Acting Chair’s Concluding Remarks

International Monetary Fund
Published Date:
April 2005
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Adopting the Euro in Central Europe—Challenges of the Next Step in European Integration—Executive Board Seminar, February 18, 200495

Executive Directors have had a rich discussion today on the challenges that lie ahead for the five former transition countries of Central Europe (CECs)—the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia—as they move forward on the path toward the adoption of the euro along with the Baltic states, Cyprus, and Malta. Directors welcomed the staff’s thought-provoking analysis of these challenges, which they viewed as forming an integral part of the implementation of the Fund’s surveillance mandate, and as providing a valuable basis for further reflection and dialogue on how best to address the two fundamental questions—namely, when to adopt the euro, and how to prepare for it. While all accession countries will face challenges, the macroeconomic issues surrounding euro adoption will be especially complex for the CECs, which now maintain flexible exchange rate arrangements. Addressing these issues will require careful case-by-case assessment, and the path and pace of euro adoption will differ according to individual country circumstances.

Euro adoption is likely to bestow substantial benefits on the CECs over the long term, provided strong supporting policies are in place. These benefits will stem from the elimination of the exchange rate risk, lower transactions costs, enhanced policy discipline, lower real interest rates, and greater transparency of prices. Although difficult to quantify, the benefits will be manifested primarily through increased trade and investment and more rapid productivity and income growth. Directors stressed that, to realize these gains, the countries will need to secure sound macroeconomic and structural conditions and continue to foster private sector development. In particular, goods and factor markets should be flexible, and public finances should be put on a sustainable track with minimal rigidities from nondiscretionary spending. In many important areas, the CECs’ policy strategies are already on a promising path toward fulfilling these conditions.

Adopting the euro will also entail costs stemming from the loss of the monetary policy instrument, given the role that monetary policy can play in offsetting asymmetric demand shocks and providing an instrument to contain demand pressures. While further convergence of business cycles will help to minimize the risk of asymmetric shocks, countries would be well advised to build up sufficient policy flexibility to deal with any remaining shocks, prior to adopting the euro. The discussion also brought out that joining the euro area would effectively eliminate the high degree of exchange rate induced volatility to which CECs are exposed.

The path to euro adoption involves participation in the Exchange Rate Mechanism (ERM2) and meeting the Maastricht criteria. Today’s discussion confirmed that decisions on the timing of these steps will need to be made on a case-by-case basis, taking into full account the policy issues involved. Three considerations appear to be of primary importance to ensure that the euro candidates will be well prepared for successful participation in EMU.

  • First, prior to adopting the euro, the harmonization of economic conditions—particularly the correlation of business cycles and trade links—should be strong. While business cycles can be expected to become even more synchronized once countries adopt the euro, a sufficient degree of cyclical convergence, prior to euro adoption, will help improve prospects for a successful experience in the euro area. A few Directors also supported greater real income convergence ahead of euro adoption.

  • Second, adjustment mechanisms—wage and price flexibility and the capacity to run countercyclical fiscal policy—will need to be in place to ensure that asymmetric shocks can be effectively absorbed in the absence of monetary policy.

  • And third, it will be essential for the euro candidates to achieve an adequate degree of nominal convergence. The discussion today indicated that the issue of how best to assess the appropriate standards for nominal convergence deserves further reflection. Several Directors saw the proposal to use the ECB’s inflation objective as the basis for defining “best performing in terms of price stability” when setting the Maastricht inflation ceiling as a judicious approach to ensure that appropriate consideration is given to the conditions prevailing in the candidate countries. However, others cautioned against interpretations of the Maastricht Treaty criteria that could raise issues of unequal treatment of new and current members.

Meeting these conditions will require further strong efforts, but it was noted that in many respects, in particular on progress with trade integration, the CECs are already at least as well positioned as some of the current EMU members at the corresponding time prior to joining the euro area.

The discussion also highlighted several sources of vulnerability that will need to be carefully managed going forward. The CECs will continue to attract capital inflows, which by virtue of their size and susceptibility to speculation about the timing and conditions of euro adoption, could be volatile. It was also noted that the prospect of rapid credit growth starting from the present low rates of bank intermediation entails possible risks of overheating and asset price bubbles. Sound and consistent macroeconomic policies and strong and effective bank supervision will be key to minimizing these vulnerabilities and positioning the CECs for a successful experience in ERM2 and the early years in the euro area. While it was acknowledged that temporary restrictions on capital inflows could, in some limited circumstances, play a complementary role, it was also considered that this option would go against the objective of greater integration.

Directors agreed that further progress toward fiscal consolidation will likely be the greatest challenge facing the CECs in preparing for euro adoption. This will require both the articulation of credible plans for medium-term fiscal adjustment based on a strong consensus, and the demonstration of sustained progress in meeting the adjustment goals. It was also suggested that the CECs should stand ready to accelerate the pace of fiscal consolidation in the event of a boom in bank credit. Directors, while acknowledging the challenge of reaching this objective in practice, saw considerable merit in a medium-term strategy that would bring structural fiscal deficits well below the Maastricht deficit criterion of 3 percent of GDP by the time of euro adoption, with a view to allowing the full operation of the automatic stabilizers in the event of adverse cyclical conditions. Such lower deficit levels would also help the CECs to achieve public debt ratios that are sufficiently prudent given the volatility of fiscal revenues and the extent of expenditure rigidities. At the same time, the need to maintain public investment at levels that support further real convergence underscores the importance of high-quality fiscal adjustments focused on restraining the least productive expenditures, in particular social transfers and subsidies.

The discussion raised several important aspects of the Exchange Rate Mechanism (ERM2) in the run-up to euro adoption. Decisions about the central parity at which the CECs will enter the mechanism will require difficult and delicate judgments about where the parity should be set given the uncertainties as to the equilibrium exchange rate. As part of a sound risk management strategy, some Directors saw merit, given these uncertainties, in choosing a central parity and ultimately a conversion rate with a view to limiting the risk of a possible overvaluation. In any event, it was acknowledged that the decisions on the parity and conversion rates will be taken by mutual agreement of the participating members.

Participation in ERM2 will also require well-planned policy strategies on the part of the CECs. There was support for the view that countries should apply to enter ERM2 only after they have made substantial progress toward achieving low inflation, correcting fiscal imbalances, and implementing structural reforms. This would allow the stay in ERM2 to be limited to the minimum two-year period. However, there was also support for the view that, once countries join ERM2, the mechanism will provide them with a useful and flexible framework for testing policy consistency and the appropriateness of the central parity, and for helping them direct economic policies toward sustainable convergence and reduced exchange rate variations. In this view, there are good arguments against any bias toward shortening the length of stay in ERM2, which may need to vary across countries. At the same time, the discussion highlighted that, for countries entering ERM2 with sound fundamentals and policies consistent with full participation in the euro area, the conversion to the euro should not be unduly delayed, given the potential risks of speculative pressures related to a prolonged stay in ERM2 and the obligation set out in the Treaty to move toward euro adoption once all criteria are fully met.

Directors pointed to the importance of a clearly defined monetary policy framework during ERM2. With the support of sound underlying policies, the aim should be to put in place a framework that enhances the stabilizing effects of an appropriately set central parity, strengthens the likelihood of achieving the exchange rate stability and inflation criteria, and offers protection against speculative pressures. Directors discussed a variety of possible frameworks, and several considered that countries already pursuing inflation-targeting regimes might usefully implement a modified form of inflation targeting that gives greater importance to limiting exchange rate fluctuations, supported by strong fiscal and structural policies. Directors cautioned, however, that there is no one-size-fits-all monetary regime that meets the requirements of all countries. They accordingly stressed the helpful and constructive role the Fund staff and regional institutions can play in encouraging national authorities in candidate countries to make choices on their monetary policy frameworks with full appreciation of the trade-offs and risks involved. Directors also stressed the need for the chosen framework to provide markets with a clear indication of how monetary policy would respond to various types of potential shocks.

Finally, Directors underscored that, given the considerable policy challenges ahead, each country will need to place a high priority on building broad-based support for its euro adoption strategy. This will be helped by maintaining clear and timely communication with the markets, and between the CECs and the European Commission and the ECB. This will also involve minimizing any uncertainties about the criteria to be used to assess compliance with the requirements for euro adoption, while preserving the room for using judgment when making the final assessment of compliance with the Maastricht criteria. Directors wished the CECs well as they embark on this historic path.

The Acting Chair for the seminar was the IMF’s First Deputy Managing Director, Ms. Anne O. Krueger.

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