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Adopting the euro in Central Europe : challenges of the next step in European integration / Susan Schadler … [et al.]—Washington, D.C.: International Monetary Fund, 2005.

p. cm.—(Occasional paper, ISSN 0251-6365) ; 234

Includes bibliographical references.

ISBN 1-58906-350-3

1. Euro—Europe, Central. 2. Europe, Central—Economic integration. 3. Economic and Monetary Union. 4. Monetary policy—Europe, Central. I. Schadler, Susan. II. Occasional paper (International Monetary Fund) ; no. 234

HG925.A36 2004

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Contents

• Preface
• Abbreviations
• • I Overview and Policy Conclusions
    • Scope of the Study
    • A Framework for Decisions on the Timing of Euro Adoption
    • Long-Term Benefits and Costs
    • What Do the CECs Bring to Euro Adoption?
    • Requirements for Successful Participation in EMU
    • The Maastricht Criteria and ERM2
    • Strategies for Meeting the Maastricht Criteria
  • II Assessing the Long-Run Benefits of Euro Adoption
    • Gains from Trade
    • Beyond Trade: Benefits on Income and Investment
  • III Long-Term Costs of Losing Monetary Policy
    • How Do the CECs Stack Up on the OCA Criteria?
    • How Useful Is the Exchange Rate as a Shock Absorber?
    • What Do General Equilibrium Models Say?
    • Appendix 3.1. Cluster Analysis
    • Appendix 3.2. Output Response to Shocks Under Different Exchange Rate Regimes—Graphical Analysis
  • IV What Do the CECs Bring to Euro Adoption?
    • Income Gap
    • Economic Size
    • Capital-Labor Ratios
    • Capital Inflows
    • Investment
    • Real Appreciations
    • Inflation
    • Financial Sectors
    • Fiscal Deficits
    • Unemployment
    • Appendix 4.1. Measuring Balassa-Samuelson Effects
  • V Vulnerabilities During Euro Adoption
    • Getting the Parities Right
    • Capital Account Volatility
    • Credit Booms: Risks and Responses
    • Macroeconomic Booms
    • Appendix 5.1. Methods of Exchange Rate Assessment
    • Appendix 5.2. Estimating Credit Behavior in the Euro Area
  • VI Institutional Arrangements for Entering ERM2 and Adopting the Euro
    • The Path Toward Euro Adoption
    • ERM2: Rules and Questions
  • VII Strategies for Euro Adoption
    • Taming Fiscal Deficits
    • Controlling Inflation While Stabilizing the Exchange Rate: Will It Be Possible?
    • Choosing Parities
    • Monetary Policy Frameworks
    • Appendix 7.1. Estimation of the Impact on Growth of Fiscal and Monetary Policy
• Acting Chair’s Concluding Remarks, Executive Board Seminar, February 18, 2004
• Bibliography
• Boxes
• • 1.1. The Core and Noncore in Pre-Euro Europe
  • 1.2. How Large Are Balassa-Samuelson Effects in the CECs?
  • 1.3. Exchange Rate Criterion
  • 2.1. Staying Out of the Euro—Rationale and Perceived Benefits and Costs
  • 3.1. The Wage Curve for the CECs
    • Figure in Box 3.1: Changes in Real Unit Labor Cost and Unemployment Rate, 1995–2002
  • 3.2. Classification and Identification of Shocks in the Mundell-Flemming (MF) Model
  • 5.1. Hungary—Experience with Increased Exchange Rate Volatility
    • Figure in Box 5.1: Hungary: Nominal Exchange Rate
  • 5.2. Estimation of Credit-to-GDP Ratios
  • 5.3. Harnessing Macroeconomic and Credit Booms—Stylized Facts in the Noncore EMU Countries
    • Figure in Box 5.3: Selected Noncore Euro-Area Countries: Macroeconomic Developments
  • 7.1. Calculating Prudent Structural Fiscal Deficits
    • Table in Box 7.1: Cyclical Sensitivity of Fiscal Deficits and Prudent Fiscal Buffers
  • 7.2. Empirical Estimates of Short-Term Fiscal Multipliers
  • 7.3. Accounting for Pension Reform—The Current Debate in Context
  • 7.4. Greece: Setting and Adjusting the ERM Central Parity
    • Figure in Box 7.4: Greece: Exchange Rate and Interest Rate
  • 7.5. Foreign Exchange Intervention: Desirability, Effectiveness, and Feasibility
  • 7.6. The Success of Hard Pegs in the Baltics
• Tables
• • 2.1. CECs: Potential Long-Run Increases in Trade and Per Capita Output Following Euro Adoption
  • 3.1. CECs and Euro-Area Countries: Correlations of Shocks with the Euro Area
  • 3.2. CECs and Euro-Area Countries: Correlations of Indicators of Economic Activity with Germany
  • 3.3. CECs and Euro-Area Countries: Manufacturing Intraindustry Trade
  • 3.4. CECs: Sectoral Distribution of Employment and GDP, 2001
  • 3.5. CECs and Euro-Area Countries: Manufacturing Asymmetry Indicator
  • 3.6. CECs and Selected Euro-Area Countries: International Investment Positions (IIPs), 2002
  • 3.7. CECs and Selected EU Countries: Overall Strictness of Employment Protection Legislation
  • 3.8. CECs and Euro-Area Countries: Clusters and Underlying Components of Susceptibility Indicators
  • 3.9. CECs and Euro-Area Countries: Clusters and Underlying Components of Susceptibility and Adaptability Indicators
  • 3.10. CECs and Euro-Area Countries: Clusters and Underlying Components of Susceptibility, Adaptability, and Interest Rate Indicators
  • 3.11. CECs: Sources of Variance in Exchange Rates and Output
  • 3.12. Cluster Analysis Variables
  • 4.1. CPI-Based Real Appreciation and Estimated Contribution of the B-S Effect for the 1990s
  • 4.2. Labor Market Characteristics
  • 5.1. CECs and Noncore Euro-Area Countries: Convergence and Interest Differentials
  • 5.2. Selected Noncore Euro-Area Countries: Banking Sector Indicators, 1997–2003
  • 5.3. Credit-to-GDP Ratios in the CECs and Noncore Euro-Area Countries, End-2002
  • 5.4. CECs and Noncore Euro-Area Countries: Credit Developments Relative to Risk Thresholds
  • 5.5. CECs: Banking Sector Indicators, 1997–2003
  • 5.6. CEC Countries: Summary Exchange Rate Assessment, 2003
  • 5.7. Unit Root Tests
  • 5.8. Johansen Cointegration Tests
  • 5.9. Vector Error Correction Estimates
  • 5.10. Weak Exogeneity Tests
  • 7.1. CECs: Cyclical and Structural Fiscal Balances, 2003
  • 7.2. GDP Growth and Its Sources in EMU Countries, 1980–2001
  • 7.3. Southern Euro-Area Countries: Policy Setting and Growth in the Run-Up to Maastricht
  • 7.4. CECs: Impact of Fiscal Consolidation
  • 7.5. Selected Euro-Area Countries: Contribution of Interest Payments to Fiscal Adjustment
  • 7.6. CECs: Expected Contribution of Government Long-Term Interest Rate Convergence to Fiscal Adjustment
  • 7.7. CECs: Required Fiscal Adjustment Relative to Estimated 2003 General Government Budget Outturns
  • 7.8. Explaining GDP Growth in EMU Countries, 1980–2001: Regressions I–V
• Figures
• • 3.1. Euro Area and the Czech Republic: Feasible Combinations of Output and Inflation Variability Under Alternative Monetary Policy Arrangements
  • 3.2. IS and LM Shocks in an IS-LM Diagram
  • 4.1. CECs: Income Gaps
  • 4.2. CECs: Selected Indicators of Size
  • 4.3. CECs: Estimates of Capital per Worker Relative to Germany
  • 4.4. CECs: Employment in Percent of Working-Age Population
  • 4.5. CECs: Total Net Capital Inflows
  • 4.6. CECs and Selected Noncore Euro-Area Countries: Current Account Deficits, Investment, and Savings
  • 4.7. CECs: Real Exchange Rates and Their Components
  • 4.8. CECs: Consumer Price Index
  • 4.9. CECs and Selected Euro-Area Countries: Measures of Size of Financial Markets
  • 4.10. CECs and the European Union: Fiscal Positions and Demographics, 2003
  • 5.1. CECs and Selected Noncore Euro-Area Countries: Capital Flows
  • 5.2. CECs and Noncore Euro-Area Countries: Interest Rate Differentials and Sovereign Ratings Prior to Euro Adoption
  • 5.3. CECs and Noncore Euro-Area Countries: Measures of Fiscal Convergence
  • 5.4. CECs: Bank Credit to the Private Sector
  • 5.5. Selected Noncore Euro-Area Countries: Bank Credit to the Private Sector
  • 5.6. Selected Noncore Euro-Area Countries: Components of Bank Credit
  • 5.7. Selected Noncore Euro-Area Countries: Residential Price Indices
  • 5.8. Selected Noncore Euro-Area Countries: Real Interest Rates
  • 5.9. Selected Noncore Euro-Area Countries: Banking Sector Assets and Liabilities
  • 5.10. Euro Area and CECs: Interest Rates on Bank Loans
  • 5.11. CECs: Net Foreign Liabilities, Credit to Private Sector, and Deposits
  • 5.12. Euro Area: Bank Credit to the Private Sector
  • 5.13. CECs: Real Bank Credit Growth to the Private Sector
  • 5.14. CECs: Baseline Simulations of Bank Credit to Private Sector
  • 5.15. CECs: Alternative Simulations of Bank Credit to Private Sector
  • 5.16. Simulated Effect of a 1 Percentage Point Reduction in Real Interest Rates on Consumption, Investment, and the Current Account
  • 5.17. CECs: Real Effective Exchange Rates
  • 5.18. CECs: Ratios of Wage Costs to Value Added
  • 5.19. Euro Area and CECs: PPP Exchange Rate Ratio and GDP per Capita
  • 5.20. Euro Area and CECs: Market Exchange Rate Compared with the PPP Exchange Rate
  • 5.21. CECs: Market Share in Euro-Area Imports
  • 5.22. Error Correction Term
  • 7.1. Noncore Euro-Area Countries and CECs: Fiscal Situation Before Euro Adoption
  • 7.2. Southern Euro-Area Countries: Policy Mix, External Setting, and Growth
  • 7.3. CECs and Euro-Area Countries: General Government Revenue and Expenditure, and per Capita GDP
  • 7.4. Euro Area: Fiscal Adjustment and Its Contributions
  • 7.5. CECs and Noncore Euro-Area Periphery: Inflation Prior to Euro Adoption
  • 7.6. Noncore Euro-Area Countries: Inflation Indicators After Euro Adoption
  • 7.7. Noncore Euro-Area Countries: Inflation Indicators Before Euro Adoption
  • 7.8. CECs and Noncore Euro-Area Countries: Real and Nominal Bilateral Exchange Rates Prior to Euro Adoption
  • 7.9. CECs: Deviations from the Average Exchange Rate
  • 7.10. Finland and Spain: Interest Rate Differential and General Government Balance
  • 7.11. Finland and Spain: Exchange Rates and Change in Reserves
  • 7.12. Reserves in the Euro Area, CECs, and Baltic Countries
  • 7.13. Czech Republic and Poland: Real and Nominal Effective Exchange Rates
  • 7.14. Selected Core Euro-Area Countries: Macroeconomic Developments Prior to Euro Adoption
  • 7.15. Baltic Countries: Macroeconomic Developments
  • 7.16. Euro-Area Countries and CECs: Determinants of GDP Growth and Openness

Preface

Upon entry into the European Union (EU), countries become members of the Economic and Monetary Union (EMU) with a derogation from adopting the euro as their currency (that is, each country joining the EU commits to replace its national currency with the euro, but can choose when to request permission to do so). For most of these countries, adopting the euro will entail major economic changes. This paper examines likely economic developments and policy challenges for the five former transition countries in central Europe—the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia—that joined the EU in May 2004, operated independent monetary policies, but had not yet achieved policy convergence with the rest of the euro area by that time.

This study was prepared by a team led by Susan Schadler and consisting of Paulo Drummond, Louis Kuijs, Zuzana Murgasova, and Rachel van Elkan. The study has benefited from comments by various departments of the IMF; staff of the European Central Bank (ECB) and the European Commission (EC); participants in a conference on Euro Adoption in Prague in February 2004; and seminars at the National Bank of Poland, Czech National Bank, and Magyar Nemzeti Bank. Material presented in this study was originally prepared as background for an IMF Executive Board seminar on euro adoption in February 2004. The cutoff date for data revision was April 2004. Since that date, revisions to data for Greece, in particular, were significant and could influence the conclusions of parts of the study.

The authors are particularly grateful to Indra Mahadewa, Socorro Santayana, and Jocelyn Rivera for processing the original text; to Jolanta Stefanska and Jehan Panthaki for excellent research assistance; and to Jim McEuen of the External Relations Department, who edited the paper and coordinated the production of the publication. The views in the paper are those of the authors and do not necessarily reflect the views of national authorities or IMF Executive Directors.

Abbreviations