade with them. Although a credible fixed exchange rate policy could lead to a counterbalancing change in the mode of behaviour in the labour market, it is unlikely that a unilateral peg to the euro could enhance credibility in order to facilitate such a change. b) Bilateral peg to the euro A bilateral peg to the euro is more advantageous insofar as it would entail some gains in terms of credibility. Under a bilateral peg, an agreement would be made with the ECB to defend certain parity against the euro, within certain limits. Changes in the central rate and the fluctuation limits of the exchange rate arrangement would be subject to an agreement between the Central Bank of Iceland and the ECB. However, the ECB would certainly have the option to cease interventions if it considered support to be contradictory to its monetary policy goals. c) Unilaterally using the euro as a legal tender ("euroisation") This is a kind of arrangement that comes closest to the direct EMU membership in terms of credibility. It would have similar advantages to EMU membership in terms of lower transactions costs and interest rate differentials and enhanced transparency in price formation, but would give somewhat larger scope for using public finances for counter-cyclical purposes. Interest rate differentials as a result of foreign exchange risk could even almost disappear, because it would be more difficult to abandon such an arrangement than a currency board. On the other hand, it would lead to a loss of the function of lender of last resort, as would a currency board, while the Icelandic monetary authorities would have no influence on ECB decision-making. It is also worth noting that both the ECB and the EU Council of Finance Ministers (ECOFIN), have strongly opposed such "euroisation" by non- Member States.

Other economic policy consequences It is likely that the financial markets will look at the criteria of the Stability and Growth Pact as a benchmark of public finance performance – and also in the case of non-EMU countries – penalising countries that do not meet the criteria with a risk premium on interest rates. It should be emphasised that the targets of the SGP are minimal.

20 PE 304.442 rev.1. EMU and the EFTA

The Icelandic economy is subject to significantly larger fluctuations than the EMU countries and the Icelandic business cycle is largely asymmetrical to that of the EMU countries. The impact that the EMU will have on the financial market will be more swift and direct than on other sectors of the economy. Foreign competition, which is already substantial, will intensify. This will demand enhanced efficiency in Icelandic financial markets especially in the banking system. Legislation to guarantee smooth transition from national currencies to euro denominations in the financial market has already been passed by the Althing. Another important mater of concern for the Icelandic financial market is the possibility of having access, via the Central Bank, to TARGET. The new exchange rate arrangement means moving from relatively fixed exchange rate peg to a more flexible one. Despite the elimination of the fluctuation limits for the crown, the Central Bank will intervene in the foreign exchange market if it deems such action necessary in order to promote the inflation objective described above or if it thinks that the exchange rate fluctuations might undermine the financial stability. The experience of recent years, most recently from Argentina, shows that it has become more difficult to maintain a stable exchange rate with the liberalisation of capital movements and even larger and more active international financial markets. In addition, a flexible approach to exchange rate policy would seem to be consistent with the fundamental characteristics of the Icelandic economy which is subject to important supply shocks, as a result of its dependence on fish and energy-intensive products. These shocks are markedly different from those facing its trading partners. Greater exchange rate flexibility does not only provide a means for ensuring stabilisation of the domestic economy in the short run, but it also helps cope with increased capital mobility in the context of the ongoing financial liberalisation 15 .

3. Switzerland and Liechtenstein

Introduction Switzerland and Liechtenstein are not a part of the European Union, but they are deeply integrated in its European environment through their geographical situation and strong historical, cultural and economic links. Switzerland's economy is based on high-quality goods and well-trained workers. Important areas are micro-technology, biotechnology, banking and insurance, know-how and pharmaceuticals. In a referendum held in 1992 the population of Liechtenstein voted to join the EEA and a second referendum confirmed Liechtenstein's definitive entry. The EEA Agreement allows Liechtenstein to participate in most fields of the internal market of the EU. An additional protocol allows Liechtenstein to keep at the same time its close ties, especially the customs treaty, with Switzerland. The main pillars of the economy are the export industry and financial services. Liechtenstein developed its financial place in a modest way already before the Second World War. There are a few different elements that make it attractive: solid political and monetary stability (Swiss franc), a highly skilled labour force and a wealthy surrounding region. Other indicators that confirm the story of a healthy economy are well developed law with a reliable judicial system, banking secrecy, low taxes, an inflation rate of 0% in 1999 and an unemployment rate of 2%.

15 Ibid.

21 PE 304.442 rev.1. EMU and the EFTA

Because of the close institutional relations between these countries, the following analysis refers to the Swiss Franc; but it covers the monetary policy of both countries. Switzerland is now surrounded by countries all sharing the same currency. That means that Swiss foreign trade is less diversified by currencies than earlier. At the same time, a common monetary policy for Europe is likely to lead – over time – to a stronger synchronisation of business activity in the EMU member states 16 . This, in turn, means that the impact of the European business cycle on the Swiss economy will become more even and thus also stronger. More than ever, Switzerland's economic destiny will be linked to that of Europe. As the single currency gains in significance, the Swiss franc/euro exchange rate will become a major factor for the development of the Swiss economy, and therefore also for the monetary policy of the Swiss National Bank (SNB). Prior to the introduction of the euro at the beginning of 1999, there were widespread fears in Switzerland and Liechtenstein that the transition to a common currency would lead to an undesirable upward pressure on the Swiss franc in the foreign exchange markets. These fears have not materialised, however: the exchange rate between the Swiss franc and the euro has remained within a narrow fluctuation band. This stable relation between the two currencies is largely a result of the SNB's monetary stance. By conducting an expansionary monetary policy, the SNB aimed at preventing the Swiss franc from appreciating excessively. It was not a question of keeping the exchange rate stable as such, but the SNB was rather compelled to keep an expansionary course in order to ward off deflationary trends in the Swiss economy. Despite imponderables, the high degree of economic convergence between these two countries and the EU is expected to ensure a natural stability between the franc and the euro. The transparency of prices will be increased, as well as more developed competition. These challenges are not only of a monetary but also economic nature. It seems that monetary policy will play a decisive role in defining the strategy of adaptation to EMU. Given the expected weight of the euro, it will be much more difficult for the National Bank of Switzerland to conduct a fully independent monetary policy 17 , although a certain margin of manoeuvre will be preserved. Generally speaking, the introduction of euro cash will have no influence on the Swiss franc. The latter will remain the sole legal currency of payment in Switzerland. However, in the tourist industry in areas near the Swiss border, the euro can be expected to establish itself as the second currency. Hotels, bars and restaurants are displaying prices in francs and euros. In an effort to remain open to foreign visitors, two big Swiss banks - Credit Suisse and UBS - have set up cash machines dispensing euro notes as well as Swiss francs. Several Swiss supermarket chains have said they are happy to accept euros from customers.

Monetary policy The SNB is ranged among a small number of central banks that have opted for a clear commitment to price stability. Moreover, it has chosen an operational framework consistent with this overriding objective. Monetary targeting was employed until the end of 1999, when it was abandoned in favour of an approach based on an inflation forecast.

16 Over 50% of Switzerland's exports go to euro zone countries, while 70% of its imports originate from the EU. 17 "La Suisse et l 'Union économique et monétaire européenne", Groupe interdépartemental "EURO", Juin 1998.

22 PE 304.442 rev.1. EMU and the EFTA

Although multi-year targeting accorded the SNB the required flexibility, it did not solve all the problems arising from the earlier approach. Some problems remained: • Demand for the SFr tends to be more stable in the long run than in the short run. For this reason, the deviations in the monetary base from the multi-year target line did not necessarily serve as a reliable barometer of the SNB's policy stance. Since high-frequency movements in the monetary base were often hard to explain, they could emit misleading signals about the monetary ease or tightness flowing from the SNB's policy course 18 . Although the trend rate was low, the SNB could not prevent a temporary resurgence of inflation early in the 1980s and in the 1990s. However, since 1993, inflation has consistently stayed at low levels. • Even in the absence of signalling problems, the procedures for determining deviations from the multi-year target line were not sufficiently consistent and transparent. The SNB did mention the exchange rate and the cyclical state of the economy as the two main indicators it would follow in order to assess the need for deviations in the monetary base from the multi-year target line. However, it could have made greater efforts to explain to the public its often complex policy analysis and the decisions based on this analysis. These difficulties, along with instabilities in the base-money demand that had surfaced in 1996, prompted the SNB to reconsider its approach to monetary policy upon the completion of the targeting period 1995-1999. At the end of 1999, it announced various modifications to its policy concept in three respects. First, it decided to abolish monetary targeting, without renouncing the role of money as an important policy indicator. Instead, it placed inflation forecasts at the centre of its internal monetary policy debate. For this reason, the SNB, at the end of 1999, published a forecast of inflation developments over the subsequent three years. The three-year forecasting horizon is designed to take account of the long lag in the effects of Swiss monetary policy. Secondly, the SNB sets its inflation forecast against its main objective of maintaining price stability. Should the inflation forecast hint at a sustained threat to price stability, the SNB will adjust its policy course accordingly. Thirdly, the policy conclusions derived from the inflation forecast are framed in terms of an operational target, expressed as a band for the three-month Libor rate of interest for Swiss francs, with the difference between the ceiling and floor of the band amounting to one percentage point. As a result of these changes, the National Bank no longer publishes a growth target for monetary aggregate; the money stock M3, however, will continue to play a major role as a monetary policy indicator. It has adopted the ECB's definition of price stability. It is considered that price stability is achieved with an annual inflation rate of less than 2% measured by the national consumer price index. However, the SNB did not follow the example of the ECB of adopting a two-pillar strategy of monetary policy, because it was concerned that the public would be confused by such an approach and would be at a loss to understand which pillar determined monetary policy in practice. To chart its policy course, the ECB relies both on inflation forecasts and a reference value for the growth in the money stock M3. For this reason, the SNB made it clear that the

18 The SNB (1990, p. 273) was aware of this problem when it announced the multi-year targeting strategy: "Although this aggregate (the money base) often leaves much to be desired as a short-term indicator, it fulfils a useful function as a leading indicator, i.e., it anticipates the development of inflation over the following three years".

23 PE 304.442 rev.1. EMU and the EFTA inflation forecast would act as its main policy compass, while the money stock would serve as an important input into that forecast. For all practical purposes, there is often a significant correspondence between Swiss and European monetary policies. The SNB and ECB not only follow similar monetary policy objectives and strategies, but they also operate in a similar environment. Even so, the similarities are not large enough to obviate the need for an autonomous monetary policy.

The stability of the Swiss franc/euro exchange rate The position of the Swiss franc can be described by means of three indicators. First, by the SFR's share in the global turnover in foreign exchange trading. Secondly, and economically more important, is the position of a currency held in international portfolios. Relative to the size of Switzerland, the SFr occupies an unusually prominent position in international institutional and private portfolios. It is the combined result of an efficient financial centre and the commitment to an independent monetary policy which lends the SFr special diversification characteristics in global portfolios. This certainly is a sign of strength and a sound basis for the value creation. Thirdly, due to relatively low interest rates, the Swiss franc – like the yen – periodically plays an important role in the short-term financing of trading positions. Currency and securities traders take short positions in the Swiss money market to finance long positions elsewhere. This is a rather volatile game, often reinforced by herd effects, which comes and goes with short-term exchange rate expectations. In the recent past, however, such strategies have lost their appeal, probably as a consequence of the appreciation of the Swiss franc in the year 2000. Trade relations with the euro area have always been strong, on the export as well as on the import side. It is clear that the Swiss economy is highly susceptible to shocks in the SFr/euro exchange rate. This marked dependence is the strongest economic argument of all those wishing to substitute the euro for the Swiss franc as soon as possible.

Chart 6 : Swiss franc exchange rate against euro

Exchange rate of the Swiss franc

1,95 1,85 1,75

CHF 1,65 1,55 1,45 1992Q01 1993Q01 1994Q01 1995Q01 1996Q01 1997Q01 1998Q01 1999Q01 2000Q01 2001Q01 Year

Source: New Cronos Database

24 PE 304.442 rev.1. EMU and the EFTA

Given certain conditions, EMU could increase the demand for Swiss franc assets. The increase in demand would then lead to an increase in the demand for francs, occasioning an appreciation of franc. Such an increase in the demand for franc assets would possibly arise from differences between the monetary policies of the euro zone and those of Switzerland. Any anticipated monetary instability in the euro countries might be expected to increase the demand for franc assets. In September 2001 the SNB eased its monetary policy in order to support activity and limit the appreciation of the Swiss franc after the uncertainties created by the 11 September attacks. So far, the relation between the two currencies has been remarkably stable. Since the introduction of the single currency, the Swiss franc/euro exchange rate has fluctuated in an extremely narrow band of only 2%. Thus, exchange rate volatility has until now been even lower than the 8% volatility between the Swiss franc and the D-Mark during the three years preceding the monetary unification. The extreme stability in the exchange rate has surprised many observers, including the SNB itself. It has led to the notion of "sister currencies", the euro being the big sister and Swiss franc following her everywhere like a shadow 19 . If one examines the reasons for the extraordinary stability in the exchange rate, one quickly finds that convergence in fundamentals has played a central role. Both Europe and Switzerland have suffered from slow growth in the 1990s and from deflation fears in the aftermath of the international financial crisis of 1998. Rising unemployment and weak economic activity led the ECB and the SNB to adopt an expansive monetary stance and to cut interest rates. Broad similitude in business cycle and monetary stance has created conditions leading to an almost fixed exchange rate between the euro and the Swiss franc. At the same time, converging fundamentals explain why both currencies have been equally weak against the US dollar; the American business cycle is well in advance of the European and Swiss business cycles, requiring a different policy response from the Fed.

Chart 7 : Dollar/euro exchange rate

Dollar/euro exchange rate

1,50 1,40 1,30 1,20

USD 1,10 1,00 0,90 0,80

1 1 1 1 1 1 1 1 4Q0 5Q0 6Q0 7Q0 8Q0 9Q0 0Q0 1Q0 99 99 99 99 99 99 00 00 1992Q011993Q011 1 1 1 1 1 2 2 Year

Source: New Cronos Database

19 "Euro and Swiss franc: Two sister currencies?", Address given by Roth Jean-Pierre, Swiss National Bank, Singapore, February 24, 2000.

25 PE 304.442 rev.1. EMU and the EFTA

One further factor which might influence the SFr exchange rate against the euro is uncertainty about the future policy of these two countries – particularly Switzerland – towards European Union. The Swiss population rejected membership in the EEA in December 1992; and this vote was regarded as an anti-EU signal by the government, which has since then shelved its plans for adhesion to the EU. In March 2001 a privately sponsored referendum advocating the opening of membership negotiations was heavily defeated (it is worth noting that the Government itself advised a "No" vote). As an alternative, Switzerland has negotiated Bilateral Agreements with the EU in order to gain free access to the EU internal market for goods and services. In conclusion, some analyses point to a number of possible dangers: • The fluctuations of the SFr vis-à-vis the euro might return to, or even exceed, those observed in the past for the SFr/DM exchange rate. • A loss of confidence in the euro might trigger an excessive appreciation of the Swiss franc. Swiss interest rates, which have been lower than anywhere else in Europe, might have to rise to the levels prevailing in the euro area.

26 PE 304.442 rev.1. EMU and the EFTA

Summary and Conclusions

♦ It is not yet entirely certain that the EMU will lead to permanent long-term benefits in terms of growth and stability, and how these potential benefits weigh against the risk of disruption in the event of, for example, asymmetric shocks. But assuming that EMU will be fully successful, it should contribute to growth and stability, not only within the euro area itself, but also in third countries. For the EFTA countries, which have a very high percentage of their trade with the EU, the benefits are likely to be strong. ♦ The Maastricht criteria have become the standard for economic policy, not only within the euro area and among prospective members of it, but among outsiders too. In view of this, and also the possibility that one or more EFTA countries might some day join the EU and EMU, these criteria are likely to be a permanent factor in the formulation of their economic and fiscal policies, irrespective of the exchange rate arrangements or relationship to the euro that are chosen. ♦ The ECB is required by the Treaty to formulate its monetary policy with the overriding primary aim of maintaining low inflation for the euro area as a whole. External effects – for example, on the exchange rate – are only taken into account in so far as they might affect the inflationary outlook. In these circumstances, non-euro-area European currencies will to a greater or lesser extent become "takers" of euro area monetary policy, and maintaining stable exchange rates against the euro might become more challenging. It might be necessary, for example, for interest rates in non-euro-area countries to be maintained at permanently higher levels than those set by the ECB for the area itself. ♦ The creation of the euro has also reinforced global financial integration and contributed to higher capital mobility, both within and outside the euro area. Large movements of funds between, for example, the euro and the US dollar can have damaging "spin-off" effects on other currencies (e.g. the £ in 1992). It might become more difficult to maintain stable exchange rate policies with free capital movements for small countries at the margin of a big currency area. ♦ The competitive position of financial institutions based in non-area countries may be adversely affected – although this has so far not been the case with the City of London. ♦ It is also possible that investment by European firms, and also inward investment from outside Europe, will be diverted from non-euro-area countries to within the euro area in order to avoid exchange costs. There has, however, again been little sign of such an effect so far in the case of the United Kingdom. ♦ The creation of the Single Currency area with a single monetary policy for the euro area has already led to further integration in other fields, notably fiscal policy. This trend may be expected to continue – for example into certain areas of taxation – with consequences for the EFTA/EEA countries. The so-called "Withholding Tax" proposals, for example, have already led to negotiations with Switzerland and Liechtenstein, aimed at requiring them to abandon their policies of banking secrecy. Recently strengthened international action against money laundering and the financing of terrorism may well be extended into the field of taxation. ♦ Since the introduction of euro notes and coins in January 2002 there is a potential for the € to become a "parallel currency" in EFTA/EEA currencies, as in the current EU "outs" and the candidate countries of Central and Eastern Europe. Such an expansion of the EMU sphere is particularly likely in Switzerland and Liechtenstein due to their

27 PE 304.442 rev.1. EMU and the EFTA

geographical location, being completely surrounded by "Euro-land". Wide acceptance of €-denominated notes and coins in Sweden and Denmark, however, might in time spread to Norway. ♦ If recent movements of public opinion towards euro area membership in Denmark and Sweden prove durable, and result in favourable referendum votes, the influence of the euro system on Norway – and also perhaps Iceland – is likely to increase. This will be even more the case if the UK, too, opts for membership. ♦ In the longer term the euro is almost certain to become the currency of virtually the whole of Europe, as the current Central and Eastern European candidate countries join first the EU, and then the euro area; and as "euroisation" takes place in other regions (as it has already, for example, in Kosovo and Montenegro). This is likely to put pressure on residual national currencies like the Swiss Franc to fully join the area, or to firmly link their rates to the €.

28 PE 304.442 rev.1. EMU and the EFTA

Economic Affairs Series Briefings

To obtain paper copies of the following publications, please contact: G.B. Patterson , Economic, Monetary and Budgetary Affairs Division, European Parliament, L-2929 Luxembourg. Tel.: (00352) 4300 24114 . Number Date Title Languages ECON 520 Sept. 2001 Background to the € EN, FR, DE ECON 519 Feb. 2002 The Belgian Economy EN, FR, NL ECON 518 August 2001 Enlargement and Monetary Union EN, FR, DE ECON 517 July 2001 The Taxation of Pensions EN, FR, DE ECON 516 June 2001 The Finnish Economy EN, FI, FR ECON 515 April 2001 Die deutsche Wirtschaft DE, EN, FR ECON 514 April 2001 The Euro and the Blind EN, FR, DE ECON 513 May 2001 Tobacco Tax EN, FR, DE ECON 512 May 2001 The Euro: Counterfeiting and Fraud EN, FR, DE ECON 511 May 2001 The Consequences of EMU for the EEA/EFTA countries EN, FR ECON 510 April 2001 Margine di Solvibilità IT, EN ECON 509 March 2001 Stability and Convergence Programmes: the 2000/2001 Updates EN, FR, DE ECON 508 Feb. 2002 The Swedish Economy EN, FR, SV ECON 507 Feb. 2002 The Economy of the Netherlands EN, FR, NL ECON 505 May 2000 The Portuguese Economy EN ECON 504 July 2000 The French Economy EN, FR ECON 503 July 2001 The Spanish Economy EN, FR,ES ECON 502 June 2000 The “Third Way” EN, FR ECON 501 April 2000 The Danish Economy EN Econ 30 Feb. 2002 The Italian Economy EN, FR, IT Econ 27 Feb.2000 The Greek Economy EN, FR, GR

Economic Affairs Series Working Papers The following publications are available on line on the Intranet at: http://www.dg4.ep.ec . They are also available on the Internet at the following address: http://www.europarl.eu.int . To obtain paper copies of the following publications, please contact: http://[email protected] or Fax (352) 4300-27722.

Number Date Title Languages ECON 129 Feb. 2002 Broad Economic Policy Guidelines 2002 EN, FR, DE ECON 128 Dec.2001 Tax co-ordination in the EU – the latest position EN,FR,DE ECON 127 July 2001 The Reform of Taxation in EU Member States EN,FR,DE ECON 124 May 2001 A Single Market in Financial Services EN,FR,DE ECON 126 Jan. 2001 The Economic Situation of the European Union and the Outlook for 2001/2 EN,FR,DE ECON 125 Jan. 2001 Tax Co-ordination in the European Union EN,FR,DE ECON 123 Aug.2000 Improving cross-border payments in the euro area EN,FR,DE ECON 120 Aug. 2000 Exchange Rates and Monetary Policy EN,FR,DE ECON 122 April 2000 Strategies for the EU Economy EN,FR,DE ECON 118 Mar. 2000 The Functioning and Supervision of International Financial Institutions EN,FR,DE ECON 117 Jan. 2000 EMU and Enlargement: a review of policy issues EN,FR,DE ECON 116 Dec.1999 The Determination of Interest Rates EN,FR,DE ECON 121 Nov. 1999 Consumer protection aspects of the UCITS amending directives of 1998 EN,FR,DE ECON 115 Oct. 1999 Options for the Exchange Rate Management of the ECB EN,FR,DE ECON 114 Sept. 1999 The Euro as 'Parallel Currency', 1999-2002 EN,FR,DE

29 PE 304.442 rev.1.