Last Monday, the Maltese lira entered the so-called ERM II period but for many the mechanism means nothing more than a complicated term best left for the economists to probe. Herman Grech wades through the economic policy to shed some light on the matter.
By agreeing to the Exchange Rate Mechanism II, Malta Cyprus and Latvia have basically agreed to carry out structural and economic reforms over the next two years - a prelude to full euro entry later this decade.
The ERM II period serves as a time where the national currencies are locked into a parity rate against the euro and can only move within a +/-15 per cent band around the locked rate for at least two years.
The member states can adopt the euro provided they also have a budget deficit below three per cent of the gross domestic product, a maximum debt to GDP ratio of 60 per cent and inflation and interest rates not much above those in the eurozone.
Estonia, Lithuania and Slovenia entered the mechanism last June, as well as Denmark, a long-standing member.
The four largest new EU members - Poland, Hungary, the Czech Republic and Slovakia - are not expected to join the mechanism this year and are still undecided whether to adopt the euro by the end of the decade, the main reason being the bad state of their government finances.
ERM II is based on the June 1997 Amsterdam Resolution of the European Council on the establishment of an exchange rate mechanism in the third stage of Economic and Monetary Union. The new ERM replaced the European Monetary System as from January 1999.
The announcement of ERM II accession last week was accompanied by a commitment by the countries concerned to pursue sound fiscal policies, effective financial supervision, appropriate wage policies and structural reforms.
Besides the formal requirement of a two-year participation in ERM II before the "examination", the mechanism is intended to help member states achieve exchange rate stability.
At the same time, the mechanism also helps protect them and the other member states from unwarranted pressures in the foreign exchange markets. In such cases, the mechanism may assist participating member states, when their currencies come under pressure, to combine appropriate policy responses, including interest rate measures, with coordinated intervention.
Ready or not?
Last November, the European Commission issued its first report on the state of practical preparations for the euro in the new member states - and confirmed all 10 states' enthusiasm to introduce the currency between 2007 and 2010.
Analysts believe the introduction of the euro in the new countries should be faster and even smoother than in the current eurozone members because an average of about 50 per cent of the population has already used euro notes and coins.
"Although the euro is already an established and successful currency, preparations for its adoption in the new member states should not be underestimated or delayed if we want to ensure a wide public acceptance and a smooth transition," Economic and Monetary Affairs Commissioner Joaquin Almunia said.
At this stage four countries have announced plans to join the euro by 2007 - Estonia, Cyprus, Lithuania and Slovenia - while the other six have expressed the wish to be part of the euro area by 2010 at the latest.
The compliance with the treaty criteria will have to be assessed by the Commission at the time and the final decision will be made by the Council on the basis of a Commission recommendation.
The current euro area countries, except Greece, had a transitional period of three years but the lessons drawn since show this is neither necessary nor advisable for the new countries.
The results of a Eurobarometer survey carried out in September show that citizens in the new member states are already familiar with the euro.
Citizens in the new member countries have mixed feelings about the euro either because they are attached to their national currency or because they fear a possible impact on prices or both.
Mr Almunia said last week that prices should start to be displayed in both currencies as soon as a country's fixed and irrevocable conversion rate has been formally decided by the Council.
This happens many months before the country joins the euro area and normally on the same date that the country's derogation is lifted.
Malta's position
Malta had its first opportunity to join the ERM II mechanism last year but the government had decided to postpone its decision in order to make more in-depth analyses and give some time for the state finances to be in better shape.
A report adopted by the European Commission last October had pointed out that Malta does not fulfil four of five convergence criteria that must be met in order to join Europe's single currency system.
The report examined whether the member states not opting out of the single currency meet the convergence criteria on price stability, the government budgetary position, exchange rates and interest rates and whether they ensure the compatibility of their legislation with that required for euro membership.
The report says that Malta satisfies only one criterion - that of long-term interest rate convergence - and fails in the other four benchmarks.
Estonia and Slovakia are in the same situation as Malta while Hungary and Poland are in a worse position, since they satisfied none of the criteria.
Out of the new member states, Lithuania and Slovenia seem to be the most advanced and with the biggest chance of adopting the euro in 2007.
The average inflation rate in Malta over the 12 months to August 2004 stood at 2.6 per cent. The government's deficit was 9.7 per cent of GDP in 2003 and the debt was 71.1 per cent of GDP. This disqualifies Malta from fulfilling the criterion on the government budgetary position.
A similar report will be issued in 2006, a year when a decision will be taken on which states will be eligible to join the euro as from 2007.
The central rate of the Maltese lira was set at €1 to 42c9.
Effectively, the only significant change that took place on Monday was a change in the basket of currencies supporting the lira.
This basket used to be made up of a mix of three currencies amounting to 70 per cent euro, 20 per cent sterling and 10 per cent US dollar. As from Monday, this was tagged 100 per cent to the euro.
Although the EU rules specify that Malta will have to remain for a minimum of two years in ERM II, there is no limit and the country can decide to take its time before dropping the lira for the euro.
At the end of the two-year ERM period, the EU, acting on a request by the Maltese government, will carry out another assessment and if the outcome is positive, the government will be able to decide when to adopt the euro currency.
The agreement on participation of the Maltese lira in ERM II is based on a firm commitment by the Maltese authorities to pursue sound fiscal policies, including containing current government expenditure and lowering the high debt level, which are essential for preserving macroeconomic stability, containing the current account deficit and ensuring the sustainability of the convergence process.
Continued vigilance will be needed to ensure that wage developments remain in line with productivity growth. The authorities will continue to ensure effective financial supervision.
Asked how the decision to join ERM will affect the man in the street, economist Edward Scicluna summed it up in a few words: "Complicated economic mechanisms, such as the ERM II, are like technological ones - the new Airbus for example is meant to be enjoyed finally by the user, which is us.
"We definitely cannot avoid tasting the fruits of the economy or boarding a plane to travel. We have every reason to be interested and be critical where necessary."
Majority in favour of joining ERM II
The majority of respondents to an online poll by The Times have given the thumbs up to the government's decision to join the ERM II.
A total of 54.9 per cent of respondents said the government took the right decision, while 17.9 per cent said it was wrong to join the mechanism. The rest - 27.2 per cent - aligned themselves with the Labour Party's stand and described the decision as "premature".
Knowledge about the subject is lacking, at least as evidenced by the shortage of comments to accompany the poll.
However, a number of those that agreed with the government's decision to join ERM also advised strict control over prices.
A respondent argued that by joining ERM II, the government was actually committing itself and future governments to follow healthy EU regulation, such as deficit control, which is after all beneficial to the country.
Another said that the longer the country opted out of the euro the more it prolonged the disadvantage of operating a small currency.
One respondent asked why Prime Minister Lawrence Gonzi had not waited for a lower deficit before forging ahead into the mechanism.
"Now we have to meet strict deadlines to get the country's finances in order - and guess who will carry the burden? The worker," the respondent charged.
What do they think?
Malta's membership of the ERM will give operators peace of mind, according to the Parliamentary Secretary in the Finance Ministry, Tonio Fenech.
The junior minister said there were several reasons why the government decided to go towards the euro sooner rather than later.
Malta did not join the mechanism last year because the government wanted to analyse the response of the economy to EU membership. It also wanted to rein in the deficit further before taking the step, Mr Fenech explained.
It did not make sense to postpone the decision further when countries like Cyprus, which are in direct competition with Malta, are members of the ERM.
"We also wanted to give an international message that our problems are in no way equivalent to those being faced in Poland and Hungary," Mr Fenech argued.
The economic targets outlined are the same mentioned in the EU Convergence Plan and it is therefore useless for anybody to claim that there are newer, tighter economic targets lying ahead, he added.
"Yes, our standard of living is still below the EU's but our economy and business cycle is in line with Europe's and that is why we forged ahead.
"The public at large should have nothing to worry about. On the contrary, they should put their mind at rest that inflation will remain in control and that they will get the right equivalent of euros once the currency is introduced."
The Opposition's finance spokesman Charles Mangion has different views and believes the entry was "hasty, premature and not in the national interest".
"It's simply not the opportune moment to get into the mechanism. Let's stop fooling ourselves into believing membership of ERM will rake in more investment," Dr Mangion said.
Malta's premature membership of ERM II would not strengthen the island's competitiveness or make it more attractive for investment, he insisted.
The basic criteria on which such a decision should have been based was economic development, including living standards compared to the other European countries, as well as other present and future economic growth indicators.
Dr Mangion claimed that the manipulation of figures had led to the government's deficit reduction target for 2004 - particularly because of one-off revenue and postponement of payments.
Furthermore, while the Maastricht criteria laid down that government debt should not exceed 60 per cent of GDP, the debt had climbed to 75 per cent last year, an increase of three per cent over 2003 when the convergence plan had only projected an increase of 0.6 per cent.
So when is the right time to join the ERM II mechanism?
"When there's a rhythm of growth and the economy is revived," was Dr Mangion's quick reply.
Economist Edward Scicluna said that like all things in life there were risks on either side of the decision.
"The government used its political prerogative and decided to join now. Since it was finally a political decision I would be extremely surprised if the subject would not be discussed at the political level too and disagreements stated as usual in no uncertain terms."
Prof. Scicluna said Malta should adopt the euro only when it is "100 per cent economically prepared" for such an important permanent bond.
"We should ensure, for our own sake, that this period is truly as short as possible. But that in turn depends on how quickly we manage a revival of our anaemic economy."
Speaking during a news conference last week, Central Bank governor Michael Bonello said Malta's application to the ERM II formed part of a logic governing the single European market, which promoted the freedom of movement of persons, goods and capital, together with a strong integration of monetary and financial systems.
"In matters like these there is no black and white. But when we evaluated the situation, we concluded that a small open economy like Malta should reduce its vulnerability and form part of a monetary union as early as possible."