Journal Issue

Exchange rate policy: EMU has exchange rate policy implications for transition countries seeking EU membership

International Monetary Fund. External Relations Dept.
Published Date:
January 1999
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The establishment of European Economic and Monetary Union (EMU) will have important consequences for Central and Eastern European countries aspiring to join the European Union. Although participation in EMU is not a formal requirement for EU accession, it is reasonable to assume that, by the time of accession, new member countries will have satisfied the requirements of stage 2 of EMU, including convergence toward EMU reference values and adherence to the new exchange rate mechanism (ERM2) created for nonparticipating EU members. In a recent study, Implications of EMU for Exchange Rate Policy in Central and Eastern Europe, George Kopits of the IMF’s Fiscal Affairs Department examines the desirability for, and the ability of, the leading candidates in Central and Eastern Europe—Czech Republic, Estonia, Hungary, Poland, and Slovenia—to participate in ERM2 and eventually in EMU. Although this study focuses on these economies, Kopits suggests that the main points are applicable to other candidate countries as well and, in some respects, are relevant for all transition economies in the region.

Basic requirements

New EU member states are expected to adopt the acquis communautaire of stage 2 of EMU, including adherence to the relevant provisions of the Stability and Growth Pact and convergence toward EMU reference values for government deficit and debt and for inflation and interest rates. Further, nonparticipating EU members (that is, those that have opted out, or been left out, of EMU) are expected to adhere to ERM2, which requires parity between a member’s currency and the euro within a margin of plus or minus 15 percent. Also, they will be expected to have completed capital account liberalization. Kopits suggests, therefore, that a basic—albeit implicit—prerequisite for EU accession would be for candidate countries to demonstrate the ability to operate within the ERM2 regime and, eventually, to participate in EMU.

Case for participation in EMU

Entering the EMU currency area entails both costs and benefits for candidate countries. On the plus side, participation would reduce the costs of economic transactions between the accession countries and the existing currency area. Also, the currency risk premium, reflected in the interest rate, would fall and eventually vanish. The combined effect would be a permanent rise in trade, investment, employment, and growth.

An important potential cost of joining a currency area is that it impairs a country’s ability to absorb asymmetric real shocks in the absence of an independent monetary and exchange rate policy. The loss in macroeconomic stability could be a problem for some economies in transition that may experience fiscal stress during accession to the European Union, as they attempt both to finance the costs of meeting the single-market requirements and to converge toward budget balance—or at least a deficit of less than 3 percent of GDP.

However, Kopits notes, the strong relationship in a currency area between trade intensity and crosscountry correlation of business cycles should reduce this potential cost. As trade intensifies, the probability of asymmetric shock declines; and, conversely, participation in a currency area leads to trade expansion and thus to more synchronized cycles.

The lead candidate countries are relatively small and have already reached a considerable degree of integration with the European Union. In fact, Kopits observes, they are at least as open to trade with the European Union as a number of noncore EU members. Their economic structure is only moderately more biased toward agriculture and industry relative to services than that of noncore EU members, except Greece. Therefore, on the basis of their size, trade integration with the European Union, and similarity in economic structure, the benefits for the lead candidate countries are likely to outweigh the cost of joining ERM2 and, eventually, the euro currency area. In addition, Hungary and, to a lesser extent, Poland should gain more than the other candidates from the decline in the currency risk premium and the interest cost associated with a relatively high level of public debt.

The benefits for the lead candidate countries are likely to out-weigh the cost of joining ERM2 and, eventually, the euro currency area.

Exchange rate system and macroeconomic framework

The five candidate countries rely on a wide range of exchange rate arrangements. At one end of the spectrum, the Czech Republic follows a managed float subordinate to the inflation target set by the central bank; Slovenia’s floating rate is managed within an undeclared margin against the deutsche mark, while the central bank targets a broad monetary aggregate. Hungary and Poland, taking the middle ground, followed a pre-announced crawling peg, with the aim of progressively lowering the rate of depreciation. At the stringent end, Estonia has a currency board arrangement with a fixed peg to the deutsche mark and, in effect, automatically participates in the euro currency area.

All five countries have liberalized their external current account, and average nominal and effective rates of protection are low by international standards. Most candidate countries have also achieved a fair degree of openness in the capital account.

To conduct monetary policy and support their exchange rate arrangements, the accession countries have been relying increasingly on indirect market-based instruments. Along with central bank independence, they have strictly limited or prohibited direct financing of government budget deficits, and all have legal reserve requirement systems. Besides intervening through outright foreign exchange sales or purchases, each country has sought to contain the monetary impact of capital movements through sterilized intervention.

In most of the countries, exchange rate policy has been increasingly governed by the twin objectives of price stability and external competitiveness and, more generally, by the need to strengthen the credibility of macroeconomic policies.

The current macroeconomic situation in these countries is broadly characterized by sustainable growth, underpinned by rapidly increasing labor productivity, and by a deceleration in inflation to low double-digit or high single-digit rates.

Determinants of exchange rate movements

Although the five economies have attained a high degree of external openness, none has yet completed the transition process. And for some—notably the Czech Republic and Slovenia and some sectors in Poland—considerable restructuring remains to be done. In these conditions, Kopits says, the main relevant sources of movements in the nominal exchange rate are productivity performance, wage formation, fiscal and monetary policy stance, soundness of financial institutions, and outside shocks.

The scope for the productivity effect—upward pressure on the nominal exchange rate or the price level fueled by gains in labor productivity in the tradables sector—is great in the economies in transition, which have emerged from decades of inefficiency under socialist central planning. The effect is compounded by a surge in foreign direct investment. However, in four of the five countries, the productivity effect has been overwhelmed by weak or inconsistent policy. While wage indexation has been a major deficiency in Poland, and to a lesser extent in Slovenia, public sector deficits and indebtedness have been the principal source of Hungary’s vulnerability. Insufficient financial and enterprise restructuring has rendered the Czech economy vulnerable. In contrast, wage flexibility and fiscal discipline, as well as substantial restructuring, have provided strength to Estonia.

The financial crises in Asia and Russia, and most recently in Brazil, have tested the resilience of these exchange rate regimes in the face of exogenous shocks. Among the candidates, the study shows that the Czech Republic was hit the hardest by the first crisis and Hungary by the second, while Poland experienced a milder effect from both. The Brazilian crisis has had no significant repercussion for any of the candidates.

Overall, these countries have been served well by their respective exchange rate regimes, when supported by appropriate flanking policies, Kopits observes, and none is inconsistent with convergence to the ERM2 regime. All are poised to move toward the ERM2 regime, admittedly from different starting points.

Path to ERM2

All five countries—to varying degrees—will need to make steady progress toward increased wage flexibility, containment of fiscal imbalances supported by a prudent monetary stance, and financial sector restructuring. In addition, Kopits observes, each accession country should follow a phased process—some are further along the path than others—to acquire sufficient operational experience in managing a stable exchange rate regime.

  • In the first phase, which virtually all lead candidates have completed, the regime should be predictable; the nominal exchange rate should be kept within relatively narrow margins and subject to few, if any, one-off adjustments. Monetary policy should be aimed at a decelerating rate of inflation, consistent with the exchange rate policy.

  • In the second phase, which some countries have reached, the candidate should approach fixed parity exclusively with the euro and widen the official margins substantially. A wide band should help shift some exchange rate risk to potential speculators against the currency. However, accession countries should exercise caution in widening the band during a period of turbulence in the foreign exchange market.

  • In the final stage, prior to formal adoption of the ERM2, the accession country should consider shadowing the euro unilaterally as closely as possible, but without adhering to it at all costs. To preserve credibility, the authorities should declare the country’s commitment to reinstate the former parity following a temporary deviation due to a speculative attack.

Although it would be unrealistic to formulate a precise timetable for formal entry in the ERM2 or for EU membership, Kopits suggests that it is plausible for the lead accession countries to aim at convergence within five years. At the same time, however, these countries will be subject to upward exchange rate pressures stemming from long-term productivity growth in the tradables sector and from capital inflows induced by successful reform and stabilization.

Two policy dilemmas arising from these pressures on the exchange rate will need to be addressed jointly by accession countries and EU members. The first dilemma concerns the difficulty faced by the candidates in simultaneously adhering to parity with the euro within ERM2 and converging to the EMU reference values for inflation and interest rates. Periodic revaluations are more likely to be an acceptable solution than relaxation of the reference values. The other dilemma centers on the requirement of full capital account liberalization while the candidate countries remain vulnerable to destabilizing capital flows prompted by rapid shifts in investor sentiment. Thus, a case can be made for delaying removal of controls on short-term movements until after EU accession.

Copies of IMF Working Paper 99/9, Implications of EMU for Exchange Rate Policy in Central and Eastern Europe, by George Kopits, are available for $7.00 from IMF Publication Services. See page 105 for ordering information.

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