A project report

On

Advantages and Disadvantages of

establishing Monetary Union

Subject:- International Financial Management

Submitted to : Submitted by:

Miss Dua Naqvi Prachi Jain

Roll no:- 25

MBA- 4rth sem (Finance)

MBA- Lucknow University

(2011-2013)

INDEX

TOPIC PAGE NO.ACKNOWLEDGEMENT

INTRODUCTION

WHY ARE THESE ACTIVITIES IMPORTANT?

EXAMPLE :- EUROPE'S MONETARY UNION

ADVANTAGES OF ESTABLISHING MONETARY UNION

DISADVANTAGES OF ESTABLISHING MONETARY UNION

REFERENCES

ACKNOWLEDGEMENT

At the outset of the project, I would like to pay my sincere thanks to my subject teacher Miss.

Dua Naqvi maam, who gave me such a brilliant assignment to work upon. Her guidance

throughout the project was quite superb.

I would also like to take this opportunity to thank my class mates and my books that have helped

me during my project.

Last but certainly not the least, I would like to thank my parents who have always been my real

hope and support.

Thank you all !!

Deepali Yadav

LUMBA

INTRODUCTION

When two or more groups (usually countries) share a common currency or decide to peg their exchange rates in order to keep the value of their currency at a certain level. One of the main goals of forming a currency union is to synchronize and manage each country's monetary policy. 

Also referred to as a "monetary union".

The Monetary Union is an agreement among the participating member states of the Union to adopt single currency, single monetary policy and coordinated macroeconomic policies. The single means that the participating countries can not pursue monetary policy at the national level. The Central Bank is responsible for the monetary policy of the participating countries. This institute is responsible for the monitoring of the money supply and for setting a key interest rate instead of the national central bank. The member states have to follow similar macroeconomic policies therefore the MU can function well.

Monetary tradition has long assumed that, in principle, each sovereign state issues and manages its own exclusive currency. In practice, however, there have always been exceptions -- countries that elected to join together in a monetary union of some kind. Not all monetary unions have stood the test of time; in fact, many past initiatives have long since passed into history. Yet interest in monetary union persists, stimulated in particular by the example of the European Union's Economic and Monetary Union (EMU), which has replaced a diversity of national monies with one joint currency called the euro. Today, the possibility of monetary union is actively discussed in many parts of the world.

A monetary union may be defined as a group of two or more states sharing a common currency or equivalent. The Monetary Union is an agreement among the participating member states of the Union to adopt single currency, single monetary policy and coordinated macroeconomic policies. The single means that the participating countries can not pursue monetary policy at the national level. The Central Bank is responsible for the monetary policy of the participating countries. This institute is responsible for the monitoring of the money supply and for setting a key interest rate instead of the national central bank. The member states have to follow similar macroeconomic policies therefore the MU can function well.

A group of countries (or regions) using a common currency. For example, in 1979, eight European countries created the European Monetary System (EMS). This system consisted of mutually fixed exchange rates between these countries. In 2002, 12 European countries agreed to a common monetary policy, thus forming the European Monetary Union. One reason why countries form these systems is to lower the transaction costs of cross-border trade.In the strictest sense of the term, monetary union means complete abandonment of separate national currencies and full centralization of monetary authority in a single joint institution.

The operations and management of MU are designed to support sustainable economic growth and high employment through appropriate economic and monetary policy-making. This involves three main economic activities:

Implementing an effective monetary policy with the objective of price stability

Coordinating economic policies in Member States

Ensuring the smooth operation of the single market

 

Why are these activities important?

Monetary policy involves influencing interest rates and exchange rates to benefit a country’s economy. This is achieved through a central bank controlling the supply of money in the economy. However, if each Member State operated its own monetary policy, then the single market would be much less effective, trade could be disrupted and the benefits would be fewer.

For this reason, under MU, monetary policy is closely coordinated, and within that area it is centralized and independent.

Member State governments control other economic policy areas. These include fiscal policy that concerns government budgets, tax policies that determine how income is raised, and structural policies that determine pension systems, labour- and capital-market regulations. However, MU brings more economic integration, and the Monetary union area even more so. As a consequence, economic policy-making becomes a matter of common concern to all Member States. To ensure the smooth operation of the MU economy as a whole, it is important that Member States coordinate their economic policies with the common objective of stability and growth.

As well as bringing the benefits of economic stability, MU and the single currency also support a more effective single market which benefits citizens and enterprises. If national economic policies act to discourage the free movement of goods, services, capital and labour, then these benefits, including jobs and growth, would be reduced. Therefore, economic policy-making in the Member States should act to support the single market.

Example :- Europe's Monetary Union

The most dramatic episode in the history of monetary unions is of course EMU, in many ways a unique undertaking -- a group of fully independent states, all partners in the European Union, that have voluntarily agreed to replace existing national currencies with one newly created money, the euro. The euro was first introduced in 1999 in electronic form (a "virtual" currency), with notes and coins following in 2002. Moreover, even while retaining political sovereignty, member governments have formally delegated all monetary sovereignty to a single joint authority, the European Central Bank. These are not former overseas dependencies like the members of ECCU or the CFA Franc Zone, inheriting arrangements that had originated in colonial times; nor are they small fragile economies like Ecuador or El Salvador, surrendering monetary sovereignty to an already proven and popular currency like the dollar. Rather, these are established states of long standing and include some of the biggest national economies in the world, engaged in a gigantic experiment of unprecedented proportions. Not surprisingly, therefore, EMU has stimulated growing interest in monetary union in many parts of the world. Despite the failure of many past initiatives, the future could see yet more joint currency ventures among sovereign states.

The History Of Monetary Cooperation

(a) The European monetary system (EMS)

In 1971, the United States decided to abolish the fixed link between the dollar and the official price of gold, which had ensured global monetary stability after World War Two. This put an end to the system of fixed exchange rates. With a view to setting up their own monetary union, EU countries decided to prevent exchange fluctuations of more than 2.25 % between the European currencies by means of concerted intervention on currency markets.

This led to the creation of the European monetary system (EMS) which came into operation in March 1979. It had three main features:

a reference currency called the ecu: this was a ‘basket’ made up of the currencies of all the member states;

an exchange rate mechanism: each currency had an exchange rate linked to the ecu; bilateral exchange rates were allowed to fluctuate within a band of 2.25 %;

a credit mechanism: each country transferred 20 % of its currency and gold reserves to a joint fund.

(b) From the EMS to EMU

The EMS had a chequered history. Following the reunification of Germany and renewed currency pressures within Europe, the Italian lira and pound sterling left the EMS in 1992. In August 1993, the EMS countries decided to temporarily widen the bands to 15 %. Meanwhile, to prevent wide currency fluctuations among EU currencies and to eliminate competitive

devaluations, EU governments had decided to relaunch the drive to full monetary union and to introduce a single currency.

At the European Council in Madrid in June 1989, EU leaders adopted a three-stage plan for economic and monetary union. This plan became part of the Maastricht Treaty on European Union adopted by the European Council in December 1991.

II. Economic and monetary union (EMU)

(a) The three stages

The first stage, which began on 1 July 1990, involved:

completely free movement of capital within the EU (abolition of exchange controls); increasing the amount of resources devoted to removing inequalities between European

regions (Structural Funds); economic convergence, through multilateral surveillance of member states’ economic

policies.

The second stage began on 1 January 1994. It provided for:

establishing the European Monetary Institute (EMI) in Frankfurt; the EMI was made up of the governors of the central banks of the EU countries;

independence of national central banks; rules to curb national budget deficits.

The third stage was the birth of the euro. On 1 January 1999, 11 countries adopted the euro, which thus became the common currency of Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. (Greece joined them on 1 January 2001). From this point onwards, the European Central Bank took over from the EMI and became responsible for monetary policy, which is defined and implemented in euro.

Euro notes and coins were issued on 1 January 2002 in these 12 euro-area countries. National currencies were withdrawn from circulation two months later. Since then, only the euro has been legal tender for all cash and bank transactions in the euro-area countries, which represent more than two thirds of the EU population.

(b) The convergence criteria

Each EU country must meet the five convergence criteria in order to go to the third stage. They are:

price stability: the rate of inflation may not exceed the average rates of inflation of the three member states with the lowest inflation by more than 1.5 %;

inflation: long-term interest rates may not vary by more than 2 % in relation to the average interest rates of the three member states with the lowest inflation;

deficits: national budget deficits must be below 3 % of GDP; public debt: this may not exceed 60 % of GDP; exchange rate stability: exchange rates must have remained within the authorised

margin of fluctuation for the previous two years.

(c) The Stability and Growth Pact

In June 1997, the European Council adopted a Stability and Growth Pact. This was a permanent commitment to budgetary stability, and made it possible for penalties to be imposed on any country in the euro area whose budget deficit exceeded 3 %. The Pact was subsequently judged to be too strict and was reformed in March 2005.

(d) The Eurogroup

The Eurogroup is the informal body where the finance ministers of the euro-area countries meet. The aim of these meetings is to ensure better coordination of economic policies, monitor the budgetary and financial policies of the euro-area countries and represent the euro in international monetary forums.

(e) The new member states and EMU

New EU members are all due to adopt the euro, when they are able to meet the criteria. Slovenia was the first of countries from the 2004 enlargement to do so and it joined the euro area on 1 January 2007, followed by Cyprus and Malta a year later.

ADVANTAGES OF ESABLISHING MONETARY UNION

Transaction costs will be eliminated. The greatest attraction of a monetary union is that it reduces transactions costs as compared with a collection of separate national currencies. With a single money or equivalent, there is no need to incur the expense of currency conversion or hedging against exchange risk in transactions among the partners

Price transparencyOne common unit of account facilitates price comparisonsConsumers “shop around” moreCompetition increases

Prices decline and consumers gain

Uncertainty caused by Exchange rate fluctuations eliminatedMany firms become wary when investing in other countries because of the uncertainty caused by the fluctuating currencies in the MU. Investment would rise in the MU area as the currency is universal within the area, therefore the anxiety that was previously apparent is there no more.

Single currency in single market makes sense.Trade and everything else should operate more effectively and efficiently with a Single currency. Single currency in a single market seems to be the way forward.

Free movement of workers Free mobility area of the labour helps the countries to prevent from an asymmetric shock which is the result of inflation in one country A and a recession in country B . If there is mobility of labour i.e., they can move freely this will lead to release the inflation in A and increasing employment of the people in B. “For example, workers from Indonesia, Malaysia, Philippines, and Thailand account for 10 percent of the employment in Singapore. Emigration has been as much as 2 percent of the labor force of the sending countries”

Prevents war. The EMU is, and will be a political project. It's founding is a step towards European integration, to prevent war in the union. It's a well known fact that countries who trade effectively together don't wage war on each other and if EMU means more happy trade, then this means, peace throughout Europe and beyond (we hope).

Increased Trade and reduced costs to firms.It brings considerable economic trade through the wiping out of exchange rate fluctuations, but as well as this it helps to lower costs to industry because companies will not have to buy foreign exchange for use within the MU. For them, MU represents the completion of the Single Market.

Other advantages of joining the currency union are as follows. The country gets an access to larger markets and thus increasing the overall income of the country. It also reduces the effect of shocks from exterior instability to an individual country. Joining the currency union is very important for those countries which lack internal control. This allows free movement of goods and services without any obstacles. This also keeps peace between the nations as they now that they are all interdependent on each other. One of the most important advantage is it will increase the tourism in the

countries as there is easy movement and no currency changes.

DISADVANTAGES OF ESTABLISHING A MONETARY UNION

First, individual partners lose control of both the money supply and exchange rate as policy instruments to cope with domestic or external disturbances. Against a monetary union's efficiency gains at the microeconomic level, governments must compare the cost of sacrificing autonomy of monetary policy at the macroeconomic level.

Loss of SeignorageAnother disadvantage of joining a monetary union is the loss of seignorage. Technically defined as the excess of the nominal value of a currency over its cost of production, seigniorage can be understood as an alternative source of revenue for the state beyond

what can be raised by taxes or by borrowing from financial markets. Sacrifice of the seigniorage privilege must also be compared against a monetary union's efficiency gains.

The instability of the system

Over estimation of Trade benefits

Some economists argue that the trade and cost advantages of EMU have been grossly over-estimated. There is little to be gained from moving from the present system which has some stability built into it, to the rigidities which EMU would bring.

Loss of SovereigntyThis means that country adopting the Common currency has to give up the Monetary policies to the body who is controlling the union, like in the case of European union all the 12 countries had to give up their monetary rights to the European central bank with decides the monetary policies for all the nation . Its biggest disadvantages come during the crisis when the situation are different in all the different countries and cannot be handled in the same way. Like in a case of sudden increase in the unemployment the governments income will decrease as taxes are not paid so the government will have to increase the taxes which will lead to further disaster decrease in the interest rates during the crisis will help some but will adversely affect the other . So it is very difficult to be in a currency union. Power would be transferred from domestic country to the other country. This would be highly undesirable because national governments would lose the ability to control policy.

Conversion costA further most important cost of currency unions arises when the common currency is introduced. Conversion costs are more readily quantifiable than the costs associated with the loss of the exchange rate policy tool and can be quite high. If a common currency is introduced, new bills and coins have to be made available and old ones have to be taken out of circulation. Consumers and businesses have to convert their bills and coins into new ones, and convert all prices and wages into the new currency. These changes involve costs as banks and businesses need to update computer software for accounting purposes and update price lists. Finally, economic agents have to get used to gathering information and making calculations in the new unit of account.

The other disadvantages of the Monetary unions are as follows, the one of the biggest disadvantage is the difference in languages with in turn leads to the decrease in the

mobility of labour “Language in Europe is a huge barrier to labour force mobility. This may lead to pockets of deeply depressed areas in which people cannot find work”.

REFERENCES

Book:- International Financial Management by P.G Apte

http://eh.net/encyclopedia/article/cohen.monetary.unions

http://library.thinkquest.org/19110/english/advantag/index.html

http://www.cepr.org/meets/wkcn/1/1457/papers/alesina.pdf

http://europa.eu/abc/12lessons/lesson_7/index_en.htm

Advantages1. Transaction costs will be eliminated.

For instance, Uk firms currently spend about £1.5 billion a year buying and selling foreign currencies to do business in the EU.With the EMU this is eliminated, so increasing profitability of EU firms.

Advice to young people: You can go on holiday and not have to worry about getting your money changed, therefore avoiding high conversion charges.

2. Price transparency.Eu firms and households often find it difficult to accurately compare the prices of goods, services and resources across the EU because of the distorting effects of exchange rate differences.

This discourages trade. According to economic theory, prices should act as a mechanism to allocate resources in an optimal way, so as to improve economic efficiency. There is a far greater chance of this happening across an area where E.M.U exists.

Advice to young people: We can buy things without wrecking our brains trying to calculate what price it is in our currency.

3. Uncertainty caused by Exchange rate fluctuations eliminated.Many firms become wary when investing in other countries because of the uncertainty caused by the fluctuating currencies in the EU. Investment would rise in the EMU area as the currency is universal within the area, therefore the anxiety that was previously apparent is there no more.

4. Single currency in single market makes sense.Trade and everything else should operate more effectively and efficiently with the Euro. Single currency in a single market seems to be the way forward.

5. Rival to the "Big Two".If we look out in the world today we can see strong currencies such as the Japanese Yen and The American $. America and Japan both have strong economies and have millions of inhabitants. A newly found monetary union and a new currency in Europe could be a rival to the "BIG TWO".EMU can be self-supporting and so they could survive without trading with anyone outside the EMU area.This fact makes the Euro very strong already, and even George Soros couldn't affect it (well, hopefully!!!!).The situation that EMU is in is good as it seems that it can survive on its own, with or without the help of Japan and U.S.A.

6. Prevent war.The EMU is, and will be a political project. It's founding is a step towards European integration, to prevent war in the union. It's a well known fact that countries who trade effectively together don't wage war on each other and if EMU means more happy trade, then this means, peace throughout Europe and beyond (we hope).

7. Increased Trade and reduced costs to firms.Proponents of the move argue that it brings considerable economic trade through the wiping out of exchange rate fluctuations, but as well as this it helps to lower costs to industry because companies will not have to buy foreign exchange for use within the EU. For them, EU represents the completion of the Single European Market. It is vital if Europe is to compete with the other large trading blocs of the Far East and North America.

8. The Political agenda.There is also a political agenda to European bank (the European System of Central Banks -ESCB), the complete removal of national control over monetary policy and the partial removal of control over fiscal policy. Individual nation states will lose sovereignty (i.e. the ability to control their own affairs). It will be a considerble step down the road towards political union. There are many in the EU who faviour economica dn political union and they are very much in facour ot EMU. There are also many who wish to keep national sovereignty and are strugging to prevent EMU, whatever its merits might be, from going ahead.

9. InflationFrom the mid-1980s onwards, there were a number of economists and politicians who argued that, for the UK at least, EMU provided the best way forward to achieve low inflation rates throughout the EU. During the first half of the 1980s high inflation countries, such as France and Italy were forced to adopt policies which reduced their inflation rates to something approximating the German inflation rates to something approximating the German inflation rate. If they had not done this, the franc and the lira would have had to be periodically devalued, negating the fixed exchange rate advantages of the system. Effectively, the German central bank, the Bundesbank, set inflation targets and therefore monetary targets for the rest of the EU. At the time, there was much discussion of why Germany had a better inflation record than many other European countries. The consensus emerged that it was because the Bundesbank, the German central bank, was independant of the German Government. In countries such as the UK and France, central banks were controlled by governments. If the UK government decided to loosen monetary policy, for example, by reducing interest rates, it had the power to order the Bank of England to carry out this policy on its behalf. There have always been especially strong pressures before an election for UK governments to loosen the monetary reins and create a boom in the economy, with the subsequent increase in inflation following the election. The Bundesbank, in contrast, was independent of government. By law it has a duty to maintain stable prices. It can resist pressures from the German government to pursue reflation policies if it believes that these will increase inflation within the economy. Events of the early 1990s have shaken the naieve faith that linkage to the independent ESBC, the central bank of Europe would solve all inflationary problems. This is because German inflation rates in the early 1990s rose to over 4% as Germany strugged with the consequences of unification. In 1993, inflation was nearly three times as high in Germany as in the UK and twice as high as that in France. Some countries, such as France, have made their central banks independent on the Germany model and therefore arguably don't need to the EMU link to Germany to maintained low inflation.The UK has gone a little way towards giving more power to the central bank by publishing reports of monthly meetings between the Chancellor of the Exchequer and the Governenor of the Bank of England. This forces the Government to justify its monetary policy publically and makes it harder for it to use interest rates for short term political ends.

Disadvantages1. The instability of the system.

Throughout most of the 1980s the UK refused to join the ERM (Exchange rate mechanism). It argued that it would be impossible to maintain exchange rate stability within the ERM, especially in the early 1980s when the pound was a petro-currency and when the UK inflation rate was consistently above that of Germany. When the UK joined the ERM in 1990 there had been three years of relative currency stability in Europe and it looked as though the system had become relatively robust. The events of Sept. 1992,

when the UK and Italy were forced to leave the system, showed that the system was much less robust than had been thought.

2. Over estimation of Trade benefits.Some economists argue that the trade and cost advantages of EMU have been grossly over estimated. There is little to be gained from moving from the present system which has some stability built into it, to the rigidities which EMU would bring.

3. Loss of Sovereignty.On the political side, it is argued that an independent central bank is undemocratic. Governments must be able to control the actions of the central banks because Governments have been democratically elected by the people, whereas an independent central bank would be controlled by a non elected body. Moreover, there would be a considerable loss of sovereignty. Power would be transferred from London to Brussels. This would be highly undesirabel because national governments would lose the ability to control policy. It would be one more step down the road towards a Europe where Brussels was akin to Westminster and Westminster akin to a local authority.

4. Deflationary tendencies.Perhaps the most important economic argument relates to the deflationary tendencies within the system. In the 1980s and 90's France succeeded in reducing her inflation rates to German levels, but at the cost of higher unemployent, For the UK, it can be aruged, that membership of the ERM between 1990 and 1992 prolonged unnecessarily the recessional period. This is because the adjustment mechanism acts rather like that of the gold standard. Higher inflation in one ERM country means that it is likely to generate current account deficits and put downward pressure on its currency. To reduce the deficit and reduce inflation, the country has to deflate its economy. In the UK, it could be argued that the battle to bring down inflation had been won by the time the UK joined the ERM in 1990. However, the UK joined at too high an exchange rate. It was too high because the UK was still running a large current account deficit at an exchange rate of around 3 Dm to the pound. The UK government then spent the next two years defending the value of the pound in the ERM with interest rates which were too high to allow the economy to recover. Many forecasts predicted that, had the UK not left the ERM in Sept 1992, inflation in the UK in 1993 would have been negative (ie prices would have fallen).The economic cost of this would have been continued unemployment at 3million and a stagnant economy. When the UK did leave the ERM and it rapidly cut interest rates from 10% to five and a half %, there was strong economic growth and the current account position improved, but there was an inflation cost. 

Another problem that the early 1990s highlighted was that the needs of one part of Europe can have a negative impact on the rest of Europe. In the early 1990s, the Germans struggled with the economic consequences of German reunification. There was a large increase in spending in Germany with a consequent rise in inflation. The Bundesbank responded by raising German interest rates. As a result, there was an upward pressure on the DM as speculative money was attracted into Germany. Germansy's ERM

partners were then forced to raise their interst rates to defend their currencies. However, higher interest rates forced most of Europe into recession in 1992 - 1993. Countries such as France couldn't then get out of recession by cutting interest rates because this would have put damaging strains on the ERM. The overall result was that Europe suffered a recession because of local reunification problems in Germany. Critics of the ERM and EMU argue that this could be repeated frequently if EMU were ever to be achieved. Local economies would suffer economic shocks because of policies, forced on them, designed to meet the problems of other parts of Europe.One way around this would be to have large transfers of money from region to region when a local area experienced a recession, e.g. N. Ireland which suffered structural unemployment for most of the post war period, has had its economy propped up by large transfers of resources from richer areas of the UK with lower unemployment. However, regional transfers are very small at the moment unfortunately. Moreover to approximate the regional transfers which occur at the moment in, say, Britain, there would have to be a huge transfer of expenditures from national governments to Brussels - just what anti Europeans are opposed to.

Emu benefit

 

If everything goes to plan, by 2002, participating member states of the European Union will have ditched their national currency in favour of the euro, a single European currency.

The advantages and disadvantages of joining the European Monetary Union (Emu) will vary from country to country, and are difficult to predict. Within the EU, each member state has its own financial system; therefore the introduction of the Euro will make a different impact on each country's economcy.

But economists say that there are a number of advantages in signing up to the euro:

Currency stability

A single currency should end currency instability in the participating countries (by irrevocably fixing exchange rates) and reduce it outside them.

Because the euro would have the enhanced credibility of being used in a large currency zone, it would be more stable against speculation than individual currencies are now.

An end to internal currency instability and a reduction of external currency instability would enable exporters to project future markets with greater certainty. This could unleash great potential for growth.

Tourism

Consumers would not have to change money when travelling within the euro zone, and would encounter less red tape when transferring large sums of money across borders.

Travellers will no longer be forced to change money and pay banks the commission charges.

A consumer might wish to make one large purchase or transaction across a European border such as buying a holiday home or a piece of furniture. A single currency would help such transactions pass smoothly.

Business benefits

Likewise, businesses would no longer have to pay hedging costs which they do today in order to insure themselves against the threat of currency fluctuations.

Businesses, involved in commercial transactions in different member states, would no longer have to face the costs of accounting in different currencies.

Surprisingly, small firms stand the most to gain. Experts estimate that currently the currency cost of exports is ten times higher for small companies than for multi-nationals, who can offset sales against purchases and command the best rates.

Cheaper mortgages, lower interest rates

A single currency should also result in lower interest rates as all member countries if the new European Central bank takes on the monetary credibility of Germany's Bundesbank.

The stability pact (the main points of which were agreed at the Dublin summit of European heads of state or government in December 1996) will force EU countries into a system of fiscal responsibility which will enhance the euro's international credibility.

This should lead to more investment, more jobs, lower interest rates - and for home owners to lower mortgages.

Introduction

In recent years, there has been a huge increase in interest in exchange rate regimes, both within New Zealand and internationally. Should countries maintain their own currencies, or adopt the currency of some other country or group of countries? If countries maintain their own currencies, should they "float", or attempt to "peg" to the currency of some other country?

As you know, New Zealand has had its own currency for many decades, and since March 1985 that currency has been floating against other currencies, with its value determined day to day in the financial market. But through the mid-nineties as our exchange rate appreciated strongly, many people became concerned about whether this was the best arrangement for New Zealand (between early 1993 and early 1997, an inflation-adjusted trade-weighted measure of the New Zealand dollar appreciated by some 29 per cent, putting considerable pressure on exporters and those competing with imports).

Interest in the subject has become even more widespread in the last couple of years, with 11 of the countries of Europe abandoning their own currencies and forming a currency union, and with the growing interest in several Latin American countries in adopting the United States dollar. Last month, Sir Frank Holmes and Dr Arthur Grimes, two highly-regarded economists, released a study they had undertaken for the Australia New Zealand Business Council entitled An ANZAC dollar?, and this has further intensified public and political interest in the matter. It is clear that there is strong interest in the subject on the part of the business community.

So today I want to make some comments from a Reserve Bank perspective.

But at the very outset I want to make it clear that any decision to abandon our own currency is fundamentally a political issue. Currency unions are generally formed as part of a larger strategic push to integrate the countries entering the currency union, often in combination with free trade agreements, harmonisation of legal standards, and liberalised migration laws. Viewed in this way, entering a currency union is a major foreign policy decision, and thus a matter for elected politicians. It is not a matter on which a central banker should express an overall opinion, and I will not be doing so.

But the choice of currency regime does have important economic implications which need to be carefully assessed, and I believe it is appropriate for me to comment on those.

One other point should be clarified at the outset. There are some differences between "currency union" (implying a new central bank and a new currency to cover a range of countries and currencies, as in the case of the European Monetary Union) and "dollarisation" (implying the simple adoption of the currency of another country, whether in New Zealand's case that be the Australian dollar or the United States dollar). And the most important of those differences for us is whether New Zealand would have any part in making the decisions about the monetary policy which would affect us. In a currency union, all the countries included in the union in principle have a say in forming monetary policy for the area covered by the union. All countries have a voice at the table, even if that is only a single voice among many. In the case of dollarisation, however, only the country whose currency is adopted makes the decisions about monetary policy.

The study by Sir Frank Holmes and Arthur Grimes suggested that a currency union with Australia (involving a new central bank for both countries, and a new currency) could have some useful benefits for New Zealand. And they suggested a currency union, rather than New Zealand's adoption of the Australian dollar, largely for reasons of political acceptability in New Zealand.

Whether such an approach would meet the political acceptability test in Australia, of course, is a bit debatable. Preliminary comments from Australia suggest no interest whatsoever in abandoning the Australian dollar in favour of a new trans-Tasman currency. But whether currency union with Australia, or the simple adoption of the Australian dollar by New Zealand, the outcome would in substance be very similar. With the exception of who gets the seigniorage income, on which I will comment in a moment, both options would involve New Zealand's relinquishing any effective control over monetary policy in New Zealand.

In the case of the United States dollar, currency union is not even being raised as a possible option. The only possibility in that case would involve New Zealand's adopting the United States dollar. And that too, of course, would mean relinquishing any control over our own monetary policy. Since the term "currency union" has been widely used in New Zealand to include both currency union as

properly understood and the simple process of adopting another country's currency, I will for the most part use the term "currency union" in the balance of my comments, while recognising that for all practical purposes we are talking about "dollarisation", be it "Australian dollarisation" or "US dollarisation".

Some myths about currency union

Before I comment on some of the economic advantages and disadvantages of currency union, it might be helpful to dispose of a few of the myths that have become rather prevalent.

The first myth is that the Reserve Bank is opposed to currency union, perhaps because "Don Brash would lose his job". Certainly, if we "dollarised", using either the Australian dollar or the US dollar, there would be no need for anybody to be employed by the Reserve Bank of New Zealand and those now employed by the Bank would lose their jobs. If we went into a currency union, presumably with Australia, it is also likely that many existing Reserve Bank staff would lose their jobs (though I must admit that the European precedent perhaps suggests that job losses would not be great in that situation!). But I can assure you that neither the Reserve Bank nor Don Brash is opposed to currency union. Nor are we promoting currency union. As indicated a moment ago, the Bank's responsibility is to advise Ministers about the economic implications of currency union, both the pros and the cons, and to foster informed public discussion on the issue.

The second myth is that small countries are in some ways just too vulnerable to have their own currencies in the modern world. This is sometimes expressed in terms of the metaphor of a tiny rowing boat, tossed around in a turbulent ocean, with the turbulence arising from the vast flows of capital which every day wash backwards and forwards at the click of a mouse. But there are some extremely successful small countries with their own currencies - Singapore and Switzerland spring immediately to mind - and, contrary to popular mythology, the New Zealand dollar is not a particularly volatile currency.

Not a particularly volatile currency? No. The Reserve Bank has looked at this issue both in terms of short-term volatility and in terms of the big exchange rate swings which are, I suspect, of rather greater concern.

Looking at short-term volatility (measured as 30 day volatility against the United States dollar), the New Zealand dollar was more volatile than the Australian dollar, the British pound, the Japanese yen, and the German mark between the time of the float in March 1985 and August 1988. But for most of the period since September 1988, and indeed on average over that whole 12 year period, the New Zealand dollar has been somewhat less volatile than any of those currencies.

Looking at the big exchange rate swings which made life difficult for exporters and those competing with imports at some stages during the last decade, we compared the size of the exchange rate appreciation from trough to peak for each of the same currencies. We found that the maximum appreciation which the New Zealand dollar experienced during the decade (measured on an inflation-adjusted, trade-weighted, basis) was, to be sure, at 29 per cent rather greater than that experienced by the Australian dollar (at 20 per cent), but was closely similar to the maximum trough-to-peak appreciation experienced by the German mark (27 per cent), the United States dollar (also 27 per cent) and the British pound (31 per cent), and very substantially smaller than that experienced by the Japanese yen (62 per cent). In other words, as I have indicated on other occasions and contrary to much current mythology, the big exchange rate swings experienced by the New Zealand dollar during the nineties were not in the least unusual by the standards of other currencies.

This suggests rather unambiguously that, while currency union would eliminate nominal exchange rate uncertainty for New Zealand traders trading within the currency union, there is no currency which we could adopt which would eliminate big exchange rate swings against countries outside the currency

union. And since New Zealand's trade with Australia amounts to little more than 20 per cent of the total, a currency union with Australia would still leave most of our exporters facing currency uncertainty. In other words, currency union with Australia would buy nominal exchange rate certainty for those handling little more than 20 per cent of our trade (perhaps especially those in the manufacturing sector), while leaving those handling the other 80 per cent of our trade still facing such uncertainty.

And I say currency union would buy some traders "nominal exchange rate certainty" to make it clear that currency union would not buy anybody real exchange rate certainty, or in other words, certainty of a constant exchange rate after inflation has been taken into account. This is something which Hong Kong has discovered over the years. Although it has had a currency which has been tightly tied to the US dollar since the early eighties, its real, or inflation-adjusted, exchange rate has appreciated quite strongly, both because the US dollar has appreciated against most other currencies and because Hong Kong's inflation rate has been markedly higher than that in the United States. This has led to the steady erosion of the competitive position of Hong Kong's manufacturing sector, and indeed has been one of the factors leading to a move of manufacturing out of Hong Kong into southern China.

The third myth is that a currency union with Australia would greatly increase competition in the New Zealand banking sector, to everybody's benefit. I find it very hard to see why this might be the case given that all of the large Australian banks are already actively involved in the New Zealand market. Moreover, New Zealand already has an open and contestable banking sector. There are few regulatory obstacles to foreign banks entering New Zealand, provided that they meet certain minimum qualitative criteria. It is clearly not necessary to enter a currency union in order to derive the benefits of foreign competition in the banking sector. In this regard, I was struck by the figures released by KPMG earlier this month, which suggested that the net interest margin earned by the major banks in New Zealand has been falling steadily in recent years, and is now markedly lower than the net interest margin earned by Australian and US banks.1

The fourth myth is that currency union with Australia would somehow suddenly enable the New Zealand economy to grow as quickly as the Australian economy, or enable New Zealanders to be instantly richer. That perception appears to drive quite a lot of the public comment on this matter. But of course that is nonsense. The fundamental driver of living standards in New Zealand is the rate at which we can improve productivity. Currency union may have a modest bearing on our productivity performance, as I will argue in a moment, but fundamentally productivity is about the quality of our education system, the quality of New Zealand management, the incentives provided by the tax and benefit system to work and acquire skills, attitudes to work and leisure, the pace of innovation, and so on. Currency union would have little effect on these matters. Currency union within Australia itself has certainly not guaranteed that economic growth in Tasmania and South Australia will match that in Queensland - any more than currency union within New Zealand has guaranteed that Southland will enjoy Auckland growth rates. And Panama's adoption of the US dollar in 1904 has not enabled Panama to perform as well as the US economy. Other factors, and other policies, are very much more important for our long-term growth than whether we are part of a currency union.

And my final myth is the argument that, because other countries are forming currency unions, or dollarising, New Zealand should do the same. But the reasons why other countries are forming currency unions or dollarising have very little relevance to New Zealand. The countries of the European Monetary Union formed a currency union, involving a new central bank and a new currency, in a situation where intra-union trade flows were a high proportion of the trade of most of the member countries (certainly a much higher proportion than is the New Zealand/Australia situation), and where currency union was simply one part of a very much wider agenda of political, economic, and regulatory integration. The countries of Latin America have, in some cases, locked themselves to the US dollar, and in some cases are thinking of full US dollarisation, after decades of extremely poor money management and hyper-inflation. Neither of these situations has any relevance to New Zealand.

Moreover, in the last few years a large number of countries, particularly but not exclusively in Asia, have movedaway from tying their currencies tightly to some other currency, in favour of a floating

exchange rate. Certainly there has not been a generalised international move towards currency union or dollarisation.

The real economic pros and cons of currency union

But there are some valid arguments why a currency union might have economic advantages.

To begin with, a currency union seems certain to reduce the transaction costs incurred now by traders and travellers exchanging New Zealand dollars for other currencies. This would probably not produce a huge saving in a currency union with Australia - although there would be worthwhile benefits for tourists in both directions - but, because so much international trade is conducted in US dollars, the savings would be rather greater if we were to adopt the US dollar as our own currency.

Second, a currency union with Australia might reduce average New Zealand interest rates a little. Over the last decade or so, Australian long-term interest rates have been pretty similar to those in New Zealand, but for much of that period (though not currently) Australia's short-term interest rates were appreciably lower than those in New Zealand. Adopting the US dollar would currently reduce interest rates in New Zealand by rather more. Although the differences are much less now than they were a decade ago, US interest rates are currently lower across the entire range of maturities than those in New Zealand. By adopting either the Australian dollar or the US dollar, we would avoid the need to pay the currency risk premium which savers currently demand for holding New Zealand dollar assets. (There could well be on-going differences in interest rates between New Zealand on the one hand and Australia or the United States on the other, of course, arising from credit and liquidity risks, but the differences would be smaller than currently.)

But it is also the case that a currency union would remove any chance of New Zealand interest rates falling belowthose in Australia (or the United States, if it was the US dollar we adopted). While it might seem unlikely that New Zealand interest rates would ever fall below those in Australia and the United States, it is worth recalling that New Zealand's long-term interest rates were somewhat lower than those in Australia through the first half of the nineties and slightly lower than those in the United States for a time in 1994; and that most interest rates in Canada, Singapore, Switzerland and the European Monetary Union are below those in the United States today.

The main reason why New Zealand interest rates have been so high in the last decade is that through much of that period we have been coping with the hang-over of high inflationary expectations, especially in the property market, the result of two or three decades of high inflation bingeing. The United States had very high interest rates in the early eighties, as it grappled with high inflationary expectations. If New Zealand continues to keep inflation well under control, and continues to maintain the confidence of financial markets by following a prudent fiscal policy, it seems entirely reasonable to expect that in time New Zealand interest rates could fall below those in both Australia and the United States. In forming a currency union, we would in effect be betting that, no matter with whom we formed that currency union, their policy performance would be better than our own could have been for the indefinite future.

Third, while currency union, with Australia or any other single country, would not eliminate the exchange rate uncertainty which New Zealand exporters face, it would clearly eliminate the nominal exchange rate uncertainty for trade with the country or countries forming part of the currency union (and probably reduce the real exchange rate uncertainty also). As indicated earlier, a currency union with Australia would eliminate nominal exchange rate uncertainty on only a relatively small part of our total trade, but it is quite an important part of our trade in a qualitative sense. A much larger part of our manufactured exports go to Australia than to any other single destination, and the Australian market is particularly important as a "testing ground" for small companies just getting into the business of exporting.

As a result of this reduction in exchange rate uncertainty within the currency union, it seems very likely that currency union would stimulate trade with other parts of the currency union. Empirical research on the effects of currency uncertainty on trade is, unfortunately, not very conclusive, with some studies suggesting that the effects of currency uncertainty are actually pretty small and others suggesting that they are quite significant. My own rather subjective view is that a currency union would indeed increase trade between New Zealand and other parts of the union, and that seems to be the view of the business community also. If that is correct, then a currency union, with Australia or the United States, would stimulate trade within the currency union, and to that extent could produce some worthwhile productivity gains, as New Zealand producers moved into areas of greatest comparative advantage. This is probably particularly true of a currency union with the United States. There is already substantial trans-Tasman trade, and for that reason arguably less scope for increasing it through the creation of a currency union.

On the other side of the ledger, there would be one potentially major and one more minor disadvantage of a currency union.

The potentially major disadvantage would be the loss of an independent monetary policy, and hence loss of a very important way of moderating demand shocks and of any ability to influence our own inflation rate. And this loss would seem to apply whether the currency union was with Australia or the United States, and whether it involved the creation of a new central bank (possible in the case of Australia) or simply dollarisation. (Clearly, in the event of New Zealand's entering a formal currency union with Australia, involving a new central bank with representatives from both countries and a new currency, New Zealand would have some say in the formulation of monetary policy, but realistically that say could only ever be a small voice alongside the much larger voice of the Australian economy.)

Views will differ on how important that loss would be. But we can see from recent international experience that the loss can have very substantial and sometimes very adverse implications. And those implications would potentially be more significant if we were to form a currency union with the United States than if we were to form a currency union with Australia, given the broad similarity between the New Zealand and Australian economies.

There seems little doubt that the fact that Argentina has had a more prolonged recession over the last few years than have some of the other major countries of Latin America has been largely a result of the fact that Argentina has been tightly tied to the United States dollar through its currency board arrangement. As a consequence, the Argentine currency has been pushed upwards, along with the US dollar, against the currencies of many of Argentina's trading partners. Similarly, Hong Kong seems to have had a more prolonged recession than many other Asian economies for the same sort of reason. (Interestingly, during the nineties the trade-weighted real appreciation of the Hong Kong dollar, tied tightly to the US dollar, was much greater than the maximum appreciation of the New Zealand dollar during the nineties.) Conversely, it seems clear that within the European Monetary Union some of the smaller economies such as Ireland have been over-heating rather dramatically recently, with monetary policy determined by the new European Central Bank in the interests of the whole currency union almost certainly too easy for those smaller economies. While that may create prosperity in the short-term, it may create considerable difficulties down the road.

I well recall the mid-nineties, when the most common complaint I encountered speaking to audiences outside Auckland was that they were suffering from high real interest rates and a rising real exchange rate even though there was no inflation (so at least it was claimed!) in those areas, the only inflation being confined to Auckland. Even had these claims been true, the reality was that all parts of New Zealand formed then, and still form, a currency union, and there is only room for one interest rate structure and one exchange rate within a currency union. Were we to join Australia in a currency union, our interest rates and the exchange rate we faced would be influenced by the common central bank (in the case of a genuine currency union), or by the Reserve Bank of Australia (in the case of Australian dollarisation). In practice, it would be the needs of the Australian economy which would dominate the monetary policy decisions in either case. And of course, adopting the US dollar would mean accepting whatever monetary policy seemed appropriate for the US economy.

This would probably tend to increase the magnitude of New Zealand business cycles, and the variability of New Zealand's inflation rate. With no ability to use New Zealand monetary policy to deal with these cycles, it would be necessary to use fiscal policy more actively, and to encourage more flexibility, both up and down, in prices and wages, to moderate these cycles.

The minor disadvantage of dollarising, and at this point I need to make a distinction between dollarising and forming a currency union where a new currency is established for the countries forming part of the union, would be the loss of what central bankers call seigniorage income. This is the income which a central bank generates by issuing little pieces of paper, or in our case little pieces of plastic, and calling them money. What happens is that we issue these little pieces of plastic in exchange for good value, and we invest that value in government securities at the going market interest rate. The interest income earned is called seigniorage income, and in New Zealand it amounts to about $130 million each year (a currency on issue of a little over $2 billion, invested in government securities to yield somewhat over 6 per cent per annum). If we were to join a currency union modelled on the European Monetary Union, we would retain a share of the seigniorage income appropriate to our relative size in the new currency union. But if we were simply to adopt the Australian dollar or the US dollar, it is very likely that we would lose the benefit of that income to the country whose currency we adopted. Not a huge loss perhaps, but $130 million each year, growing gradually, should not be given away without some thought!

How to weight the pros and cons?

As I indicated at the commencement of my comments, joining a currency union, or adopting the currency of another country, has potentially important implications which go well beyond economic issues. But even focusing on the economic issues, weighting the various pros and cons is not easy.

It is sobering to note that Canada, a country doing almost 80 per cent of its trade with the United States, has nevertheless chosen to retain its own currency. And a recent article by a senior economist at the Bank of Canada argued that, given the way in which Canada's terms of trade behave relative to those of the United States, having a separate Canadian currency was very much in Canada's national interest.2

It seems clear from the survey conducted for the Holmes/Grimes study by the National Bank of New Zealand that a substantial majority of the New Zealand business community - or at very least a substantial majority of those who responded to the survey - are in favour of a currency union with Australia.

But I am not myself entirely sure what to make of this strong support for currency union with Australia. Of coursebusinesses are in favour of less currency uncertainty. I suspect if the business community were asked if they were in favour of lower taxation they would also register a strongly favourable reaction. The real question is not whether less currency uncertainty would be helpful but whether less currency uncertainty would compensate for the costs of a currency union, such as the risks of greater variability in output and domestic inflation. And the answer to that question is much less clear.

To illustrate, let's suppose there is a sharp fall in New Zealand export prices. With our own currency, this is quite likely to lead to a fall in the New Zealand dollar, as it did in the second half of 1997 and 1998. This fall in the currency cushions New Zealand exporters to some extent from the adverse impact of the fall in world commodity prices, effectively by spreading the "pain" of that fall across the rest of us, who find that our New Zealand dollars can now buy fewer imports than before. Without our own currency, on the other hand, there is an increased risk that a fall in New Zealand export prices leads to no fall in our (new) currency, our exporters have to suffer the full pain of the fall in international prices, and may well be forced to lay off staff and reduce output. That has an indirect

effect, of course, on the rest of the country, but those who are not closely associated with the export industries may be relatively little affected.

In the final analysis, the choice of exchange rate regime is mainly a choice about the nature of the pain we prefer to experience as a consequence of international shocks. It does not provide an opportunity to escape the pain inevitably caused by those shocks.

Conclusion

It would be nice to conclude my comments today with a clear conclusion, or an on-balance judgement. I don't propose to do that, partly because the decision about currency regime is, as I have indicated, finally a matter for elected politicians not for central bankers, and partly because even the economic pros and cons do not point to a clear conclusion.

Moreover, it may well be appropriate to widen the range of options somewhat, and to think more laterally before we reach any conclusions at all. For example, might it be possible to negotiate a comprehensive free trade agreement with the United States as part of a package involving our adoption of the US dollar and surrender of the relevant seigniorage income? Losing the seigniorage income might well be a worthwhile concession in return for a free trade agreement with the US.

Clearly, there are lots of potential options. There can be little doubt that this issue will be a matter for public discussion and debate for a considerable time to come. I believe the Reserve Bank has already made a constructive contribution to that discussion, through the publication of a number of papers relevant to the issue.

But it is crystal clear that currency union is not a magic path to substantially faster New Zealand growth. It is no substitute for domestic policies that promote stronger productivity growth. It is not an issue which should be decided in haste. And it is not an issue on which the Reserve Bank will be taking sides. Anybody who accuses me of promoting a currency union, or for that matter of opposing a currency union, has not read this speech!

The Euro: Advantages and Disadvantages Of A Single Currency

Every national currency around the globe is subject to identical market laws and its

value changes according to the same factors that influence all other currencies. Within

the Eurozone, all countries share the same currency - the euro, and are less affected by

changes in the euro exchange rate.

There are many advantages of the euro adoption by the countries in the Eurozone,

despite that disadvantages also exist, and the most well known are the following:

obliteration of the existing exchange rate fluctuations between a number of currencies

and reduction of transaction costs (no other currency is necessary when conducting

business or travelling in the Eurozone). The single European currency also stimulates

trade activities and free movement of capital, goods and people but these effects

should be subject to a profound academic research.

Previously, the national economies of the European Union member states sometimes

suffered from fluctuations of the local currencies within a common market. The euro

exchange rate does not offer shelter from currency fluctuations in general but provides

predictability and unifies the means of exchange in all countries in the Eurozone.

Following the adoption of the euro, 12 countries in the EU witnessed their national

currency disappear with more new member states entering the Eurozone gradually and

other waiting at the door.

Thus, all current members of the Eurozone take advantage of the single currency but

they share the same disadvantages as well. When the U.S. Federal Reserve releases

data showing increasing unemployment rate, falling number of new mortgages and

growing number of businesses going bankrupt the most immediate consequence will

be a falling exchange rate of the U.S. dollar. The same applies to the single European

currency, but in addition to the data released by the European Central

Bank, Forex traders around the globe take decisions whether to buy or not to buy euro

depending on data about the national economies of the countries participating in the

Eurozone. Hence, negative signals reported by the French or German economy could

result in depreciation of the euro exchange rate as a whole despite that the economies

of all other Eurozone member states are running smoothly.

From the average customers’ point of view, the single euro exchange rate is a good

thing, though. There is no need to exchange your money into a new currency every

time you cross a border within the Eurozone. The euro facilitates also the currency

transfers within and outside the EU and reduces the costs of such transfers. As a rule,

the risks of a currency collapse cannot be eliminated but the safety provided by the

euro is good enough to reduce such risks to a minimum and to maintain largely

predictable euro exchange rate.