Unlike the United Kingdom and Denmark, which have an opt-out option, the new member states all have an obligation to adopt the euro, although it is up to each country to decide on the timing. Countries must first fulfill the four criteria set out in the Maastricht Treaty—one of which is a minimum two-year stay in ERM2, the exchange rate mechanism that links the currencies of prospective euro area members to the euro. Some countries have indicated they intend to join ERM2 as quickly as possible. Still, January 1, 2007, in Wijnholds’ view, is probably the earliest realistic date for any new member to adopt the euro.
ERM2: a waiting or workout room?
There are two views on how to approach ERM2, Wijnholds said. It is seen either as a waiting room, where the attitude is “Let’s get it over as quickly as possible because…you might be subject to capital flows that could be quite disruptive” or a workout room, where “you build up muscle to be strong when you enter the euro zone as a fullfledged member.” The view of the ECB is that countries should undertake necessary major adjustments of their economies before they join ERM2, he said.
One question often asked about ERM2 is how much exchange rates will be allowed to diverge from the central parity, Wijnholds said. It has now been clarified that the standard fluctuation band of ±15 percent will apply. An important caveat remains, however: When it comes to deciding on adoption of the euro, countries need to participate in ERM2 for a period of at least two years prior to the convergence assessment without severe tensions, in particular, without devaluing against the euro.
Fiscal deficits matter for growth
The World Bank’s Bokros focused his remarks on what the new member states must do “to put their house in order” before joining ERM2. Currently, patterns of economic growth in the Baltic countries (Estonia, Latvia, and Lithuania) and the Visegrad countries (Poland, the Czech Republic, Hungary, and Slovakia) differ greatly, he said. The Baltics experienced a recession in 1999 following the financial crisis in Russia. But since 2000 all three countries have enjoyed rapid growth. In contrast, Poland and Hungary grew rapidly until 2000, but have since slowed markedly. The same pattern applies to Slovenia. In the Czech Republic and Slovakia, important structural reforms undertaken in 1998 have resulted in higher unemployment and slow growth.
The size of the public sector reveals even greater differences between the Baltic and Visegrad countries, he said. In the Baltics, the public sector now accounts for less than 40 percent of GDP. In the Visegrad countries, it has expanded continuously and now accounts for considerably more than 40 percent.
What this adds up to, Bokros said, is “high growth, a small public sector, low deficits, and prudent fiscal policies” in the Baltics, and “markedly slower growth, a big public sector, high deficits, and much less prudence in managing fiscal affairs” in the Visegrad countries. Accordingly, he said, it is no surprise that Estonia, Lithuania, and Slovenia have indicated that they will join ERM2 very soon. The Visegrad countries are likely to follow only after they have undertaken comprehensive reforms to reduce the size of the public sector, as well as their fiscal deficits and public debt.
Greece’s experience is of interest because it is the only current member of the euro area that was not a founding member, Vittas said. There are also similarities between Greece’s economic structure and stage of development and that of the new member states.
Research shows that the economic benefits derived from integration are potentially very large—perhaps as large as 20 percent of GDP, Vittas said. But there are also significant costs, the most important of which is the loss of monetary autonomy. What is less clear is how quickly economic benefits accrue. In Greece, standards of living actually declined relative to the EU average during the first 15 years of EU membership. However, the situation improved from the late-1990s, when Greece decided to give up its monetary independence.
Greece’s experience shows that the potential benefits of monetary integration may be large, but they are not automatic and can easily be wasted in the absence of good policies, Vittas said. Monetary integration may help countries by providing strong incentives to pursue disciplined macroeconomic policies. “For Greece,” he added, “the loss of monetary autonomy was more a blessing than a curse.”
The typical advice given to new member states with respect to ERM2 has three elements, according to Vittas. First, do not rush—it is important to achieve nominal convergence before entering the mechanism. Second, avoid a prolonged stay in ERM2, as this could be risky. Third, have a clear target date for adopting the euro.
Greece’s experience supports the first and, perhaps to a lesser extent, the third element of this advice, but not the second, Vittas said. Greece stayed in ERM for more than two years, and significant tensions emerged only in the early part of that period. Setting a clear target for adopting the euro certainly helped. It provided an anchor to stabilize market expectations, and it also helped marshal support for the policies required to meet the convergence criteria. “Greece was very fortunate…in that it had a very clear target date to choose. It had missed the opportunity to be among the founding members of the euro area, and it was determined not to miss the second most significant event in the history of EMU, which was the introduction of euro notes and coins.”
ERM2 a stiff and asymmetric test
During the cold war, it was said that the North Atlantic Treaty Organization (NATO) was meant to keep the Russians out, the Americans in, and the Germans down. Cynics have suggested that the Maastricht Treaty’s convergence criteria were meant to lure the Germans in and keep the Italians out, Princeton’s Kenen said in his presentation. However, “it would be more accurate to say that these criteria were devised to require that the national governments do the hard work of achieving domestic price stability and fiscal sustainability before EMU began, thereby assuring that the ECB…could start its work in a benign environment and escape the onus of imposing the hardships required to create that environment.”
The convergence criteria are, noted Kenen, colored by Europe’s recent monetary history. For instance, the decision in 1993 to suspend the ERM’s old, narrow margins of ±2¼ percent reflected recognition of a basic truth: “Free capital mobility, fixed exchange rates, and independent monetary policies constitute what Robert Mundell [a Nobel Prize winner in economics] described as an unholy trinity.” ERM members themselves learned that when they dismantled their capital controls but then tried to keep their currencies within the old, narrow margins. This led them to choose for ERM2 the wide margins of ±15 percent they had adopted temporarily for ERM. Yet the new member states will face “an asymmetric and stiff test” when they join ERM2, Kenen said. The European Commission has said that their eligibility for EMU will depend on their ability to respect the old, narrow margins, so they will be unable to let their currencies depreciate by the full 15 percent allowed by ERM2.
ERM2 differs from ERM in another fundamental aspect, Kenen said. Under ERM, the obligation to stabilize exchange rates was borne jointly by the strong and weak currency countries. Under ERM2, this obligation will reside primarily with the government of the country concerned—there is no legal obligation for the ECB to intervene. This, Kenen said, could cause problems for the new member states. During a country’s stay in ERM2, market participants will be tracking its progress in meeting the other criteria. If they do not see satisfactory progress, they will bet against it by selling its currency.
The EMU is a rules-based system, and everybody agrees that opening up the box of rules would be a mistake, Susan Schadler noted. But, she asked, “Is it good to have a strict interpretation of the rules that provides a clear marker for countries, or is flexibility in interpreting those rules a good thing?” The range of considerations specific to the new member states raised during the forum suggests the latter, even though it could lead to some ambiguity “that could easily be construed as being unfair or politically motivated.” In this context, strong communications will be critical to a smooth entry of new member states to the euro area, Schadler said.
Photo credits: Jeff Christensen for Reuters, page 149; Denio Zara, Eugene Salazar, and Michael Spilotro for the IMF, pages 149-56, 161, and 163-64; W.E. Perryclear, pages 158-59; and United Nations, page 160.
The IMF Survey (ISSN 0047-083X) is published in English, French, and Spanish by the IMF 22 times a year, plus an annual Supplement on the IMF and an annual index. Opinions and materials in the IMF Survey do not necessarily reflect official views of the IMF. Any maps used are for the convenience of readers, based on National Geographic’s Atlas of the World, Sixth Edition; the denominations used and the boundaries shown do not imply any judgment by the IMF on the legal status of any territory or any endorsement or acceptance of such boundaries. Text from the IMF Survey may be reprinted, with due credit given, but photographs and illustrations cannot be reproduced in any form. Address editorial correspondence to Current Publications Division, Room IS7-1100, IMF, Washington, DC 20431 U.S.A. Tel.: (202) 623-8585; or e-mail any comments to