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Enlargement and the euro

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Published 16 October 2003, updated 29 January 2010
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ECB EMU ERM European Central Bank

All future members of the European Union will be eligible to join the European single currency, the euro, in accordance with the provisions of the Maastricht Treaty. The ten countries that are due to join the EU on 1 May 2004 have all expressed interest in joining the eurozone at the earliest possible time. However, monetary integration may take longer for some future members, notably Poland and Hungary, whose budget deficits are deteriorating while unemployment is soaring. The future members will also have to make further efforts toward catching up to EU levels of income per capita, which requires hard work in the area of labour markets and fiscal policy reform.

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Summary

On 1 January 1999, eleven EU countries started the eurozone. On that day, the exchange rates of all EMU currencies were irrevocably fixed and the euro was officially introduced as legal currency.

In January 2002, euro coins and bank notes will be introduced and six months later national currencies will disappear.

The UK, Sweden and Denmark decided to stay out of the Eurozone for now, whereas Greece initially did not join because it did not meet the Maastricht criteria. On 1 January 2001, Greece became the 12th country to join the Euro, after it fulfilled all requirements.

Issues

All applicants must fulfill a number of formal and substantial conditions before joining the euro:

  • Maastricht convergence criteria of fiscal stability,
  • Central Bank i ndependence;
  • Low inflation and interest rates;
  • Monetary stability of their currencies by participating in the Exchange Rate Mechanism II (ERM II) for a minimum period of two years.

No restrictions will be placed on the candidate countries' exchange rate policies before entry to the EU. Once they have gained EU membership they will treat the exchange rate as a matter of common interest. Some voices in the EU have warned that premature efforts to join ERM II or the euro area may, however, be harmful both to the candidate countries and to the euro area itself.

The candidate countries can already now re-denominate their external trade in the single currency. They will also benefit from new sources of funding from the newly integrated euro financial markets, which have seen massive issuance of international bonds denominated in the euro since the launch of euro in January 1999.

There is no euro-zone exchange rate strategy that the candidate countries should follow in the run-up to accession and the Economic and Monetary Union (EMU). The European Council of Nice (December 2000) recommended that the candidates adopt such monetary policies as best suit their own economic conditions and are consistent with their other policies.

Upon accession, the new members will participate in EMU with the status of Member States with a derogation from adopting the euro. This status will be granted in the Accession Treaties. During this phase, the new Member States will have to treat their exchange rate policy as a matter of common concern and they are expected to join the exchange rate mechanism, the ERM II.

Once the new Member States reach a high degree of sustainable nominal convergence, which means fulfilling all the Maastricht Treaty convergence criteria, including at least two year participation in the ERM II, they can adopt the euro.  

At the same time, the candidates must fulfil the Copenhagen economic criteria. These criteria require them to be functioning market economies, able to cope with competitive pressures and market forces within the Union, by the time of accession. The Commission warns that the candidate countries should not try to meet the convergence criteria prematurely. They should rather concentrate on the structural and economic reform leading to well-functioning market economies.

The candidate countries are already participating in the pre-accession fiscal surveillance, which is similar to surveillance procedures for Member States. They are presenting to the Commission medium-term pre-accession economic programmes, which serve as a basis for a high-level economic policy dialogue with Member States. The Commission will also make an assessment of macroeconomic and financial stability in the candidate countries.

Positions

In a surprise move, the Commission proposed that euro zone-hopefuls should keep their currencies within a narrow 2.25 per cent trading range against the euro. According to the Commission, the new Member States wishing to enter the euro zone will have to join the Exchange Rate Mechanism II for two years and will have to keep their currencies within a 2.25 per cent trading range against the single currency. Under ERM II, currencies are generally required to trade within a 15 per cent band around a central euro rate. However, Economic and Monetary Affairs Commissioner Pedro Solbes has said that the narrower 2.25 per cent band will be applied when judging the stability of the currencies preparing to join the euro.

According to analysts , the move will make it more difficult for the new EU Member States to join the euro zone. In 1992, Britain was forced to drop out of ERM I after a tidal wave of selling the pound on the foreign exchanges left it defenceless against international currency speculators. The UK could not keep the sterling within a narrower band than that allowed under ERM II.

Lithuania plans to adopt the euro as early as 1 January 2007, Hungary by 1 January 2008 and Slovakia and by 1 January 2009. To meet the eurozone conditions, the 10 new EU members will have to cut public spending over the next few years. This means their governments will have to break promises to create more jobs and improve pensions and health care. Political analysts and economists observe that this might force several coalition governments to resign. Particularly under pressure are the governments in Poland, the Czech Republic and Hungary, where disputes over painful spending and tax cuts have weakened the centre-left ruling coalitions. Most analysts believe that, due to deteriorating economic conditions, Poland will not be able to meet the Maastricht criteria before 2009 or 2010.

Central bank governors of Poland, Hungary and the Czech Republic have called on the single currency countries to respect the Stability and Growth Pact. The governors expressed fears that demands by France and Germany for more flexible rules on budget deficit could undermine the new Member States' efforts to join the euro-zone.

Meanwhile, Hungary, along with Estonia, Latvia, Lithuania, Malta and Cyprus have initiated confidential negotiations with the ECB on entering their currencies into the EU's ERM II (Exchange Rate Mechanism for candidate countries).

In its study about the exchange rate options of the future EU member states in Central and Eastern Europe, the German Economic research institute IFO (Institut fur Wirtschaftsforschung) says in the transitional phase, the growing liberalisation of capital flows implies a choice between two poles:

  • fixed exchange rate ties without an independent monetary policy,
  • flexible exchange rates and monetary policy autonomy.

IFO says that for the small Baltic countries the advantages of a fixed link to the euro (for example by means of currency boards) are obvious because the EU is their most important trading partner and because their financial markets will receive an anchor for the long-term expectations. These countries are also too small for an effective, independent monetary policy.

For the candidate countries that have made the most progress in stabilization and creation of institutions (Poland, Hungary, Czech Republic, Slovenia), a greater flexibility in exchange rates is still appropriate, according to IFO.

The Dutch Scientific Council for Government Policy (WRR) believes that the enlargement will not damage the internal market or monetary union. Monetary union has stringent requirements for accession, and the economic and financial weight of the candidate countries relative to that of the euro-zone is fairly small, says a WRR study, entitled "Long-run Economic Aspects of the European Union's Eastern Enlargement".

The European Union's planned enlargement towards central and eastern Europe could further damage the EU common currency, the euro, according to the vice-president of the European Investment Bank , Massimo Ponzellini. Mr Ponzellini said that the euro may weaken further when eastern European countries join the EU. "As an economic bloc, they are not big enough to generate a request for euros on the market and thereby strengthen the currency. And the inflationary impact of these countries when they enter Europe will not help the euro," according to Mr Ponzellini.

The Brussels-based Centre for European Policy Studies (CEPS) says it is misleading to say that EMU membership of Central and Eastern European countries will come long after EU membership because t he candidates are supposedly not ready to meet the Maastricht criteria. The author, CEPS Director Daniel Gros, says that the starting point to join the EMU has to be full EU membership. The minimum delay between the start of EU membership and joining the euro area is 2 years of membership in the ERM II. If advanced member countries join the ERM II immediately upon joining the EU, i.e. in early 2004, they could just joint EMU by July 2006, says Gros.

CEPS believes that the enlarged euro area of 2006, with a number of new members from Central and Eastern Europe, should be more dynamic and could sustain higher interest rates. Both elements, stronger growth and somewhat higher interest should support a stronger euro. On purely economic grounds the euro should thus become stronger when the euro area is enlarged with a number of high growth countries with strong public finances.

Deutsche Bank Research disputes theories of sustained weakness of the euro because of the forthcoming eastward enlargement of the European Union and EMU. Deutsche Bank says that the first Central and Eastern European countries are not likely to join EMU until 2008. This allows sufficient time for the necessary preparations in the EU and applicant countries. It stresses that steps must be taken to ensure that the candidates strictly observe the convergence criteria for accession to EMU in order to ensure the stability of monetary union.

Deutsche Bank adds that the accumulated GDP of the ten applicant countries is equivalent to a mere 6 percent of GDP in the present eleven EMU member states. Their influence on economic development of the EMU area is thus marginal.

The European Central Bank (ECB) has pledged to support the process of economic and monetary integration between candidate countries and the euro zone. The ECB has urged the candidate countries to adapt their legislation in the area of the Economic and Monetary Union before becoming members of the EU, especially in the three areas:

  • legislation on central banks to ensure that they are compatible with the independence of the European System of Central Banks (ESCB),
  • legislation on capital movements,
  • legislation relating to the creation of conditions for sound banking systems and financial stability.

The International Monetary Fund (IMF) sees a substantial cause for the weakness of the euro in the ambiguity over further integration and enlargement of the EU. A senior IMF representative has expressed concern that uncertainty about EU enlargement and reform may disrupt the markets. The markets are under the impression that structural reforms were neither implemented thoroughly nor fast enough in many EU Member States. The official, who did not want to be named, called for "more clarity over further integration and enlargement process of the EU" as the most important step to return to the true value of the euro.

Most financial analysts believe that the candidates will receive protection from currency crises because of their proximity to the EU. Speculators would have to assume that the euro-zone members would not allow a currency collapse in a candidate country, and will therefore refrain from attacking those currencies.

Timeline

The candidate countries will be eligible to join the EMU after having participated in the ERM II for two years. They are eligible to participate in the exchange-rate mechanism only after their accession to the EU. The first accession will take place on 1 May 2004.  

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