KYKLOS. Vol. S O - 1007 - F a x .

I , 63 82
~

Evaluating the EMU Criteria: Theoretical Constructs, Member Compliance and Empirical Testing
Julie E. McKay*

I INTKODUCTION

In I99 1 Europcan Community members committed themselvcs to monctai-y union before thc turn of thc century, which, despite setbacks, is still on track. Monetary union is dcscribed as a currency area whcrc monetary policies arc jointly determined and exchange rates arc irrcvocably and completely fixed'. in order to movc to completely fixed exchange rates, members havc to rncct five criteria as spccified in thc 1991 Maastricht Treaty. These criteria have attracted much controversy and little theoretical support. Where do they originate and are they necessary for exchangc rate stability? This paper investigates thcse questions and empirically tests the usefulness o f the criteria as indicators o f exchange rate stability. To borrow from Hendry: let the data dccide! According to thc Deloi-s Report, monetary union is to be achicvcd in threc stages: firstly, completion of the internal market and accession to the European Monctary System (EMS) oC all European Union (EU) members; secondly, thc founding of' thc necessary monetary institutions and transferencc of national monctary responsibility for reserves; thirdly, the irrevocahlc locking of cxchange rates. The focus of this paper is on the necessary prc-requisites for graduation to stage thrcc, as specified in the 1991 Maastricht Treaty.

I k . Faculty of Economics and Politics, University of Cambridge, Sidgwick Avenuc. Cnnlbridgc C H i 9DE. U K . I would like to thank Dr A.W.A. Peterson. an anonymous reteree and pirticipants oi' the Applied Econoinctrics workshop for hclpfiil cominenls
:&

63

JULIE E. M c K A Y

Progress towards Europcan Monetary Union (EMU) has not been smooth. Following tracturcs in Scpteniber 1992. the Exchange Rate Mechanism (ERM) suffered a major crack in July 1993. Ofthccleven member currencies, two were. forced out, and those remaining had their fluctuation bands widened from k 2.25% to? 15%. a de-facto exit at the time. Protracted weak growth and high unemployment in the EU has dampened enthusiasm, causing political will to falter. Some countries risk social upheaval in the struggle to meet the rcquirements. Nevertheless. plans for monetary union remain intact. In 1993 the forerunner to the European central bank. the European Monetary Institute, was established in Frankfurt. The single currency has been named and the Inter-governmental Conference will have implications for progress towards EMU. Consequently. the question of whether these convergence criteria are good indicators of suitability to a fixed rate regime remains pertinent. In the absence of a sound theoretical justification. we turn to the empirical analysis of OECD countries for an answer. Positive results would justify their selection and may permit an evaluation of the suitability of current and prospective E U members t o fixed exchange rates. Findings of insignificance would add considerable weight to the argument that their origin was purely political in nature, covertly designed to create a two-speed Europe. It would not only leave open the question of which currencies are suited to fixed exchange rates, but more importantly. would condemn some countries to fiscal consolidation and protracted recessionary conditions. since the theory predicts that attempting to meet the criteria is likely to impose unnecessary hardship on member countries and fiscal contraction o n the EU as a whole (Dc Grauwe 1992, Buitcr 1992). The paper is laid out a s follows. Part I1 reviews the literature regarding the theory behind the criteria. Given the heavy policy orientation ofthis study, the arguments and context of the debate are discussed. Part 111examines the criteria with reference t o EU members to provide some indication of the practical implications of the criteria for individual countries. Part IV tests the model on various data sets and reviews the qualifications and policy implications. Unlike the usual approach, this paper is concerned with testing the policy model rather than attempting to derive the most appropriate model. Part V concludes thc study.

I I THE B A S I S OF THE h i o r m

Thc purpose o f the study is to empirically test whether the Maastricht convergencc criteria are indicatoi-s of an economys suitability t o a completely fixed
64

EVALUATING THE EMU CRITERIA

exchange rate. The criteria therefore form the independent variables. This scction examines the arguments for and against their adoption.

I . The Criteria
The convergence criteria, all of which must be fulfilled or close to fulfilment for admission to completely fixed exchange rates in 1999, are fivefold. I . An annual rate of inflation of no more than I .5 per cent above the three best inflation performers in the EU. 2. A planned or actual budget deficit as a percentage of GDP of no more than three per ccnt. 3. A government debt to GDP ratio of sixty per ccnt or less. 4. An average long tcrm interest rate at most two hundred basis points above the levels observed in the three countries with the best inflation performance. 5. No devaluations or revaluations of exchange rates within the two ycars preceding accession, i.c., the exchange rate has remained within the bands of the ERM. Only two of these measures (inflation and interest rate differentials) bear any rcscmblancc to the variables that feature in optimum currcncy area (OCA) theory - the body of knowledge usually drawn on to explore questions of suitability to a fixed rate regime. OCA literature, from analysis of the source and magnitude of balance of payments disturbances to which an economy may hc susceptible, identifies seven criteria considered pertinent to the sustainability of a single or pcgged exchange rate, viz. capital mobility (Mundell 1961); inflation rate differentials (Fleming 1962, Haberler 1970); export product diversification (Kenen 1969); relative size ofthe trade sector (McKinnon 1963); geographic concentration of trade (Heller 1978); GDP (Heller 1978) and level of economic development (Holden, Holden and Suss 1 979)2. Empirical studies have attempted to evaluate the strength of the relationship between the criteria and regime choice, with mixed results. On balance a low inflation rate differcntial between trading partncrs augers well for an exchange rate pegged to the partner, while capital mobility shows no robust relationship with a fixed rate regime.
2. Tower and Willet (1976) provide a comprehensive overview of the main issues 3. See, for example, Heller (1978) and Holden, Holden and Suss (1979).

JULIE E. McKAY

In view of the inconclusive evidence of the significance of these variables it is not altogether surprising that they were not used in the Maastricht plans for monetary union. However. there has hcen even less theoretical discussion and empirical testing of the criteria chosen. W e examine the variables more closely.

2. It!flatiori Rate Differentids

I n OCA theory an inflation rate differential reflects a countrys inflation ratc compared to the weighted inflation rate of its major trading partners. In the Maastricht Treaty, it is not clear what acountrys inflation rate is to he compared with: i ) the inflation rate of the third hest inflation performer in the EU, i i ) the mean of the best three, or i i i ) the GDP weighted average of the hest three! Additionally. the reason for selecting a I .5 per cent differential is neither provided nor obvious. Fleming (1962) and Haherler (1970) argue that only a low inllation rate differential is conducive to a fixed rate regime. since if a large intlation rate differential exists, the price of exports will move in the opposite direction to the price o f imports and the resultant payment flows will put the exchange rate under pressure. Empirical analysis by Heller (1978) and Holden, Holdcn and Suss ( 1979) found this variable t o he, respectively, unimportant and vei-y significant. Recent discussion argues that it is the source of the differential that determines whether pressure will he exerted on the exchange rate. If price riscs arc due to increases in productivity - i.e.. there is no change in competitiveness - no realignment of the exchange rate will be necessary (Balassa 1964). This will not be the case if competitiveness has changed (c.g.. inflation represents the exercise of trade union power). Several analyses4 ascribe thc persistent inflation rate differentials in Europe to differences in national monetary authority credibility. Expectations o ! inflation arc a product of the reputation o f tlic central hanks, and the resultant actual inflation rates will necessitate an cxchange ratc adjustmcnt if they Lire out of step Lvith other ELJ members. The ma.jor qucstion is whether prior convergence o f intlation n t c s is ;I tcchnical necessity for completely fixed rates. There are two ways t o view the problem. One approach hinges on the specifics of monetary reform and suggests convcrgence is desirable for a common starting point if national currencies are to he continued. An altcrnative and more popular view is that convergence is not ii technical, but a political prc-requisite. Low inflation EU mcmhers arc

EVALUATING THE EMU CRITERIA

afraid of losing their reputation upon monetary union if high inflation members participate. To allay the fears of these countries (thc top three inflation performers) all members are required to show evidence of serious commitment to price stability by bringing rates into line. Studics by De Grauwe (1992) and Poloz ( 1990) found divergence greater than 1.5 per cent already existing within monetary unions - the German Lander and the Canadian states respectively. Empirical estimation should throw some light on the necessity of low inflation rate differentials for exchange rate stability.

3. Interest Kate Di~erentials

The wording in the Treaty leaves room for various interpretations of this criterion. It is not clear whether interest rates are to be kept within two percentage points of the interest rate cxperienced by the third best inflation performer, or the mean interest rate, or indeed the lowest interest rate of the three best inflation performers. Thcre has been little discussion of this variable. It may he considered consistent with the capital mobility element of OCA theory, since this implies that, in the absence of capital restrictions, interest rates across countries should equalise. However, this refers to real interest rates whereas the EMU criterion seems to imply nominal rates. The nominal rate differential is closely related to inflation performance and inflationary cxpectations. It also stands in a positive, but not irrefutable relationship to the budgct dc lici t . Again, the question arises of why a differential of two hundred basis points was chosen. It is likely related to the I .5 per cent inflation rate differential, and o f note is that only Germany, the Netherlands and Luxembourg have consistently mct the criterion since the introduction of the EMS.

4. The Deficit to GDP Rutio

The requirement that government budget deficits be no more than three per cent of GDP is softened somewhat by the accompanying text of article 109j of the Maastricht Treaty. The ECOFIN Council has the discretion to rule budget dcficits that are higher than the reference value not excessive if the deficit ratio is converging at a satisfactorily fast rate and is close to three per cent at the date of accession. Exceptional and temporary departures may also hc permitted. This criterion is no less controversial than the foregoing. What is the significance of three per cent? No member except Germany has consistently

67

JULlE E. McKAY

remained within this limit from 1978 to 1992, although France succeeded on all but three occasions and was only marginally outside even then. If the clue does not lie therc, the only other rationale is provided by Buiter (1992). He points out that a three per cent deficit coupled with a sixty per cent gross debt ratio are compatible with a stationary long run equilibrium if the growth of real G D P is three per cent, inflation is two per cent and there is no monetization of the deficit or debt5. However, he is quick to add that insisting on these values is unadulterated economic nonsense and dangerous nonsense to boot ( 1992. p. 3). This remark illustrates that theories expounding the necessity of deficit limits for a fixed currency area are far from sound. One notion suggests that running alarge deficit will put upward pressure on interestrates, crowd out private sector investment and nccessitatc tighter monetary policy. However, in the absence of country specifics. these relationships are not rcliable. A counter argument suggests that the sourcc, not the size is important. A largc deficit poses problems for exchange rate stability where it is the product of subsidies and transfers, since outlays are not expected to be recouped. Deficits induced by tax cuts and public works or infrastructure expenditure are expected to be replenished by the tax revenues resulting from the growth induced. Gros and Thygesen ( 1992) regard the three per cent limit as arbitrary and indefensible. Buiter ( 1992) claims it reflects Bundesbank liscal-political dogma and suggests that attempts to meet the criterion will rcsult in unnecessary hardship and a deflationary stance for the EU as a whole, which accords with the EU cxperiencc since 1992. These concerns aside, the test here is whcther this condition is nccessary lor cxchangc rate stability.

5. Tlie Gross Debt to GIIP Ratio

The gross debt to CDP ratio has attracted much the same criticism as the deficit ratio. Again. it is tnadc less strict by the surrounding text along the same lines ;IS the delicit requircmcnt. There are equally vague reasons behind the choice o f thc sixty per cent reference value. It represents approximately the annual average of EU member debt ratios since 198 I . Germany and France, as well as thc lJK and Spain. consistently met this criterion between 1978 and 1991. It is
5 . In a stationary continuous time equilihnurn. h = (d-s)/g : where h = the constant ratio to GDP of govemmment deht held hy all hut thc central ha&: d = the constant deficit to GDP ratio; g = the constant GDP growth rite and s = the constant ratio of credit - from the central bank to the government - to GDP ratio (Buitcr 1992).

68

EVALUATING THE EMU CRITERIA

compatible with a stationary long run equilibrium state as discussed in Buiter ( I 992). There is argument over why gross debt was specified as opposed to net debt. Ease of measurement is one suggested reason. That aside, using gross debt results in a bias against countries such as the Netherlands with a large government-funded pension scheme for civil servants, which adds twenty percentage points to its debt ratio. In theory, this should not affect the stability ofthe Dutch Guilder. Based on past experience, the Netherlands has little difficulty maintaining a stable exchange rate despite its high debt ratio.

6. Past Exchange Rate Vuriubility This criterion is one of the simplest to interpret and understand. Gros and Thygesen (1992, p. 387) comment that it seems well justified, though the choice of two-year stability appears arbitrary. But is past experience a reliable guide to future exchange rate movements? If so, after five years without noteworthy realignments, no-one would have predicted the problems faced by the Lira, the Pound Sterling, the Peseta and the Escudo in 1992. The results of this study will indicate whether there is a relationship between previous and current exchange rate volatility. In short, the validity ofthe criteria is theoretically questionable. The inflation and interest rate criteria overlap with OCA theory, and the previous variability condition has some intuitive appeal. Neither of the fiscal criteria enjoy theoretical support. Let us turn our attention to an empirical evaluation of the criteria after considering EU member consistency.

Ill. EU MEMBER CONSISTENCY WITH EMU CRITERIA

From part I1 it is apparent that the EMU convergence criteria lack a sound tlicoretical base, and that the reference values appear arbitrary. This section evaluates EU members performance against the criteria with a view to inferring the likelihood of meeting the criteria for admission to monetary union. Bascd on members experience, the inflation and interest criteria would appear achievable by the majority of countries. The exchange rate measure would exclude
6. Data and forecasts for this section are drawn from Deutsche Bundesbank (1995).OECD ( 1995), European Economy ( I 996), and national accounts.

69

JULIE E M c K A Y

half the group. The fiscal criteria, most notahly the debt ratio, arc the real stumbling blocks and are likely to prevent entry for most of the fifteen members, The three major economies are the only group expected to meet all five criteria by the specified schedule. This outcome hinges primarily on two factors. Firstly\ the French Franc and Pound Sterling have to increase their stability vis-ii-vis the Deutsche Mark and the latter rejoin the ERM. Secondly, plans to reduce the excessive deficits ran by all three countries in 1995 need to take cffect. I n the Ineantimc. Germany has to reign in gross government debt fhllowing unification-related liability assumption in 1995. while the UK needs to constrain inflation. The excesses are negligible compared t o other countries and reduction should be easily achievable. Gcrmany has hccn in the strongest position of all EU members t o meet the f'ive criteria since the beginning of the E M S in 1978. Germany's fiscal criteria came under pressure with unification and the related take-over of dcbt. but both ratios are forecast to he corrected by 1999. The small countries are remarkably consistent with the criteria. The group contains thc two strongest currencies after the Dcutsche Mark (thc Belgian Franc and the Dutch Guilder), and the only two deficit ratios outside thc three hlot per cent limit are expected to fall below i t by 1999. The sole hut SCVCI-c on this otherwise outstanding record is the debt ratio. on which all except I.,uxeinhourg are likely t o taltcr. Luxembourg's 199.5 critcria prol'ilc was exemplary, with the lowest fiscal iratios of all EU members. and Holland leads the field in exchange rate stahility vis-%-visthe Deutsche Mark. Convcrscly. Belgium's dcbt ratio, I34 per cent in 1995. is the highest in thc EU and is due in part to a different definition (to include social security dcbt and 'off-budget' debt largely for sector support). and in part to a period of unstable debt dynamics. Only minor reductions arc expected before the monetary union deadline. Ireland has two weak arcas. The Punt's continued use of' the widened band signals tension if moved to rigid lixing. Imprcssivc debt ratio reduction is forecast to proceed by containins govci-nment cxpenditurc. h u t will still be wcll outside the sixty per cent limit hy 1999. The southern countries. which include Italy, arc the most distant from thc criteria and the convergence outlook is hleak. Despite commitment and progrcss towards convergence. falls in interest rates and deficit ratios are at too slow a pace to achieve the targets by 1999. Debt ratio performance differs markedly within the group but none is encouraging. Currencies of two countries (the Lira and the Drachma) are not ERM members, while the Peseta and Escudo underwent devaluation in I995 (7 per cent and 3.5 per cent respectively) as a result o f the strains arising from the strong Deutsche Mark. The, sole bright spot is

70

EVALUATING THE EMU CRITERIA

inllation for Spain and Portugal, which if import-price appreciation feedthrough is contained, may yet satisfy the criterion. Italy, the fourth largest EU economy, has most in common with the group of southern countries. Despite OECD predictions of progress towards convergence for all but the dcbt ratio, movements will be insufficient to pass. Italy's exchange rate came under pressure with Germany's delay in cutting interest rates in 1995, which augers badly for re-entry to the ERM. Spain's debt ratio is forecast to climb further away from the threshold by 1999. Portugal has committed itself to EMU, targeting its monetary policy at curbing intlation, and implementing a deficit reduction plan based primarily on higher revenues. The 'forced' 3.5 per cent devaluation kept interest rates high in 1995, and debt. which rose in the period 1993-95, is forecast to increase before stabilising. Greece continues to be the farthest of all EU members from convergence. Its 1995 9.3 per cent budget dcficit is the highest of all, and its debt ratio rosc to 114 per cent in 1995, fuelled by high interest payments on debt arising from years of assistance to ailing enterprises and absorption of labour in recessions. Long term interest rates are declining slightly, but remain high to ensure order in the foreign exchange market. Inflation has been reduced to single figures for the first time since the 1970's, and the forecast is for a virtuous circle of lower inflation, easing of interest rates and improvement of the fiscal position. Unfortunately, this will not be sufficient to meet the convergence criteria in 1999. The new members are all likely to pass the inflation standard and fail the debt criterion. All three countries implemented fiscal consolidation programmes in 1995 targeting convergence by 1999 or sooner. Set against moderate wage claims and strong growth, they are forecast to reduce deficits but are likely to, at best, only stabilise the debt ratios. Sweden's position is the most precarious and heavily reliant on the virtuous circle of economic growth, deficit reduction and intcrcst rate easing. Austria joined the ERM smoothly immediately, whereas Finland and Sweden have yet to enter and are not likely to fare as well. In 1995 Finland had the lowest inflation rate of all EU members, which is expected to remain low. The fiscal convergence programme, formulated against 17 per cent unemployment in 1995, is targeted at a sixty per cent debt ratio by 2000, which the OECD predicts is unlikely to be achieved. Sweden has a lot to achieve in all areas but inflation. Its consolidation plan is ambitious and relies on continued strong growth. Sweden's long term interest rate, disciplined somewhat by membership of the EU, is forecast to remain just outside the criterion. In conclusion, striving for fulfilment of the inflation criterion appears to have made fulfilment of the fiscal criteria harder. As the inflation rate has been

71

JULIE E. M c K A Y

reduced, deficit and debt ratios for many countries have worsened with concomitant pressures on interest rates. The major countries (Germany, France and the UK) are expected to fulfil the five criteria by the due date. Both the small and new members are likely to falter on debt, and two of the new members have yet to join the ERM. The southern countries including Italy are forecast to meet none of the criteria, and remain the farthest away from the thresholds.

IV. DATA, ESTIMATION AND RESULTS

The Maastricht plan implies that conformity to the criteria will ensure the smooth operation of a fixed, or single, currency. That is, fulfilment ofthc criteria will produce a stable exchange rate. To test this a measure is needed to reflect the fixity of the exchange rate. The obvious choice is the official classification of the exchange rate regime, but its drawbacks are equally clear (see Holden, Holden and Suss 1079). Two questions arise: which rate of exchange is appropriate and what measure best captures its variability'? This study adopts an effective multilateral exchange rate based on Rhomberg ( 1976), calculated by weighting bilateral rates hetween a country and its significant trading partners by import shares. Import shares are chosen for convenience and representation to serve as a proxy lor the proportion of total transactions conducted in each currency. This measure is unreliable if the assumptions - that imports are purchased in the currency of the exporter, and trade has a major effect on the exchange rate - do not hold. The importance of the choice of exchange rate is subordinate to that of variability. Variability is measured in standard deviations from the mean effective exchange rate - a variation of Lanyi and Suss's (1982) suggested measure'. This measure is useful since it is sensitive to movement in cross-rates both between a country and its import partners, and among import partners themselves. The hypothcsised relationship is then;
V = fn ( PD, ID. BB, GD, PV)

where;

= variability index PD = Inflation rate differential ID = Interest rate differential B B = budget balance to GDP (BB>O = surplus, BB<O = deficit)

7. Details arc availnhlc from thc author on rcqursr

72

EVALUATING T H E EMU CRITERIA

GD = government debt to GDP (gross) PV = previous variability index

1. Data

Cross-sectional data were collected for twenty-two industrial countries for the years 1980-91. The period chosen covers a diversity of experience with flexible and fixed rates by industrial countries and a converging of EC economies up to fissures in the ERM in 1992. The Maastricht criteria do not lend themselves directly to testing. Instead, proxies were constructed. V The standard deviation of the composite multilateral* real exchange rate is used to measure the volatility of the exchange rate. Variability is calculated from four quarterly observations where effective exchange rates are standardised against a mean of 100 for purposes of comparability. This lends the index informational content in that the standard deviations represent the variability in percentage points from the mean effective exchange rate. The index can take values from 0 (complete invariability) upwards. PD The differential between a country's CPI and a composite CPI for its significant trading partners weighted by respective normalised import shares was used as a proxy for the Maastricht inflation rate differential criterion. ID This was calculated by the same method as the inflation rate differential but using long term government bond rates. BB The budget balance as apercentage of GDP was used. Deficits are negative. GD Gross government debt as a percentage of GDP. PV Previous variability over the two-year period before that under study was used as a proxy for realignments made. This is less strict than, say, a dummy for realignments, and is in harmony with the dependent variablc.

2. Estimation and Results

The aim is to ascertain whether the model holds as it stands - without the addition or deletion of'variables. It was tested against yearly data sets for 1980
8. A weighted real exchange rate was calculated which incorporated rates with all trading partners that accounted for five per cent or more of the imports.

73

JULIE E. M c K A Y

to 1991 inclusivc. A review of the results offered mixed support for the model. It appeared very sensitive to the period under analysis"; Adjusted R"s lluctuatcd between an insipificant low 01' 0. I8 in I9X I and a significant high o f 0.8 I in I O K ? . There w a s little consistency in terms of variable significance and signs varied unpredictably despite plausible magnitudes. indicating specification problems. O t h e r specifications 01' variables were tested t o indicate the most promising model for further analysis. Firstly, nominal variables were questioned. The inclusion 01' inflation and nominal interest rate differentials in the same model g i w s causc for concern over possible multicollinearity. borne out by the application of Klein's rule. Substitution o f the real for the nominal interest rate differential removed the potential problem, and established a preference for the modcl including the real interest rate differential'(). Next, nominal effective cxchange rate variability was replaced by real variability lor the dependent wri;iblc and ineasurc oi' past volatility. Based o:i the rather mechanical Amcmiya's criterion. the nominal variability model fared better. However, the real interest differential was prone to negativity i n this model which is difficult t o explain. From analysis of best fit. the adjusted R"s s, (Twstcd the nominal u" , variability niodcls fitted the data better than the real models. Nevertheless, there was no clear zlioicc between nominal and real variability models across data sefs. The 'real' incasure tended to produce significance of' only the constant tcrni more often, but o n the whole rcsults wcre sensitive t o the data yeat. In sum. the basic model received no across-the-board support based on F-tests o f joint probability. Despite (almost) no evidence of heteroskedasticity and adjusting for outliers. parameter s i p s and significance of individual coefl'icients were nor consistent. The question of' real variables versus nominal variables suggested preference for nominal cxchange rate variability and rcnl interest rate differentials. Results ofthis model are shown in Tublc 1. It reveals that based o n the F-statistics for joint probability and the insignificance 01' individual coefficients. the model is exceptionally weak in six of the twclvc years analyscd. Its best pcrl'ormance w a on I99 I data". The adjusted R' was ~ remarkably high and all yuriables but the debt and deficit iratio were s i p i f i c a n t at thc I'i\,c pcr cent level. Ne\.crtheless. the inflation rate. deficit and gross debt

0 . A complete sct of results was n r i t rhe author on request.

provided here for the sake of hrcvity hut w e available

Ii.oiii

10. Alternative rerncdics such

a 5 Kidre regression were not adopted since thc detlatctl \,ari:rhlc rr;idily wgpcsted itself. and thr Kidge correction i \ not beyond controvcrsy. I I The improveinent inay he duc to the iiiemhership 0 1 llic sinaller sample.

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EVALUATING THE EMU CRITERIA

variables had unexpected signs and coefficient magnitudes on deficit and debt ratios were very small. Removal of the weakest variable for 1991 data, debt, improved the results. Thc 1991 ad.justed R2 rose to 0.71 and all the coefficients were significant, including the budget deficit variable. The signs on the remaining variables did not alter, indicating low model sensitivity, and magnitudes adjusted slightly upward, in line with original expectations. The ANOVA test confirmed the insignificant contribution of the debt variable to the model. Re-estimating the model without the debt variable for each year improved results slightly, as shown in Table 2. The adjusted R2s improved in seven of the twelve years, predominantly after 198.5;the signs behaved as predicted more often and there was an improvement in significance of some coefficients on particular data sets. However, despite the good fit in 199 1, it is evident that thc performance of the model is patchy. Using the F-statistic, it is relevant to years 1980, 1982-83, 1986and 1991.Itsworstperformanceisin 1981 and 1985.Signs and magnitudes of coefficients are not consistent. The inconstancy of signs indicates model mis-specification, and while it is not thc focus of this paper to produce a better model, an attempt was made to reduce any omitted variable bias with a possible relevant variable. Given the jumps in oil prices over the decade, a measure of the impact of changes in oil prices on industrial countries was introduced into the model. The chosen proxy was the yearly change in the oil import bill for each country. (Results of addition to the most promising model are appended in Table 2.) The model selection criteria indicated superiority of the enhanced model in 1983, 1987 and 1991 only, though the oil bill proxy was found to contribute significantly to the model in an additional three ycars. Adjusted R2s tend to be higher, but with lower significance in all but 1991 and 1983. This experimental additional variable highlights the absence of important variables which renders the model misspecified. In summary, there is little empirical support for the criteria as proxied here. Thc most promising model using the criteria arose from 1991 data. It does not include the debt ratio variable, but has a remarkably high and significant adjusted R2 and highly significant coefficients. A negative sign was expected for the deficit ratio and a positive sign for thc inflation rate differential, but the I-everse occurred. Magnitudes of coefficients are small but plausible, for cxample, it is reasonable to expect that a one per cent increase in the interest rate differential will cause a change in the variability of the nominal cxchangc rate of 0.14 per cent.

7s

JULIE E. M c K A Y

76

Tabk 2
Estimation Results 11 Dependent Variable = Variability in the Nominal Effective Exchange Rate

1980 2 673 0 549

0 670

1981 0.328 1.902 1.351 2.213 2 006 0.450

1982

1983

1984

1985

1986

1987

1988

1989

1990 0.752
0.689

1991 1.002
4.036

Constant
3 476

2 099
0 199 0 450

1.871
2.770

I180

0.193

0.933

1.477

2 736

T >
-2.09 1
-1.732

PD

0.542
0 005

0 001
0 922
0811

0.172
3.639 0 149 -3 851 0 512 -0,080

0.5 13 -0.519 0.135

0.368 1.071 0 692 -0.110

0.181 0.702 0 183 -0.063

4.329

-0.012 -0 474 -0.012 -0.074

4.613

0.111 0.364
1211

0 080

0.090
0.331

-0.11 1
-2.635

g
0.402
1.460

2 285

RID
0 793

-0.309
-3.400

-0 01 I 0.266 0 021
0 135 -1.267 -1.314

-0.332
-1.237

0.142
2717

5 z
-0.024
0519 -0.403

n
4

0 868

4 065

3 :

BB

-0 549
0 060

0 005
-0.151
1 I58

-0.221 0.010 0.096

0 113 0 587
4 483

0.054

0.181
1.515

0.073
2.676

rn

-2 476

5
0.142
1698

PV

-0.047
0 969 3.187 -2.045 0.061 0.445

0 104 0.62 9.61 5.02 22

9.97 5.67

0.330 0.36 3.89 9.06 22 5.29 2.14 0.67 5.42 0.18 -0.07 0 49

-0.194

0 140
1530

0.092
0.926

0.495
2.205

0.269
5.002

-0 272

=j

m
0.13

Adjusted R

0.49 0 80 4 10 22 0 82

-0 04

0 10

0.08

0.14

0.71

F-Statistic

6.01

5 87
4 22

I .72
4.76

151

1.40 4 06 3.62

1.62 3.87

9.68 0.82

Anienuya

5.55

Observations

22

-77

21
0.60

21
5.76

21 2.27

20 I43

19 1.31

16
14.74

15
13.51

ANOVA .F if MP is added

5.83

I .98

Siiiall numbers are t-statistics

JULAE E. M c K A Y

Before suggesting a rationale behind these findings, we note the qualifications

to the model. Signs on coefficients arc inconsistent. which suggest omitted

variables. The 1991 adjusted K', remarkably high for cross-sectional data. gives cause I'or concern, and coupled with the instability of signs across data sets would suggest multicollinearity - however, this is not likely to be a problem as evidenced by the low standard errors and significance of the coel'licients. There is also the possihility of errors in the variables. The use of import shares for weights in the dependent variable is not uncontentious. Additionally. exchange rate movements were calculated against all significant trading partners, while the EMU condition is n o t so strict. Members need only keep their exchange rates stahle vis-Lvis other members. Another problem could arise from the cross sectional country data. which is notorious for lack 01' consistency. as evidenced by the definition of' debt I'or Belgium and the Nctherliinds for example.

The theory underlying the model is far from sound. Empirically. the model indicates some relevance for particular periods. though there docs not uppear to he any clear cxplanation. It does not indicate greater significance as economies convei-ge. Its pool- pcrl'ormance in 19x1 indicates an inability to cope with exogenous shocks, although it showed significance foi- 1986 when a Favourable shock occurred. Its good perl'orrnance is loosely coincident with upswings in OECD GDP growth. Results from the year o f best I'it. 1991. suggest that although signil'icant. thc specification is largely perverse. They contradict the requirement that all criteria must be met. The gross debt condition appears unnecessary. even obstructive. and evcn more disconcertins, signs too often dciy expectations. Most notably. the 'wrong' signs on the dcficit/GDf and inflation rate differentials requirc I'urther analysis. since if correct. they imply that the criteria as stipulated require counterproducti~'ebehaviour. Real interest rate dil'fcrentials appear to he ;I hcttcr criterion than nominal. There are ample reasons to be sceptical of thc r c ~ u l t s . discussed. hut at the same time. the indications coininand considcras ation. If the gross debt stipulation is inconsistent with the other criteria. countries such a h Belgium are constraining themselves on that count unncccss x i l y . It is noteworthy that all hut the thrcc tiiqjor countrics and 1,uxcnitioul-y ;ire likely to lail this criterion.
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EVALUATING T H E EMU CRITERIA

The regular occurrence of perverse signs on inflation differentials, interest rate differentials and the deficit/GDP ratio warrant further investigation. Consider the possibility that it is not the particular size of the differential or deficit that causes variability but thc dynamics. To recap, a positive sign was expected for PD since a high differential was thought likely to lead to an adjustment in exchange rates. However, it could also be suggested that exchange rates would not adjust if the inflation rate differential was consistently high and factored into cross-border contracts. That is, the volatility ofthe inflation rate differential could be positively linked to exchange rate variability, but not nccessarily the size of the differential per se. For the countries under study in 1991, those with the smallest differential could have experienced the highest volatility in intlation rates and thus exchange rates. The same argument could be applied to interest rate differentials and government deficits as well. For example, changes in government spending patterns may be linked more closely to variability ol' the cxchangc rate, and signs vary from data set to data set here too. If so, i t suggests the EMU criteria are mis-specified. This holds some intuitive appeal and would have important consequences for thc EMU entrance criteria. It would imply that once a country had met the targets, its exchange rate stability would be positively linked to stability of thc criteria (perhaps evcn irrespective of the chosen target values). In turn, this suggests that those countries that have the most adjustments to make to satisfy the targets are the least likely to exhibit exchange rate stability, (which is the fifth criterion), and this would effectively block admission of such countries. In other words, the most divergent countries now will not be accepted because in order to meet four of the criteria they would violate the fifth. Moreover, the instability of the exchange rate is a highly visible indicator with which to rally political support against admission. Providing a sound basis for these arguments would require estimation employing differences rather than levels and lays outsidc the purpose of this exercise, but would provide an interesting avenue for further research

V . CONCLUSIONS A N D FURTHER RESEARCH

The EMU criteria have met with great disapproval from economists arguing the lack of theoretical support. This paper has attempted an alternative evaluation based on empirical testing. There are difficulties in the selection of suitable proxies for thc criteria and yet the problcms are not insurmountable. The original specification did not receive much support. This could well be due to data difficulties. The model that fitted best is characterised by regularly occur79

JULIE E. McKAY

rinp perverse signs on four variables, a re-specification of thc interest rate differential and omission of the gross debt/ratio variable. There arc also reasons to doubt the validity of thc model. Most notably, it does not hold consistently across periods. This suggests that it is a poor indicator of medium term cxchangc rate stability and is an unnecessary set of constraints for much of the time. An attempt was made to enhance its power by the inclusion of a proxy for oil-pricc shocks, and though the improvement was not remarkable, it highlighted the need to identify omitted variables. A further step would be to evaluate the model over a longer period. Four quarters is insufficient to gauge the medium term implications of the model. These results provide further information lor the debate on thc usefulness of the EMU criteria. We conclude that the model appears as weak empirically as the criteria are theoretically.

Aineiniya, A . Takeshi ( 19x5). ildvciric.eclEcoriotnerric..s. Oxford: Basil Blackwell Ltd. Balassa, K. ( 1964). Purchasing Power Panty: A Reappraisal, Jourriul o/'Poli/ic.tilEcorrortiy. Huiter, Willern H . ( 1992). Should We Worry About The Fiscal Nurnerology of Maastricht'! Iliscussion Paper No. 668. June. Centre for Economic Policy Research. L)e Grauwe. Paul ( 1992). Inflation Convergence During the Trinsition to EMU, L)iscussion Paper No. 658. June. Ccntrc for Economic Policy Kesearch. Delors Report see European Council Ikutsche Bundesbank ( 1995). Deulsdie Nundeshonk A W I UKeporr. Frankfurt. ~ Eurolxan Council Coinmittee for the Study of Economic and Monetary Union. Brussels (l9XO). /<epor/OII Er~owtrirc. wid Morrercip Uniori I n rlie EifropeLin ComrtlunitT. Brussels. European Coininission ( 1996j. Europeou E(.onortiy No. I .Supp/ement A. Brussels January. Flcining, Marcus J . ( 1962). Domestic Financing Policies under Fixed and Floating Exchange Rates. /MI; S r n f f ' P q , r n 0 : 369-380. Giavazzi. F. and A. Giovannini ( 1989).Lirriiriri,y E d i t i r l g r Rule Flexihi/ify. Cambridge: MIT Press. Giavxzzi, F. and L. Spaventa (1990). The 'New' EMS. in: P. I k Grauwe and Papadelnos (eds.). 7'11~ EMS i r i the lYY0.r. London: Longrnan. Groa. Daniel and Niels Thygesen ( 1902). Europem M o r i e f q /nfe<yr(ifio!i F ~ O Jflw EuuqxwI H MorIef~ii:v .Sysrrm 10 Eiiropetiti M ( ~ t i e f t i i - ~ Utiioti. London: Longrnan. Haherler, Gottfried ( 1970). The International Monetary System, in: G.N. Halin (ed.), Appro'rc.hes rr! Grecirer F k r r h i l i f y of E.~c./iti~i,ye Kates. Pnnceton: Pnnceton University Press. Hellcr. H . Robert ( 1978). Determinants of Exchange Rate Practices, Jourmil ~ J ~ M o ~ I ~OTJ .I C'retlir Hnn/iin,y. 10: 308-321 Holden, Holden and Suss ( 1979).The I)ctermin:ints of Exchange Kate Flexibility, Tlrv R o i ~ i ~ , o/ iv
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1069). The Theory of Optimum Currency Areas, in: Mundell and Swobodn ( e d s . ) ~ hlfuleftJr\.Pr~oIdcrm rhc IrirermirirJriril E , o t i o u i X . Chicago: University o f Chicago I k s s . of Klcin. L.R. ( 1962).Air Irftrodwrioti f o Ec.~,rrr,rrterric..s. New Jersey. Prentice Hall
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EVALUATING THE EMU CRITERIA Mundell, R. (1960). A Theory of Optimum Currency Areas, Americ.utr Economic. RevieMj. 60: 6.57-66.5. OECD. Country Studies, Paris Various Issues. OECD ( I 9%). OECD Economic Outlook 58, Paris: OECD. Poloz, S . (1990). Real Exchange Rate Adjustment Between Regions in aConimon Currency Area, Bunk of Cunudu,February. Khombcrg, Rudolf R. (I976). Indices of Effective Exchange Rates, IMF SruffPupers. 23: 88- I 12. Tower, Edward and Thomas Willctt (1976). The Theory of Optimum Currency Areas, Speciul lupers in Inrrrnufionul Economic.s I I , Princeton University. Waltcrs, A. ( 1985) London: Brituins Economic Renuissunce.

SUMMARY

European monetary union, planned for January I 1999, requires EU incmbers to fulfil five criteria. Theoretical support for these five criteria is, at best, weak, and empirical tests have not been attempted. This study addresses itself to that gap. It reviews the theory, investigatcs the extent to which EU inemhers meet the requirements and tests the criteria empirically. It assesses whether the EMU criteria, as proxied, are indicators of exchange rate stability. Results are not supportive: the model is clearly mis-specified. The best results obtained suggest, if anything, that the debt criterion has no role to play, and that, contrary to the specified criteria, high inflation diffcrentials and high budget deficit/GDP ratios arc more consistent with exchange rate stability. We conclude that thc empirical results confirm the theoretical weakness of the criteria to a fixed exchange rate or single currency.

ZlJSAMMENFASSlJNG

Fiinf Kritcrien inussen die EU Mitglieder erfullcn, uin der Europaischen Wiihrungsunion, die fur den 1 . I ,99 geplant ist, hcitreten zu kiinnen. Die theoretische Grundlage fur dicse funf Kriterien ist bcstenfalls schwach. Noch sind dazu keinc cinpirischen Tests ausgcfuhrt worden. Die vorlicgende Untersuchung fullt dicse Luckc. Sie gibt einen kritischen Uberblick uber die Theorie, untcrsucht, inwieweit die EU Mitgliedsstaaten die Bedingungen erfiillen und testet die Kriterien auf empirischer Basis. Die Ergebnisse sind nicht positiv: das Model isteindeutig falsch spezifizicrt. Die hesten Ergchnissc deuten an, daB die Staatsvcrschuldung kcine Rolle spielt, und daB, im Gegensatz zu den festgelcgten Kriterien, groBe Unterschiede in den Inflationsraten und hohc Staatsvcrschuldung iin Verhiiltnis zum Bruttosozialprodukt mchr mil Wahrungsstabilitat ubereinstimmen. Somit bcstatigen die cmpirischen Ergcbnissc die thcoretische Schwache der Kritcrien eines festen Weclisclkurses oder ciner geineinsamcn Wahrung.

RESUMB

LUnion MonCtaire Europcenne, planifiec pour le ler janvicr 1999, exigc que les inembres dc IUnion Europeenne doivent repondre h cinq criteres. Le support theorique pour ces criteres est au riiieux faible, alors quaucune estimation cmpiriquc na CtC cffectuec. Cette Ctude coinhle cettc lacune: e l k prend en comptc la thCoric, examine jusquh quel point lcs inenibres de IUnion Europ4cnnc reinplisscnt ces conditions ct analyse lcs critkres dunc manierc empiriquc. Elk Cvalue lcs critkrcs de I Union Monetaire EuroNcnne pour voir si ce sont des indicateurs dc la stahilitd du taux de change. Ces rCsultats ne confirment pas Ihypothkse: lc modile ncst pas clairement sp6citiC.

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JULIE E. McKAY

Lcs meillcurs rcsultats ohtenus laissent supposer que. si ccst le cas, le critere de la dcttc na a u c m r61e i .jouer. et quau contrairc du cntere spticifit?. les differentiels 6levi.e~de Iintlation ct Ics proportions dlcvCe5 du deficit budgCtairelPUB sont plus coinpatihles avec la stahilitt! du taux de change. Pour conclurc. les rbuAtats einpinqucs confirrnent la faiblessc theonque du critcrc dun taux tic change fixe o u dune inonnaie unique.

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