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  • 1. -: A PROJECT REPORT ON:- EURO AND ITS IMPACT ON EUROPEAN ECONOMY PREPARED BY:- SUBMITTED TO:-SUPRIYA 35AFSANA 36 DEVANG KALEYOGESH 37 (SCHOOL OFLILA 38 MANAGEMENT-SVU) 1
  • 2. ABOUT EUROPE ECONOMYThe economy of Europe comprises more than 731 million people in 48 different states. It contributes 11% of the worlds population. Like other continents, the wealth of Europes states varies, although the poorest are well above the poorest states of other continents in terms of GDP and living standards. The difference in wealth across Europe can be seen in a rough East-West divide. Whilst Western European states all have high GDPs and living standards, many of Eastern Europes economies are still rising from the collapse of the communist Soviet Union and former Yugoslavia. Throughout this article "Europe" and derivatives of the word are taken to include selected states whose territory is only partly inEurope such as Turkey, Azerbaijan, and the Russian Federation and states that aregeographically in Asia, bordering Europe such as Armenia and Cyprus.Europe was the first continent to industrialize led by the United Kingdom in the 18th century and as a result, it has become one of the richest continents in the world today. Europes largest national economy is that of Germany, which ranks fourth globally in nominal GDP, and fourth in purchasing (PPP) GDP; followed by the UK, which ranks sixth globally in nominal GDP and fifth in PPP GDP; France, ranking seventh globally in nominal GDP, followed by Italy. The end of World War II has since brought European countries closer together, culminating in the formation of the European Union (EU) and in 1999, the introduction of a unified currency the euro. If the European Union was taken as a single country, today it would be the worlds largest economy see List of countries by GDP. In 2009 Europe remained the wealthiest region. Its $37.1 trillion in assets under management represented one-third of the world s wealth. It was one of several regions where wealth surpassed its pre crisis year-end peak. 2
  • 3. THE EORO CURRENCY:-The euro was introduced to world financial markets as an accounting currency in 1999 and launched as physical coins and banknotes in most of the above countries in 2002. Slovenia joined the Euro zone on 1 January 2007, Malta and Cyprus a year later, and Slovakia on 1 January 2009. All EU member states are eligible to join if they comply with certain monetary requirements, and eventual use of the euro is mandatory for all new EU member states.The euro is managed and administered by the Frankfurt-based European Central Bank (ECB) and the European System of Central Banks (ESCB) (composed of the central banks of its member states).As an independent central bank, the ECB has sole authority to set monetary policy. TheESCB participates in the printing, minting and distribution of notes and coins in all memberstates, and the operation of the Euro zone payment systems. 3
  • 4. CHARACTERISTICS OF THE EUROCoins and banknotesThe euro is divided into 100 cents (sometimes referred to as eurocents). All euro coins (including the 2 commemorative coins) have a common side showing the denomination (value) with the EU-countries in the background and a national side showing an image specifically chosen by the country that issued the coin. All coins can be used in all member states. The euro coins are 2, 1, 50c, 20c, 10c, 5c, 2c and 1c (known as tinies for their small size), though the latter two are not minted in Finland or the Netherlands (but are still legal tender). Many shop owners in the Euro zone prefer having all their prices end in 0 or 5 Cents, so that 1c and 2c coins are not needed. All euro banknotes have a common design for each denomination on both sides. Notes are issued in 500, 200, 100, 50, 20, 10, 5. Some of the higher denominations, such as 500 and 200, are not issued in a few countries, though are legal tender. The ECB has set up a clearing system for large euro transactions (TARGET). All intra-Euro zone transfers shall cost the same as a domestic one. This is true for retail payments, although several ECB payment methods can be used. Credit card charging and ATM withdrawals within the Euro zone are also charged as if they were domestic. The ECB hasnt standardized paper based payment orders, such as cheques; these are still domestic-based.The currency signA special euro currency sign ( ) was designed after a public survey had narrowed the original ten proposals down to two. The European Commission then chose the final design. The eventual winner was a design allegedly created by a team of four experts who have not been officially named. The official story of the design history of the euro sign is disputed by Arthur Eisenmenger, a former chief graphic designer for the EEC, who claims to have created it as a generic symbol of Europe.The glyph is (according to the European Commission) "a combination of the Greek epsilon, as a sign of the weight of European civilization; an E for Europe; and the parallel lines crossing through standing for the stability of the euro". The European Commission also specified a euro logo with exact proportions and foreground/background color tones. Although some font designers simply copied the exact shape of this logo as the euro sign in their fonts, most designed their own variants, often based upon the capital letter C in the respective font so that currency signs have the same width as Arabic numerals.Placement of the currency sign varies from nation to nation. While the official recommendation is to place it before the number (contravening the general ISO recommendation to place unit symbol after the number), people in many countries have kept the placement of their former currencies. 4
  • 5. ECONOMIC AND MONETARY UNIONHistory (1990-2006)The euro was established by the provisions in the 1992 Maastricht Treaty on European Union that was used to establish an economic and monetary union. In order to participate in the new currency, member states had to meet strict criteria such as a budget deficit of less than three per cent of their GDP, a debt ratio of less than sixty per cent of GDP, low inflation, and interest rates close to the EU average. Economists that helped create or contributed to the euro include Robert Mundell, Wim Duisenberg, Robert Tollison, Neil Dowling and Tommaso Padoa-Schioppa. (For macro-economic theory, see below.)Due to differences in national conventions for rounding and significant digits, all conversion between the national currencies had to be carried out using the process of triangulation via the euro. The definitive values in euro of these subdivisions (which represent the exchange rates at which the currency entered the euro) are shown as:- Currency Abbr. Rate Fixed on Austrian schilling ATS 13.7603 31/12/1998 Belgian franc BEF 40.3399 31/12/1998 Dutch gulden NLG 2.20371 31/12/1998 Finnish mark FIM 5.94573 31/12/1998 French franc FRF 6.55957 31/12/1998 German mark DEM 1.95583 31/12/1998 Irish pound IEP 0.787564 31/12/1998 Italian lira ITL 1936.27 31/12/1998 Luxembourg franc LUF 40.3399 31/12/1998 Portuguese escudo PTE 200.482 31/12/1998 Spanish peseta ESP 166.386 31/12/1998 Greek drachma GRD 340.750[4] 19/06/2000 5
  • 6. The rates were determined by the Council of the European Union, based on a recommendation from the European Commission based on the market rates on 31 December 1998, so that one ECU (European Currency Unit) would equal one euro. (The European Currency Unit was an accounting unit used by the EU, based on the currencies of the member states; it was not a currency in its own right.) These rates were set by Council Regulation 2866/98 (EC), of 31 December 1998. They could not be set earlier, because the ECU depended on the closing exchange rate of the non-euro currencies (principally the pound sterling) that day.The procedure used to fix the irrevocable conversion rate between the Drachma and the euro was different, since the euro by then was already two years old. While the conversion rates for the initial eleven currencies were determined only hours before the euro was introduced, the conversion rate for the Greek Drachma was fixed several months beforehand, in Council Regulation 1478/2000 (EC), of 19 June 2000.The currency was introduced in non-physical form (travellers cheques, electronic transfers, banking, etc.) at midnight on 1 January 1999, when the national currencies of participating countries (the Euro zone) ceased to exist independently in that their exchange rates were locked at fixed rates against each other, effectively making them mere non-decimal subdivisions of the euro. The euro thus became the successor to the European Currency Unit (ECU). The notes and coins for the old currencies, however, continued to be used as legal tender until new notes and coins were introduced on 1 January 2002.The changeover period during which the former currencies notes and coins were exchanged for those of the euro lasted about two months, until 28 February 2002. The official date on which the national currencies ceased to be legal tender varied from member state to member state. The earliest date was in Germany; the mark officially ceased to be legal tender on 31 December 2001, though the exchange period lasted two months. The final date was 28 February 2002, by which all national currencies ceased to be legal tender in their respective member states. However, even after the official date, they continued to be accepted by national central banks for several years up to forever in Austria, Germany, Ireland, and Spain. The earliest coins to become non-convertible were the Portuguese escudos, which ceased to have monetary value after 31 December 2002, although banknotes remain exchangeable until 2022.Current Euro zoney The euro is the sole currency in Austria, Cyprus, Belgium, France, Finland, Germany, Greece,Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain. These 16countries together are frequently referred to as the eurozone or the euro area, or more informallyEuro land or the Euro group. The euro is also legal currency in the Euro zone overseas territoriesof French Guiana, Reunion, Saint-Pierre et Miquelon, Guadeloupe, Martinique and Mayotte.y By virtue of some bilateral agreements the European microstates of Monaco, San Marino, andVatican City mint their own euro coins on behalf of the European Central Bank. 6
  • 7. y Andorra, Montenegro and Kosovo adopted the euro as their legal currency for movement ofcapital and payments without participation in the ESCB or the right to mint coins. Andorra is in theprocess of entering a monetary agreement similar to Monaco, San Marino, and the Vatican City.EFFECTS OF A SINGLE CURRENCYThe introduction of a single currency for many separate countries presents a number of advantages and disadvantages for the participating countries. Opinions differ on the actual effects of the euro so far, as most of them will take years to understand. Theories and predictions abound.Removal of exchange rate riskOne of the most important benefits of the euro will be lowered exchange rate risks, which will make it easier to invest across borders. The risks of changes in the value of respective currencies have always made it risky for companies or individuals to invest or even import/export outside their own currency zone. Profits could be quickly eliminated as a result of exchange rate fluctuations. As a result, most investors and importers/exporters have to either accept the risk or "hedge" their bets, resulting in further costs on the financial markets. Consequently, it is less appealing to invest outside ones own currency zone. The Euro zone greatly increases the potentially "exchange-risk free" investment area. Since Europes economy is heavily dependent on intra-European exports, the benefits of this effect can hardly be overstated. This is particularly important for countries whose currencies have traditionally fluctuated a great deal such as the Mediterranean countries.At the same time, this is likely to increase foreign investment in countries with more liberal markets and reduce that in those with rigid markets. Some people worry that thus will see profits flowing away from particular member states to the detriment of their traditional social values. It might also result in the reduction of local decision makers in businesses.Removal of conversion feesA benefit is the removal of bank transaction charges that previously were a cost to both individuals and businesses when exchanging from one national currency to another. Although not an enormous cost, multiplied thousands of times, the savings add up across the entire economy.For electronic payments (e.g. credit cards, debit cards and cash machine withdrawals), banks in the Euro zone must now charge the same for intra-member cross-border transactions as they charge for domestic transactions. Banks in France have attempted to circumvent this regulation by charging for all bank transfers (domestic and cross-border) unless the transfer is instructed via online banking a method unavailable to cross- 7
  • 8. border payments. In this way, banks in France continue to charge more for cross-bordertransfers than for domestic transfers.Deeper financial marketsAnother significant advantage of switching to the euro is the creation of deeper financial markets. Financial markets on the continent are expected to be far more liquid and flexible than they were in the past. There will be more competition for, and availability of financial products across the union. This will reduce the financial servicing costs to businesses and possibly even individual consumers across the continent. The costs associated with public debt will also decrease. It is expected that the broader, deeper markets will lead to increased stock market capitalization and investment. Larger, more internationally competitive financial and business institutions may arise.Price parityAnother effect of the common European currency is that differences in prices in particular in price levels should decrease. Differences in prices can trigger arbitrage, i.e. speculative trade in a commodity between countries purely to exploit the price differential, which will tend to equalise prices across the euro area. It is held that this is supposed to result in increased competition or consolidation of companies, which should help to contain inflation and which therefore will be beneficial to consumers. Similarly, price transparency across borders should help consumers find lower cost goods or services. In reality, the effects of the euro over the level of the prices in Europe are disputable. Many citizens cite the strong increase in prices in the years after the introduction of the euro, although numerous empirical studies have failed to find much real evidence of this. It is speculated that the reason for this perception is that the prices of small, everyday items were rounded up significantly. For example, a cup of coffee that once cost two German Marks might now cost 1.50 or even 2.00 - a 50-100% increase. At the same time, a large appliance or rent payment rounded up to the next obvious euro level would be a negligible proportional increase. The fact that the prices people see every day were affected more strongly might explain why so many people perceive the "euro effect" as being significant, while official studies which look at the breadth of expenditures, in proportion would downplay it.Competitive fundingCompetitive funding is also a benefit for many countries (and companies) that adopted the euro. National and corporate bonds denominated in euro are significantly more liquid and have lower interest rates than was historically the case when denominated in legacy currency. Likewise, companies have greater freedom to borrow competitively from cross- border banks without incurring exchange rate risk. This has forced the incumbent banks to reduce their rates to compete. 8
  • 9. Macroeconomic stabilityImproved macroeconomic stability is an important benefit of the euro for the entire continent. Much of Europe has been susceptible to economic problems such as inflation throughout the last 50 years. Because a high level of inflation acts as a highly regressive tax (Seigniorage) and theoretically discourages investment, it is generally viewed as undesirable. In spite of the downside, many countries have been unable or unwilling to deal with serious inflationary pressures. Some countries have successfully contained by establishing largely independent central banks. One such bank was the Bundesbank in Germany; since the European Central Bank is modeled on the Bundesbank, it is independent of the pressures of national governments and has a mandate to keep inflationary pressures low. Member countries join the bank to credibly commit to lower inflation, hoping to enjoy the macroeconomic stability associated with low levels of expected inflation. The ECB (unlike the Federal Reserve in the United States of America) does not have a second objective to sustain growth and employment.Less-specific monetary policySome economists are concerned about the possible dangers of adopting a single currency for a large and diverse area. As the euro-Zone has a single monetary policy and a single interest rate set by the ECB, it cannot be fine-tuned for the economic situation in each individual country. Prior to the introduction of the euro, however, exchange rate volatility had reduced substantially after the European currency crisis in the early 1990s. Public investment and fiscal policy in each country is thus the only way in which government-led economic stimulus can be introduced specific to each region or nation. This inflexible interest rate might stifle growth in some areas, while over-promoting it in others. The result could be extended periods of economic depression in some areas of the continent, disadvantaged by the central interest rate. Given such a situation, resentment and friction within the community and toward the bank might increase. Others point out that in todays globalised economy; individual countries do not really have power to effectively manage their monetary policy, as it creates other imbalances. This effect was already visible in the last European currency crises of 1992, when the Bundesbank was effectively coordinating monetary policy for the whole continent.Some proponents of the euro point out that the Euro zone is similar in size and population to the United States, which has a single currency and a single monetary policy set by the Federal Reserve. However, there are also substantial differences between the two regions. The US has a common fiscal policy (Fiscal federalism) that it can use as an instrument to smooth out regional differences. The countries of the EU that may not all be in sync each may be at a different stage in the boom and bust cycle, or just be experiencing different inflationary pressures cannot appeal to a centralized fiscal authority for remedy. Furthermore, Labor mobility is also much lower in the Euro zone than across the United States, largely due to the vast differences in language and culture between European nations despite labor, capital and goods full mobility rules. 9
  • 10. A new reserve currencyThe euro will probably become one of two, or perhaps three, major global reserve currencies. Currently, international currency exchange is dominated by the US dollar (USD). The US dollar is used by banks world-wide as a stable reserve on which to ensure their liquidity and international transactions and investments are often made in US dollars.A currency is attractive for foreign transactions when it demonstrates a proven track record of stability, a well-developed financial market to dispose of the currency in, and proven acceptability to others. The euro will almost certainly be able to match these criteria at least as well as the US dollar, so given some time to become accepted, it will likely begin to take its place alongside the dollar as one of the world s major international currencies.Since money is effectively an interest free loan to the government by the holder of the currency foreign reserves act as subsidy to the country minting the currency (see Seigniorage). As the euro assumes status a reserve currency, the EU member states stand to gain a share of this benefit.Euro and petroleumThe Euro zone consumes more imported petroleum than the US, meaning more Euros than US dollars would flow into the OPEC nations. However, oil is priced by those member states in US dollars only. There have been frequent discussions at OPEC about pricing oil in Euros. In 2006, Iran announced its plans to open an International Oil Bourse for the express purpose of trading oil priced in other currencies, including petroeuros. This would require countries to hold stores of Euros to buy oil, rather than the US dollars they hold now. If implemented by OPEC, the changeover to the euro would be a transfer of a float that presently subsidizes the United States to subsidies the European Union instead. 10
  • 11. EURO EXCHANGE RATEFlexible exchange ratesThe ECB targets interest rates rather than exchange rates and in general does not intervene on the foreign exchange rate markets, because of the implications of the Mundell-Fleming Model, being the fact that a central bank cannot maintain an interest rate target and an exchange rate target simultaneously, as increasing the money supply would result in a depreciation of the currency. In the years following the Single European Act, the EU has liberalized its capital markets, and as the ECB has chosen for monetary autonomy, the exchange rate regime of the euro is flexible, or floating. This explains why the exchange rate of the euro vis-à-vis other currencies is characterized by strong fluctuations. Most notable are the fluctuations of the euro vs. the US dollar, another freely floating currency. However this focus on the dollar-euro parity is partly subjective. It is taken as a reference because the European authorities expect the euro to compete with the dollar. The effect of this selective reference is misleading, as it give to the observers the impression that a rise in the value of the euro vs the dollar is the effect of an increased global strength of the euro, while it may be the effect of an intrinsic weakening of the dollar itself.Against other major currenciesAfter the introduction of the euro, its exchange rate against other currencies, especially the US dollar, declined heavily. At its introduction in 1999, the euro was traded at US$1.18; on 26 October 2000, it fell to an all time low of $0.8228 per euro. It then began what at the time was thought to be a recovery; by the beginning of 2001 it had risen to nearly $0.96. It declined again, although less than previously, reaching a low of $0.8344 on 6 July 2001 before commencing a steady appreciation. The two currencies reached parity on 15 July 2002, and by the end of 2002 the euro had reached $1.04 as it climbed further.On 23 May 2003, the euro surpassed its initial ($1.18= 1.00) trading value for the first time. At the end of 2004, it had reached a peak of $1.3668 per euro ( 0.7316 per $) as the US dollar fell against all major currencies, fuelled by the so called twin deficit of the US accounts. However, the dollar recovered in 2005, rising to $1.18 per euro ( 0.85 per dollar) in July 2005 (and stable throughout the second half of 2005). The fast increase in US interest rates during 2005 had much to do with this trend. 11
  • 12. EUROPEAN EXCHANGE RATE MECHANISM (ERM)The European exchange rate mechanism (or ERM) was a system introduced by the European Community in March 1979, as part of the European Monetary System (EMS), to reduce exchange-rate variability and achieve monetary stability in Europe, in preparation for Economic and Monetary Union and the introduction of a single currency, the Euro, which took place in January 1999. All 9 member states of the Community at the time joined the EMS.Until 1999, all member states that participated in the ERM, also participated in the ECU.European Currency UnitThe European Currency Unit ( ; ECU) was a basket of the currencies of the European Community member states, used as the unit of account of the European Community, before being replaced by the Euro. The European Exchange Rate Mechanism attempted to minimize fluctuations between member state currencies and the ECU. The ECU was also used in some international financial transactions. Just as the dollar was at the center of the BW system and was its de facto numeraire and reserve asset (dollar is as good as gold ), the ECU was designed to be the unit of account and the reserve asset at the center of the European Monetary System (EMS).The ERM is based on the concept of fixed currency exchange rate margins, but with exchange rates variable with those margins. It was a new institutional framework for maintaining stability between Community currencies while allowing them to float against the other currencies.Before the introduction of the Euro, exchange rates were based on the ECU, the European unit of account, whose value was determined as a weighted average of the participating currencies. It was just more than a unit of account as ECU was also an official reserve asset held by the European Monetary Cooperation Fund (later replaced with a European Monetary Fund).A grid of bilateral rates was calculated on the basis of these central rates expressed in ECUs, and currency fluctuations had to be contained within a margin of 2.25% either side of the bilateral rates (with the exception of the Italian lira, which was allowed a margin of 6%). For example: FF/ECU divided by DM/ECU is the FF/DM bilateral central rate as a ratio of two ECU central rates and the margin of fluctuation between FF and DM bilateral central rate could not exceed the + or 2.25 percent. 12
  • 13. The structure of the bilateral central rates was to be agreed unanimously by the Ecofin Council, composed of the Finance Ministers and by the Governors of the Central Banks of the participating countries. The bilateral central rates were aligned 11 times between 1979 and 1987, once in 1990 and 5 times between 1992 and 1993 (due to the speculative attack on the weaker currencies of the ERM). Last realignment was in 1995.ECU also provided an early warning signal to participating member States that their macroeconomic policies are inconsistent with the established ECU parities (central parities).ERM assigned more evenly the obligations between Member States with strong and weak currencies: They both had a legal obligation to intervene in unlimited amounts to defend these margins. The country with the strong currency had the obligation to prevent further appreciation and the country with the weak currency had the obligation to prevent further depreciation in excess of the predetermined margin of 2.25% either side of the bilateral rates. Determined intervention and loan arrangements protected the participating currencies from greater exchange rates fluctuations.For example: Suppose that bilateral central rate for FF and DM is set at 335.386FF=100DM (or 3.35 FF=1DM) as of 1995. This is a fixed parity with 2.25% margin of fluctuations on each side: The FF can go as low as 343.050FF=100DM or as high as 327.92FF=100DM).If the actual FF/DM bilateral rate hits or exceeds 343.050FF=100DM, then FF is about to cross the bilateral margin on the low edge (weak FF and strong DM), then Banque de France is required to buy its own currency against the DM on the Paris foreign exchange market and the Bundesbank is required to lend DMs to Banque de France so that the latter can purchase FF using the DMs at its disposal. Since Banque de France has to repay its intervention credit in DMs or ECUs, its reserves at the EMCF is immediately reduced or its liability is recorded while Bundesbank s reserves at the EMCF are immediately increased.In support of this intervention, Bundesbank is required to sell its currency against the FF on the Frankfurt exchange market. As a result of these transactions, the monetary base and foreign exchange reserves in Germany increase and the monetary base and foreign exchange reserves of France decreases. 13
  • 14. ADVANTAGES AND DISADVANTAGES OF ERMADVANTAGES:-1. 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 calculatewhat 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 couldnt affect it (well, hopefully!!!!). 14
  • 15. The situation that EMU is in is good as it seems that it can survive on its own, with orwithout the help of Japan and U.S.A.6. Prevent war: - The EMU is, and will be a political project. Its founding is a step towards European integration, to prevent war in the union. Its a well known fact that countries that trade effectively together dont 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 considerable step down the road towards political union. There are many in the EU who favors economical den political union and they are very much in factor to EMU. There are also many who wish to keep national sovereignty and are struggling to prevent EMU, whatever its merits might be, from going ahead.9. Inflation: - From 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 independent 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 15
  • 16. boom in the economy, with the subsequent increase in inflation following the election. TheBundesbank, in contrast, was independent of government. By law it has a duty to maintainstable prices. It can resist pressures from the German government to pursue reflationpolicies if it believes that these will increase inflation within the economy. Events of theearly 1990s have shaken the naive faith that linkage to the independent ESBC, the centralbank of Europe would solve all inflationary problems. This is because German inflationrates in the early 1990s rose to over 4% as Germany shrugged with the consequences ofunification. In 1993, inflation was nearly three times as high in Germany as in the UK andtwice as high as that in France. Some countries, such as France, have made their centralbanks independent on the Germany model and therefore arguably dont need to the EMUlink to Germany to maintained low inflation. The UK has gone a little way towards givingmore power to the central bank by publishing reports neither of monthly meetingsbetween the Chancellor of the Exchequer and the Govern nor of the Bank of England. Thisforces the Government to justify its monetary policy publically and makes it harder for it touse interest rates for short term political ends. 16
  • 17. DISADVANTAGES:-1. 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 overestimated. 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 undesirable 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 90s France succeeded in reducing her inflation rates to German levels, but at the cost of higher unemployment, For the UK, it can be argued, 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 17
  • 18. fallen).The economic cost of this would have been continued unemployment at 3millionand a stagnant economy. When the UK did leave the ERM and it rapidly cut interest ratesfrom 10% to five and a half %, there was strong economic growth and the current accountposition improved, but there was an inflation cost.Another problem that the early 1990s highlighted was that the needs of one part of Europecan have a negative impact on the rest of Europe. In the early 1990s, the Germans struggledwith the economic consequences of German reunification. There was a large increase inspending in Germany with a consequent rise in inflation. The Bundesbank responded byraising German interest rates. As a result, there was an upward pressure on the DM asspeculative money was attracted into Germany. Germansys ERM partners were thenforced to raise their interst rates to defend their currencies. However, higher interest ratesforced most of Europe into recession in 1992 - 1993. Countries such as France couldntthen get out of recession by cutting interest rates because this would have put damagingstrains on the ERM. The overall result was that Europe suffered a recession because of localreunification problems in Germany. Critics of the ERM and EMU argue that this could berepeated frequently if EMU were ever to be achieved. Local economies would suffereconomic shocks because of policies, forced on them, designed to meet the problems ofother parts of Europe.One way around this would be to have large transfers of money from region to region whena local area experienced a recession, e.g. N. Ireland which suffered structuralunemployment for most of the post war period, has had its economy propped up by largetransfers of resources from richer areas of the UK with lower unemployment. However,regional transfers are very small at the moment unfortunately. Moreover to approximatethe regional transfers which occur at the moment in, say, Britain, there would have to be ahuge transfer of expenditures from national governments to Brussels - just what antiEuropeans are opposed to. 18
  • 19. IMPACT OF CURRENCY RISE IN EUROPEAN ECONOMYWhile few believe that this increase will have a positive impact on some of the sectors inthe country, others voiced their concerns over the negative repercussions that this willhave on the overall economy. Obviously the increase in euro exchange rate will affect the price structure in Lebanon,said head of Beirut traders association Nicolas Chammas who explained that traders will,to some extent, be able to eat the extra cost for a while but once the euro becomes veryexpensive they will not be able to sacrifice their margin anymore. They will have to relaythe impact of the increase in the exchange rate of euro on their selling prices, Chammastold The Daily Star.Chammas believes that this will be translated into higher inflation in the country. Thistakes us back to the year 2008 when the euro climbed to $1.50 and inflation rate waseating away the purchasing power of the population at that time, he added. It seems thatwe are getting there again.Despite the euro s fundamental weakness over the past year, the past few days have seenstrongly resurgent growth for the 16-nation single currency. The EUR/USD has recentlytouched an eight-month high mark and climbed above $1.40; the EUR/JPY and EUR/GBPare both at five-month highs, and still climbing; and the EUR/CAD ascended to a seven-month high to currently trade at 1.417.As far as exports are concerned, Chammas said that Lebanon s export of goods and servicesshould benefit from the weakening in the US dollar since the Lebanese pound is pegged tothe dollar. When you export to Europe for instance and you have a weakening US dollaryou will be able to export at more competitive prices, he added. However, the fact that theUS dollar is weakened is not enough by itself to be able to export your way out of thecrisis.Chammas noted that the climb in the euro will create social tensions in Lebanon because alarge chunk of exports are euro denominated. So this promises to cause more demandsfrom the unions and other stakeholders in order to increase wages and perhaps subsidizesome products and this is not very good news, he added.Moreover, when the dollar is weakened the price of commodities such as oil will increasebecause it moves in opposite to the dollar exchange rate, he said. Since oil is such animportant component of our imports, this will also cause some problems as far as thenational budget is concerned because you will have to have more transfers to EDL, he said. You cannot increase oil price for consumption and the state will be losing some of its taxrevenues, he added. 19
  • 20. Chammas concerns were echoed by the head of the association of food importers Adel AbiShaker who said that prices have not increased yet with the latest hike in the euroexchange rate but if the latter continues to go up, merchants are expected to increase theirprices by around 5 percent. Importers do not have the hobby of constantly increasing theirprices, and the process is not easy because they have to inform supermarkets every timethey do that, he said. But when the euro increases then prices will automatically go upand this is normal.Shaker said that merchants normally would want to increase their profits. However, headded, it is fair to say that with the presence of a high competition in Lebanon it is hard forthem to generate a great profit.Shaker doubted that some merchants attempt to hide their food products when the eurogets higher for them to increase their prices and generate higher profits. They have tostick to the date of production displayed on the commodities. Moreover, manufacturersusually give only a period of two years for the expiry date for them to be able to sell more,he said. From his side, head of the consumers protectionassociation Zouhair Berro said that prices movement in Lebanon has nothing to do with thechange in international prices. He argued that even when the euro goes down, prices inLebanon remain the same. However, when it climbs, merchants tend to take advantage ofthe situation and increase their prices.Berro cited the example of the price of wheat which dropped from $600 per ton in 2008 to$180 per ton in June 2010 while the price of bread remained the same in Lebanon at thattime. Today, the price of wheat reached $330 per ton and the price of bread increased inparallel, he said.Meanwhile, economist Ghazi Wazneh believes that this increase will impact the prices ofgoods and services in addition to affecting the inflation rate. This increase will lead to afurther deficit in trade while negatively impacting the surplus in the balance of payments,not to forget that the number of Lebanese tourists to Europe will go down, he said.Wazneh said that the prices will stay the same for the time being but he believes that theywill go up if the euro exchange rate climbs above $1.50. We still don t know if it will keepon increasing but if it does then traders will probably resort to the US for their imports.However, Wazneh s view of the situation was not totally pessimistic because this increase,in his opinion, will not have any negative impact on the public debt. Moreover, if the eurokeeps on increasing, Lebanese products will be more able to compete and exports willconsequently go up, he said.Likewise, president of the Lebanese industrialists association Nemat Ifram expressed hisoptimistic view on the increase of euro and its impact on the Lebanese industrial sector. 20
  • 21. If we sell to countries who originally import from the euro zone, our goods will then beable to compete because European products will be much more expensive, he said.Moreover, he added that at the time of increase in the euro exchange rate, if Lebanon sellsits products to markets dealing with the euro currency, then it will be able to increase itsprices using the US dollar currency because the Lebanese economy is dollarized. Lebanonwill then be able to benefit from better selling prices.However, Ifram said that if euro climbs to more than $2 then demand in the Europeancountries will go down and the European economy will witness a slowdown. However, weare still on the safe side because the euro exchange rate did not even reach $1.70 yet.According to the statistics of the European commission, total EU-Lebanon trade amounts toapproximately 4.4 billion Euros ($6.12 billion), but is its third largest market for exports(12.4 percent), behind Syria (24.9 percent) and the United Arab Emirates (12.9 percent). Itsaid that EU goods exports to Lebanon in 2009 amounted to 4.2 billion Euros while EUgoods imports from Lebanon during the same year reached 0.25 billion euro.As a result of the recent increase in the euro exchange rate, money exchange companies inLebanon agreed that the demand on the euro currency by businesses and companiesdropped since the currency started to climb. The demand on euro dropped by 40 percentcompared the same period of the year 2009, said Wissam Mallah, representative of CashUnited.His comments were echoed by Khaled Shouman, one of the owners of Shouman exchangein Beirut, who said that demand on euro by businesses has dropped lately due to thissudden increase. 21
  • 22. DECLINE IN VALUE OF CURRENCY COULD LEAD TO INCREASE INEXPORTSMany economists think the 16-country currency is headed for a significant declinebecause of Europes government debt crisis.Some are even predicting that by next year the euro will sink to whats called parityagainst the U.S. dollar ² ¼1 equals $1, a level last seen in July 2002 and an 18 percentslide from Fridays $1.23.Such a decline would take some of the shine off Europes vaunted project in a sharedcurrency. And it would cut Europeans purchasing power for imports. But if it happensgradually enough, the slide in the euros exchange rate could help exports and providethe boost Europes troubled economy needs.Export-focused companies would be more competitive on price outside the eurozone,likely boosting their revenue and helping to remove the threat that Europe will dragdown the global economy and stock markets.With a lower euro, Parisian hotel owners could sell more Left Bank hotel rooms totourists from North America, while Italy would surely sell more shoes and textiles. AndSpain just might be able to turn over some of that vacant seaside property left from aU.S.-style real estate bubble.And since China and other Asian countries link their currency to the dollar, the eurowould weaken in that direction as well and help trade with Asia.All that would come as a relief to U.S. officials and investors, who have seen Europestroubles weigh on stocks and expectations for the world economy in the past severalweeks.Exports have been a key factor lifting Europe out of recession. In the fourth quarter of2009, exports from the euro zone rose 1.9 percent over the prior quarter and totaled¼838 billion ² or 36 percent of euro zone economic output. 22