A European Monetary Fund

7 March 2017

There have been repeated calls for a European Monetary Fund (EMF) for the Euro Area.1 The European Commission affirms the proposal of establishing an EMF on the basis of the European Stability Mechanism (ESM).2 It now also seems to become a core proposition as part of the 60th anniversary celebration of the Treaty of Rome this month.3 However, for an EMF to be effective it would have to be constituted quite differently from the ESM. It would only make sense if an EMF was based on borrowing directly from the European Central Bank (ECB).4 An EMF would also at last incorporate into the statutes of the European Union the notion that adjustment forms an integral part of monetary unions.

The International Monetary Fund (IMF) maintains a unique finance model for its core lending operations. The IMF’s financing is monetary in nature. The IMF has unconditional access to IMF member countries’ central bank foreign exchange holdings, similar to an overdraft facility, up to the level of the countries’ quota subscriptions to the IMF. Central banks that issue currencies that can be used in transactions with the IMF, so-called usable currencies, can replenish their holdings freely. Central banks that do not issue usable currencies can lend only in amounts given by total foreign exchange reserves.

The IMF lends through an exchange of currencies between lenders and borrowers. In a lending operation, the lender obtains a claim on the IMF, a so-called reserve tranche position, the borrower obtains foreign exchange and the IMF obtains a claim in national currency on the borrower. The process is reversed with the repayment to the IMF (therefore the notion of purchases and repurchases for IMF financing operations). The repayment is ensured through the application of strict conditionality, adjustment measures, and the preferred creditor status of the IMF. The IMF creates net additional resources to the extent that borrowing comes from central banks with freely usable currencies.

The ESM’s financing is fiscal in nature. It borrows in international capital markets to lend to countries in distress. The ESM therefore does not create additional resources but merely redistributes existing resources. The nature of its funding would also make its resources relatively limited in particular if it had to lend to a large Euro Area country.

The ECB would lend to the EMF in exchange for a claim on the EMF. This would be an operation similar to the Bundesbank lending to the IMF. Since the ECB is the only central bank in the Euro Area, it would be the only entity lending to the EMF. This could be varied by allowing the national central banks to perform the lending operations. While at the IMF, the lending risk is more spread as the number of countries’ making their resources available to the IMF through the IMF’s transaction plan is normally large, the nature of the risk of lending to the EMF would be identical to lending to the IMF. There is therefore a priori no reason why an EMF should not be funded by the ECB or the Euro Area national central banks. An ECB-funded EMF would allow creating new net resources in amounts to address credibly present and future financial crises in the Euro Area.

The adoption of an EMF, assuming it requires a treaty change, would also mean that the E.U. at last internalises the notion of adjustment into the European treaties. The Maastricht Treaty, surprisingly, had no notion of the need for adjustment. This is all the more astonishing as the IMF's Articles of Agreement, the de facto predecessor to the framework guiding the European Exchange Rate Mechanism (ERM) and therefore the euro, was based entirely on the notion of adjustment. The establishment of an EMF would thus show forcefully that the E.U. sees convergence merely as a journey. The latter should help improve economic policy formulation and recommendations for the Euro Area.

The establishment of an EMF would naturally be a complex matter. However, again the IMF offers a formidable example of how to set-up such an institution in particular with regard to its governance structure. An EMF would have to be at least as independent as the ECB and technocratic at heart. The over-towering role played by Germany in the decisions of the Troika in the European rescue programmes should serve as a reminder that all EMF member countries need to adhere to the governance rules to ensure the legitimacy of and ownership in the institution.5

The 60th anniversary of the Treaty of Rome marks an important occasion to celebrate and advertise the achievements of the E.U. However, it also needs to serve demonstrating that the E.U. remains committed to new bold steps. An ECB-funded EMF would be a very concrete signal indeed.