Adopting the Euro: Dilemmas and Tradeoffs Facing EU Accession Countries James W. Dean

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Adopting the Euro Dilemmas and Tradeoffs Facing
EU Accession Countries James W. Dean

• James W. Dean
• Professor
• Simon Fraser University
• jdean_at_sfu.ca

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State of Play

• 10 countries Cyprus, Czech Republic, Estonia,
  Hungary, Latvia, Lithuania, Malta, Poland,
  Slovakia and Slovenia join EU May 1, 2004
  
• These countries must join EMU with derogation
  this means a grace period before they join ERM II
  and then at least 2 years in ERM II before
  theyre allowed in to EMU.
• EMU now includes all EU countries except Denmark,
  Sweden and the UK. These 3 countries opted out,
  but 2004 entrant cannot. Recall that Norway
  Switzerland are not in the EU.

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Conditions for Joining EMU

• To join EU, accession countries had to meet many
  economic criteria (eg, creating market economies)
  
  
• To join EMU they must join ERM II and then for at
  least 2 years maintain
  
• Inflation and long term interest rates within
  1.5 and 2 respectively of best 3 EMU countries
  
• Exchange rate within /- 15 (de jure) or /-
  2.25 (de facto) band aroung the euro
  
• Public debt at or below 60 of GDP and budget
  deficits at or below 3 of GDP
  

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State of Preparation

• Most of the Maastricht Convergence criteria are
  already met by accession countries. 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 ((avg of lowest 3 EU
  countries plus 1.5), their long-term interest
  rates are also below reference (avg of 3
  lowest-inflation EU countries plus 2), and their
  average debt/GDP ratio is only 40.
• However, their fiscal deficits in 2002 averaged
  5.1 of GDP, well above the required 3.

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States of Unpreparedness

• Czech Republic Appreciating nominal exchange
  rate
  
• Estonia Central bank independence?
• Hungary Recent currency instability high
  inflation high budget deficits
  
• Latvia Privileged access of public sector to
  financial institutions
  
• Lithuania Conflicts of interest among central
  bank board members
  
• Poland High inflation, though now curbed by
  strong zloty and high interest rates
  
• Slovakia High inflation and deficits
• Slovenia High inflation

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State of controversy

• 3 best EMU countries or EMU average as reference
  level for inflation and long term interest
  rates?
  
• /- 2.25 or /- 15 band for exchange rate
  fluctuations?
  
• Abandon currency boards?
• Relax inflation ceilings or relax nominal
  exchange stabilization to allow real exchange
  rates to appreciate as productivity catches up to
  EU?
• Centralized lender of last resort? Centralized
  banking supervision?
  
• Bad bank debt (CZ, SLK, POL) manageable at
  country levels?
  

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Times of Joining EMU

• As declared by accession 10
• Cyprus 2007 despite recent fiscal slippages
  (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)

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Times of Joining EMU (contd)

• 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 govt deficits
  2008 or 2009 (PEP 2003)

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Times of Joining EMU (contd)

• 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)

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Times of Joining EMU (contd)

• In short, declarations of accession countries
  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

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Current regimes of acceding countries

• Cyprus De jure Peg to euo 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

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Small country peggers

• Small acceding countries already have hard pegs
  or currency board arrangements (CBAs), some to
  the euro and some to baskets
  
• Since they lack feasible exit strategies, they
  will likely maintain their present arrangements,
  except that those pegged to baskets will re-peg
  to the euro

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What will small country peggers do?

• Estonia and Lithuania will likely maintain their
  CBA pegs to the euro
  
• Cyprus will likely maintain its narrow peg to the
  euro
  
• Latvia and Malta will need to move from their
  basket pegs (with euro-weights of 35 and 70) to
  sole pegs to the euro.\
  
• Slovenia will have to from its current gradual
  depreciation vs the euro to a peg with horizontal
  band
  

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Rationale for SMPs to keeping current regimes

• The small-country peggers (SMPs) on the preceding
  slide
  
• have very open economies but very thin foreign
  exchange markets.
  
• Their pegs have served them well in terms of
  access to intl financial markets, low inflation
  and strong output growth.
  
• Moreover they have not needed to intervene or use
  interest rates to maintain their 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

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Larger accession countries have more flexible
regimes

• Larger countries have actually moved recently
  toward more flexibility
  
• Czech Republic has a managed float with inflation
  targeting
  
• Hungary pegs to the euro but with a /- 15 band,
  and with inflation targeting ie it runs a
  managed float with two targets
  
• Slovakia also has a managed float with hybrid
  targets
  
• Poland runs a free float with inflation targeting

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Strategy for larger countries

• Larger countries will have to harden their
  regimes, but it can be gradual, using ERM IIs de
  jure /- 15 band
  
• However in mid-2003 Pedro Solbes, EU monetary
  affairs commissioner, expressed a preference for
  a /- 2.25 band
  
• The wider band would be wiser since these
  countries still face transition challenges Czech
  Republics crown rose by 25 1999 mid-2002 then
  has fallen by 10 since then Hungarys florint
  has also been volatile, as has Polands zloty and
  Slovakias crown.

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Tradeoffs and Dilemmas 1

• Exchange rate flexibility versus stability
• A continued history of volatility vs the euro
  suggests that transitional restructuring and/or
  volatile capital flows necessitate continued
  flexibility for several years (eg, Czech Rep.,
  Hungary, Latvia, Poland, Slovakia

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Tradeoffs and Dilemmas 2

• Fix of central parity 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
  (Balassa - Samuelson effect) not offset by
  deflation in tradeables prices, or via nominal
  appreciation
• Hence the central parity consistent with current
  account balance may be higher in, say, 2007 than
  now

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Tradeoffs and Dilemmas 3

• Central parity now or later? Contd
• Also, secular growth in capital inflows can cause
  real exchange rate appreciation, again via
  inflation or via nominal appreciation.
  
• This can also delay the date to fix parity
• In both cases (catch-up productivity growth and
  rapid capital flows), the parity rate consistent
  with current account balance is a moving target.
  Moreover current account deficits are appropriate
  as long as prod. growth and returns on capital
  are above EMU and world averages.

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Tradeoffs and Dilemmas 4

• The European Central Bank (ECB, Feb 2004, p. 22)
  regards the two-year participation requirement in
  ERM II as a testing phase for both readiness
  for reduced exch. rate volatility, and for fixing
  the correct parity rate.
• In short, continued real and financial
  restructuring may warrant continued flexibility
  moreover premature exch. rate stability may cause
  excessive current account deficits (in case of
  undervaluation), or excessive inflation (in case
  of overvaluation).

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Convergence

• Most of the Maastricht Convergence criteria are
  already met by accession countries. 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 ((avg of lowest 3 EU
  countries plus 1.5), their long-term interest
  rates are also below reference (avg of 3
  lowest-inflation EU countries plus 2), and their
  average debt/GDP ratio is only 40.
• However, their fiscal deficits in 2002 averaged
  5.1 of GDP, well above the required 3.

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Fiscal challenges

• In recent years, fiscal deficits have widened in
  Czech Rep., Hungary, Poland and Slovakia also,
  Cyprus and Maltas deficits are above 3.
  
• These deficits may prove more intransigent than
  in Western Europe given continued pressure for
  government spending on both infrastructure and
  transfer payments. Moreover. After they join EMU,
  the scope for contractionary counter-cyclical
  fiscal policy (a la Ireland recently) may be more
  limited in the CEECs than in Western Europe given
  this reluctance to cut spending so too the scope
  for stimulatory fiscal policy may be limited
  given the Growth and Stability Pacts 3 deficit
  ceiling.

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Next to Adopt the Euro?

• Bulgaria and Romania hope to join the EU in 2007.
  Croatia may also apply. Hence all three could
  officially euroize by 2010.
  
• In addition, several countries could unofficially
  euroize that is, withdraw local currency and
  adopt the euro without permission from Brussels
  or Frankfurt. Kosovo and Montenegro have already
  done this. Bosnia and Serbia could be next,
  especially if they hold out no hope of joining
  the EU in the foreseeable future.

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Informal Use of the Euro

• 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 ( For data, see Feige Dean, 2004).
• However the number of national currencies Eastern
  Europe and Central Asia has multiplied in the
  last decade with the creation of new nation
  states. It is not clear that formal
  dollarization, euroization, or currency union is
  likely in the near future.

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Recent related publications by the author 1

• Recent related publications by the author
• The Economic Case Against the Euro Revisted In
  Patrick Crowley, Before and Beyond EMU.
  Routledge, 2002.
  
• Exchange Rate Regimes in Central and Eastern
  European Transition Economies,
  
• With Lessons for Ukraine CASE, Kyiv, Ukraine and
  Warsaw, Poland, 2002.
  
• Monetary Policy in Advanced and Transition
  Economies Illustrations from Canada, Poland and
  Ukraine CASE, Kyiv, Ukraine and Warsaw, Poland,
  2002.
• The Dollarization Debate (editor, with Dominick
  Salvatore and Thomas Willett). Oxford University
  Press. March 2003.
  
• Should Latin Americas Common Law Marriage to
  the U.S. Dollar Be Legalized? Should Canadas?
  In The Dollarization Debate, op. cit.

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Recent related publications by the author 2

• Should Canada Dollarize? Lessons from Europe In
  L.-P. Rochon and M. Seccareccia (eds),
  Dollarization Lessons from Europe for the
  Americas, London/New York Routledge, 2003.
• Dollarization and Euroization in the Transition
  Countries Asset Substitution, Network
  Externalities and Irreversibility (with Edgar
  Feige). 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.
• "Distributional Effects of Dollarization  The
  Latin American Experience" (With Anil Hira) Third
  World Quarterly, Vol.25, 3, April 2004.  
  
• Putative Exchange Rate Regimes in Central and
  Eastern European Transition Economies
  Forthcoming in Journal of Policy Modeling, 2004.