Finance

Exchange Rate Mechanism and European Currency Unit

The European Union (EU) is a sterling example of successful economic integration among the countries of a region. Formerly known as the European Economic Community (EEC), the Union was born out of the `Treaty of Rome’ entered into among six European countries—Belgium, Netherlands, Luxembourg, France, Germany and Italy—who are also its founder-members. It came into operation on January 1, 1958. At present the number of member countries is 28.  But the United Kingdom is due to leave the EU on 29 March 2019, leaving 27 countries in the union. This is termed as Brexit or British Exit from EU.

Under the Treaty of Rome the member-countries agreed to:

(i) gradual liberalization of trade among the members with a view to achieving zero tariff level as early as possible;

(ii) evolving a common external tariff among the member-countries for inter-regional trade;

(iii) evolving a common agricultural and transport policy;

(iv) removal of obstacles to the free movement of persons, services and capital;

(v) establishing the European Common Market (ECM) with a view to reducing intra-regional income disparities and promote trade among the members; and

(iv) evolving common fiscal and economic policies to the extent possible for the functioning of the ECM and to remedy disequilibrium in their balance of payments.

The member-countries agreed to abolish in a phased manner all the tariffs among themselves and adopt a uniform tariff for trade with other countries. This was achieved by 1968. The next step was to integrate the European Community into a single market with a single set of laws, tariffs and fiscal barriers. This was to be achieved by 1992.

In June 1985, the European Commission issued the White Paper listing various legislative proposals on completing the internal market’. The proposals essentially center on abolishing existing physical, technical and fiscal barriers. These include border controls, technical standards and regulations and disparities in tax regulations.

The Single European Act, which became effective in July 1987, provided the legal basis necessary to implement the integration of European market.

The European Union is operating as a single market with effect from 1st January, 1993 with the elimination of barriers to the movement of goods, services, capital, manpower and skills within the block. At present the membership includes 28 countries with the addition of England, Ireland, Denmark, Greece, Spain, Portugal, Austria, Finland and Sweden. It now constitutes the world’s largest and prosperous market with a share of 40% in the world trade.

One of India’s major trade partners is the EU which accounts for 25% of its exports. While the scope for exports has been enlarged by the mere size of the market and flexibility of quota for different items, the Indian industry has to survive the severe competition arising from throwing open the market to all. India has signed a trade and economic co-operation agreement with the EU. This provides for preferential trade between EU and India and mutual co-operation in economic and agricultural and industrial development. It is expected that in course of time India may be assigned an associate member status.

European Monetary System

On the monetary front, the European Monetary System (EMS) was conceived to pave the way for European monetary integration. The main objective of EMS is to establish a zone of monetary stability in Europe and to achieve a greater convergence of financial and economic policies among member-countries. It is thought of as a protection to the European countries from the instabilities of US dollar.

The EMS became operative from March 1979 with the members of EEC except Britain which opted to remain outside the system. Each member-country of the EMS agrees to maintain exchange rates within certain margins through concerted intervention policies. It also provides for mutual credit facilities to implement the policy of stability of exchange rates.

An innovation of the EMS is the creation of European Currency Unit (ECU). The ECU occupies the central position in the system. ECU is the unit of account for mutual monetary assistance. It also serves as an indicator of divergence in exchange rates of currencies of member-countries.

In addition, it is used as a area sure of settlement among the central banks of the members. In short, ECU is the unit of account of the EMS and occupies the same position that is occupied by SDR in IMF.

Exchange Rate Mechanism (ERM)

ECU is a basket of fixed amount of EEC currencies. The parties of all EMS currencies are declared against the ECU. As the party of all EMS currencies is fixed in terms of ECU, each pair of these currencies will have a fixed cross parity.

The central bank of a member is required to keep the market rate for its national currency against each other participating currency within 2.25% above and below its cross parity. The central bank of each participating country declares selling and being rates for each other participating currency at 2.25% above and below the cross parity, at which rates it will deal in unlimited amounts. The willingness of the central bank to deal at these rates will ensure that the market rates do not go beyond the limits.

In addition to maintaining the cross parity with other currencies, each currency has been allocated a maximum percentage deviation against its ECU central rate, known as the divergence indicator. When this divergence is reached, there is a presumption (but not an obligation) that corrective action will be taken by the country concerned. The maximum divergence indicator against a currency’s ECU central rate varies from currency to currency.

Although among themselves the EMS currencies have fixed parity, the currencies are floating as a block against other currencies.

Economic and Monetary Union

The integration of the European Union is complete only with the evolving of a single currency for all EU countries. At a summit meeting of the EC heads of government held in Maastricht in the Netherlands in December 1991, it was decided to achieve the economic and monetary union in three stages. Stage I began on July 1, 1990 (earlier to Maastricht) with free movement of capital in the EC. Stage II began on January 1, 1994 with the establishment of European Monetary Institute as a precursor to the eventual formation of Central Bank for Europe.

At Stage III, commencing from 1997 and not later than January 1, 1999, the members would irrevocably fix inter se exchange rates and proceed towards a single currency. Under Maastricht, Britain has retained the right not to join the monetary union.

The European political leaders who met in Madrid in December 1995 took final decision to implement the economic and monetary union (EMU), commencing from January 1, 1999. The single currency for Europe is named ‘Euro’.

The members of the EMS are eligible to join the EMU subject to fulfillment of the following conditions:

(i) The yearly average inflation of the country not to exceed by more than 1.5% the inflation levels of three of the best performing member-countries;

(ii) The yearly average long-term interest rates not to exceed by more than 2% that prevailing in the three best performing member countries;

(iii) The government deficit not to exceed 3% of the GDP or should be falling substantially towards this figure;

(iv) The gross government debt not to exceed 60% of GDP or must show a satisfactory fall towards this figure;

(v) The exchange rate of country’s currency must have moved for at least two years within the normal EMS margin.

On January 1, 1999, fixed exchange rates will. be set between the currencies g of the member-countries. Irrevocable exchange rates would also be fixed for each member currency against the Euro. All transactions between the member countries will be done at the fixed exchange rates and or at Euro until it replaces the national currencies as legal tender.

Euro notes and coins was brought into circulation in 2002. After an initial period of six months, the national currencies will lose their status as legal tender.

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