What do countries hope to gain from adopting the euro? According to Jeffrey Frankel (Harvard University), the key benefit of joining a currency union arises from trade creation. The gains are considerable, with two-thirds being realized within three decades. Even in the short period since the inception of the EU’s Economic and Monetary Union (EMU), studies have estimated that trade volume within the euro zone has increased by 15 percent—beyond what can be explained by growth and other factors. The already significant trade links between the new member states and the euro area are expected to strengthen in coming years even without adopting the euro. Frankel also said that patience may be rewarded on the timing of euro adoption. By waiting—perhaps for as long as five years—countries may achieve higher cyclical convergence, thereby reducing their risk of experiencing asymmetrical shocks.
Christian Thimann from the European Central Bank discussed the link between real convergence and monetary integration which, in his view, has so far been insufficiently highlighted in the debate. He argued that real convergence matters for monetary integration through its impact on economic dynamics. While trade and financial market integration between accession countries and the EU is already well advanced, there is still room for further convergence in business cycles. Advances in real convergence can be expected to increase similarity in economic dynamics between the new member states and the euro area, and thereby reduce possible problems of macroeconomic stabilization for prospective euro area entrants.
Costs of giving up monetary independence
Paul De Grauwe (Katholieke Universiteit, Leuven) suggested that exchange rate stability would support low inflation—particularly in the early stages of convergence. The positive relationship between exchange rate stability and economic growth is even more robust than for exchange rate stability and inflation. Moreover, a period of exchange rate stability within ERM2—the transitional exchange rate mechanism that countries have to join at least two years before they adopt the euro—with a clear end-point for adopting the euro could anchor expectations and be a source of macroeconomic stability. Against this background, Central European countries need not wait until they meet all the common currency area criteria before joining ERM2, De Grauwe said.
The Central European countries are likely to be buffeted by significant shifts in their capital accounts, Leslie Lipschitz (Director, IMF Institute) said in his presentation. The volatility of capital flows would be related to changes in market perceptions of risk and, based on historical experience, would likely be so great at times that it would overwhelm stabilization policy. The analysis suggested that an independent monetary policy would not be able to buffer these shocks. On the other hand, an inappropriate exchange rate regime could exacerbate the volatility. Lipschitz saw the greatest danger in a “soft peg” regime that could invite challenges from markets in difficult times. “Hard pegs” or “free floats”—the choice depending on various structural characteristics—were less dangerous. In any event, strong fiscal positions, rigorous prudential and financial regulation, and transparent policies would militate against large and sudden shifts in risk premiums and capital account volatility.
Eduard Hochreiter (Austrian National Bank) and George Tavlas (Bank of Greece) shared the experiences of their two countries. In both cases, establishing policy credibility and political consensus was essential. However, the choice of exchange rate regime differed in the run-up to euro adoption: whereas Austria achieved nominal convergence before entering ERM2 with a hard currency peg that was able to withstand the test of capital mobility, Greece was a latecomer and had to meet the Maastricht criteria within a fairly short time. Greece used a strategy of setting the central parity below the market rate to help preserve some monetary independence. Following ERM2 entry, Greece benefited from the increased credibility of its exchange rate arrangement, in the context of a supportive fiscal policy and a credible exit date.
The already significant trade links between the new member states and the euro area are expected to strengthen in coming years even without adopting the euro.—Jeffrey Frankel
Challenges of adopting the euro
What are the main challenges facing the new member states? Ensuring fiscal discipline and flexible labor markets, as well as anticipating the effects of euro adoption on countries’ financial sectors were some of the issues highlighted during the conference.
Lowering fiscal deficits below the Maastricht ceiling of 3 percent of GDP will be key for new member states, Professor Jurgen von Hagen (University of Bonn and Indiana University) said. While the Maastricht government debt limit of 60 percent of GDP is not a serious problem for most of the new member states, some countries could breach it within a decade if they do not undertake fiscal consolidation. Extrabudgetary spending, open-ended and indexed spending programs, mandatory spending outside the budget framework, and contingent liabilities should be avoided, he said. New member states should also adopt best practices, such as binding fiscal targets and a strong supervisory role for the ministry of finance, and use revenue windfalls to retire public debt.
While the need for labor market reforms is no greater in new member states than in current ones, reforms are needed and are best started early, according to Tito Boeri (Bocconi University, Milan). The key labor market challenges will be to absorb asymmetric shocks, resist wage pressures, accommodate stronger competitive pressures in product markets, create a favorable environment for foreign direct investment, and adjust to a reorientation of trade. Because many of the new member states already have flexible wage-setting mechanisms, it could be risky for them to introduce formal social pacts to restrain wage growth, as this might result in more centralized wage bargaining that would limit the ability of these states to respond to shocks.
Boeri identified three key labor market reforms:
• increasing labor market mobility by making employment protection laws less stringent while giving greater weight to unemployment benefits;
• raising employment rates by implementing stricter activation policies for workers who receive unemployment benefits; and
• bringing the underground economy to the surface by discouraging employers and employees from colluding to avoid paying social security contributions.
Francesco Giavazzi (Bocconi University) focused on developments in the financial industry of the euro area since the euro’s launch and the lessons these may hold for new member states. Five years after the adoption of the euro, the degree of home bias has been reduced; the financial industry is more consolidated (though still largely limited to home markets); country–specific factors are less important in determining risks and returns; a liquid corporate bond market has developed; and a few world–class asset managers have emerged in the euro area, Giavazzi said. But some business activity has been lost, most notably investment banking to U.S. institutions, and attempts to establish new financing opportunities for small enterprises through stock exchanges have largely failed (possibly due to unfortunate timing). Moreover, only limited cross–border mergers have taken place between euro area banks, and many of those banks that have crossed borders expanded by acquiring local banks (mostly in the Central European countries).
The period leading up to euro adoption could expose countries to potentially large risks emanating from volatile capital flows, credit booms, asset bubbles, foreign exchange borrowing by residents, and “testing” by financial markets.—Susan Schadler
Defining the right strategy
What strategies can help maximize the benefits of joining a currency union while ensuring that key challenges are met? In their analysis of this question, IMF staff looked specifically at the issues facing the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia.
Susan Schadler (Deputy Director, European Department, IMF) agreed with Frankel that introducing the euro as the national currency offers the potential for a significant catching–up of income through increased trade. She also pointed to the benefits of lower borrowing costs and implementation of a rigorous macroeconomic framework that would follow entry into ERM2. But Schadler warned that the period leading up to euro adoption could expose countries to potentially large risks emanating from volatile capital flows, credit booms, asset bubbles, foreign exchange borrowing by residents, and “testing” by financial markets. Strategies for adopting the euro should therefore be aimed at mitigating these and other vulnerabilities, she said, and should take into account each country’s specific circumstances.
Schadler identified three critical tasks facing the five countries on the road to adopting the euro:
• pursuing fiscal consolidation that aims at prudent debt management and seeks to offset the prospect of a private sector demand boom while creating room for automatic stabilizers to operate after adoption of the euro;
• lowering inflation to a rate no higher than the euro area average plus the Balassa–Samuelson effects (see box, page 54) arising from productivity gains in the tradable goods sector; and
• implementing structural reforms that ensure flexible product and labor markets, a strong legal and institutional framework, and a lean public sector.
The five countries also face the difficult task of choosing the “right” parity for entry into ERM2, Schadler said. And they must select a monetary policy framework that is not only consistent with various policy objectives (such as disinflation and exchange rate stability) but also able to withstand “testing” by financial markets once in ERM2. And, finally, countries must decide on a well–defined exit horizon from ERM2. Clear communication with markets would be essential in all circumstances, she concluded.
What are Balassa–Samuelson effects?
The rate at which real incomes in less advanced economies catch up to the income levels of more advanced economies depends on labor productivity gains stemming from increases in both capital labor ratios and total factor productivity. Generally, these gains are faster in the tradables sector, which is dominated by manufacturing, than for nontradables. As wages in the tradables sector rise with productivity, they also bid up wages in the nontradables sector. Then, to maintain profit margins, the prices of nontradables must increase relative to those of tradables. This process is called Balassa–Samuelson effects.
There is strong evidence of Balassa–Samuelson effects in the new member states, with three main implications.
• First, these effects tend to raise domestic inflation relative to what it would be without them. Empirical evidence for Central European countries suggests that productivity growth differentials have been increasing the relative price of nontradables by up to 4 percent a year in recent years.
• Second, they tend to cause appreciations in real, CPI–based terms of new member states’ currencies relative to the advanced economies in the euro area. On average, sectoral productivity differentials have been adding 1–2 percent a year to the CPI–based real exchange rates of the new member states relative to Germany.
• Third, depending on the extent of nominal appreciations, Balassa–Samuelson effects also result in inflation differentials between countries. Empirical studies suggest that Balassa–Samuelson effects contribute between 0.2 and 1.8 percentage points to the excess of Central European countries’ inflation over German inflation. Because Balassa–Samuelson estimates would differ between periods of nominal exchange rate flexibility and fixed exchange rates, these results cannot, however, be extrapolated to determine likely inflation differentials once countries limit exchange rate movements in ERM2 or EMU.
Many studies conclude that Balassa–Samuelson effects on the real exchange rate—and on inflation when nominal exchange rate flexibility is curtailed in ERM2 or EMU—will probably be on the order of 1–2 percent a year.
European Union perspectives
Representatives of the European institutions (Tommaso Padoa–Schioppa, a member of the European Central Bank’s Executive Board, and Klaus Regling and Johan Baras from the European Commission) agreed that no single path toward euro adoption can be prescribed. Strategies would have to be developed on a country–specific basis and should take into account the experiences of current euro area members, with the principle of equal treatment applying during the entire period leading to monetary integration. No additional criteria for adopting the euro would be introduced, they said. At the same time, there would be no relaxation of the existing criteria established by the Maastricht Treaty (see IMF Survey, February 16).
The EU officials also said that the current controversy within the EU regarding the Stability and Growth Pact should be resolved, and European Union rules followed. In this respect, Regling added, there is no controversy over the medium–term objective of budget balance, given today’s high debt levels, and the deficit ceiling of 3 percent of GDP should be seen as a ceiling and not as a norm.
The existence of Balassa–Samuelson effects has led to some criticism of the inflation criterion. However, given the generally limited size of these effects, the criterion should be able to accommodate them, Baras said. Alternative benchmarks (such as the average inflation rate in the euro area) from which to measure the allowable excess of ½ percentage points would imply moving away from the Maastricht Treaty and conflict with the principle of equal treatment. Moreover, alternative benchmarks would risk accommodating other, less benign causes of inflation, including domestic demand pressure, which can, in practice, be difficult to distinguish from Balassa–Samuelson effects.
While there are no preconditions for joining ERM2, any significant policy adjustments that may still be outstanding (such as major fiscal consolidation or adjustments in administered prices) should be undertaken prior to entry, the EU officials said. Once countries join ERM2, markets could test the authorities’ commitment to exchange rate stability. Thus, a credible fiscal policy must be in place, and the exchange rate policy within ERM2 would have to be consistent with the overall macroeconomic policy framework. At the same time, ERM2 should be seen as a convergence tool intended to steer policies toward macroeconomic stability. But while ERM2 is a flexible mechanism (which avoids setting up a “one–way” bet for the markets), a free float within the +/–15 percent margins would not be consistent with the exchange rate stability criterion, according to the EU officials.
The central parity and the width of the exchange rate band—which initially will be set at +/–15 percent unless the country has reached a high degree of convergence with the euro area, as is the case for Denmark—will be determined by all parties to the agreement. But beyond the minimum two–year stay in ERM2, the appropriate time frame for adopting the euro would have to be assessed in terms of“what is most helpful” for achieving real economic convergence, the EU officials said. Concerns about a prolonged stay in ERM2 would have to be weighed against the significant benefits of participating in the mechanism, which—together with a clear exit—has the potential to act as a catalyst for good policies, as it did for most of the present euro area members during their stay in the ERM (the exchange rate mechanism that preceded ERM2).
Edmond Alphandery (Chairman of CNP Assurances and a former French Minister of Finance) stressed that countries must make key policy adjustments before they join ERM2. He also said that they should not remain in the mechanism too long beyond the minimum two year stay. Finally, Michael Deppler (Director, European Department, IMF) observed that adopting the euro is not an end in itself, but an instrument of income convergence. As countries move closer to euro adoption, most risks they encounter will stem from inconsistent and inappropriate policies—hence the need to focus on an appropriately ambitious macroeconomic framework. Leszek Balcerowicz (National Bank of Poland) echoed these sentiments, counseling policymakers in new member states to focus less on timing and more on fiscal adjustment.
A volume containing the various conference papers and the comments of discussants will be published by the IMF.