With the launch of the euro less than one year away, one of the most uncertain aspects of European economic and monetary union is the exchange rate policy that will govern the future single currency.

Europe's exchange rate relations with the rest of the world are sure to undergo change as the euro's introduction reshapes the region's economy.

The interplay between European and other currencies may turn out to be very different from what it was in the past.

Yet exchange rate policy after January 1 1999 remains a largely unresolved issue. That appears rather surprising in light of the fact that the conversion rates for currencies participating in Emu are due to be announced in May.

While the European Union's Maastricht treaty stipulates that the European Central Bank (ECB) should be concerned primarily with internal stability, there remains significant room for interpretation about the need to secure external stability, especially concerning the euro/dollar exchange rate.

The question of future exchange rate policy is the subject of a detailed discussion paper* by the Centre for Economic Policy Research in London.

The paper makes the point that Emu will transform a group of small open economies into a large closed economy, similar in some respects to that of the US.

This will change the importance of the exchange rate for domestic policy.

Under Emu, the export share of gross domestic product will be about 10 per cent, similar to prevailing levels in the US, but significantly lower than current levels in all the EU economies.

The reason is that trade between two EU members is now accounted for as foreign trade, while it will become "domestic" trade under Emu.

"In a closed economy, monetary policy operates through interest rates and asset prices, including housing. In an open economy, the exchange rate assumes paramount importance," the paper notes.

A relatively closed economy, such as the US, has more monetary independence than a small open economy such as the UK, where monetary policy is severely constrained by the exchange rate.

The paper argues that this difference becomes important once the central bank faces a policy dilemma.

The Federal Reserve, for example, would invariably focus on the internal objectives, if faced with a conflict between internal and external stability.

"For these reasons, it is natural to expect the ECB will devote less attention to the exchange rate than has been the case with European central banks so far."

With an exchange rate policy of "benign neglect", the exchange rate will become a policy issue only under extreme economic circumstances or under extreme exchange rate volatility.

Is extreme exchange rate volatility more or less likely under Emu?

The paper gives no conclusive evidence, but points out that Emu will remove one stabilising factor.

At present, when the dollar weakens against the D-Mark, other European currencies also weaken against the D-Mark.

As a result, the dollar's overall rate against a basket of European and other international currencies weakens by less than the dollar/D-Mark rate would suggest. Under Emu, that buffer would no longer be there.

Other factors could add to volatility. "Each major currency has its fringe of hangers-on and the euro will be no exception," the authors note. This is a reference to the post-1999 Exchange Rate Mechanism, a voluntary exchange rate system to link the currencies of non-participating EU countries, such as Denmark, to the euro.

Some eastern European countries might also maintain links, such as the currency board operated by Estonia, which at present ties the kroon to the D-Mark.

But where no formal exchange rate links exist, the result could be increased volatility in intra-European exchange rates, for example between the euro and the pound.

"Extreme caution will be required to avoid trade friction from boiling over into political tensions on suspicions of beggar-thy-neighbour policies," the authors note.

Under a policy of benign neglect towards the exchange rate, in both the US and the EU, close policy co-operation in international organisations such as the International Monetary Fund and the Group of Eight industrialised countries could in times of need become critical.

But the report argues that formal exchange rate systems, such as the Bretton Woods system in the 1950s and 1960s or the ERM, are unrealistic, because they work only if one currency acts as an anchor.

Given the relatively equal economic weight of the US and the Emu zone, the conditions for this are unlikely to apply.

Policy co-operation would therefore have to be voluntary and geared to "informal and ad hoc exchange rate arrange-ments", on lines similar to the exchange rate accords of the 1980s.

So far, relatively little attention has been paid by EU officials and central bankers to how such policy co-operation would work in practice.

* Begg, D., Giavazzi, F., Wyplosz C. : "Options for the Future Exchange Rate Policy of the Emu"; Centre for Economic Policy Research, Occasional Paper No. 17 - 'Each major currency has its fringe of hangers-on and the euro will be no exception'

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