Forthcoming in Journal of Policy Modeling, special issue on adoption of the euro by new members of the EU. Abstract The ten countries that acceded to the European Union on May 1, 2004, must now decide how and when to adopt the euro. All do so eventually, and their self-declared deadlines range from 2006 to 2010. This paper analyzes tradeoffs, controversies and dilemmas that are likely to face such countries over the next six years, and in closing offers brief conjectures about future adoption of the euro by countries still outside the EU. Adopting the Euro: Dilemmas and Tradeoffs Facing EU Accession Countries James W. Dean Simon Fraser University jdean@sfu.ca The ten countries that acceded to the European Union on May 1, 2004 must now decide how and when to accede to European Monetary Union. All must join EMU 1 eventually, and their self-declared deadlines for accession range from 2006 to 2010. This paper analyzes tradeoffs, controversies and dilemmas that are likely to face such countries over the next six years, and in closing offers brief conjectures about future adoption of the euro by countries still outside the EU. State of play On May 1, 2004, ten countries Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia joined the European Union (EU). Unlike their predecessors in the EU, these countries must adopt the euro, but not immediately. That is, they must join European Monetary Union (EMU), but with derogation. In euro-speak this means a grace period before they join the hardening-up process of Exchange Rate Mechanism (so-called ERM II ), and then at least two years in ERM II before they re allowed into EMU. Recall that EMU now includes all EU countries except Denmark, Sweden and the UK. These three Parts of this manuscript draw from Dean (2002a,b). I am grateful to Elinor Johansen and Inna Golodniuk for comments, and in particular to Maria Silgoner of the National Bank of Austria for drawing my attention to a variety of facts that I got wrong in an earlier draft. 1 Throughout this paper I use the term EMU to mean European Monetary Union, by which I mean countries that have withdrawn their national currencies and adopted the euro as their sole official currency. Usage in the European bureaucracies is different: EMU means Economic and Monetary Union, to which all 25 EU members belong. I prefer the vernacular and use the phrase accession to EMU interchangeably with adopt the euro. 1
countries opted out 2, but 2004 entrants cannot. Recall also that Norway and Switzerland are not in the EU. Box 1 is a wish list : it contains recent statements from the accession countries about their intended dates of accession to EMU. These dates range from Estonia s 2006 to Czech Republic s 2009 2010. INSERT BOX 1 Conditions for joining EMU - To join the EU, accession countries had to meet many economic criteria, the most basic of which was to create market economies. Before adopting the euro they must join ERM II and commit to maintaining exchange rates within +/- 15% (de jure) or +/- 2.25% (de facto) bands around a parity peg to the euro for at least two years. In addition, they must have met the following Maastricht criteria during the year before they want to adopt the euro (i.e., at the earliest, during the second year of their period in ERM II): - Inflation and long term interest rates within 1.5% and 2% respectively of the three EU countries 3 with the lowest inflation rates - Public debt at or below 60% of GDP, and budget deficits at or below 3% of GDP States of preparation Most of these criteria are already met by the new member states. In fact they are much closer to convergence than the current EMU countries were in 1994. Their inflation average is just below the required reference value, their long-term interest rates are also below reference, and their average debt/gdp ratio is only 40%. However for several, their Achilles heal is fiscal deficits: in 2002 and 2003 these averaged over 5% of GDP, well above the required 3%. While fiscal deficits are perhaps the most fundamental challenge to adoption of the euro, there are others: The Czech Republic, as a by-product of rapid productivity growth and strong investment inflows, has until recently faced a rapidly appreciating nominal exchange rate, and may experience further increases that could push the limits allowed under ERM II. 2 Technically, only Denmark and Britain have been granted opting out, but it would seem unlikely that Sweden will ever be expelled from the EU or even penalized for repeatedly voting against adopting the euro. 3 Note that in this context EU countries means all 25 existing members, including all 10 new members as well as the 3 old members that have not adopted the euro. 2
Hungary until mid-2003 experienced currency instability, and still suffers from inflation that exceeds ERM II criteria, not to mention high budget deficits (5.6% of GDP in 2003). Also, net FDI outflows in 2003 forced increased reliance on financing the substantial current account deficit via debt. Latvia has made the slowest transition from central planning and will be under pressure from Brussels and Frankfurt to reduce privileged access of the public sector to financial institutions. Lithuania maintains conflicts of interest among central bank board members. Poland has successfully reduced inflation to less than 2%, but at the cost of a strong zloty and high interest rates, policies that have exacerbated unemployment. Slovakia suffers from both high inflation and high deficits. Slovenia suffers from high inflation. In these contexts it should be noted that high (inflation, deficits, etc.) means simply too high to meet Maastricht criteria, not necessarily too high for the good of the country. Indeed, even in countries that are in the late stages of transition to market systems, there may be good grounds for tolerating stable but relatively high inflation and deficits. To impose prematurely low inflation and deficits may reduce real growth, increase unemployment, and exacerbate income differentials. This is partly because structural rigidities take time to break down, and partly because productivity growth in these Central and Eastern European Countries is typically well above the Western European average. In short, some ERM II and Maastricht conditions may be too onerous. States of controversy Indeed, several aspects of the route to adoption of the euro are currently controversial in Warsaw, Prague, Budapest, Bratislava, Ljubljana etc., and even, soto voce, in Brussels and Frankfurt. Here are six of the most controversial: Should the three best EU countries or the over-all EU average dictate inflation reference levels for inflation and long term interest rates? If the latter, reference levels would, of course, be higher. Should +/- 2.25% or +/- 15% be allowable as a band for exchange rate fluctuations? The band was officially widened to +/- 15% after the Western European currency crises of 1992/93, but in mid-2003 Pedro Solbes, the EU 3
Monetary Affairs Commissioner, startled putative accession countries by proclaiming that de facto the band expected within ERM II will be +/- 2.25%. More generally, should ERM II relax its inflation ceilings and/or relax nominal exchange stabilization to allow real exchange rates to appreciate as productivity catches up to the EU? Does the European Central Bank ever contemplate acting as a centralized lender of last resort? If so, might it not also want to centralize banking supervision? Bad bank debt is particularly problematic in the Czech Republic, in Slovakia and in Poland. Is it manageable at country levels? Should the new member states with currency boards abandon them before joining ERM II? This would seem pointless unless re-alignment of parity with the euro is contemplated. This last controversy raises a broader issue. How do countries that already fix to the euro or to baskets these countries are relatively small - loosen up, or will that be necessary? And how do the countries that currently float these countries are relatively large tighten up? Current currency regimes of the ten acceding countries are described in Box 2. The ten divide neatly into six small country peggers and four large country floaters. INSERT BOX 2 Small peggers Slovenia, which is small in size and population (albeit top of the ten in terms of per capita GDP), will have to move from its current peg with a downward sloping band (i.e. gradual depreciation versus the euro), to a peg with a horizontal band. This is a potential problem for trade competitiveness if inflation persists above the EU average. The smallest five - Cyprus, Estonia, Lithuania, Latvia and Malta - all have hard pegs to external currencies: the first three to the euro, Latvia to the SDR, and Malta to a basket that is 70% euro-weighted. It makes no sense for the euro-peggers to loosen up unless their pegs are seriously misaligned: in any case they lack feasible exit strategies. But the other two must make an explicit decision about whether to maintain the parity rate with the euro that is implicit in their baskets. Moreover they face the problem that their new pegs to the euro will conform less to their trade patterns to the extent that their current baskets are de facto trade weighted. This is not likely to be a problem for Latvia, whose trade is overwhelming with euro-land. Malta, however, still does considerable trade with Britain, its former 4
colonial master: tourism in particular may suffer slightly from increased exchange rate uncertainty. But the previous problems are minor by comparison with the benefits likely to be reaped from tighter integration with euro-denominated capital markets. Indeed, many of these benefits have already been reaped. The small-country peggers have very open economies but very thin foreign exchange markets. Their pegs have served them well in terms of access to international financial markets, low inflation and strong output growth. Moreover they have not needed to intervene or use interest rates to maintain the pegs. Long term domestic-currency rates have converged toward euro-levels; to exit and then re-enter their hard pegs would unnecessarily cost them credibility. In short, Estonia and Lithuania will likely maintain their currency board pegs to the euro and Cyprus will likely maintain its narrow peg to the euro, whereas Latvia and Malta will need to move from their basket pegs (with euro-weights of 35% and 70%) toward sole pegs to the euro. Large floaters The larger new member states have moved recently toward more flexibility. The Czech Republic has a managed float with inflation targeting; Hungary pegs to the euro but with a +/- 15% band, and also inflation-targets: i.e. it runs a managed float with two targets; Slovakia has a managed float with hybrid targets; Poland runs a free float with inflation targeting. Larger countries will have to harden their regimes, but they should be permitted to harden gradually. Under ERM II, de jure they can fluctuate within a +/- 15% band. But as already mentioned, in mid-2003 Pedro Solbes, the EU Monetary Affairs Commissioner, expressed preference for the much narrower, traditional +/- 2.25% band. The wider band would be wiser since these countries still face transition challenges: Czech Republic s koruna rose by 25% 1999 mid-2002, and since then has fallen by more than 10%; Hungary s forint has also been volatile, as has Poland s zloty and Slovakia s koruna. This volatility reflects both Balassa- Samuelson effects due to rapid productivity growth, and large changes in capital inflows. Exchange rate flexibility versus stability is one of several tradeoffs and even dilemmas that will face new member states in the transition process toward adopting the euro. Tradeoffs, dilemmas and challenges How much flexibility? As suggested, among the large floaters a continued history of volatility against the euro suggests that transitional restructuring and/or volatile capital flows may necessitate continued flexibility for several years. The Czech 5
Republic, Hungary, Poland, and Slovakia have already been mentioned. Latvia might be added to the list. As the poorest of the new member states it has the longest way to go to catch up to EU productivity levels; moreover, capital inflows are likely to increase sharply. Recall that Latvia pegs to the SDR; hence unlike other small floaters, flexibility against the euro can be introduced without abandoning a preexisting fixed parity. What central parity, and when? A second challenge facing new member states that do not already fix to the euro is whether to lock in to a central parity rate now or later. Rapid productivity growth relative to the EMU causes appreciation of real exchange rates. This can occur via inflation in non-tradeables prices (the Balassa - Samuelson effect) that is not offset by deflation in tradeables prices, or via appreciation of the nominal exchange rate: in short via inflation that is higher than the EU average, or via increases in the nominal exchange rate. In any case, the central parity consistent with current account balance may be higher in, say, 2007, than now, especially if new member states are constrained by the Maastricht criteria to inflation rates no higher than the lowest three EMU countries. The EU Commissioner s declaration last year of a de facto ERM II exchange rate band of only +/- 2.25% could force countries to make a premature choice of parity. An additional consideration in the choice between fixing parity now or later is that secular growth in capital inflows can cause real exchange rate appreciation, again via inflation or via nominal appreciation. This can also delay the date for fixing parity. In both cases (catch-up productivity growth and rapid capital flows), the parity rate consistent with current account balance is a moving target. A final complication is that the medium term parity rate is not necessarily one that is consistent with current account balance. On the contrary, continuing current account deficits are appropriate as long as productivity growth and returns on capital are above EMU and world averages. The European Central Bank itself (ECB, Feb 2004, p. 22) regards the two-year participation requirement in ERM II as a testing phase, both for readiness for reduced exchange rate volatility, and for fixing the correct parity rate. However in practice the ECB is likely to confront tradeoffs and dilemmas. Continued real and financial restructuring may warrant continued flexibility; moreover premature exchange rate stability may cause excessive current account deficits (in case of undervaluation), or excessive inflation (in case of overvaluation). Fiscal challenges A third set of challenges is fiscal. First, in recent years fiscal deficits have widened in Czech Republic, Hungary, Poland and Slovakia. Even in Cyprus and Malta, deficits are above 3% of GDP. These deficits may prove more intransigent than in Western Europe, given long socialist traditions and the consequent likelihood of continued pressure for government spending on both infrastructure and transfer payments. Second, given a reluctance to cut spending, 6
the scope for contractionary counter-cyclical fiscal policy may be more limited in the Central and Eastern European Countries than in Western European countries like Ireland; so too the scope for stimulatory fiscal policy will be limited if the Growth and Stability Pact s 3% deficit ceiling is enforced. Next to adopt the euro? Bulgaria and Romania hope to join the EU in 2007. Croatia has just applied, and Macedonia may do so soon. All four could, in principle, officially euroize by 2010, although Croatia and Macedonia are likely to accede to both the EU and EMU later than Bulgaria and Romania. Turkey has had official EU-candidate status since 1999, but is not expected to be admitted until at least 2015. Several countries could unofficially euroize: that is, withdraw their domestic currency and adopt the euro without permission from Brussels or Frankfurt. Kosovo and Montenegro have already done so. Bosnia and Serbia could be next, especially if they hold out no hope to join the EU in the foreseeable future and therefore have no particular incentive to jump through hoops devised by Brussels and Frankfurt. It is not, however, crystal clear that abandonment of local currencies is typically immanent. Although many if not most countries in Eastern Europe and Central Asia already use the euro or the dollar informally for transactions and/or store of value purposes (Feige & Dean, 2004), the number of national currencies in the region has multiplied over the last decade with the creation of new nation states (Pomfret, 2003). It is not clear that widespread formal dollarization, euroization, or currency union is likely in the near future except in countries that accede to the EU. 7
BOX 1 Self-declared Intentions to Join European Monetary Union Cyprus: 2007 despite recent fiscal slippages (Pre-Accession Economic Programme [PEP] 2003) Czech Republic: as soon as plausible economic conditions have been created (PEP 2003) [More concrete statements by CZ point to 2009 2010] Estonia: as soon as 2006 (PEP 2003) Hungary: 1 January 2008 (PEP 2003) Latvia: earliest 1 January 2008 (PEP 2003) Lithuania: Realistically start of 2007 (Governor Sarkinas, March 2003) Malta: second half of 2007 or Jan 2008 latest (Governor Bonello, Feb 2004) Poland: only when macro conditions make it possible [given projected gov t deficits] 2008 or 2009 (PEP 2003) Slovakia earliest realistic target 2008 (Strategy of the Slovak Republic for adoption of the euro, June 2003) Slovenia Both the Bank and the Government judge it will be possible at the beginning of 2007 (Joint programme of the Slovenian Government and Bank of Slovenia for ERM II entry and adoption of the euro, November 2003) In short, declarations of the new member states range from 2006 (Estonia) to Jan 2010 (Czech Rep.) Most optimistic (2007 or earlier) are Cyprus, Estonia, Lithuania, Malta, and Slovenia Least optimistic (2008 or later) are Czech Republic, Hungary, Latvia, Poland and Slovakia Source: European Central Bank (2004), pp. 7 8. BOX 2 Cyprus: De jure: Peg to euro with +/- 15% band. De facto: Narrow range of fluctuation Czech Republic: Managed float; 2 4% inflation target by end 2005 Estonia: CBA fix to euro since 1992 Hungary: Peg to euro with +/- 15% band; inflation target of 3 5% by end 2005 Latvia: Peg to SDR with +/- 1% band Lithuania: CBA fix to dollar in 1994, then to euro in February 2002. Malta: Peg to basket of 70& euro, 30% dollar and pound sterling Poland: Free float with inflation target of 1.5 3.5% Slovakia: Managed float: hybrid strategy; implicit infl. targeting Slovenia: Crawling band with monetary, real, external and financial indicators Source: European Central Bank (2004), pp.14 15. 8
REFERENCES Dean, James W. (2002a) The Economic Case Against the Euro Revisited In Patrick Crowley, Before and Beyond EMU. Routledge. Dean, James W. (2002b) Exchange Rate Regimes in Central and Eastern European Transition Economies, with Lessons for Ukraine CASE, Kyiv, Ukraine and Warsaw, Poland. European Central Bank (2004), The Acceding Countries Strategies Towards ERM II and the Adoption of the Euro: An Analytical Review, Occasional Paper Series No. 10, February. http://www.ecb.int. Feige, Edgar and James W. Dean (2004) Dollarization and Euroization in the Transition Countries: Asset Substitution, Network Externalities and Irreversibility In Monetary Unions and Hard Pegs: Effects on Trade, Financial Development, and Stability, George M. Von Furstenberg, Volbert Alexander and Jacques Melitz, eds., New York: Oxford University Press, March, 2004. Oesterreichische Nationalbank (2002) Focus on Transition 2. http://www.oenb.at Pomfret, Richard (2003) Currency Areas in Theory and Practice Working Paper, School of Economics, University of Adelaide. 9