Terminal date risks

Markets have already formed, and will continuously revise, expectations about the terminal date of euro adoption. The expected terminal date, together with a credible central parity, will anchor the path for interest rates and the market exchange rate to converge to euro area interest rates and the conversion rate, respectively. Changes in expectations about the terminal date would have potentially large effects on capital flows and/or the market exchange rate. Such changes could result from revisions to perceptions about a country’s ability to meet the Maastricht criteria by a certain date.

These shocks will be largely, but not completely, under policymakers’ control. Consistent policies with adequate cushions vis-á-vis the Maastricht criteria, complete transparency, and good communications with markets—for example, on intentions about the timing of euro adoption, monetary policy frameworks for ERM II, and medium-term fiscal plans—will go a long way toward avoiding surprises or errors in expectations about policies. But sources of uncertainty outside official control, such as contagion from perceptions about progress of other candidate countries toward the Maastricht criteria, could alter market views of unchanged and known policies. Even news about how the Maastricht criteria will be assessed could buffet markets.

Spreads on long bond interest rates in the CECs vis-á-vis interest rates in the euro area will be a bellwether for changes in market views on the pace or success of nominal convergence. In noncore euro area countries, spreads against Bunds, which had varied around 300–400 basis points until three years before euro adoption, fell quickly and steadily once rapid progress in reducing inflation and fiscal deficits began (Figures 6 and 7). A precise mapping of interest rate and policy convergence is impossible, but rapid bond price convergence in the absence of policy convergence would raise questions about sustainability, while slower convergence would suggest market skepticism about the credibility of policies or the central parity. Current market views on the likely date of euro adoption by the CECs have shifted from 2007–2008 to the end of the decade.

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CECs and Noncore Euro Area Countries: Interest Rate Differentials and Current Ratings Prior to Euro Adoption¹

(Percentage point differentials; end of period)

Sources: IMF, World Economic Outlook; and IMF staff estimates.¹ t is the year before euro adoption for the noncore euro area countries.²Difference between actual ESA-95 deficit of general government as percent of GDP and the Maastrict criterion for fiscal deficit.³Excluding second-pillar pension funds from the general government.⁴Including second-pillar pension funds to the general government.

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CECs and Noncore Euro Area Countries: Measures of Fiscal Convergence¹

(In percentage points)

Sources: IMF, World Economic Outlook; and IMF staff estimates.¹t is the year before euro adoption for the noncore euro area countries.²Difference between actual ESA-95 deficit of general government as percent of GDP and the Maastricht criterion for fiscal deficit.³Excluding second-pillar pension funds from the general government.⁴Including second-pillar pension funds to the general government.

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As of October 2003, five-year bond yield differentials against Bunds ranged from 400 basis points in Hungary to close to zero in the Czech Republic. Excluding the latter, the CEC differentials are roughly similar to those in the noncore euro area countries some three to four years before euro adoption.² At that point, the noncore countries had fiscal deficits of over 6 percent of GDP and inflation of about 5 percent. In the CECs, fiscal and inflation convergence varies widely but shows a distinctly different pattern from that in the noncore euro countries when interest rate differentials were at comparable levels (Table 7). Specifically, when average interest differentials in noncore euro area countries equaled typical interest differentials in the CECs, fiscal deficits in the noncore euro area countries were smaller than those in some of the CECs, but public debt ratios and in some cases inflation rates were generally higher. Therefore, while interest rate convergence could be getting ahead of deficit reduction in some of the CECs, the risks are probably balanced by the better record on inflation and debt.

^{Table 7.}

CECs and Noncore Euro Area Countries: Convergence and Interest Differentials

Sources: Eurostat; country authorities; IMF, International Financial Statistics; and IMF staff estimates.

¹Southern European countries (SE): Greece, Italy, Portugal, and Spain. Indicators for Greece measured two years after the date shown for the SE average.

²ESA-95 deficit and debt exclude government guarantees that have not been called.

³Excluding second-pillar pension funds from general government.

⁴Interest differential measured with the benchmark five-year domestic currency sovereign bond and the five-year Bund rate.

⁵ESA-95. General government.

^{Table 7.}

CECs and Noncore Euro Area Countries: Convergence and Interest Differentials

	Czech Republic		Hungary		Poland		Slovak Republic		Slovenia
	SE avg1	Actual2	SE avg1	Actual	SE avg1	Actual3	SE avg1	Actual	SE avg1	Actual
Date of comparable interest rate differential4	1999	2003 est.	1994	2003 est.	1995–96	2003 est.	1996	2003 est.	1995	2003 est.
Fiscal deficit (percent of GDP)5	−0.9	−6.6	−7.2	−5.9	−4.6	−5.6	−3.3	−3.6	−5.8	−1.8
Inflation (in percent)	1.4	−0.1	4.8	4.7	3.7	0.7	3.2	8.5	4.2	5.7
Debt-to-GDP ratio (in percent)	83.9	31.3	89.3	59.1	85.1	49.1	84.2	42.8	86.0	26.7

Sources: Eurostat; country authorities; IMF, International Financial Statistics; and IMF staff estimates.

¹Southern European countries (SE): Greece, Italy, Portugal, and Spain. Indicators for Greece measured two years after the date shown for the SE average.

²ESA-95 deficit and debt exclude government guarantees that have not been called.

³Excluding second-pillar pension funds from general government.

⁴Interest differential measured with the benchmark five-year domestic currency sovereign bond and the five-year Bund rate.

⁵ESA-95. General government.

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^{Table 7.}

CECs and Noncore Euro Area Countries: Convergence and Interest Differentials

	Czech Republic		Hungary		Poland		Slovak Republic		Slovenia
	SE avg1	Actual2	SE avg1	Actual	SE avg1	Actual3	SE avg1	Actual	SE avg1	Actual
Date of comparable interest rate differential4	1999	2003 est.	1994	2003 est.	1995–96	2003 est.	1996	2003 est.	1995	2003 est.
Fiscal deficit (percent of GDP)5	−0.9	−6.6	−7.2	−5.9	−4.6	−5.6	−3.3	−3.6	−5.8	−1.8
Inflation (in percent)	1.4	−0.1	4.8	4.7	3.7	0.7	3.2	8.5	4.2	5.7
Debt-to-GDP ratio (in percent)	83.9	31.3	89.3	59.1	85.1	49.1	84.2	42.8	86.0	26.7

Sources: Eurostat; country authorities; IMF, International Financial Statistics; and IMF staff estimates.

¹Southern European countries (SE): Greece, Italy, Portugal, and Spain. Indicators for Greece measured two years after the date shown for the SE average.

²ESA-95 deficit and debt exclude government guarantees that have not been called.

³Excluding second-pillar pension funds from general government.

⁴Interest differential measured with the benchmark five-year domestic currency sovereign bond and the five-year Bund rate.

⁵ESA-95. General government.

Risks from asymmetric shocks

Asymmetric shocks are likely to be the biggest threat to macroeconomic stability outside the authorities’ control before and during ERM II. Prior to ERM II, countries will continue to have the tools with which they have responded to such shocks over the past several years. The Russia shock in 1998, which affected the CECs considerably more strongly than it did the euro area, illustrates the scope for responding to asymmetric demand shocks. Most CECs, in the face of substantial potential effects on market confidence, raised interest rates, allowed their currencies to depreciate, permitted the operation of fiscal stabilizers, and supported industrial restructuring that hastened the switch in production toward goods destined for Western markets. No country experienced a speculative attack. The experience of the Baltic countries during the Russia crisis, however, points to the viability of other strategies as long as they are clearly communicated to the markets and backed by consistent policies. These countries allowed interest rates to rise sharply and survived the cyclical downturn, which proved to be short-lived, with their fixed exchange rates intact.

During ERM II, the CECs’ ability to withstand comparable shocks will depend on the nature of the shocks, the consistency of the policy response, and the clarity of communications with the markets on how monetary policy decisions will be made. For most shocks, serious risks would arise primarily if policies were not responsive enough and monetary frameworks did not provide sufficient latitude for and clarity about absorbing disruptions to financial conditions. In short, in the face of a significant shock with effects on capital flows, credible mechanisms for allowing either exchange rates or interest rates to adjust are essential. ERM II could weaken this credibility if it were perceived as limiting the scope for exchange rate changes without adequate alternative adjustment mechanisms.

The 1992/93 ERM crisis is the prime illustration of this risk. Following the German unification shock, the crisis brought to the fore the growing mismatch between equilibrating exchange rate changes in the anchor country, domestic objectives in other ERM countries (some of which had parities that become overvalued during years of adhering to narrow exchange rate bands), and the pressures of free capital flows. After initial efforts to defend parities, it became apparent that intervention and interest rate hikes entailed domestic costs that would not be endured. Only the countries with broadly appropriate parities and the ability to mount a strong policy response to the shock survived with unchanged parities. The ERM crisis points to the rigorous conditions of a narrow band framework—willingness to subordinate economic policies entirely to the exchange rate objective—and the vulnerability of countries that err toward overvaluation.

Risks from policy inconsistency

ERM II will place a high premium on the consistency of policies. The rigor the market will bring to evaluating policy consistency is illustrated by the strains on the forint in 2003. Fundamentally at issue in Hungary were increasingly obvious conflicts between an ambitious inflation target and an exchange rate pressing against the top end of a wide band. Tensions in monetary policy from this conflict resulted in an attack on the strong edge of the band in January 2003. After June, however, weak economic data and market doubts about the consistency of policies led to strong downward pressures on the currency and a sharp increase in exchange rate volatility toward the end of 2003.

Risks from policy inconsistency loom over all countries, regardless of their monetary frameworks. The CECs could face a particular challenge, however, in avoiding policy inconsistency while steering their economies toward the Maastricht criteria. Specifically, the combination of an ambitious inflation target and an actual or perceived exchange rate band—asymmetric or not—may well be prone to problems of credibility in markets in a way similar to the Hungarian experience. As in all instances where fairly narrow ranges of outcomes would be consistent with potentially conflicting objectives, supporting policies—in this case fiscal and structural—will be necessary, but possibly not sufficient to avoid disruptive market pressures.

What does the experience of the noncore euro area countries tell us?

Rapid increases in bank credit began in several of the noncore euro area countries about five years before euro adoption and continued after euro adoption. Growth rates were dramatic, pushing BCPS relative to GDP substantially above the euro area average in Portugal and, to a lesser extent, Ireland (Figure 9). Changes in policies and perceptions related to prospective euro adoption undoubtedly contributed to these booms: governments reduced borrowing requirements, interest rates fell, and prospects for growth improved (reflected, e.g., in rising real estate prices). But other policy changes also played a role. For example, deregulation of domestic financial sectors (eliminating most interest rate caps, bank entry restrictions, and external capital controls in the early 1990s) set the stage for more dynamic banking sectors and higher foreign borrowing by banks.

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selected Noncore Euro Area Countries: Bank Credit to the Private Sector

(In percent of GDP)

Sources: Eurostat; IMF, International Financial Statistics; and IMF staff calculations.

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Real interest rate developments after euro adoption in some of the noncore countries continued to support private credit growth. Nominal bank lending rates in the noncore countries remained at euro area levels, while inflation tended to increase, reflecting the full influence of B-S-induced real appreciations under exchange rate fixity and buoyant cyclical positions. Therefore, real interest rates stayed low (particularly vis-á-vis nontradables) or dropped. Overheating pressures may even have set up a cycle of ongoing monetary easing, by lowering real interest rates and further fueling growth in credit and domestic demand (Walters, 1990; Rebelo, 1992).

Private sector credit ratios in Ireland and Portugal, well above euro area levels, have raised concerns about the future health of their domestic banking sectors. Standard indicators of banking sector soundness, however, remain strong overall, and nonperforming loans relative to total loans have been broadly stable since 1999. Average risk-based capital adequacy ratios remain above—in some cases well above—the Bank for International Settlements’ recommended 8 percent minimum, although the ratio has fallen in Portugal. An added risk factor in both Ireland and Portugal is the exposure of banks to the real estate market: property-related loans account for more than 40 percent of total BCPS, compared with 28 percent in the euro area. Housing price increases in Portugal have been quite modest, as supply has tended to expand with demand. But in Ireland, real house prices have risen by over 130 percent since 1993.

Will the CECs follow suit?

While the likelihood that the CECs will also experience credit booms is high, how they will compare with the booms in some of the noncore euro area countries is unclear. Some factors will lessen the risks. Nominal and real interest rates are already below those in the noncore countries 5–7 years ahead of their euro adoption. Heightened competition in domestic banking sectors (particularly where the foreign presence is large) has also helped push down bank lending rates, particularly for mortgages, toward levels in several euro area countries (Figure 10). Interest subsidies on mortgages in Hungary and—until recently—in the Czech Republic as well as tax deductibility of mortgage costs in the Czech Republic have further lowered effective borrowing costs. Persistent FDI inflows could continue to substitute for some bank borrowing by the corporate sector.

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Euro Area and CECs: Interest Rates on Bank Loans

(In percent)

Source: Eurostat.

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Other factors, however, suggest that credit expansion in the CECs could exceed that in the euro area noncore countries. Credit-to-GDP ratios in the CECs are lower, so the potential for catch-up is greater. B-S effects are expected to keep inflation somewhat above that in the noncore euro area countries, implying real interest rates below levels in those countries.

Lower per capita incomes combined with expectations of income convergence after EU accession could also fuel a more rapid catch-up. The fact that widespread credit expansion has not yet taken place in the CECs despite low interest rates may reflect a legacy of consumer, business, and bank caution with credit instruments. Overcoming this reticence could start a rapid adjustment in BCPS. Eliminating controls on housing purchases by foreigners (which have suppressed residential property prices in the CECs) over the next decade in accordance with accession agreements could also spur strong increases in house prices and mortgage borrowing. On the supply side, CEC banks have so far relied primarily on deposits as their main source of funding but, like the southern noncore group, could increase funding from foreign sources.

What are the risks?

Getting a handle on the potential rate of bank credit expansion is tricky. Estimates based on historical data, when credit ratios have lingered substantially below equilibrium, provide little guidance on the inevitable adjustment. In these circumstances, the best indication of the potential size and speed of credit expansion in the CECs is likely to come from the recent experience in the euro area. Schadler and others (2005) reports on a vector error correction model (VECM) estimated with data from the euro area and used to derive both the equilibrium value of BCPS and the dynamic adjustment to this equilibrium.

Based on these estimates, equilibria BCPS average 75 percent of GDP in the CECs, implying that actual credit is about 60 percent of equilibrium values. Simulations of the path to equilibrium suggest that credit in the CECs may accelerate rapidly, with annual growth rates peaking at 30–45 percent—substantially above historical growth rates—followed by a fairly rapid drop-off. The sharp initial spike reflects the fact that the error correction term is at its largest at the beginning of the catch-up process and that the adjustment implied by behavior in the euro area is rather rapid.

These implied credit paths may overstate the actual speed of adjustment in the CECs since they are based on estimates from the euro area, where deviations from equilibrium have been much smaller. Also, remaining institutional differences between the euro area and the CECs, including weaker protection of creditors’ rights and banks’ uncertainty about the reliability of credit assessments in the CECs, may slow the pace of credit growth. The predicted growth rates are, however, below the annual peak growth rates in some of the noncore euro countries (66 percent in Ireland) and are similar to rates observed recently in other transition countries where initial credit stocks were low (Bulgaria, Latvia, and Lithuania).

A critical concern in rapid credit expansion is the risk of banking distress or even a banking crisis (i.e., an episode when a significant segment of the banking sector is illiquid or insolvent). With a substantial share of bank credit denominated in foreign currencies in some of the CECs, even perceptions of banking sector fragilities could generate pressures leading to a depreciation that would aggravate weaknesses in bank balance sheets. After euro adoption, the risks involved in credit booms—in particular sharp exchange rate changes that exacerbate credit risks—will be reduced. Nevertheless, rapid credit growth could still generate overheating, asset price bubbles, and ultimately an impaired banking sector. Quelling such developments without an independent monetary policy or adjusting to the aftermath of overheating or asset price bubbles without the help of an exchange rate to effect needed changes in relative prices could be challenging. Thus, whether a country with a large impending increase in bank credit to the private sector is helped or hurt by joining a currency union is far from clear.

Assessing the risks of rapid credit growth is complicated by the unique circumstances of the CECs. Several cross-section studies have shown that banking crises tend to be preceded by credit booms.³ This link presumably reflects a tendency for banks’ screening of borrowers to worsen when funding is easy and competition among banks is strong. It may also stem from the interaction of rapid credit growth with other factors—surges in capital inflows not directly related to the credit opportunities banks face (Hardy and Pazarbasioglu, 1998), asset price inflation (Borio and Lowe, 2002), financial deregulation (Eichengreen and Arteta, 2000), or overexposure to credit risk.

Of course, not all rapid credit expansions herald future banking distress. Gourinchas and others (2001) find that financial development typically occurs at an uneven pace, characterized by short periods of intense financial deepening. Consequent rapid output growth is likely to scale down the impact on credit ratios. That a banking crisis is far from a certain consequence of a lending boom is evident in estimates of probabilities of banking crises. For example, Gourinchas and others (1999) find a relatively low probability (10–21 percent) of a banking crisis after a lending boom, while Tornell and Westermann (2002) estimate the probability at 6–9 percent, only slightly greater than during periods of tranquil credit growth (4–4½ percent).⁴

Although the forward-looking simulations of credit growth in the CECs raise questions about vulnerabilities to banking distress, some special circumstances of the CECs mitigate the risks. Simulated maximum predicted bank credit growth rates in the CECs frequently exceed thresholds of credit growth defined in other studies as lending booms, when risks of distress in the banking sector are heightened. However, two caveats should be borne in mind. First, the simulations, based on an error correction model for the euro area, are likely to be upper bounds on future credit growth. Second, each of the four noncore euro area countries examined had credit growth rates in excess of many estimates of thresholds at some point in the past decade without experiencing a banking crisis. This suggests that close ties with the EU, generally sound macroeconomic frameworks, and reasonably strong bank supervision can reduce the risks for any given rate of credit growth.

Good booms

EU accession and the prospect of euro adoption will reinforce the divergence of domestic saving and investment through greater integration of goods and financial markets and convergence of nominal interest rates. Through these channels, effective borrowing costs will be reduced, access to financial intermediaries will increase, and relative prices will converge to EU levels. The accompanying increase in investment and consumption will be financed partly by inflows from wealthier countries, the counterpart of which will be widening current account deficits. Consistent with this pattern, Blanchard and Giavazzi (2002) show that euro area current account positions have become more positively correlated with per capita income during the 1990s: poorer countries have tended to run deficits (accumulating foreign liabilities), and richer countries have tended to run surpluses (accumulating foreign assets). Moreover, this pattern is not explained by differences in the behavior of the fiscal deficit.

Nor is there a clear mapping of “good booms” with investment growth and “bad booms” with consumption growth. Whether foreign inflows finance higher consumption or investment will depend on countries’ structural characteristics. Even where a large share of households is still liquidity-constrained, a drop in interest rates will boost consumption and lower saving. Where the low per capita income reflects capital scarcity rather than low total factor productivity, integration should increase investment. Both effects will probably be at play in the CECs.

A simple optimizing model of consumer and firm behavior illustrates the importance of these basic structural characteristics for the paths of savings and investment.⁵ The process starts when nominal interest rate convergence generates a permanent 1 percent decline in the real interest rate (Figure 11). In the base case, 65 percent of individuals are assumed to be liquidity-constrained. The drop in interest rates induces a pickup in investment and in consumption by individuals with access to capital markets. In the base scenario, investment as a share of GDP gradually increases to a peak 0.5 percent of GDP above baseline in the fourth year and stabilizes at this new long-run level. Consumption’s share in GDP increases in the first year to about 0.3 percent of GDP above baseline and then falls, eventually declining below baseline in the fourth year as individuals with access to credit increase saving to service their higher debt. The increase in the current account deficit (which reflects these changes in saving and investment) peaks in the third year at 0.7 percent of GDP and then declines gradually. In this case, higher investment is the main determinant of the expansion in the current account deficit.

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Simulated Effect of a 1 Percentage Point Reduction in Real Interest Rates on Consumption, Investment, and the Current Account

(Deviation from baseline in percentage points of GDP)

Source: IMF staff simulations, using the IMF’s Global Economic Model (GEM) and MULTIMOD.

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Yet a range of equilibrium investment and consumption paths are consistent with EU- and EMU-related financial integration and domestic financial deepening. The size of the consumption boom, for example, is sensitive to the share of liquidity-constrained consumers. Where a larger share of individuals has access to credit, the initial increase in consumption is greater and the subsequent decline is slower. If, however, financial intermediation became more efficient (e.g., because foreign bank presence increases), the share of liquidity-constrained consumers would fall, causing a slower—but ultimately larger—increase in consumption compared with the scenario where half the population is liquidity-constrained throughout. In this scenario, the widening of the current account deficit peaks several years after the interest rate drop, and rising consumption contributes slightly more than rising investment. The widening of the current account deficit is also sensitive to preference and technology parameters: greater substitutability of capital for labor on the production side generates a larger increase in investment and a faster fall in consumption compared with the baseline.

Bad booms

A danger in this process is that the demand boom exceeds any equilibrium path and creates overheating pressures, unsustainable indebtedness, or asset price bubbles. For example, increases in aggregate demand in the converging country could boost inflation. With the European Central Bank (ECB) fixing nominal interest rates, real interest rates would drop, triggering an additional, disequilibrating, demand response. Such a spiral may stop if creditors—concerned about mounting levels of indebtedness—halt new financing and debtors are forced to abruptly increase saving. In a monetary union, this would precipitate a drop in growth, the size depending on the flexibility of prices and wages. Similarly, if newly available mortgage financing were to lead to unsustainable asset or real estate price inflation, adjustment to appropriate levels would produce stresses on incomes, demand, and growth. The size of the initial increase in domestic demand is an imperfect indicator of excessive convergence-related spending. Buoyant reactions of consumption and investment may be equilibrium responses to interest rate convergence and the elimination of liquidity constraints. An equilibrating boom, however, should be followed by an orderly correction in consumption growth after the initial spurt. Of course, the fact that the uncertainty about whether a boom is a “good” boom will only be resolved once the correction takes place means that policymakers facing strong growth and a rising current account deficit will have difficulty knowing whether remedial measures are needed or not. Thus, particularly in the early years of euro area membership, the authorities will need to watch diverse indicators for signs of overheating, though none will provide unambiguous signals.

In the EMU, fiscal policy in the converging countries will be one of the most powerful macroeconomic tools for mitigating the effects of private demand booms. Judging the appropriate degree of fiscal restraint, however, will be as difficult as judging whether demand booms are excessive. Fiscal policy should not attempt to fully offset the increase in private spending coming from integration and financial deepening. Eliminating an equilibrium widening in the current account deficit would close off a key benefit of integration—the ability to reallocate consumption and investment through time. But a fiscal withdrawal would help head off a spiraling increase in inflation and private sector indebtedness. In this context, several noncore euro area members have relied on fiscal policy to varying degrees to mitigate convergence-related increases in private consumption and expansions in their current account deficits.

How much fiscal adjustment is needed?

Clear yardsticks for the appropriate fiscal position in the CECs prior to adopting the euro do not exist. The Maastricht criteria represent essential minimum conditions, but it will be important to determine whether the CECs should have tighter standards. Several considerations are relevant—prudent debt limits for emerging market countries, risks of credit and demand booms in the run-up to or soon after euro adoption, and the need to remain within Stability and Growth Pact (SGP) limits on the deficit once the country is inside the euro area.

Fundamentally, optimal fiscal balances are linked to sustainable public debt levels. Greater inherent volatility in the CECs than in the euro area suggests, for several reasons, that the maximum prudent public debt ratio in the CECs is likely to be lower than in the existing euro area countries (International Monetary Fund (IMF), 2003).⁶ First, fiscal revenues as a share of GDP in the CECs tend to be lower and, owing to greater underlying volatility of real activity, more variable than in the euro area. Second, because a substantial portion of domestic debt is still of relatively short maturity, interest costs are likely to be more volatile in the CECs than in the euro area. Third, for countries with relatively short records of fiscal prudence, lenders are likely to become concerned about sustainability issues at lower debt levels.

Participation in the EMU, however, will make maximum safe debt ratios in the CECs higher than in other comparable emerging market countries. Specifically, while the IMF (2003) concludes that the sustainable public debt level for a typical emerging market economy may be as low as 25 percent of GDP, the CECs, with the security of the euro policy framework, should be able to sustain higher levels of debt. Applying the IMF (2003) methodology, which considers the mean and standard deviation of fiscal revenues and expenditures as well as the gap between the real interest rate and the real growth rate, suggests a prudent public debt ratio of around 45 percent of GDP for the CECs. This would argue for keeping debt ratios in the Czech and Slovak republics and Slovenia near current levels or even allowing some modest increase, while in Hungary and Poland, debt ratios should be lowered. Lending further support to this conclusion is the finding that in emerging markets, public debt exhibits a stabilizing tendency only if the debt ratio lies below 50 percent of GDP (IMF, 2003).

From a shorter-term standpoint, fiscal policy will be the central macroeconomic policy tool for managing the effects of possible credit and demand booms. In view of the difficulty of shifting the stance of fiscal policy rapidly when discretionary spending is a rather small share of the total, fiscal balances would need to be positioned well in advance of such booms to prevent overheating.

From a more procedural standpoint, prudence argues for fiscal balances well below the Maastricht/SGP limit of 3 percent of GDP. Two considerations are relevant here. First, conservative targets would prevent adverse cyclical conditions from derailing schedules for attaining the Maastricht deficit criterion: while budget sensitivity to the cycle is relatively small in the CECs, output variability can be large, creating the potential for sizable variations in budget balances. Second, entering the euro area with a structural budget deficit at the SGP limit of 3 percent of GDP or, worse yet, a headline deficit at the limit during a cyclical upswing would risk requiring a procyclical reduction in the deficit once the country was in the euro area.

These considerations point to the need to calculate a maximum prudent fiscal deficit. This is a level of the structural balance that would, for a large range of past variations in output growth, allow full play of automatic fiscal stabilizers while keeping the headline deficit at or below 3 percent of GDP and public debt at or below 4.5 percent of GDP. Simple calculations suggest that a structural fiscal deficit of 1–2 percent of potential GDP would fulfill these criteria. Achieving such structural deficits would also help offset excessive demand pressures attendant on credit or demand booms. These estimates are similar to recent European Commission (EC) reestimates of “minimum cyclical safety margins” for existing euro area members. These estimates indicate that on average euro area countries should run deficits of 1.4 percent of potential GDP to stay under the 3 percent limit. Based on estimated 2003 outturns, the CECs (excluding Slovenia, where the structural deficit is currently below this level) would need to reduce their structural deficits relative to GDP by between 2¾ percentage points (in Hungary and the Slovak Republic) and 5¾ percentage points (in the Czech Republic) to achieve prudent deficit levels.

Reaching prudent fiscal deficits—the immediate implications for demand and output

The short-run Keynesian effect of fiscal consolidation on growth is likely to be negative, notwithstanding positive medium- to long-term effects. Panel estimates of the growth impact of a fiscal impulse for the current euro area countries—controlling for foreign demand and exchange and interest rate changes—suggest a fiscal multiplier on average of almost 0.4 in the adjustment year, with weaker fiscal multipliers and stronger effects from partner countries’ growth in smaller, more open countries. This suggests that, ceteris paribus, attaining prudent structural fiscal deficits in the CECs would reduce GDP (relative to a no-policy-change baseline) by between 0.7 percent (in Hungary) and almost 2 percent (in the Czech Republic). However, this short-term effect on growth may be mitigated somewhat by convergence-related interest rate reductions and, more important, by favorable external demand. The CECs should therefore be opportunistic in implementing fiscal adjustment: a cyclical recovery in Western Europe would provide ideal conditions for decisive fiscal action. Moreover, adjustment that relies on credible expenditure reductions rather than ad hoc measures and revenue increases could reduce growth-dampening effects.

Reaching prudent fiscal deficits—how can it be done?

Strategies for reaching prudent fiscal balances should factor in several near-term challenges that may contribute to or detract from achieving the fiscal goal.

• Nominal interest rate convergence and declining public debt ratios will produce windfall fiscal savings. But because interest rates and debt ratios are, for the most part, fairly low, this gain will be substantially smaller than in the southern noncore euro area prior to EMU. It should range from negligible in the Czech Republic to 1½ percent of GDP in Hungary.

• EU accession (excluding the effects of indirect tax harmonization) is expected to add 1–1½ percent of GDP to fiscal deficits in 2004–06. This will stem primarily from contributions to the EU budget, but also from cofinancing obligations (averaging about one third of the cost of EU-supported projects) and loss of customs revenues from imports originating in the EU.

• Mandated harmonization of indirect taxes with the EU will raise budgetary inflows significantly only in the Czech Republic (1½ percent of GDP) and Poland (½ percent of GDP).

• Based on the CEC’s current plans, yearly allocations for general government investment—including transfers from the EU and required cofinancing—will be about 1 percent of GDP higher than the average in recent years. Overall, the increase in infrastructure spending to meet standards laid out in the acquis communautaire will be much greater, but a portion will be covered by higher user fees and public-private partnerships.

• Pension reform to secure system solvency has recently been undertaken or is needed in all countries. Costs could be significant. For example, the up-front fiscal costs of introducing a fully funded second pillar ranged from 1¼ percent of GDP in Poland to ¾ percent in Hungary.

After accounting for prospective nondiscretionary influences on budgets from savings on interest payments, budgetary effects of EU accession, and harmonization of indirect taxes, the CECs will face sizable residual adjustments to reach the maximum prudent fiscal deficit. The needed saving relative to 2003 outcomes amounts to some 2½ percent of GDP for Hungary, 3½ percent for the Slovak Republic, 4½ percent for Poland, and 5¼ percent for the Czech Republic.

This adjustment will need to come mainly from expenditure restraint. Two considerations militate toward this conclusion. First, revenues as a share of GDP—while below the euro area average—are (with the exception of the Slovak Republic) close to or somewhat above ratios in the EU adjusted for per capita income differences (Figure 12). Moreover, tax competition, particularly as regards corporate income taxation, is likely to drive rates down in the future. Second, primary expenditure relative to GDP in several CECs is close to or above the euro area average, and well in excess of ratios adjusted for per capita income.

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CECs and Euro Area Countries: General Government Revenue and Expenditure, and Per Capita GDP^1,2

Sources: Eurostat; IMF, World Economic Outlook; and IMF staff estimates.¹ For the euro-area countries, average for 1995–2003. For the CECs, 2003 estimates. Regression line based on OLS estimation over the 15 EU countries. Classifications of expenditure items for the CECs may not be fully comparable across countries.² For Hungary, investment spending includes capital transfers.³In percent of GDP.

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Spending priorities and efficiency considerations argue against across-the-board proportional expenditure cuts. Measures will need to be tailored to the conditions in each country, but cross-country comparisons of the size of government and the composition of expenditure relative to GDP may help shed light on inefficiencies within CECs’ budgets. Such comparisons suggest substantial scope for cutting subsidies and social transfers in medium-term adjustment plans. As an illustration, in each of these areas, moving to EU norms adjusted for per capita GDP would yield savings of about 5 percent of GDP in Poland, 3 percent in the Czech Republic and Hungary, and 1 percent in the Slovak Republic.

The broad picture that emerges is that for most countries, the needed fiscal adjustment could be achieved through changes that could well improve economic efficiency without diverting resources from infrastructure spending—and in some cases even while increasing it. For Hungary and Poland, in particular, the scope exists to meet prudent budget targets wholly or largely through reductions in subsidies and social transfers. In the Slovak Republic, accelerated expenditure reform is the most sustainable way to reconcile the recent tax reform—based on a single uniform rate for income and value-added taxes—with continued fiscal consolidation. More efficient tax collection would also help. For the Czech Republic, with the largest imbalance but least scope for interest savings, a broader examination of the sources of excessive current spending will be needed.

Strategies for parity setting

At best, objective indicators will provide little more than a range of parities that would be consistent with underlying equilibrium real exchange rates. Summary measures based on changes in real exchange rates over time, PPP exchange rates, changes in profitability, and model-based estimates of equilibrium exchange rates suggest that measures of competitive positions in the CECs have varied widely in recent years. Also, objective indicators provide less guidance on the absolute size of any under- or overvaluation than on movements toward or away from equilibria.

Narrowing the choice of parities to one rate will therefore require that other considerations also come into play. These include current market pressures on the rate; the strategy with respect to inflation during ERMII; and recent developments in growth, investment, and export market penetration. The market rate should provide guidance, although the very notion of considering measures of the equilibrium reflects the fact that markets are subject to transitory influences that should not be built into the parity. The operational question is only where within a range of equilibrium estimates the parity might best be targeted.

A key consideration is that risks in ERM II are asymmetric. Assuming a relatively narrow definition of the exchange rate stability criterion, pressures pushing a currency below parity will require a strong defense through interest rate hikes and possibly even intervention. As the scope for these is constrained by the country’s tolerance for high interest rates and by the availability of foreign exchange reserves, downward pressure could snowball into a situation that requires a devaluation. In contrast, resistance to upward pressure—interest rate cuts and sterilized purchases of foreign exchange—is subject to less binding constraints (the risk of overheating and the cost of sterilization). Also underpinning these considerations is the likely asymmetry in the exchange rate stability criterion: no downward adjustment of parity may be made over the two-year assessment period, but revaluations are not ruled out. This asymmetry means that setting a parity too high is riskier than setting it too low.

The choice of the parity will also influence the strategy for keeping inflation low or reducing it, although the implications for the choice of parity are not clear-cut. On the one hand, if a parity below current market rates is seen as a credible terminal rate, it would provide scope for holding interest rates above the euro area level, allowing a measure of monetary policy independence without pushing the market exchange rate to uncompetitive levels. The viability of such a strategy is borne out by the experience of Greece: establishing the parity substantially below the prevailing market rate permitted interest rates to be held above euro area levels for much of the ERM/ERM II period. On the other hand, two differences between the environment that Greece faced and that which the CECs are likely to face may put the Greek strategy out of reach. First, the CECs have the precedent of two countries (Greece and Ireland) revaluing shortly before final conversion. Markets may now anticipate a late revaluation, reducing a country’s ability to hold interest rates above euro area levels without large capital inflows. Second, the recent history of real appreciations in the CECs, together with the large benefits for growth expected from euro adoption, may militate against the credibility of low parities as terminal conversion rates. Thus, a low parity may well be realizable as a terminal conversion rate only with substantial increases in prices and wages to bring the real value of the currency as it approaches the terminal rate into line with market views of a sustainable equilibrium. In these circumstances, convergence to the low parity would actually exacerbate wage and price inflation. On balance, the CECs that enter ERM II with disinflation objectives will probably need to err on the side of slightly stronger parities within their equilibrium ranges than those that enter with inflation better under control.

Another consideration in setting CEC parities is the presumption that the equilibrium exchange rate is rising over time in line with B-S effects of 1–2 percent per year. This suggests that the parity should be set above the current market rate by a margin sufficient to absorb at least the lower end estimates of this equilibrium appreciation. Conceptually, this proposal has much appeal. But from a practical point of view, taking into account the asymmetric risks of ERM II and the high degree of uncertainty about the equilibrium exchange rate either at the time of setting the parity or two to three years later, this would not seem prudent. The scope for revaluation of the parity before final conversion should rather be used to accommodate any appreciation in the equilibrium rate subsequent to the setting of the parity. Moreover, arbitrage conditions mean that setting a credible parity above the market rate would require that domestic short-term interest rates be below euro area levels, undermining any semblance of monetary restraint.

Getting to the right parity

Ideally, parities will be set at or close to existing market rates. Although consideration of parities different from existing market rates cannot be ruled out, potential conflicts with the exchange rate stability criterion are likely to be minimized when the market rate starts out close to the parity. The best approach to ERM II, therefore, is to establish a sound policy mix aiming for a prudent fiscal balance and as easy monetary conditions as are compatible with an appropriate inflation target. This is likely to push the market rate toward the lower end of the equilibrium range, consistent with a viable parity.

But market conditions in the run-up to ERM II entry may not be so tranquil. Added to the normal volatility of CECs’ financial markets will be the potential for strong speculative pressures as the market takes positions on where the central parity will be set. In these circumstances, countries will need to form a view well before ERM II entry on the appropriate parity and, within their scope for maneuver, attempt to guide the market rate toward that level. For the four inflation targeters this means placing a significant weight—for the more pure inflation targeters, a higher weight than now maintained—on the nominal exchange rate in interest rate decisions. Obviously, this would have to be balanced against the inflation objective—a consideration that argues for countries to wait to enter ERM II until their inflation rates are close to a level acceptable under the Maastricht criterion. With clear signals through interest rate policy on a country’s preferred parity, market forces can be harnessed to help guide the rate toward that level.

Arguments for “corner solutions”

Recent exchange rate crises in emerging market and advanced countries point to the vulnerabilities implicit in soft peg arrangements when capital accounts are open. Underpinning this view is the impossible trinity—fixed exchange rates, capital mobility, and a monetary policy dedicated to domestic goals—which can generate disequilibria that risk fomenting a speculative attack. In the absence of impediments to capital flows, undoing this “trilemma” implies forgoing either monetary independence (and adopting a hard peg regime) or exchange rate stability (and adopting a floating rate). In either case, markets are given unambiguous signals about how exchange rates will respond to exogenous or policy-induced shocks and about the risks inherent in taking open foreign exchange positions.

Each of these “corner solutions” has its own advantages. A hard peg provides a nominal anchor, promotes trade and investment, and avoids speculative bubbles. A floating rate provides substantial monetary policy independence, acts as an automatic shock absorber, and discourages unhedged currency exposure. Moving away from these polar regimes toward the middle ground would seem to imply trading off some of these benefits for those of the other extreme.⁸ Such intermediate solutions, however, typically do not offer a safe harbor.

The key weakness of fixed-but-adjustable pegs is the perception that defending the peg is not the highest policy priority of a government. In essence, the authorities may be reluctant to wage an all-out defense of the exchange rate target because of the substantial damage that high interest rates over a prolonged period could do to the banking system, the budget, and the real economy. Without full credibility that such side effects would be ignored indefinitely, a fixed exchange rate actually becomes more vulnerable to a speculative attack (Obstfeld and Rogoff, 1995). Of course, similar concerns about the effect of exchange rate changes on the budget, bank balance sheets, real wages, and inflation can make governments reluctant to allow exchange rates to change. But markets are quick to realize when fundamental imbalances will not be resolved without an exchange rate adjustment, and persistent market pressure is likely to make resolution through a large exchange rate adjustment eventually irresistible.

Recent empirical evidence confirms that intermediate exchange rate regimes (soft pegs and tightly managed floats) are more prone to currency crisis than hard pegs and other floating regimes. Defining currency crisis as severe exchange market pressures associated with sharp movements in either exchange rates or interest rates, Bubula and Otker-Robe (2003) find that in 1990–2001 the frequency of crisis under intermediate regimes was substantially higher than under polar regimes. In fact, the chance of a crisis under intermediate regimes was about three times higher than under hard pegs across all countries and close to five times higher for the group of developed and emerging market countries. Intermediate regimes were also more susceptible to crisis than floating regimes across all countries. For developed and emerging market countries, the incidence of crises appears to be about the same in hard peg and floating regimes. No significant differences in the incidence of crises in different types of intermediate regimes was found.

Fashioning monetary policy frameworks in ERM II that are consistent with these lessons from the 1990s will be challenging. Free floating will not be an option, and only countries with exemplary policies—policies that would surely qualify a country for euro area membership—should consider a hard peg to the euro. The challenge, therefore, will be to work within the constraints of ERM II and the exchange rate stability criterion while ensuring that a transparent framework that encourages appropriate hedging and that is credible to markets is put in place. Several frameworks are considered in the remainder of this section.

Inflation targeting with wide bands

In recent years, the Czech Republic, Hungary, and Poland have operated direct inflation targeting (IT). Success in meeting inflation has been mixed: the Czech Republic and Poland have reduced inflation to low levels, but Hungary, which has operated an exchange rate band simultaneously, has been less successful in doing so. At the same time, exchange rates have varied largely within ±15 percent of the average exchange rate for 2000–2003 (Figure 15) with only moderately supportive fiscal, wage, and structural policies, and, except in Hungary, without a central parity. This experience suggests that with some modification—in particular, setting a central parity against the euro—a variant of inflation targeting would be feasible in ERM II.

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CECs: Deviation from the Average Exchange Rate

(In percent)

Sources: Bloomberg; and country authorities.¹Deviation from the average of the euro per Polish zloty from January 2001 to April 2004.²Deviation from the average of the euro per Slovenian tolar from January 2001 to April 2004.³Deviation from the average of the euro per Slovakian koruna from January 2001 to April 2004.⁴Deviation from the average of the euro per Czech koruna from January 2001 to April 2004.⁵As set by the National Bank of Hungary.⁶Average exchange rate from May 4, 2002 to May 5, 2004.

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IT in ERM II would need to be a hybrid of IT and exchange rate targeting. Within the selected band, monetary policy would target inflation; as the market exchange rate approached the limits of the band, however, monetary policy would give primacy to keeping the exchange rate within the band. Countries would need to be able and willing to defend the band through interest rate changes and possibly foreign exchange market intervention. Even with perfect clarity on this approach, however, in certain situations, IT with wide bands would leave markets to guess on the policy response. For example, if the exchange rate approached the strong (appreciated) end of the band, markets would become sensitive to the question of whether policy resistance would be successful or the parity would be realigned, particularly if the inflation outlook were inconsistent with interest rate reductions. On the weak end of the band, where conflicts between the inflation and exchange rate objectives would be unlikely, markets could still question the scope for intervention and the tolerance for high interest rates to support the currency.

A hybrid IT framework supported by strong fiscal and incomes policies should be capable of delivering the Maastricht criteria. In particular, barring significant asymmetric shocks, both the exchange rate criterion and the inflation criterion should be achievable. However, the principal risk is of nominal appreciations, whether as part of a deliberate policy to reduce inflation or due to strong capital inflows that would render the parity incompatible with a credible final conversion rate. A sizable revaluation of the parity in the run-up to conversion would then become unavoidable. Thus, while the framework would perhaps hold the greatest appeal to countries with an unfinished disinflation agenda, it is precisely in these circumstances that the framework risks producing an overly strong conversion rate. Attempting to keep the exchange rate very close to parity even on the upside would likely lead to inconsistencies between the exchange rate and inflation targets and undermine the scope for IT entirely.

Hungary’s experience with IT within a wide band illustrates the tensions that may arise from inconsistent policies and targets. In mid-2001, after disinflation had stalled under a narrow exchange rate band regime, the Magyar Nemzity Bank (MNB) (with the agreement of the government) widened its exchange rate band to ±15 percent and adopted IT. All foreign exchange restrictions were lifted, and parliament approved the new Central Bank Act, which defined the primary objective of the MNB to be achieving and maintaining price stability. The MNB initially set an objective of reducing inflation to EMU-compatible levels by 2004/05. The first year of IT saw a resumption of disinflation and only modest upward pressure on the exchange rate. But by late 2002, the exchange rate had risen to the top of the band. At that time, considerable stimulus from an expanding fiscal deficit and a large public sector wage increase fueled market expectations that priority would be given to the inflation target over defense of the band. This resulted in a currency attack in January 2003 and a sharply subsequent increase in exchange rate volatility.

Exchange rate targeting

Exchange rate targeting is an option perhaps more in keeping with the spirit of ERM II, while providing a considerable degree of protection against speculative attacks by markets. In an exchange rate targeting framework, interest rate and fiscal policies would aim to stabilize the exchange rate over time at a central parity, although no implicit or explicit bands interior to the ±15 percent ERM II bands would be set. Thus, any market pressure might initially be allowed to move the exchange rate—even quite significantly—within the ±15 percent band, but subsequent fiscal and monetary policy adjustments would aim to guide it gradually back toward parity. Direct intervention in the foreign exchange market would be minimal at most, to avoid any signals of implicit bands. Inflation would be a key secondary objective but subordinated to the exchange rate target if and as the market rate moved away from parity.

The objective of this arrangement would be to maximize the magnet effect of a well-chosen central parity. Such an effect should be strong when the market sees policies as fully consistent with the parity and expects an early conversion date. Ex ante commitment to flexibility in the exchange rate on both sides of parity would be critical to establishing the credibility of potential exchange rate variations—a key component of communications to markets on the risks of taking unhedged positions. Paradoxically, barring exogenous disturbances, these conditions could produce exchange rate behavior in line with the narrow interpretation of exchange rate stability.

Properly implemented, this arrangement would combine a high degree of transparency of the monetary policy objective with a strong likelihood that the Maastricht exchange rate and inflation criteria could be met. Obviously, its success would be contingent on adequately supportive fiscal, incomes, and structural policies. As in an IT framework, conflicts between inflation and exchange rate stability objectives could arise. Exchange rate targeting, however, would consistently prioritize the objective of moving the exchange rate toward parity, albeit not necessarily in a short-term time frame.

Narrow bands

Countries might opt for an explicit narrow band (±2¼ percent) around parity for several reasons. First, ERM participants might be uncertain about how the EC and the ECB will interpret exchange rate stability and, therefore, wish to aim for an outcome that will almost certainly be accepted as consistent with stability. Second, countries might expect that they could enhance the credibility of their parity and thereby minimize upward pressure on their final conversion rate by constraining the market rate within the narrow band. Third, countries might be highly confident about the strength of supporting policies and choose a narrow band arrangement because it is administratively easier than but substantively similar to a hard peg.

Whatever the case for a narrow band arrangement, the risks are substantial. It is true that consistent supporting policies aimed at reducing inflation and relieving pressure on domestic interest rates, together with a credible parity, should help secure greater exchange rate stability than in recent years. In fact, theory suggests that if the authorities’ commitment to the defined target zone were fully credible, the exchange rate would stabilize even if no active intervention was in progress (Krugman, 1991a).⁹ But the assumption that the exogenous influences that might have contributed to exchange rate volatility in recent years will be tamed in the future has less basis. Moreover, in the middle ground between broad exchange rate flexibility and a hard peg, when markets are left room to guess how policies will respond to stress on the exchange rate, risk premiums are subject to considerable volatility, which in turn can propagate surges in inward or outward capital flows. Indeed, some argue that even with the confidence-instilling effects of a central parity, to adopt a narrow band in an emerging market subject to several sources of capital account volatility is to invite speculators to test the central bank’s determination and ability to enforce the margins (Begg and others, 2003). In effect, the credibility and transparency of the framework under stress would have the well-known problems of soft pegs.

The potential for inconsistency between the exchange rate criterion and the inflation criterion would be significant in a narrow band arrangement and could jeopardize meeting the inflation criterion. Any gain in the credibility of the parity relative to that in a wider-margin arrangement would come at the cost of monetary policy independence. By reducing the scope for a gap between parity and the market rate, narrow bands would all but eliminate the possibility of establishing domestic interest rates above those in the euro area. Thus, a persistent challenge to the strong edge of the band that required a defense beyond the power of sterilized intervention could prove incompatible with the interest rate policy needed to reach the inflation target. On the weak side, of course, the resources available for intervention and the tolerance for high interest rates could well prove inadequate to a credible defense of the lower band.¹⁰

Hard pegs

As an alternative to narrow bands, a hard peg—that is, a rigid commitment to a single exchange rate coupled with fully endogenous determination of interest rates and monetary aggregates—will warrant serious consideration. Its attraction will stem from several sources. First, successfully implemented, it would ensure compliance with the exchange rate criterion. This would be an especially attractive feature for countries that are concerned about how exchange rate stability will be defined. Second, transparency vis-ă-vis the market would be maximized: properly designed, a hard peg would provide the market with a clear statement of how the monetary authorities would react to any pressures, leaving virtually nothing for the market to second-guess. This would be especially attractive to countries that fear upward speculative pressure on their currency.

Third, this enhanced transparency would come at a negligible cost in terms of the rigor of policies required and loss of monetary autonomy as compared with a narrow band arrangement. Fourth, a decisive break with the past may provide a boost to the political process of securing public support for strong fiscal and wage policies. Of course, a hard peg also reduces the risk of a loss of competitiveness, transitory or long-lasting, that could result from shocks or a sustained interest rate differential in a wide band arrangement.

While transparency is maximized under a hard peg, policy demands would be rigorous. To ensure viability of a hard peg, fiscal policy and inflation would need to have been brought under control—preferably to levels consistent with Maastricht criteria, but at least to levels that would ensure meeting the Maastricht criteria within two years. Thus, the realization of the benefits of euro adoption—elimination of exchange rate risk premiums, lower interest rates, and absence of vulnerability to exchange rate changes—would accrue almost fully with the adoption of the peg.

The long experience of the Baltic countries with currency boards points to the feasibility of a hard peg even in the face of internal structural transformation and an asymmetric shock as large as the Russian default in 1998. These small, open economies have maintained currency boards (Estonia since 1992, Latvia since 1994) or a hard peg (Latvia since 1994) for a decade. With initial conditions in terms of fiscal positions and structural characteristics little different from those in several of the CECs, the discipline of their monetary arrangements is often held up as an important factor behind the reining in of budget deficits, progress with privatization, and a high degree of wage and price flexibility (Gulde and others, 2000). The response of interest rates and monetary aggregates to the Russia shock was sharp but contained within a period of about one year (Figure 16). Overall, these countries experienced downturns more severe than the CECs, yet subsequent rebounds were far stronger due to the countries’ flexible economic structures and macroeconomic policies.

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Baltic Countries: Macroeconomic Developments

Sources: Eurostat; IMF, International Financial Statistics; IMF, World Economic Outlook; and IMF staff estimates.¹Spread against the German short-term rate. Call money rate for Germany and money market rates for Estonia, Latvia, and Lithuania.²General government.

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In sum, the monetary policy frameworks available to the CECs during ERM II entail significantly different mixes of transparency, required rigor of accompanying policies, and suitability for delivering compliance with the Maastricht criteria for the exchange rate and inflation. While all will require strong and consistent fiscal policy and rigorous wage discipline, the more constraining the exchange rate arrangement, the greater the demands on fiscal and wage policies. In contrast, the transparency of the framework and the clarity about how policies would respond to stresses on the exchange rate—a critical determinant of vulnerability to speculative attacks—is greatest in a hard peg and weakest in the case of narrow margin arrangements. Embedded in a scheme whereby the Maastricht criteria on all but the exchange rate and interest rate are met before ERM II, a hard peg would deliver the remaining Maastricht criteria with the greatest certainty, although with such supportive policies the more flexible arrangements could prove equally successful.