As real convergence is progressively achieved and as structural reforms proceed, the case for a narrow band would also become stronger. Should this latter path be followed, the burden of adjustment to external shocks would, of course, have to be borne by the real economy. In the first instance, this means pursuing a prudent fiscal policy. The current aim of fiscal policy is indeed to reduce the deficit to GDP ratio to around 2.5% by 2004, from 5.3% last year and over 10% in the late 1990s. By restraining domestic absorption, tighter fiscal policy should enhance the credibility of the exchange rate peg. Moreover, a smaller borrowing requirement also frees up resources for the private sector and helps to contain upward pressure on interest rates, thereby stimulating economic growth. Finally, bringing the budget deficit closer to balance will then give fiscal policy the leeway to respond in the event of adverse shocks or cyclical downturns. The response to shocks will also depend on the degree of flexibility in the economy as a whole. Unlike most accession countries, Malta has a long experience of a functioning market economy, driven by private ownership of productive assets and with much of it exposed to international competition. In general, therefore, the private sector has already proved that it can cope with adverse shocks. In this regard, the flexibility of the labour market has been especially important. This flexibility must, however, be enhanced in order to safeguard competitiveness.
This has been confirmed in an ECB assessment of Malta’s monetary and exchange rate policy in connection with the Pre-Accession Economic Programme Report for 2002, where it is noted that the current regime has served Malta well in promoting real and nominal convergence. In view of these considerations, and given the importance which exchange rate stability has for trade and investment, the current regime remains the preferred arrangement for Malta. Taken together, therefore, the institutional arrangements governing ERM II and the successful experience with the current fixed exchange rate regime suggest that the way forward will consist of a gradual reduction in the weight of the US dollar and sterling in the currency basket, such that by the time Malta will be ready to join ERM II the euro will be the sole reference currency. If the United Kingdom were to join EMU in the meantime, this would automatically raise the proportion of the euro in the currency basket, making the approach to ERM II that much easier. Consistently with this objective, the weight of the euro in the basket was increased from 56.8% to 70% last August. BIS Review 70/2002  3  Given that Malta’s optimal exchange rate strategy in the run-up to ERM II has been identified, the next question concerns the choice of the central exchange rate and the fluctuation bands. The choice of the central exchange rate and fluctuation bands Some might argue that the choice of the central rate is not vitally important.