The accession, in May 2004, of 10 countries (Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, the Slovak Republic, and Slovenia) to the European Union (EU) marked the end of the first phase of the economies’ integration into the EU. These countries are also committed to entering the European Monetary Union (EMU) and adopting the euro, but when should they do so? There is no predefined timetable, and in a new IMF Working Paper, Alěs Bulíř and Kateřina Šmídková warn that an early “race to the euro” may entail substantial economic costs in terms of growing external imbalances and real exchange rate misalignment.
Under the Maastricht rules, to qualify for euro area membership, a country must achieve a high degree of price stability, have a sustainable fiscal position (in terms of the public deficit and public debt), maintain a stable exchange rate—the country must be a member of the Exchange Rate Mechanism (ERM2) for a minimum of two years—and have long-term interest rates close to those in the euro area (see box below). Bulíř and Šmídková point to potential difficulties in sustaining the ERM2 regime prior to adoption of the euro, if the accession countries enter with domestic currencies appreciating in real terms or with weak policies, or both.
New members and the Maastricht criteria
Four conditions—described in the Maastricht Treaty, which sets out the legal principles for Europe’s Economic and Monetary Union—must be met before countries can adopt the euro. These conditions, which must be assessed at a single point in time, are
• annual average inflation rate that does not exceed that of the three best-performing member states by more than 1½ percentage points;
• annual average nominal interest rate on the 10-year benchmark government bond that is no more than 2 percentage points above the corresponding average in the same three countries;
• a fiscal deficit below 3 percent of GDP and public debt less than 60 percent of GDP; and
• trading of the country’s currency against the euro without severe tensions within “the normal fluctuation margins” of the Exchange Rate Mechanism for at least two years.
Volatile real exchange rates
How challenging will it be for the new EU member countries to meet the EMU criteria and adopt the euro? Bulíř and Šmídková foresee a possible conflict between appreciation of real exchange rates in the Central European transition countries in recent years and the EMU criteria of low inflation and a stable nominal exchange rate. Looking at a sample of four new accession countries—the Czech Republic, Hungary, Poland, and Slovenia—for which consistent data are available, Bulíř and Šmídková find that, on average, between 1992 and 2003, exchange rates appreciated by 3.3 percent a year.
Is real exchange rate appreciation now over, making EMU entry relatively simple? Or is it likely to continue for a few more years, resulting in potentially costly adjustment in those countries? If the latter is true, would a switch to the euro do harm? If so, how serious would the resulting exchange rate misalignment be? And what drives this appreciation anyway?
To answer these questions, Bulíř and Šmídková derive estimates of sustainable real exchange rates, which are motivated by foreign direct investment (FDI)-driven integration gains, for each of these countries (see box, page 195). Sustainable exchange rates are defined as being consistent with macroeconomic fundamentals, including the requirement that external liabilities can be financed in the long run. They use the estimates derived on this basis in two ways. First, measure the misalignment of historic real exchange rates; and, as a forward-looking measure of real exchange rate stability following the adoption of the euro. Their model simulates exchange rate developments over 2004–09, conditional on macroeconomic projections from the Global Econometric Model of the U.K. National Institute of Economic and Social Research and asks the question: How would the trajectory of the estimated real equilibrium exchange rate change if the nominal exchange rate had been fixed on January 1, 2004?
Test driving on forerunners
Before applying their framework to the new accession countries, Bulíř and Šmídková tested it on a sample of three countries that joined the EU in the 1980s—Greece in 1981, and Portugal and Spain in 1986. The choice of countries was based on the fact that, prior to adopting the euro, these forerunners appeared to fit a pattern of stylized facts that is similar to that of the new accession countries. The forerunners’ real exchange rates appreciated on average by 0.5 percent annually during the 10 years prior to joining the EMU; their net external liabilities increased, partly reflecting FDI inflows; and their current account deficits widened.
Following the mandated two-year period of nominal convergence, Portugal and Spain adopted the euro in 1999, and Greece, in 2001. Did the change in exchange rate regime affect external equilibrium or cause misalignment? Bulíř and Šmídková found, first of all, that all forerunners started their ERM membership with fundamentally appropriate parities vis-à-vis the euro and, second, prior to euro adoption, after two years in the ERM, their parities appeared sustainable. Third, post-adoption real appreciation vis-à-vis the sustainable real exchange rates in these countries seemed to be persistent, with no signs of abating.
Implications for new entrants
Applying the same framework to the Czech koruna, Hungarian forint, Polish zloty, and Slovenian tolar, Bulíř and Šmídková found that at end-2003, just before EU enlargement, real exchange rates were not close to their fundamentals-based values, and an early fixing vis-à-vis the euro would have resulted in overvalued currencies in all countries except Slovenia. Fixing the euro conversion rates at the early-2004 exchange rates without major macroeconomic policy adjustments to reverse the slide in fundamentals would have posed major problems for the Czech Republic, Hungary, and Poland.
Simulating the performance of sustainable real exchange rates through to 2010, the model suggests that if the forint, koruna, and zloty had been fixed against the euro at their end-2004 exchange rates under then-current macroeconomic policies, they would not have stayed within the ERM2 stability corridors even though they may have converged to their fundamentals-based exchange rates. As a result, say Bulíř and Šmídková the Czech Republic, Hungary, and Poland would have faced a growing accumulation of debt and an erosion of external competitiveness, and real exchange rate misalignment. An early “race to the euro” would have been costly indeed.
What would need to be done to achieve convergence in their model? Either the growth and export performance of the new accession countries would have to improve substantially compared with the past, or their fiscal deficits and external debt would have to be sharply reduced. In other words, what Bulíř and Šmídková paraphrase as the pragmatist’s approach to euro adoption—wait for the right time and do what you can— may not be viable. While this approach served some countries well in the past— most notably Greece—it may not work for the new EU accession countries, given the simulated slow adjustment of their exchange rates to fundamental equilibrium and large initial disequilibria. Moreover, increased uncertainty may be a problem: finding the “right” time and the “right” exchange rate at the time of high capital mobility is likely to be more difficult than in the past.
Their results also suggest that following the adoption of the euro, the convergence problems would not disappear. For example, should a slowdown of FDI inflows—similar to that in the forerunner countries—materialize, the real convergence in the new accession countries might decelerate substantially. Moreover, levels of external debt in the accession countries are higher than they were in Greece, Portugal, and Spain at a comparable point of time. Although external financing of fiscal deficits has been modest to date, as the fiscal deficits in the Czech Republic, Hungary, and Poland continue to swell, their governments are likely to start competing with the private sector for external financing.
A model of sustainable exchange rates
In the Bulíř and Šmídková model, a sustainable exchange rate is determined by external and domestic demand, the effective prices of exports and imports, and the stock of foreign direct investment (FDI). Empirically, the stock of FDI is found to be associated with an improvement in net exports. Moreover, the sustainable rate is constrained by a maximum permissible external debt, the level of which is binding in 2022.
Copies of IMF Working Paper 05/27, “Exchange Rates in the New EU Accession Countries: What Have We Learned from the Forerunners?” are available for $15.00 each from Publication Services (see page 200 for ordering details) or on the IMF’s website (http://www.imf.org).