Friday, 6 May 2005

Audacious Brave or Foolish

The Malta Independent - Friday Wisdom

What description most fits the decision to join the ERM II at current fixed central rate, in the process putting the authorities (Central Bank and government) on line to defend this fixed rate right up to full euro adoption, proposed for 1 January 2008? Audacious, brave or foolish?

In general, I favour doing what we have to do, the sooner the better. My greater concern is with the timing of the decision to join the euro in 2008, rather than with the timing to join the ERM II in May 2005. This will require fiscal discipline and an accelerated pace of economic restructuring which experience shows that politicians are incapable of delivering in the second half of a legislature.

It takes a strong dose of optimism to assume that this time it will be different and that the euro process will discipline our political leaders to sacrifice themselves to do what’s right rather than what’s popular.

The strategy document published jointly by the Central Bank of Malta and the Malta government admits that most methodologies used to calculate the correct equilibrium rate of the Maltese lira shows that it is currently over-valued, and some studies indicate that it could be so by about six per cent. Other studies not referred to in the strategy document show that taking as a base 1995, the last year we had relative order in our public finance situation, the over-valuation could be higher than 10 per cent.

Consequently I consider it very audacious to attempt to lock our currency into the euro at an uncompetitive rate, as this will require deeper restructuring to achieve international competitiveness. Just look at the pain that
Germany and Italy are going through because they have not delivered on the real economic re-structuring necessary to sustain the fixed parity they chose when the euro was launched in 1999.

In real terms, entry into the ERM II has not changed anything except that the basket of currencies to which the Maltese lira was formerly pegged (which in any case had a 70 per cent euro content already) has been replaced by a complete fixed currency board to the euro. Our rate of exchange will now completely shadow euro movements in international foreign exchange markets and will no longer by influenced by the fortunes of the pound sterling and the dollar as hitherto.

The real difference is more psychological. Now that a target date for joining the euro in 2008 has been set, will Maltese savers have confidence that the government can deliver the promised fiscal discipline and economic convergence to sustain the chosen rate or will they start suspecting that in the end the chosen rate is unsustainable and will have to be reviewed before joining the euro or the whole process will have to be delayed?

The Maltese lira is not freely traded and its value is arrived at by administrative decisions of our monetary authorities. The market test for the value of the Maltese lira will be the performance of our external reserves position during the ERM II period. To protect both the foreign reserves and the chosen central parity, the Central Bank now has only one policy left, ie interest rates.

If we start losing reserves as people start doubting the sustainability of the chosen central rate and government’s ability to deliver in time on its fiscal consolidation programme, then interest rates will need to be increased. Such a measure could of itself dent the macro-convergence programme and force a misalignment in other Maastrict criteria for the single currency.

Because in the past we have been within such criteria for interest rates and price stability, one cannot assume that this will remain so if the monetary authorities are forced to use interest rate policy more aggressively to defend the currency board.

We have now put our credibility on line with the international community. If, at the end of the ERM II period, the misalignment from the criteria is considered to be wide enough to conclude that
Malta has failed its apprenticeship, than the only logical thing to do is to postpone entry into the euro until proper convergence has been achieved. This would be a blow to our international image and coming close to an election would present poor credentials for a government seeking confirmation.

It would, however, be a choice of the lesser evil, as more harm to the economy will result long-term from joining the euro unprepared and at a conversion rate that prejudices our international competitiveness. Compare the performance of
Italy and Germany, which joined at uncompetitive rates, to that of Ireland, which joined at a competitive rate.

It is for this reason that I have consistently argued that in joining the euro it is much safer to err on the side of under-valuation than on the side of over-valuation. I think the government and the Central Bank are taking excessive risks in planning to join at an over-valued rate. The true consequences will not be felt over-night but in the course of time. The anaemic economic growth we have experienced since 2000 is partly due to an uncompetitive exchange rate regime which we are now seeking to harden in perpetuity into the euro.

Audacious, brave or foolish? As always, time will be the best judge.

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