Profile of the Euro – Economic Overview and Monetary Policy

The European Union currently consists of 28 member countries, while five other nations are on the list of candidates and three others are potential candidates. As the EU continues to expand, the currency it aims to adopt fully within its boundaries – the euro – will continue to grow in significance.

The founding of the European Monetary Union, which took the EU one step further in its process of economic integration that started in 1957, is aimed at bringing the benefits of greater size, internal efficiency and robustness to the EU economy, both as a whole and to each individual member. The EMU is both a trade-driven and capital flow-driven economy, underscoring the importance of trade for each country. Thanks to the Union’s growing mass and the volumes of trade with the rest of the world, it possesses substantial power in the international trade arena as a whole. This allows the individual member countries, grouped as one entity, to negotiate on equal terms with other major economies – such as the United States and China – and to protect their own interests as well.

The European Union is the world’s biggest economic power, with a gross domestic product of €12.945 trillion in 2012. In terms of trade, the EU is the world’s second-largest exporter with external exports (excluding intra-EU trade) of $2.173 trillion in 2012, closely following China’s $2.210 trillion achieved in 2013 and well ahead of the US ($1.575 trillion in 2013). Meanwhile, the EU is the world’s biggest importer, with 2012 inbound shipments estimated at $2.312 trillion, compared with $2.273 trillion and $1.950 trillion in the US and China in 2013, respectively.

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Extending reach

Although the euro has not been adopted by every member, 18 countries currently use it and, under the Treaty, all other EU members must join the Eurozone once the necessary conditions are met. Only the United Kingdom and Denmark have negotiated an ‘opt-out’ clause that allows them to remain outside the single-currency bloc. This ensures that the euro’s widely renowned role as a second reserve currency will continue to grow, along with its attractiveness beyond the EU’s borders.

Apart from being used to make payments for trade with EU members, the euro is increasingly utilised worldwide to issue government and corporate debt. The euro’s share in international debt markets jumped to almost a third by 2006, compared with the US dollar’s 44%. The Union’s major role on the global trade arena has made it important for foreign trade partners to hold large amounts of reserve currency to reduce exchange risk and transaction costs. In 1999, when the euro was introduced, it accounted for 17.9% of global currency reserves, compared with the US dollar’s 71%. Although the euro’s share declined after the 2009 recession, in 2013 it accounted for 24.4% of global currency reserves, compared with 61.2% for the US dollar, so a clear shift in favour of the euro can be observed.

As for currency trading, the euro understandably remains the second most traded currency, although its share has fallen compared with three years earlier. In 2013, the euro stood on one side of 33% of all trades, firmly remaining the second largest currency vehicle. Its share dropped from 39% in 2010, while the US dollar was on one side of 87% of all trades, according to the latest Triennial Central Bank Survey by the Bank for International Settlements.

Policy and regulation

Having outlined the role of the European Union and the euro in the global economy, we will now take an overview of monetary policy. The European System of Central Banks (ESCB) consists of the members’ national central banks (NCBs) and the European Central Bank. The ECB is the governing body responsible for determining monetary policy for the member countries.

Decisions are taken independently by the ECB’s Governing Council, which includes the governors of the Eurozone’s NCBs and the members of the ECB’s Executive Board. New monetary policy decisions are adopted by majority vote, with the president holding the casting vote in the event of a tie. Member states outside the single-currency bloc co-ordinate their monetary policy with the European Central Bank. Both the ECB and the ESCB are institutions outside the control of national governments and other European institutions; thus, their monetary policy decision-making is completely independent.

Monetary policy tools

The ECB’s primary goal is to ensure price stability and sustainable growth within the European Union. The ECB has defined price stability as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below, but close to, 2%. It has three sets of instruments to control monetary policy: open market operations, standing facilities and minimum reserve requirements for credit institutions.

There are four types of open market operations:

– Main refinancing operations
– Longer-term refinancing operations
– Fine-tuning operations
– Structural operations

Standing facilities aim to provide and absorb overnight liquidity, signal the general monetary policy stance and bound overnight market interest rates. Two standing facilities are available:

– Marginal lending facility
– Deposit facility

If you want to learn more about the two types of instruments listed above, as well as the minimum reserve requirements, visit the European Central Bank’s website.

Requirements

To further ensure its economic integrity, the EU has implemented a set of criteria for the financial performance of each member, imposing heavy fines on those who do not comply. Under the 1992 Maastricht Treaty, the criteria for member countries to enter the third stage of the European Economic and Monetary Union and adopt the euro as their currency are:

– Inflation rates should be no more than 1.5% higher than the average of the top three best-performing members of the EU, calculated as a 12-month year-on-year rate.

– Long-term interest rates should not have exceeded the average rates of the same three low-inflation countries by more than 2% in the past 12 months.

– Two major requirements regarding government finance. First, the government deficit should not have exceeded 3% of the country’s gross domestic product in the preceding fiscal year, but small deviations can be tolerated. Exceptional temporary excesses can be allowed in exceptional cases. Second, general government debt must not be more than 60% of the country’s GDP at the end of the previous fiscal year. However, due to specific conditions, a higher ratio may be permitted if it is ‘sufficiently diminishing’ at a satisfactory pace.

– The applicant country should have joined the Exchange Rate Mechanism (ERM II) under the European Monetary System, and its currency’s exchange rate should have fluctuated within the normal margins of the exchange rate mechanism for at least two years.

In ERM II, the exchange rate of a non-Eurozone member’s currency is fixed against the euro and is allowed to fluctuate only within set limits. It covers several aspects:

– After a central exchange rate between the euro and the country’s currency is agreed, the currency is allowed to fluctuate by up to 15% above or below this central rate.

– If necessary, the currency is supported by buying or selling to keep the exchange rate against the euro within the 15% fluctuation limits. Interventions are co-ordinated by the ECB and the central bank of the non-euro area member.

– Non-Eurozone members within ERM II can decide to maintain a narrower fluctuation band, but this decision has no impact on the official 15% fluctuation limits unless the ERM II stakeholders agree to it.