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

1. Adopting the Euro: Dilemmas and Tradeoffs Facing EU Accession CountriesJames W. Dean James W. Dean Professor Simon Fraser University jdean@sfu.ca

2. 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 they’re 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].

3. 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

4. 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%.

5. 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

6. 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?

7. 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)

8. Times of Joining EMU (cont’d) • 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)

9. Times of Joining EMU (cont’d) • 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)

10. Times of Joining EMU (cont’d) • 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

11. 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

12. 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

13. 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

14. 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 int’l 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

15. 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

16. Strategy for larger countries • Larger countries will have to harden their regimes, but it can be gradual, using ERM II’s 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 Republic’s crown rose by 25% 1999 – mid-2002 then has fallen by 10% since then; Hungary’s florint has also been volatile, as has Poland’s zloty and Slovakia’s crown.

17. 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

18. 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

19. Tradeoffs and Dilemmas 3 • Central parity now or later? Cont’d … • 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.

20. 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).

21. 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%.

22. Fiscal challenges • In recent years, fiscal deficits have widened in Czech Rep., Hungary, Poland and Slovakia; also, Cyprus and Malta’s 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 Pact’s 3% deficit ceiling.

23. 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.

24. 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.

25. 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 America’s Common Law Marriage to the U.S. Dollar Be Legalized? Should Canada’s?” In The Dollarization Debate, op. cit.

26. 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.