BACKGROUND INFORMATION

IMPACTS OF THE EUROPEAN ECONOMIC AND MONETARY UNION

On 1 January 1999, stage 3 of the European Economic and Monetary Union (EMU) will be launched. Eleven member states of the European Union will introduce the single currency (euro) and single monetary and exchange rate policy. The impact on the real economy, foreign exchange and financial sector will be felt all over the world but the strongest and most direct impact will be on the countries in the euro zone and on countries that have close trade and financial relations with the euro zone, ie the rest of the EU member states, Norway, Switzerland and the Central and Eastern European countries.

It is difficult to distinguish the impact of the single currency from the effect of the general integration. Undoubtedly preparations for EMU have accelerated and strengthened European integration and the interaction of these two processes has helped to improve the economic situation in Europe. Thus, the economic position of the countries entering stage 3 is favourable: inflation is low, expectations related to the start of single currency and fiscal consolidation together with accelerating economic growth have lowered interest rates, and both changes in the global environment as well as the preparation for the single currency have promoted consolidation of the European financial sector.

Trade-related Impacts

EMU will have through trade relations a dual impact on the real economy of the European countries. Countries exporting into EMU countries would benefit from probably higher import demand in the euro area. This aspect will influence primarily the European countries. Among the Central and Eastern European countries, the impact should be the strongest on Hungary, as it has the closest relations with the EU (71% of Hungary's exports goes to the EU, compared with 64% of Estonia's exports). The development of the single market with a single currency should facilitate trade relations even further. Potential trade growth within EMU resulting from increasing competitiveness in the euro area in mid-term could create trade diversion which is unfavourable for other exporting countries. It would probably happen as the use of euro will enhance the transparency of prices and costs, eliminate foreign exchange risk and related costs as well as currency exchange costs, leading to a further restructuring and integration of markets in the euro area.

Impacts Related to the Exchange Rate

The overall opinion is that the volatility of the euro exchange rate could increase in the beginning of stage 3 of EMU. It would be facilitated by both the lack of experience in the European Central Bank as well as by the inadequacy of common economic and other indicators and insecurity caused by differences in economic cycles and the uncertainty concerning the future fiscal and structural reforms. Exchange rate fluctuations of euro against eg US dollar would increase the exchange rate risk; the latter would affect trade flows. Exchange rate volatility could affect debt servicing costs in case of a large foreign debt if the foreign exchange structure of the external debt does not correspond to that of the trade.

Fixing the exchange rate against the euro could be even more favourable than fixing it against the currency of a single country (German mark): the larger and more diversified economy of the euro area will reduce the threat of demand shock transfer. Pegging a national currency to the euro will protect against the negative impact of exchange rate volatility in case of close trade relations. This factor is of direct importance in the case of Estonia. After Germany joins the euro zone, Estonia will peg the kroon to the euro at the conversion rate of the German mark.

Impacts of the Euro on the Financial Sector

Apart from higher exchange rate fluctuations, interest rates can also be volatile in the beginning. The negative impact of interest rate volatility could be in particular noticeable in countries with a fixed exchange rate, especially in countries with internationally integrated financial markets. Unstable interest rates could affect Central and Eastern European countries with a large and/or short-term foreign debt in the euro. However, the European Central Bank seems to be committed to ensuring low and stable inflation in the euro area, reducing, thus, the potential volatility of interest rates and capital flows.

The loss of profits from foreign exchange and hedging of currency risk, as well as the enlargement of the financial markets and the liquidity growth through the disappearance of protectionism and segmentation, will enhance competition in the financial sector. Naturally, the impacts of the EMU are intertwined with changes in the global environment. The surge in the number of mergers and take-overs in the European financial sector will sooner or later reach the Central and Eastern European countries as well.

Presumably low interest rates in EMU and a larger and more liquid capital market will increase capital mobility as well. It will happen in several ways:

1. borrowing costs will go down both for issuers in the euro area and for issuers of other euro-denominated instruments;
2. financial institutions in the euro area (insurance companies, pension funds) will diversify their portfolios to include the emerging markets;
3. direct and portfolio investments to the Central and Eastern European countries will increase, as profitability in the euro area will converge and investors from EMU countries will want to diversify their assets for risks, interest, and differences in economic cycles.

Whereas the impact of the start of EMU and the development of the economies of the participating countries is direct and strong, the direct impact on the USA, Canada and developed countries in Asia is much weaker as these regions have relatively little trade with the euro area. The indirect impact of EMU on the United States is more significant. In the long-term, the euro area market could become a fair competitor to low-risk T-bills and reduce capital inflow to the United States. Another indirect factor is the increasing role of the euro as a reserve currency.