Lira between Scylla and Charybdis

Evaluating the hazards to Malta of the timing and choice of central parity to participate in the EU's Exchange Rate Mechanism II (ERM II) recalls Odysseus navigating the straits between Scylla and Charybdis. To avoid Charybdis, a whirlpool which would suck his entire vessel, he had to pass close to the rock on the other side on which the six-headed monster Scylla stood ready to devour six of his crew.

Charybdis is the risk of choosing and fixing a central rate, only for it to turn out to be harmful to the economy. Scylla takes the form of a dangerous part of ERM II. It allows fluctuations of up to 15 per cent on either side of the central rate set on joining the mechanism, which all new members have to do, at some time or another. If one joined the ERM with a fluctuation margin, the market could help the authorities to conclude what was the best rate to drop the domestic currency for euro.

Equally, though, holders of the domestic currency might worry that it would weaken, or speculate, and convert financial assets into foreign currency. Despite that danger, Cyprus did not undertake to maintain its pound unilaterally (without additional help from the European Central Bank, if needed) well within the 15 per cent standard fluctuation band. Latvia, in contrast, chose a "hard peg", undertaking a unilateral obligation to keep any fluctuations within one per cent.

Malta left no leeway in taking the two decisions facing them.

The first was, did we need to join now? Not necessarily. The four bigger countries - Hungary, Poland, Slovakia and the Czech Republic - are still out. I do not expect there will be accelerated inward foreign direct investment because the lira has been locked in. Still, the decision had to be taken. Scylla could not be ignored. Cautionary or speculative outflows of funds might have built up.

The second decision required was on the rate at which to join the ERM and whether to take a unilateral obligation beyond the standard fluctuation band, and if so, by how much. The Central Bank recommended, and the government accepted, the current rate. The central rate was set at the Friday close, €=Lm 0.4293 (or the more familiar Lm= €2.3294). Moreover, the authorities also chose the absolute peg. They assumed a unilateral obligation to maintain the central rate against the euro as set - hence the absence of any leeway.

That, I feel, was unwise. It is not enough to have long experience of a fixed rate regime, as Malta did. Experience does not guarantee performance. It was crucial to lock in, once it was decided to do so, at a prudent rate. The "equilibrium rate" is that which indicates that the currency is neither over- nor under- valued. It is impossible to identify it with absolute certainty.

As with all assessments and predictions, therefore, one would allow for a prudent margin of error. The Central Bank must have factored in such a margin in its deliberations. One can presume that the probability that the lira could be overvalued at the recent levels was higher than that it was undervalued.

The weekend decision reflected no such consideration. By locking in at Friday's closing rate and, moreover, undertaking to maintain it unchanged, the Bank and the government ignored the possibility of any margin of error at all in the central rate they selected.

I feel it should have been done differently. While I share with various leading exporters the view that the lira is overvalued, I continue not favour devaluation. Its net effect, I hold, would be harmful to the economy. I would, however, have preferred stepping into the ERM II more cautiously, within a fluctuation band of, say, plus or minus 2.5 per cent. There might have been some outflow of funds. But the band would have given the market time to test our performance and, if necessary, bring about a gradual correction, up 2.5 per cent. Small, but, exporters will confirm, not unimportant.

The Central Bank advised otherwise and we have woken up today as the hardest participant in the ERM. That is only the beginning of the story. The objectives - and EU requirements - of financial and economic health remain to be achieved. The EU has made it clear that the burden remains on the government to "lower current government expenditure and to lower the high debt level and ensure sustainability of the convergence process". So has the Central Bank, which is now effectively a currency board, and will concentrate on managing the external reserves and on the interest rate structure.

The government has up to 2007 to get the public finances right if we are to enter the eurozone in 2008. On the economic side, the consequences of totally ignoring the Charybdis of potential pressure on the productive sector can only be assessed through time.