Enlarging the Euro Zone to the new Member States

Enlarging the Euro Zone to the new Member States

The European Policy Centre held a Dialogue on enlarging the euro currency zone to the countries currently in line to join the European Union. Hervé Carré, Director of the European Commission’s Directorate-General for Economic and Monetary Affairs, György Szapáry, Vice President of the National Bank of Hungary, Pierre Van der Haegen, Director-General for International and European Relations for the European Central Bank were the panel members under the chairmanship of EPC Senior Policy Adviser, John Wyles. This is not an official record the proceedings and specific remarks are not necessarily attributable.

John Wyles, EPC Senior Policy Adviser, said that the larger than expected turnout for the conference was a measure of the tremendous interest in, and importance of, the topic. While the candidate countries expect to conclude the three main chapters on accession negotiations (budget, structural policies and agriculture) by the end of this year, he warned that there were some pitfalls ahead. Setting the stage for the speakers, Mr Wyles said it had long been assumed that it would be inappropriate for candidate countries to adopt the euro from the first day of their joining the EU. Today’s conference would seek to shed light on the conditions these countries, once in the EU, must fulfil in order to join the euro-zone as well, as the benefits and risks involved.

Hervé Carré, Director of the European Commission’s Directorate-General for Economic and Monetary Affairs, said that enlargement of the EU was of historical significance, to which the EU executive attached the highest political priority. Enlargement of the euro zone should be seen as the “key component” of this wider objective.

During the first six months of 2002, “decisive progress” on enlargement negotiations has been made. At the EU summit in Seville last month government leaders said that if the present level of progress was maintained, the EU could conclude negotiations with 10 of the candidate countries by the end of this year. It is expected that the accession treaty will be signed by spring 2003, and that the new Member States will be able to participate in European Parliament elections in 2002. “Enlargement is happening,” said Mr Carré. “Its benefits will be felt in economic, political and cultural terms.”

After enlargement, the next challenge for the new Member States will be the successful participation in the euro area. But it is absolutely crucial that countries wishing to join the currency union follow the right sequence for economic integration. In November 2000 EU Economic and Finance Ministers issued a report on exchange-rate strategies for candidate countries.

Mechanics of joining the euro

This report laid down three stages that candidate countries had to go through to prepare for monetary integration: pre-accession; accession to the EU; and adoption of the euro. Mr Carré then elaborated on each of these stages:

Pre-Accession

During the pre-accession period countries had to maintain a sustainable economic policy and undertake structural adjustments and macroeconomic reforms. Without such measures, countries’ exchange-rate strategies would most likely run into difficulties. This period should be one of establishing macroeconomic stability and preparing for integration into the EU. Mr Carré conceded that it would not be easy to meet all these criteria.

The choice of an exchange-rate regime is the responsibility of each individual country, as long as it is compatible with the economic situation and characteristics of the country concerned. Success depends on a country’s ability to cope with the internal discipline imposed; a clear path to lower inflation will also create future nominal convergence. Mr Carré emphasised that participation in Economic and Monetary Union (EMU) was both a structural and multilateral process, but not a unilateral process at all. The adoption if the euro is the last step in a long process, he added.

Accession

Once a new country decides to participate in EMU, it must treat exchange rates as a matter of common concern; in other words, competitive devaluations of its currency are no longer allowed. But joining the exchange-rate mechanism-2 (ERM2) is not an automatic process, as the central exchange rate between the national currency and the euro must be decided by all participants. Mr Carré repeatedly emphasised the multilateral nature of the process, adding that requests to participate must be decided on a case-by-case basis. He said that currency board arrangements were not an acceptable substitute for participation on ERM2. The adoption of the euro by candidate countries is both feasible and desirable.

EMU Participation

Accession to EMU is the end of a long process, based on multilateral decision-making and based on the principle of equal treatment. A unilateral decision by any country to adopt the euro would run counter to this principle, Mr Carré said. Asking whether a country should only have to satisfy the Maastricht criteria or more intangible ones, he pointed out that only the former would be used to assess countries’ readiness to adopt the euro. The process for candidate countries will be akin to the one that current euro-zone members went through in 1998.

György Szapáry, Vice President of the National Bank of Hungary, opened his presentation by saying that eight members of Central and Eastern Europe (CEE) would probably be ready to join the EU in 2004. For these and other new members, joining EMU is not an option but an obligation.

These countries will have control over the timing of their entry into the euro, which of course depends upon fulfilling the criteria laid down in the Maastricht treaty. If a country does not meet these criteria – either because it is unable to do so or deliberately chooses not to – it cannot enter the EMU. There is debate both in the candidate countries and the Member States on how soon the new members should join EMU. The Maastricht treaty stipulates that a country spend at least two years in the ERM following EU accession. Assuming the first countries join in 2004, Mr Szapáry predicted that the earliest any candidate could join EMU was January 2006 and 2007.

Optimal Currency Area (OCA)

Mr Szapáry examined to what extent the CEE countries possess the properties of optimal currency areas (OCAs), a concept that originated with Nobel prize laureate, Robert Mundell, in 1961. According to OCA theory, the benefits and costs of monetary integration depended on whether the countries contemplating a currency union shared certain characteristics, commonly called the OCA properties. He then proceeded to discuss each of these properties:

Degree of openness

The more open a country, the more the domestic rate of inflation is determined by the prices of internationally traded goods. Mr Szapáry presented a chart showing that to a large extent the accession countries are as open as Member States, as reflected by exports plus imports of goods and services as a percentage of GDP.

Trade integration and similarity of economic structures

If trade is integrated and economic structures are similar within a group of countries, then these countries are less likely to be subject to asymmetric shocks and their business cycles are more likely to be synchronised. Economic structures of Hungary, the Czech Republic and Poland are fairly similar to those in EMU, as reflected in contribution to GDP and employment of different economic sectors.

Integration of financial markets

By facilitating cross-country owners hip of assets, financial market integration can smooth the impact of idiosyncratic shocks. This integration also allows more risk sharing across borders, thereby giving countries room to run higher current account deficits than would otherwise be the case.

Synchronisation of business cycles

When business cycles are synchronised, there is less need for an independent monetary policy to smooth the cycles. In general one would expect a fair degree of synchronisation of the business cycles between the CEE countries and the euro area, given the latter’s close trade ties with the euro zone, high degree of openness and similarity of economic structures with those of EMU.

Price and wage flexibility

When nominal prices and wages are flexible, there is less need for the exchange rate to function as a mechanism of adjustment to shocks. In the CEE countries labour market flexibility is extremely high, in part due to unions’ weaker bargaining power resulting from the stigma attached to them under Communist rule.

Labour mobility

When nominal and real wages are unlikely to adjust downwards, labour mobility can help the adjustment to shocks. But Mr Szapáry cautioned against attaching too much importance to labour mobility for the optimal currency area, adding that monetary policy was only able to deal with short-term and not long-term shocks.

Transition mechanism of monetary policy

If this mechanism works very differently among countries, the response to the monetary policy steps taken by the common central bank may vary. One factor that affects the mechanism is financial depth, which is low in the candidate countries as a result of the low level of domestic credit to companies and households.

Fiscal Policy

Generally it is thought that automatic stabilisers are preferable for smoothing business cycles than discretionary fiscal measures. The smoothing effect depends mainly on the composition of revenue and expenditure and the degree of openness of the economy. A study made for the EU-15 found large differences in stabilisers across countries, with the effects generally weaker in more open countries. Mr Szapáry said he knew of no similar studies for the candidate countries, but would expect the smoothing effect of automatic stabilisers there to be weaker.

Summing up, Mr Szapáry said that most developed candidate countries possessed the OCA properties vis-à-vis the EMU at least as much as current EMU members.

Benefits of EMU Membership

The main benefits of EMU membership, according to Mr Szapáry, were the elimination of nominal exchange-rate uncertainty, reduction of the risk premium on domestic interest rates which leads to lower interest rates and credibility gains for member countries, resulting in lower interest-rate spreads on government borrowing. Such narrowing could be observed in the case of Greece immediately after entering the ERM, even before it joined EMU.

The main risk for the candidate countries joining EMU early arises from the surrender of an independent monetary and exchange rate policy. However, this danger is moderated by the sharing of OCA properties with the current EMU members. Moreover, room to conduct an independent monetary policy is already very constrained in several candidate countries, including Hungary, as a result of the nearly full liberalisation of capital flows and the consequent close financial integration. Large capital movements into the candidate countries make it much harder for central banks to pursue a stable and predictable monetary policy.

It would be useful to assess where a candidate country now stood with regard to the Maastricht criteria and compare it to the position in which current EMU members found themselves at the time when they were the same distance away from having t o meet the criteria. Mr Szapáry presented a chart showing that for all but one of the criteria, Hungary is in a better position now than Spain, Portugal or Greece was at the same period. All this goes to show that satisfying the Maastricht requirements should not be more difficult for the advanced candidate countries than it was for the less developed members of the EMU.

One of the greatest fears for enlarging the euro-zone was that it would lead to higher inflation. But Mr Szapáry argued that the impact on the euro-area inflation would be negligible, since the GDP of the 10 candidate countries was only about 5% of the GDP of an enlarged euro area. An economic argument is that inflation, for example, in Germany, should not be affected by an increase in taxi rates or other non-traded goods in Budapest. The question then is whether the inflation target set by the European Central Bank (ECB) provides enough room to accommodate the equilibrium inflation differentials due to differences in productivity increases across the euro zone without imposing unwarranted sacrifice. The jury is still out on this question, but the issue is of relevance.

Mr Szapáry warned against telling candidate countries that it was all right not to hurry in preparing for EMU. In fact, he said that peer pressure was exactly what was needed, just as the Maastricht Treaty did for the current EMU members. “Peer pressure is better than market pressure,” he said, asking what market pressure have really achieved.

In conclusion, Mr Szapáry noted that the Maastricht requirement for the inflation rate refers to the three EU countries where inflation is the lowest. While he said this policy made sense at the time, it no longer makes sense to tie the reference rate to the performance of individual countries, which can even include those outside the monetary union. Instead, it would make much more sense to use the Harmonised Index of Consumer Prices for the euro area as a reference point.  

Pierre Van der Haegen, Director-General for International and European Relations for the European Central Bank, said he was in broad agreement with everything that had been said by the two previous speakers. In large part, he said that this demonstrated the high degree of institutional consistency between the ECB and the Commission. He then proceeded to discuss the risks – preferring to call them ‘challenges’ – perspectives and time frames surrounding the accession countries’ membership in EMU.

Challenges

Mr Van der Haegen broke down the challenges into three main categories:

• Institutional: The EU institutions will have to be reformed to cope with enlargement. One of the most important will be the reform of the governing council of the ECB. The Nice Treaty asks the ECB or the Commission to come up with a reform plan, but Mr Van der Haegen said that this would happen only after ratification of the Nice Treaty. For accession countries, the main challenges will be to adopt the acquis communautaire and ensure central bank independence.
• Technical: This relates to the smooth integration into the European system of central banks and the euro system. The ECB has held a dialogue with central banks of accession countries for several yeas on a number of matters including security of settlement systems, operational and procedural issues and the collection and dissemination of statistics; many of these changes are huge but often overlooked, Mr Van der Haegen said. All euro-area national central banks have been involved in the dialogue as well.
• Economic: This is an important part of the dialogue between the ECB and national banks and pertains to the real convergence, nominal convergence and economic strategies. Real convergence, which relates to adjusting economic structures, building appropriate institutions and adopting international standards on competition law and other areas, is desirable for its own sake apart from preparing to join EMU. It will both enhance economic cohesion as well as minimise the effects of shocks. Mr Van der Haegen argued that there was still a great deal to be done and said it was essential that the momentum be maintained. Candidate countries have made “remarkable progress” on nominal convergence, for example by bringing down inflation rates to single digits; nevertheless it is still higher than desirable.

Among the greatest challenges were microeconomic factors such as price liberalisation and high productivity growth, which put pressure on prices. During this period it is important to get rid of “pathological” inflation but be willing to accept “physiological” inflation in the interim. Real convergence in the broad sense will enhance growth potential in a low-inflation environment.

While the candidate countries are pursuing different strategies, Mr Van der Haegen said that the consistency of the whole policy was of utter importance. While candidate countries have been good about bringing inflation down, progress must be kept on track.

Perspectives and time frame

The accession countries have achieved broad economic stabilisation, as evidenced by positive GDP growth in all countries in 2000. As a result, these countries have been “fairly resilient” to the global economic slowdown. But he said that there was still much work to be done on the structural side. Most of the candidate countries have inflation under control, with rates averaging about 6 to 7% in 2001, but it is important to keep progress on track. In the medium to long term, candidate countries must also keep progressing on structural reforms and fiscal policies. He said the latter was an area of concern, arguing that there was “fiscal slippage” in some countries.

Mr Van der Haegen said that the negotiating process for accession to EU was proceeding “quite well.” He emphasized that meeting the Maastricht criteria meant more than just meeting technical criteria, but also was an assessment of sustainable convergence.

In conclusion, he said that entry into the euro area would have to be conducted on a case-by-case basis, taking each country’s specific circumstances into account. Following up Mr Szapáry’s warning against telling candidate countries not to hurry to join EMU, Mr Van der Haegen said this should not mean that countries should do so hastily. Instead, they should do so in a timely way and be fully prepared.

Discussion

Effect of Enlargement on Euro Area

Werner Schuele of DG Ecofin, who took Mr Carré’s place on the panel, explained that given the size of the economies of the candidate countries, the statistical effect on the economy of the enlarged euro-zone area was not a concern. But the question was whether these countries would be able to maintain a favourable inflation rate over time, he said, calling for low-inflation cultures and consistent policies. He said that a decline in interest rates may be a risk, and warned that coping with a boom in consumer spending and credit in the candidate countries was not an easy challenge.

Maastricht Criteria

There was some discussion as to whether the Maastricht criteria should be revised at all to take into account the situation of the candidate countries. Mr Van der Haegen said there was no need to revise the Maastricht treaty to take into account changing economic situations. He said that in its convergence reports the ECB examines both the criteria and the outcome. Mr Szapáry said that although not all of the criteria in the treaty were perfectly logical, without it there would be no monetary union. He also said that once countries agree to become a part of the monetary union, this makes it easier for them to undertake structural reforms.

Public Support

Mr Szapáry said that public support for EU and EMU membership was very strong (for the former 80% i n Hungary). While there have not really been any opinion polls on fulfilling the Maastricht criteria, there has been an ongoing debate about the sacrifices that may or may not have to be made to fulfil them. In Hungary the previous government accepted the central bank’s recommendation that the country join the EU as soon as possible, meaning by 2007, while the new government is more reluctant. In the Czech Republic and Poland the governments there have said they would like to join EU as soon as possible, but have not said why and when. Szapáry predicted that by 2010 most of the candidate countries would be members of EMU.

International Debt Markets

Mr Szapáry was asked about interest rates on government debt in the candidate countries. He said that in Hungary, long-term interest rates are about 7.1% or 7.2%, just above the 7% rate that would be in line with the Maastricht criteria. This shows that Hungary is already benefiting from the fact that the EMU exists despite the fact that it is not yet a member.

Currency Boards

Mr Van der Haegen said that currency boards were a “demanding arrangement”! and required a lot of internal flexibility. The situation in Argentina demonstrates the weaknesses of an inconsistent policy.

Will the euro fall apart?

One participant asked whether economist Milton Friedman’s recent prediction that the euro will fall apart in 10 years was a reasonable one. Mr Van der Haegen said it was too “challenging” to respond, while Mr Schuele said he did not consider such a scenario likely although theoretically it was possible.

Bail-out programmes in case of financial crises?

One member of the audience asked the panellists whether they saw a need for bail-out packages for candidate countries in times of financial crisis. Mr Szapáry said that if there was a financial crisis there were other mechanisms for support such as the Bank of International Settlements and the International Monetary Fund. Further, there is a mechanism for EU members in terms of balance of payments against conditions. (This has been used so far only by Greece and Italy). Mr Van der Haegen agreed, saying that during the pre-accession phase it was especially important for the EU to speak with a single voice in international monetary institutions, so that any crises arising could be addressed within a multilateral context.

Euro political or economic?

The panellists were asked whether the decision to join the euro was more political than economic. Mr Szapáry said it was clearly the latter, saying that countries had to fulfil economic conditions and the right discipline to fulfil the Maastricht criteria. But he said that there was always a political dimension to the process as well.

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