Chapter

I Impact of EMU on Selected Country Groups

Author(s):
Dominique Desruelle, Robert Feldman, Klaus-Stefan Enders, Karim Nashashibi, Peter Allum, Heliodoro Temprano-Arroyo, Roger Nord, and Robert Kahn
Published Date:
February 1999
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Dominique Desruelle, Robert Kahn, and Roger Nord

The IMF’s Interim Committee has welcomed the creation of European Economic and Monetary Union (EMU) as one of the most important international monetary developments in the post-Bretton Woods period. EMU is expected to have powerful implications for the international monetary system, based on the promise of a fully dynamic and integrated economy of 300–400 million people. Economic benefits for Europe and its economic partners include lower transactions costs, reduced exchange rate risk, greater competition, and a broadening and deepening of European financial markets. Supported by strong macroeconomic policies and a European Central Bank (ECB) committed to achieving low inflation, the euro further holds the promise of becoming an important international currency, second only to the dollar, and, over time, perhaps a rival to it. For its part, the IMF has been working to examine the repercussions of the introduction of the euro on the international monetary system, relations of euro-area members with the IMF, and other EMU-related matters.1

As part of this agenda, this paper seeks to analyze the likely impact of EMU on selected non-EU countries. In particular, it highlights the sizable medium-term benefits that could result from a successful launch of EMU on the countries of three regions: Central and Eastern Europe (CEE), the Mediterranean Basin (MB), and the CFA franc zone. The paper is partial equilibrium in approach, focusing on the transmission mechanisms—trade and financial—through which EMU affects economic activity and structure in the three regions.

After a brief introduction, the paper begins with a discussion of economic and financial characteristics of the CEE, MB, and CFA franc zone regions. These regions are distinguished by the strong trade and financial channels through which developments in the EU affect them.

The third section considers the impact on economic activity in the three regions. It argues that the level of GDP in selected non-EU countries—especially those Central and Eastern European countries with the strongest trade and financial links to the EU—can be significantly affected by the level of activity and financial market conditions in the future euro area. In particular:

  • Changes in the level of real GDP in the euro area will have significant effects on the level of economic activity in all three regions—on the order of 0.2–0.6 percent of regional GDP for each 1 percent increase in euro-area GDP over the medium term.

  • Shifts in euro interest rates will also have important effects, reflecting the substantial share of these countries’ debt denominated in euros and at variable rates.

  • Under a “reform” scenario simulation, in which the European countries accelerate structural reform, medium-term increases in GDP are estimated at 0.2 percent for the CFA franc zone, 0.4 percent for the Mediterranean Basin countries, and 0.9 percent for the CEE countries for each 1 percent increase in euro-area GDP, Under an alternative “reform fatigue” scenario, activity falls in Europe and the partner countries are adversely affected.

  • Lower transactions costs on intra-European trade could partly offset the gains outlined above for partner countries through trade diversion effects, but are unlikely to change the positive result fundamentally.

  • Variations in the euro’s exchange rate vis-à-vis other major currencies could have important effects on the region—even if perceived as temporary—through changes in euro-area GDP or a sizable movement in euro interest rates.

The fourth section looks at the impact of EMU on the economic structure of selected countries. It highlights the role of institutional factors in the smooth implementation of EMU, including the provisions on central bank independence, criteria on debt and fiscal policy, and the design of a new exchange rate mechanism (ERM II). On a positive note, the launch of EMU could strengthen the incentive to increase investment and reduce trade barriers, further spurring the ongoing process of economic integration (particularly for countries that aspire to join the European Union). EMU also could lead to increased reliance on euro-area financial markets by fostering larger, more liquid, and more efficient financial markets. At the same time, the introduction of the euro is likely to put the financial systems of some non-EU countries—primarily those with a large degree of integration with EU financial markets—under greater competitive pressure.

Box 1.1.Future Role of the Euro

Most economists believe that the launch of EMU should eventually result in a tripolar financial system, or possibly bipolar, depending upon the evolution of Japanese financial markets. This case for a major international role for the euro is based on consideration of the relative economic importance of the future euro area, the expectation of low European inflation, and the anticipation of deeper, more efficient European financial markets.

There is no doubt that the euro area will be economically significant. The EU–15’s share in world output and trade (around 20 percent for both aggregates) is of an order of magnitude similar to that of the United States and more than double that of Japan (see Figure 1.1). European domestic financial markets together are slightly larger than the U.S. domestic financial markets (at end–1995, the combined market value of bonds, equities, and bank loans in EU and U.S. markets amounted to $27 and $23 trillion, respectively), but are less liquid and efficient owing to greater fragmentation (and with a government bond market a third the size of the U.S. market). Introduction of the euro should also be a catalyst for the development of broader, deeper, more liquid, and more efficient markets.

European Union, United States, and japan: Selected Indicators

Sources: IMF, Prati and Schirasi (1997): Direction of Trade Statistics; and World Economic Outlook.

1 Excludes intra-EU trade.

As for the level of the euro, there is less of a consensus. Some expect a major rebalancing of financial portfolios away from the U.S. dollar and into the euro, while others argue that any change in the currency composition of reserves, loans, bonds, and other assets will be gradual. Official reserves—which are dwarfed by private asset holdings—are not expected to move sharply, given that monetary authorities may be expected to conduct their activities with due attention to the risk of foreign exchange market turbulence. Influence of the euro’s introduction on the composition of private portfolios may be overshadowed by the ongoing, long-term international portfolio diversification of both European and non-European investors. Short-term factors may also play a role, as the ECB seeks to establish its credibility as a strong central bank and in light of uncertainties about the new regime.

Similarly, opinions on the effects of EMU on the long-run exchange rate volatility between major currencies vary widely, in light of different perceptions on the role of the exchange rate in the ECB’s decision making and on EMU’s impact on international monetary cooperation. One argument is that, in the long run, policymakers in a less open and more protectionist euro area will pay less attention to the exchange rate of the euro vis-à-vis the U.S. dollar than did EU countries’ central banks prior to EMU (see Cohen, 1997). Conversely, it has been noted that limited openness may not necessarily mean that the exchange rate is a matter of indifference, as past pronouncements by, say, U.S. or Japanese authorities would attest. In addition, at least for a certain period of time, uncertainties about intermediate targets of monetary policy may compel the ECB to pay particular attention to the exchange rate, which could be an additional factor of stability (see Masson and Turtleboom, 1997). Contrasting views exist as well about the impact of EMU on the desire for, and feasibility of, international monetary cooperation.

It is expected that EMU will have a profound, though gradual, influence on European financial markets. Overall, the depth and liquidity of European securities markets is expected to increase post-EMU: the elimination of currency risk on intra-euro-area transactions should increase competitive pressures, lead to greater uniformity and transparency of market practices, and contribute to a convergence of credit spreads. In addition, EMU should directly reduce certain barriers lo intra-euro-area cross-border investment, such as restrictions on currency exposure of insurance companies and pension funds. As regards banking, EMU is thought likely to induce greater competition at both the wholesale and retail levels. In addition, it will directly entail the disappearance of some profitable banking activities, such as intra-euro-area exchange trading. Altogether, EMU should increase existing pressures for banking sector restructuring, including the gradual reduction of intermediation through the banking system because of direct access to securities markets and the implementation of the EU Banking Directives (see Prati and Schinasi, 1997; and McCauley and White, 1997).

Finally, the paper draws some implications for IMF surveillance. It notes the importance of the IMF continuing to press euro-area members to address structural rigidities promptly and to maintain appropriate financial policies, so as to ensure EMU’s success for both members and nonmembers. Another implication of EMU for the IMF’s surveillance activities over selected non-EU countries is that greater attention to the implications for non-EU countries of global changes in economic and financial conditions in the euro area and to financial sector issues will be necessary. For future members, EMU and accession to the EU will put constraints on the framework, design, and implementation of macroeconomic policies. In its surveillance activities, the IMF should take into account these future constraints and help prepare its members to face them with appropriate recommendations on complementary macroeconomic and structural reforms.

Introduction

With the January 1, 1999, date for the launch of the euro fast approaching, a large amount of popular and professional attention has been devoted to the likely initial membership of the euro area and the requirements for a successful Economic and Monetary Union. Following the decision on May 2, 1998, to begin EMU on schedule with 11 countries, attention has turned to other issues, including the consequences of the introduction of the euro for countries outside the euro area.

All countries and regions are potentially affected by EMU, given the vast size of the market covered by the new currency. To highlight the channels through which effects are transmitted, the scope of this study has deliberately been limited to three regions, Central and Eastern Europe (CEE), the Mediterranean Basin (MB), and the CFA franc zone. These regions were chosen because of an ex ante belief that, with Norway and Switzerland, they would be the non-EU countries most affected by EMU, given their location and existing economic and financial links with the EU. Norway and Switzerland, which both have unique economic characteristics, are not covered in this study2 Together, the three selected regions have a population in excess of 400 million, trade more than $250 billion of goods with the EU (a figure equivalent to close to 30 percent of their combined GDPs), and have significant links with European financial markets.

Not surprisingly, the impact of EMU on the international monetary system has been a topic of extensive analysis, focusing in particular on the international role of the euro and the level and long-run volatility of its rate of exchange against other major currencies.3 There is broad agreement that the euro will play a major international role and have a profound influence on international financial market development, though differences of opinion arise regarding the likely level and volatility of the euro. The basic lessons from this work are summarized in Box 1.1.

EMU can have notable positive spillovers on these non-EU countries stemming first from higher demand for their exportable goods and, second, from lower rates of interest, if it is a catalyst for further macroeconomic and structural reforms. Conversely, if appropriate structural and fiscal policies in the EU do not complement EMU’s macroeconomic policy framework, there is a risk that non-EU countries will be negatively affected by sluggish growth and high interest rates in the European Union. A successful EMU is expected to contribute to greater trade and financial flows between non-EU countries and the euro area. It is also expected to lead indirectly to liberalization of capital flows, at least in CEE countries that aspire to become EU members.

In the short term, while the transition from national currencies to the euro and from national monetary policies to a common monetary policy may well be smooth, uncertainties remain as can be observed from the active debate on the likely monetary policy stance and interest rates in the euro area in 1999. In these circumstances, countries with large external imbalances may place themselves at risk of sudden changes in market sentiment coming from changes in interest rates in the euro area or in the value of the euro vis-à-vis other major currencies. To alleviate such risks, early and sustained implementation of corrective macroeconomic policies may be required in some cases.

It is important to stress the limitations of this paper. The analysis is by its nature partial equilibrium and does not claim to capture all the spillover and feedback effects. Further, it does not deal with important procedural issues, such as the role of the French government in providing guaranteed convertibility for the CFA franc zone.

Two companion papers are included as Chapters 2and 3 in this volume: one covers Central and Eastern European countries and a few Mediterranean countries, the other North Africa and Middle Eastern countries. These papers provide a detailed treatment of various topics covered in this paper as well as information on related issues.4

Selected Economic and Financial Characteristics of Country Groups

An analysis of the impact of EMU on non-EU countries revolves around issues extensively studied in the literature on international trade and finance. Some of these questions are positive in nature: How are monetary and fiscal policy shocks transmitted from one country to the next? How does the international environment affect the effectiveness and modes of operation of domestic financial policies? How does a reduction in the cost of economic transactions between two countries affect trade and investment flows with third countries? And some are normative: What exchange rate regime should a country adopt given its domestic characteristics and international environment? What combination of policies will forestall or eliminate internal and external imbalances?

While existing economics literature is far from providing unanimous answers to these questions, it helps identify the relevant economic and financial variables. In particular, studies on international policy transmission and optimal currency areas suggest paying attention to country size, GDP per capita, trade openness, the geographic and commodity compositions of external trade, the amount and composition of external debt, the size of cross-border capital flows, and general indicators of sensitivity to external shocks, such as the current account balance (see Boxes1.2 and 1.3). Summary data on these variables for the three selected regions are provided below. More detailed information on general, macroeconomic, trade, and financial indicators is presented in a Statistical Appendix, Tables 1.61.9.

Table 1.1.Summary Indicators for Selected Countries, 1995–97
MinimumAverage1Maximum
Central and Eastern European countries
Population (1997, in millions)1.5939
Trade openness (exports + imports in percent of GDP)4982154
Exports to euro area (in percent of total exports)305263
Share of manufacturing goods in exports (1994–96. in percent)778096
Net private capital inflows (in percent of GDP)-0.45.414.4
External debt (stock at end-1997, in percent of GDP)113892
Mediterranean Basin countries
Population (1997. in millions)0.41964
Trade openness (exports + imports in percent of GDP)4060191
Exports to euro area (in percent of total exports)214571
Share of manufacturing goods in exports (1994–96, in percent)35396
Net private capital inflows (in percent of GDP)-3.23.938.9
External debt (stock at end-1996, in percent of GDP)13476
CFA franc zone
Population (1997, in millions)0.4715
Trade openness (exports + imports in percent of GDP)3872179
Exports to euro area (in percent of total exports)224766
Share of manufacturing goods in exports (1994–96, in percent)31729
Net private capital inflows (1994–96, in percent of GDP)-8.03.744.0
External debt (stock at end-1996, in percent of GDP)35112324
Sources: IMF, international Financial Statistics; World Economic Outlook database; Global Development Finance database: national authorities, and IMF staff estimates.

Except (or population, averages are weighted by GOP

Sources: IMF, international Financial Statistics; World Economic Outlook database; Global Development Finance database: national authorities, and IMF staff estimates.

Except (or population, averages are weighted by GOP

Table 1.2.Medium-Term Impact of a 1 Percent Increase in Euro-Area GDP and Relation to Selected Indicators(in percent unless otherwise indicated)
Change in

Exports
Change in

GDP
Exports to

Euro Area

(In percent of GDP)
Share of

Manufactured

Goods in Exports
CEE countries1.50.61780
Mediterranean Basin countries1.00.31053
CFA franc zone members0.60.21617
Sources: IMF.Direction of Trade Statistics; and staff estimates.
Sources: IMF.Direction of Trade Statistics; and staff estimates.
Table 1.3.Medium-Term Impact of a 1 Percent Increase in Euro Interest Rates on GDP and Debt Service and Relation to Selected Indicators
Operation of “Financial Channel” Change in GDP Growth (In percent)Change in Debt-Service Ratio (In percentage points)Net Private Capital Inflows (In percent of GDP)Stock of External Debt in EU Currencies at Variable Interest Rates (In percent of GDP)
CEE countries-0.20.55.45.2
Mediterranean Basin countries-0.1/0.00.63.93.2
CFA franc zone members0.053.7
Sources: IMF, World Economic Outlook database; Global Development Finance database; and staff estimates.
Sources: IMF, World Economic Outlook database; Global Development Finance database; and staff estimates.
Table 1.4.Medium-Term Impact of EMU on Trade and GDP in Selected Country Groups Under a “Reform” Scenario—Simulation Results for 2002

(Deviations from baseline, in percent, unless otherwise indicated)1

Change in GDP
Change in ExportsTotalShare of trade channel

(In percent of total)
CEE countries1.50.967
Mediterranean Basin countries0.90.475
CFA franc zone members0.60.2100
Source: IMF staff estimates.

Baseline in the World Economic Outlook of October 1997. Adherence to the Stability and Growth Pact is assumed in both scenarios. It is also assumed that all current EU member countries participate in EHU from the start.

Source: IMF staff estimates.

Baseline in the World Economic Outlook of October 1997. Adherence to the Stability and Growth Pact is assumed in both scenarios. It is also assumed that all current EU member countries participate in EHU from the start.

Table 1.5.Medium-Term Impact of EMU on Trade and GDP in Selected Country Groups Under a “Reform Fatigue” Scenario—Simulation Results for 2002 1(Deviations from baseline, in percent unless otherwise indicated)
Change in

Exports
Change in

GDP (Total)
CEE countries-0.9-0.6
Mediterranean Basin countries-0.6-0.3
CFA franc zone members-0.4-0.1
Source: IMF staff estimates.

Baseline in the W6rid Economic Outlook of October 997. Adherence to the Stability and Growth Pact is assumed in both scenarios. It is also assumed that all current EU member countries participate in EMU from the start.

Source: IMF staff estimates.

Baseline in the W6rid Economic Outlook of October 997. Adherence to the Stability and Growth Pact is assumed in both scenarios. It is also assumed that all current EU member countries participate in EMU from the start.

Table 1.6.Basic Indicators, 1997
Population

(in millions)
GDP

(in billions

of US$)
GDP per

Capita

(in US$)
Central and Eastern Europe
Albania3.52.9830
Bulgaria8.910.31,150
Croatia4.820.84,351
Czech Rep.10.352.05,044
Estonia1.54.73,085
Hungary10.145.04,437
Latvia2.55.72,252
Lithuania3.89.12,436
Macedonia, FYR2.23.91,760
Poland38.7135.63,500
Romania22.636.21,603
Slovak Republic5.419.13,557
Slovenia2.018.99,485
All116.5364.43,129
Mediterranean Basin
Algeria30.246.91,555
Cyprus0.69.414,919
Egypt61.472.81,135
Israel5.895.216,452
Jordan4.98.01,628
Lebanon3.315.04,572
Libya6.655.38,317
Malta0.43.79,754
Morocco28.233.21,176
Syrian Arab Rep,5.218.51,212
Tunisia9.120.72,285
Turkey64.3185.52,885
All230.1564.22,452
CFA franc zone
Benin5.82.2374
Burkina Faso11.62.4208
Cameroon14.19.1648
Central African Rep.3.61.0271
Chad6.71.2173
Congo, Rep. of2.72.3869
Côte d’lvoire15.310.3672
Equatorial Guinea0.40.61,402
Gabon1.45.43,859
Guinea-Bissau1.10.3257
Mali10.42.6249
Niger9.51.8194
Senegal9.04.8530
Togo4.41.4322
All96.045.3472
Source: IMF, World Economic Outlook database.
Source: IMF, World Economic Outlook database.
Table 1.7.Macro economic Indicators, 1997
General Government

Fiscal Balance

(In percent of GDP)
Consumer

Price Inflation

(In Percent)
Current Account

Balance

(In percent of GDP)
Central and Eastern Europe
Albania-11.732.1-12.1
Bulgaria-6.21,089.41.8
Croatia-1.43.6-12.5
Czech Rep.-2.18.4-6.3
Estonia2.411.3-12.2
Hungary-4.618.3-2.2
Latvia1.48.4-6.9
Lithuania-1.98.8-9.2
Macedonia, former Yugoslav Rep. of-0.31.3-8.5
Poland-1.715.0-3.2
Romania-4.5154.8-5.1
Slovak Rep.-4.96.2-8.4
Slovenia-1.29.1
Mediterranean Basin
Algeria2.85.77.2
Cyprus-3.13.1-3.7
Egypt-0.96.20.7
Israel-3.19.0-3.4
Jordan0.74.0-1.7
Lebanon-19.38.5-30.9
Libya-0.56.01.0
Malta-5.82.5-9.2
Morocco-2.71.0-1.1
Syrian Arab Rep.-4.82.51.9
Tunisia-2.63.7-2.9
Turkey-8.885.4-1.7
CFA franc zone
Benin3.3-4.6
Burkina Faso-2.22.0-9.6
Cameroon-1.34.3-1.3
Central African Rep.-2.70.6-1.8
Chad-4.86.7-12.3
Congo, Rep. of-9.68.6-12.3
Côte d’lvoire-2.05.6-4.5
Equatorial Guinea6.53.0-20.8
Gabon6.12.53.2
Guinea-Bissau-13.149.1-8.2
Mali-3.4-0.4-4.5
Niger-3.02.9-3.3
Senegal0.31.8-6.3
Togo-2.18.2-3.1
Source: IMF, World Economic Outlook database.
Source: IMF, World Economic Outlook database.
Table 1.8.Trade Indicators, 1995–97
Trade Openness1

(In percent of GDP)
Share of Trade

with EU-11

(In percent)
Share of Manufactured

Goods in Exports to EU2

(In percent)
Central and Eastern Europe
Albania48.653.3
Bulgaria124.730.088.4
Croatia91.854.4
Czech Rep.115.552.378.3
Estonia154.444.2
Hungary93.257.577.0
Latvia106.229.7
Lithuania80.929.7
Macedonia, former Yugoslav Rep. of78.237.4
Poland54.055.880.0
Romania59.047.478.0
Slovak Rep.125.036.2
Slovenia111.262.895.9
Mediterranean Basin
Algeria54.762.03.3
Cyprus102.524.285.0
Egypt53.633.147.5
Israel75.833.684.6
Jordan123.421.113.7
Lebanon70.235.271.6
Libya40.068.13.0
Malta190.553.5
Morocco58.656.956.1
Syrian Arab Rep.67.436050.0
Tunisia87.070.779.8
Turkey50.042.477.8
CFA franc zone
Benin59.637.66.4
Burkina Faso41.628.917.2
Cameroon45.965.92.8
Central African Rep.44.247.869.1
Chad74.152.63.3
Congo, Rep. of147.253.547.3
Côte d’lvoire85.453.09.3
Equatorial Guinea178.542.511.7
Gabon95.226.98.6
Guinea-Bissau46.148.1
Mali58.728.926.1
Niger38.232.093.1
Senegal67.250.24.8
Togo72.422.028.8
Sources: IMF, World Economic Outlook database; Direction of Trade Statistics database; and staff computations.

Defined as the sum of exports and Imports.

Based on 1994–96 data.

Sources: IMF, World Economic Outlook database; Direction of Trade Statistics database; and staff computations.

Defined as the sum of exports and Imports.

Based on 1994–96 data.

Table 1.9.Financial Indicators, 1997
Stock of Debt (in percent of GDP)Debt Service (In percent of exports)Share of Debt in EU Currencies1(in percent)Share of Debt at Concessional Rates1(In percent)Net Private Capital Flows (in percent of GDP)
Central and Eastern Europe
Albania35.911.316.536.15.5
Bulgaria92.213.69.22.97.2
Croatia20.910.120.126.61.9
Czech Rep.42.320.710.51.23.4
Estonia22.90.923.929.220.8
Hungary53.130.835.22.0-0.2
Latvia10.96.29.744.98.8
Lithuania19.33.818.421.05.3
Macedonia, former Yugoslav Rep. of51.912.48.231.28.1
Poland33.04.930.026.46.2
Romania28.98.222.310.01.6
Slovak Rep.58.79.715.924.421.0
Slovenia22.38.323.11.43.3
Mediterranean Basin
Algeria60.431.027.710.1-0.2
Cyprus22.37.41.9
Egypt41.410.137.364.92.4
Israel6.6
Jordan75.518.227.748.5-1.4
Lebanon26.137.610.717.033.3
Libya1.4-0.3
Malta27.75.912.875.07.3
Morocco61.031.336.924.33.8
Syrian Arab Rep.46.119.44.190.11.3
Tunisia52.820.532.737.22.0
Turkey43.028.120.913.83.3
CFA franc zone
Benin63.112.417.083.80.4
Burkina Faso56.420.18.790.26.0
Cameroon109.224.261.250.95.1
Central African Rep.81.478.56.789.4-4.4
Chad73.510.014.888.5-2.2
Congo, Rep. of221.924.461.842.3-0.9
Côte d’lvoire172.125.654.432.25.4
Equatorial Guinea35.019.819.367.625.6
Gabon62.833.269.624.0-3.8
Guinea-Bissau323.9496.83.590.1-5.4
Mali113.921.740.298.15.1
Niger69.840.243.369.31.7
Senegal68.221.121.574.81.1
Togo101.121.114.672.8-6.2
Sources: IMF, World Economic Outlook database; Global Development Finance database; and staff computations.

Data for 1995.

Sources: IMF, World Economic Outlook database; Global Development Finance database; and staff computations.

Data for 1995.

Central and Eastern European Countries

Central and Eastern European countries are relatively small,5 with an average population of 9 million (Table 1.1). Eight of the 13 selected CEE countries have a population of 5 million or fewer inhabitants, and 3 others have a population of around 10 million. Only Poland and Romania are larger, with populations of 39 and 23 million, respectively. These countries exhibit a large degree of openness to international trade. International trade flows, computed as the sum of exports and imports, amount to 82 percent of GDP on average and exceed 100 percent of GDP for 5 of the 13 CEE countries. Thus, most CEE countries correspond well to the archetype of the small, open economy.

Given their location, CEE countries conduct a large share of their trade with the European Union. On average, 52 percent of these countries’ exports go to the 11 countries that constitute the euro area, while about 40 percent of their imports come from the euro area. In addition, given their accumulated human and physical capital and, given existing European trade restrictions on agriculture under the Common Agricultural Policy (CAP), an overwhelmingly large share of these countries’ exports consist of manufactured goods.

Openness to trade and, more generally, the progressive integration of Central, Eastern, and Western European countries’ structures of production are reflected in large private capital flows to some CEE countries, particularly the Czech Republic, Estonia, and Hungary. The composition of these inflows—shares of foreign direct investment, portfolio investment, and loans—varies substantially across countries, with the largest net private capital inflows (as a share of GDP) for the Czech Republic, Estonia, and the Slovak Republic. The external debt of most CEE countries is below—and, for some, well below—40 percent of GDP. However, in a few cases, including Albania, Bulgaria, and Hungary, external debt or debt service is sizable. Most of CEE countries’ external debt is on commercial terms. Approximately half of it is at variable interest rates and roughly a quarter denominated in EU currencies.

Mediterranean Basin Countries

The Mediterranean Basin region includes countries with large and small populations, oil exporters and oil importers, islands and continental countries Table 1.16 The average population is 19 million, with Egypt the largest (64 million) and Malta the smallest (less than 400,000). Reflecting this heterogeneity, their degree of openness to trade varies across a wide range, from 40 to 191 percent of GDP. The geographical distribution of their trade also considerably varies from one MB country to another. Some MB countries (notably Algeria, Morocco, and Tunisia) conduct most of their trade with the European Union. Others have sizable trade with EU as well as with other partners, such as countries of the Arabian Peninsula in the cases of Jordan and Lebanon or Russia in the case of Turkey. Heterogeneity is also noticeable in the commodity composition of trade. While manufactured goods represent an overwhelming share of exports for many of these countries, oil and gas and agricultural goods are important exports of others.

Box 1.2.International Policy Transmission

The workhorse of international policy analysis remains to this day dynamic versions of the Mundell-Fleming model, despite the long-standing criticism of the ad hoc nature of its assumptions and the academic fate of Keynesian economics since the 1970s. In particular, most multicountry empirical models of the current generation, including the IMF’s MULTIMOD, are based on this framework (see Masson, Symansky, and Meredith. 1990).

These models’ short-term characteristics can essentially be characterized as Keynesian: output is determined by demand for goods, price adjustment is sluggish, and the demand for real money balances depends upon real output and nominal interest rates. Meanwhile, the exchange rate is driven by an arbitrage condition that equates the interest rate differential between home and abroad with the expected rate of appreciation or depreciation of the domestic currency. Conversely, in the long term, prices are flexible, output converges to potential output, potential output depends on the capital stock and in turn on investment, and money is neutral.

In this framework, the transmission of domestic policy to foreign countries operates primarily through two channels—a trade channel, whereby changes in domestic income and exchange rate level affect the demand for tradable goods, and a financial channel, whereby changes in domestic interest rates influence foreign interest rates and external debt payments of foreign countries.1 Some empirical or theoretical models also incorporate additional channels of policy transmission through pertinent modifications to the basic framework. For instance, MULTIMOD assumes that developing countries’ ability to attract foreign financing depends upon a measure of their capacity to service additional debt. As a consequence, a new channel of policy transmission is taken into account, where changes in interest rates in developed countries affect in turn developing countries’ debt-service-to-exports ratios, their ability to finance imports, investment, and GDP growth.

The importance of these various policy transmission channels varies depending upon the pairs of countries and the time horizon under consideration (see, for instance, Bryant and McKibbin, 1994; Bartolini and others, 1995; Bryant, 1995; Furman and Leahy, 1996). Generally, studies on international policy transmission between industrial countries conclude that the trade channel dominates the financial channel. Conversely, simulations of the impact of policies in OECD countries on developing countries tend to report that monetary and fiscal shocks are predominantly transmitted through the financial channel. Beyond this basic difference, these studies also show that the magnitude of the transmission effects depends on the extent of trade and financial links between pairs of countries. For instance, the impact of a fiscal expansion in the United States is estimated to be both initially higher and more rapidly dampened in Canada than in any other G-7 country, given the high sensitivity of Canadian exports to U.S. demand and that of Canadian interest rates to U.S. interest rates.

These studies thus suggest paying particular attention to variables that affect the magnitude of the trade and financial channels between pairs of countries or regions. Among such variables, one can count the degree of openness to trade, the geographic distribution of exports, the commodity composition of exports (which affects the income elasticity of exports), the amount and composition of foreign debt, the size of cross-border capital flows (as a proxy for the degree of integration of local financial markets with outside financial markets), and indicators of vulnerability to external shocks, such as the current account balance.

1 Of course, strictly speaking, a clear delineation between various transmission channels does not exist as prices and volumes of traded goods, exchange rates, and interest rates are all endogenously determined.

With the noticeable exception of Lebanon and Malta, foreign direct investment in the MB group appears limited. Private financial flows (measured as the sum of portfolio investment and net private borrowing) have been very substantial to Israel, Lebanon, and Malta and have reached around 3 percent of GDP in four other MB countries. Overall, abstracting from the particular situations of Israel, Lebanon, and Malta, private capital inflows to the region (measured as the sum of foreign direct investment and private financial flows) amounted to 3.9 percent of GDP. (Lebanon had inflows of more than a third of GDP during 1995–97; most other countries are nearer the average.) A number of MB countries have a large external debt and consequently face a heavy debt-service burden. On average, slightly over two-thirds of MB countries’ external debt is on commercial terms, one-fourth of it at variable interest rates, and around 20 percent denominated in EU currencies.

CFA Franc Zone Members

CFA franc zone members are relatively small countries; the highest population among them is 15 million and the average population is about 7 million Table 1.17 Like CEE countries, this moderate size is generally accompanied by a high degree of openness to trade, which is on average equal to 72 percent of GDP.

Box 1.3.Optimal Currency Areas and Choice of Exchange Rate Regime

The literature on optimum currency areas analyzes the conditions under which different regions or countries may benefit from adoption of a common currency. By extension, it focuses on the choice between a (permanently) fixed versus a flexible exchange rate policy.

The seminal contributions of Mundell (1961), McKinnon (1963), and Kenen (1969) analyzed the choice of exchange rate regime that, in combination with appropriate fiscal and monetary policies, can best ensure achievement of the objectives of stable domestic prices, full employment, and balanced external accounts. In addition, these articles considered the impact of the choice of exchange rate regime on the domestic currency’s ability to discharge its traditional roles of unit of account, medium of exchange, and store of value.

The general conclusions that emerged from these early studies and the vast literature that they spawned can be grouped according to characteristics seen to favor or disfavor participation in an optimum currency area (or equivalently, adoption of a fixed or a flexible exchange rate regime):

  • Size and openness to trade: The smaller the economy, or the more open to trade, the more desirable a fixed exchange rate. This is because money progressively loses its role of medium of exchange as the number of users dwindles, an open economy’s domestic prices are very sensitive to variations in the nominal exchange rate, and variations in the nominal exchange rate are less likely to translate into variations in the real exchange rate—and thus output and employment—when the economy is very open.

  • Economic structure and the nature of potential shocks: The greater the similarity in economic structure or, equivalently, the more symmetric the shocks affecting two economies, the greater the incentive to share a common currency. Clearly, the greater the similarities between two economies’ structures of production, taxation, trade, and so forth, the more likely they will be affected in identical fashion by any given shock, and the lower the need for a bilateral exchange rate adjustment to facilitate restoration of internal balances following said shock. Similarly, the greater the flexibility of real wages and prices, the stronger the case for a fixed rate.

  • Labor mobility, flexibility, and fiscal transfers: The greater the degree of labor mobility or labor flexibility, or the greater the extent of fiscal transfers between two countries, the easier the adoption of a common currency. Quite logically, if adjustment to asymmetric or one-sided internal imbalances can be resolved through fiscal means, labor movements, or variations in wages, the need for a recourse to exchange rate adjustment is correspondingly reduced.

These conclusions have received some empirical support in a recent paper by Bayoumi and Eichengreen (1996). Using a composite index, these authors show that the variables described above capture broadly shared views on the degree of convergence of various pairs of European countries and, thus, on the advantages of sharing a common currency. At the same time, in a related study, Frankel and Rose (1996) caution that some of these country characteristics may not be considered independently. In fact, they conclude that closer trade links (i.e., greater openness) result in more closely correlated business cycles (i.e., greater symmetry in shocks), and infer from this that economic integration can endogenously create conditions favorable to adoption of a common currency.

All CFA franc zone members have extensive trade relations with the European Union. On average, trade with the European Union represents about 50 percent of total trade. The commodity composition of trade of CFA franc zone members is, of course, substantially different from that of CEE and MB countries. The main exports of all countries of the region are primary commodities and derived products.

In recent years, the region has received some inflows of foreign direct investment, primarily in the natural resources sectors. All other private inflows of foreign capital have been negligible. Overall, private capital inflows were limited to 4 percent of GDP over the 1995–97 period. Total external debt and debt service of most CFA franc zone members are high. On average, external debt amounted to more than 110 percent of GDP in 1996, while debt service equaled 24 percent of exports of goods and nonfactor services. A large share of the CFA franc zone members’ external debt is at concessional terms: this share exceeds 60 percent on average and reaches 90 percent or more for a number of the poorer countries of the region. Approximately 40 percent of this debt is denominated in EU currencies and 20 percent is at variable interest rates.

Regarding the mechanics of the exchange rate relationship for the CFA franc zone countries, there is some question about the role of the French government after EMU. Because Article 109 of the Maastricht Treaty transfers competence over exchange rate policy to the EU level, some have asked whether the CFA franc zone would need to be recast as an EU-wide commitment rather than as an arrangement between France and the members of the zone. This issue is not treated here. For the purpose of the analysis in this paper, it is simply assumed that under EMU, the CFA franc will be pegged to the euro at a rate equivalent to the current peg to the French franc.

Impact on Economic Activity in Selected Countries

This section considers the impact of EMU on exports, output, and debt service in the selected country groups. It has generally been agreed that if the start of EMU’s Phase III is accompanied by determined implementation of structural reforms—particularly labor market reforms—and firm control over fiscal policy (so that enough room for maneuver is created for the operation of automatic stabilizers within the rules fixed by the Stability and Growth Pact), output and interest rate developments would be expected to be favorable within the euro area. In turn, the world economy as a whole would benefit from the launch of the euro. Conversely, if euro-area members’ fiscal and structural policies are incompatible with the EMU’s fiscal rules and the national exchange rate as a tool of adjustment is completely eliminated, monetary policy conflicts could emerge. Unbalanced policy mixes inside the euro area, and sluggish growth linked to a lack of progress in reducing structural unemployment, could then negatively affect economic and financial partners of euro-area members. To delve into this issue further, we analyze the effect of changes in euro-area GDP and interest rates on the selected country groups and consider the impact of EMU under two opposite scenarios.

Some commentators have also stressed that introduction of the euro would reduce costs on intra-euro-area transactions and thus alter the relative competitive position of euro-area members and non-members. This question is the topic of the second part of this section. Finally, as reported above, there has been considerable discussion about the evolution of the euro’s level in both the short and long term.

Thus, this section concludes by considering the effect of variations in the exchange rate of the euro vis-à-vis other major currencies on external trade and economic activity in selected non-EU countries.

Effect of Variations in Euro-Area GDP and Interest Rates

The present examination of the impact of euro-area GDP and interest rates on economic activity in selected non-EU countries is based on partial equilibrium analysis. We consider first, a variation in euro-area GDP; second, a variation in euro-area interest rates; and third, two combinations of deviations in euro-area GDP and interest rates from the baseline, which to an extent mimic two EMU scenarios presented in the IMF’s October 1997 World Economic Outlook8

Starting with the first exercise, we estimate that a permanent 1 percent increase (decrease) in the euro-area GDP will bring about an average increase (decrease) in exports of 1.5 percent in CEE countries, of 1.0 percent in MB countries, and of 0.6 percent in CFA franc zone countries and, in turn, will induce an average increase (decrease) in GDP in these three regions of 0.6, 0.3, and 0.2 percent, respectively Table 1.2.9

On the basis of these figures, the GDP level in the euro area can be seen to have a measurable influence on exports and GDP of all three selected country groups. At the same time, this influence varies in magnitude among these three regions in a ratio of one to three. What accounts for the differences? Two factors appear predominant: the volume of exports to the euro area; and the commodity composition of these exports. The impact of a change in euro-area GDP on CEE countries is particularly large because the future euro area is the CEE countries’ predominant market for exports and because they export to that market manufactured products—such as machinery, transport equipment, and other durable goods—whose demand is very sensitive to the level of economic activity. The impact on MB countries is lower on average than in CEE countries mainly because the volume of trade is lower in proportion to GDP. The effect of a variation in the level of activity in the euro area on CFA franc zone countries is much less than in the other two groups because these countries principally export homogeneous, primary commodities, and revenue from these exports depends more on the world level of activity and, consequently, world prices, than the GDP level in one or another region of the world. Should the EU make progress in reforming its Common Agricultural Policy, the trade effects (through higher agricultural exports from the non-euro area to Europe) could be much larger.

Applying these arguments to individual cases, we would expect that countries such as the Czech Republic and Tunisia—whose exports to the EU amount to around 30 percent of GDP and mainly consist of manufactured goods—would be affected the most by any change in level of activity in the euro area, while countries like Jordan—whose exports to the EU amount to less than 5 percent of GDP and consist principally of primary goods—would be least affected. Country-by-country information provided in Chapters 2and 3 confirms this view.

As discussed in Box 1.2, a “financial” channel of transmission of policy shocks from one country or region to another is said to operate when a change in interest rates in one country or region affects interest rates in another. Under the second simulation, this financial channel is estimated to have a measurable effect for CEE countries: on average, a 1 percent increase in the level of interest rates in the euro area brings about a decline in GDP level of 0.2 percent in CEE countries (Table 1.3). This is explained by the extensive financial links between CEE and EU financial markets,10 A precise estimate for MB countries is not available. However, considering the measured effect of euro-area interest rates on CEE countries, the relative size of private capital inflows to CEE and MB countries, the nature of monetary and exchange rate policies in the region, and restrictions on capital account transactions, the effect can be assumed to be less than half of what it is for CEE countries. The financial transmission of shocks between the euro area and the CFA franc zone countries is modest, despite the exchange rate link, given the relative insensitivity of economic activity in most of the countries of the zone to interest rate movements in international financial markets.

Selected countries may also be affected by changes in interest rates on euro assets through their foreign debt service. Logically, the larger the share of debt denominated in euros, or the larger the share of debt at variable interest rates, the larger this effect. On the basis of 1995 figures on the composition of debt, the average impact of a 1 percent increase in euro interest rates on CEE and MB countries is estimated to equal 0.5 and 0.6 percent of current export receipts respectively. The highest impact is registered for Morocco and Albania at 1.5 and 1.1 percent of current receipts respectively, which is explained by Morocco’s level and composition of external debt and Albania’s low level of exports. Precise numbers are more difficult to obtain for CFA franc zone countries. These countries’ external debt, measured in proportion to GDP, is generally much higher than that of CEE and MB countries. At the same time, the share of debt at fixed (concessional) terms is much higher. All in all, one may attempt to use the figures for CEE and MB countries as benchmarks for CFA franc zone members as well. These estimates are not insignificant. If debt service is sufficiently high that it exerts pressure on public finances or external accounts, a variation of a few percentage points in the debt service, caused by a variation of a few percent in euro interest rates, could have a measurable impact on macroeconomic developments.

Variations in euro-area GDP and interest rates can be combined in various ways to produce different scenarios. Two such scenarios are considered here—a “reform” scenario and a “reform fatigue” scenario. These scenarios are analytically and quantitatively similar to the scenarios presented in the IMF’s October 1997 World Economic Outlook (WEO).

Under the “reform” scenario, euro-area countries are assumed to pursue fiscal consolidation, principally through expenditure reduction, and labor market reforms. Together, these measures allow for a looser monetary policy than under the baseline scenario of the October 1997 WEO and raise potential output: the level of real GDP in the euro area exceeds the baseline by 0.2, 0.9, and 1.0 percent in 2000, 2001, and 2002, respectively, while long-term interest rates fall short of the baseline by 0.7, 0.8, and 0.9 percentage points in the same three years. In addition, the euro/dollar and euro/yen bilateral exchange rates are assumed to remain at baseline levels. Under this scenario, by 2002, the level of GDP is estimated to exceed the baseline by 0.9 percent in CEE countries, 0.4 percent in MB countries, and 0.2 percent in CFA franc zone countries (Table 1.4). Under this scenario also, in all country groups, the strength of the trade channel of policy transmission (that is, the impact of a higher euro-area GDP on CEE exports) is double or more that of the financial channel (that is, the impact of lower interest rates).

Under the “reform fatigue” scenario, structural reforms are assumed to lag, the natural rate of unemployment remains high, and government spending is allowed to drift upward in response to social pressures (Table 1.5). This scenario entails sluggish productivity growth and an unbalanced macroeconomic mix: the level of real GDP in the euro area falls short of the baseline by 0.3 and 0.6 percent in 2001 and 2002 respectively, while long-term interest rates exceed the baseline by 0,6 and 1.0 percentage points in the same two years. Under this scenario, by 2002, the level of GDP is estimated to fall below the base-line by 0.6 percent in CEE countries, 0.3 percent in MB countries, and 0.1 percent in CFA franc zone countries. One mitigating positive factor for non-EU countries in this scenario—particularly neighboring countries of Eastern Europe—is that reform fatigue in Western Europe could lead to firms investing outside the region to avoid persistent labor market rigidities in the euro area. The extent of such an offset is difficult to anticipate and has not been included in this paper’s calculations.

In sum, if EMU is a catalyst for further macroeconomic and structural reforms it can have notable positive spillovers on selected countries, stemming first from higher demand for their exportable goods and, second, from lower rates of interest. Conversely, if appropriate structural and fiscal policies in the EU do not complement EMU’s macroeconomic policy framework, there is a risk that non-EU countries will be negatively affected by sluggish growth and high interest rates in the European Union.

Effect of Reduction in Transaction Costs Within the Euro Area

Introduction of the euro is expected to reduce the costs of intra-euro-area transactions. Thus, the competitiveness of euro-area producers in all euro-zone markets outside their home markets should be enhanced. This improvement could theoretically be at the expense of exporters from other regions of the world, including the selected country groups. The trade effects on euro and non-euro countries are akin to the standard trade creation and trade diversion effects of the customs union literature. Assessing with precision the size of this effect is difficult, as it requires accurate estimates of the potential impact of EMU on euro-area exporters’ costs, of the effect of this cost reduction on relevant euro-area price aggregates, and of the price elasticity of selected countries’ exports to the euro area. This section attempts to estimate a broad order of magnitude of this effect.

On the basis of foreign exchange market data, a figure of 5 percent can be used as an upper bound for the cost reduction on intra-euro-area transactions.11 Considering that this cost reduction affects only intra-euro-area trade and assuming, on the basis of present average figures for the EU, that intra-euro-area trade accounts for 20 percent of all euro-area sales, we estimate euro-area costs and prices would fall on average by 1 percent. Depending on the extent to which exports to the EU respond to average prices compared with prices of goods traded only within the euro area (that is, the extent to which non-EU country exports compete with nontradables for a share of the EU market), a benchmark price elasticity of exports could range from 0,6 to 3. Thus, this price decline would translate in a reduction in exports to the EU by non-euro-area producers of 0.6 percent to 3 percent. With a ratio of exports to the EU to total exports of around 50 percent for all three selected regions, the trade diversion effect entailed by the intra-euro-area drop in transaction costs would thus amount to an average 0.3–1.5 percent reduction in exports for the three selected regions. Of course, the calculated effects could be larger or smaller if EMU results in a more general regime change, including changes in trade policy.

A reduction in the lower end of this range is not entirely negligible. It is, however, significantly lower than the estimated impact of a 1 percent increase in euro-area GDP for all three selected regions (see Table Table 1.2).12 In addition, it is possible that these calculations overestimate the costs for non-euro-area countries. In particular, they do not take into account the benefits that non-euro-area exporters themselves would also likely obtain from a reduction in intra-euro-area transaction costs: exporting to one large market in one currency must be less cumbersome and less costly than exporting to a number of smaller markets each with their own currency. Overall, taking into account this effect is not likely to modify the general conclusions reached in the previous section: a successful EMU will lead to higher exports and output in the three selected country groups.

While a successful EMU per se is thus likely to be beneficial to all three selected country groups, extending the above line of reasoning could lead to the conclusion that, in the absence of appropriate policy actions, some selected countries could suffer negative repercussions from developments in the European Union as a whole—including EMU and a potential extension of membership to a number of CEE and MB countries. For instance, if a country were to delay macroeconomic and structural reforms intended to provide a sound basis for sustained private-sector-led growth, it could find itself at a disadvantage compared with potential new EU members, as these countries would benefit from—or be about to benefit from—open access to a large market, relatively low costs of production in some activities, and lower transaction costs in their trade with other EU countries.

Effect of Variations in the Euro’s Exchange Rate vis-à-vis Other Major Currencies

To parallel the above discussion of the impact of variations in euro-area GDP and interest rates, two potential effects of changes in the level of the euro are examined. The first concerns exports and output in non-EU selected countries; the second their external debt service.

The impact of movements in the value of the euro vis-à-vis other major international currencies on a particular country obviously depends upon that country’s exchange rate policy and trade pattern. To take hypothetical examples, abstracting from the impact of competition in third markets, a 10 percent appreciation of the euro vis-à-vis the dollar would result in

  • no change in the real effective exchange rate of a country conducting all its trade with euro-area members and with a currency peg to the euro;

  • a 10 percent appreciation of the real effective exchange rate of a country conducting all its trade with the United States and with a currency peg to the euro (assuming that the real effective exchange rate is computed on the basis of simple bilateral trade shares); and

  • a 10 percent depreciation of the real effective exchange rate of a country conducting all its trade with the euro area and with a currency peg to the U.S. dollar.

Thus, it is not possible to make general statements, region by region, about the effect of variations in the value of the euro. Instead, based on specific assumptions, one can attempt to compute an order of magnitude for this effect in particular cases.

Let us assume a price elasticity of imports of -0.9 and a price elasticity of exports of 0.6. Thus, starting from a position of initially balanced trade, the (domestic) value of net exports increases by 0.5 percent of initial exports (or imports) following a 1 percent depreciation in the real effective exchange rate. Let us assume as well that an increase in net exports of a real amount X ultimately contributes to a rise in real GDP of 1.5 times X. Let us consider a country whose ratio of trade to GDP is 70 percent and whose exchange rate policy and trade pattern is such that a 10 percent appreciation of the euro vis-à-vis the dollar and the yen leads to a 3 percent appreciation of its real effective exchange rate. Then such an appreciation of the euro would lead to a fall in the GDP level in that country below baseline of 0.8 percent.13

As can be seen from Tables 1.2 and Table 1.3 above, for CEE countries, a fall in GDP of 0.8 percent could also be the consequence of a reduction in euro-area GDP of 1.2 percent or an increase in euro-area interest rates of 4 percent. The current computation thus suggests that appreciation or depreciation of the euro vis-à-vis other major currencies can have as powerful an impact on the level of activity in some non-EU countries as a significant change in euro-area GDP or a sizable movement in euro interest rates.

The above rules of thumb relate to a sustained change in the exchange rate of the euro. Alternatively, one could examine the effect on non-EU groups of a temporary “bump” in the euro’s value. Temporary strength or weakness in the euro, associated with shifts in credibility and the operation of monetary policy, could have important effects on capital flows and competitiveness. They also create uncertainty and require diligence to avoid allowing policy to move off course.

Are the assumptions in this computation realistic, and thus is the above conclusion likely to have empirical validity? Figures for price elasticities are not out of line with published estimates for a number of countries. A measure of openness to trade of 70 percent is around the average for CEE, MB, and CFA franc zone countries reported in (Table 1.1. As for the exchange rate movement vis-à-vis the euro, historical data on MB countries exhibit standard deviation of the real exchange rate vis-à-vis European currencies of 3 percent and above for a number of countries.14

The impact of a change in the euro’s exchange rate against other major currencies on debt service of a given non-EU country depends upon the share of that country’s external debt denominated in euros and its exchange rate regime. Present data show a large number of countries that, by virtue of their combination of debt composition and exchange rate regime, would be exposed to sizable changes in debt-service ratios in the event of movements in the euro/U.S. dollar exchange rate.15 In particular, a number of CEE countries have a low share of external debt denominated in EU currencies and an exchange rate regime emphasizing stability vis-à-vis these currencies. Conversely, a number of MB countries have a substantial share of external debt denominated in EU currencies and an exchange rate regime emphasizing stability vis-à-vis the dollar.

Impact on the Economic Structure of Selected Countries

Finally, the level and composition of a country’s external trade and the extent and nature of its capital inflows and outflows can have profound consequences on the design and implementation of appropriate macroeconomic policies. For instance, the degree of openness to trade has an influence on the optimal currency regime (see Box 1.2), and the effectiveness of monetary policy is affected by the size and nature of capital flows. Thus, it appears worthwhile to consider the extent to which the structure itself of trade and financial flows of the three selected groups of non-EU countries could evolve in the years following introduction of the euro. In addition, this section considers the potential impact of EMU on financial systems in selected non-EU countries and EMU-related institutional considerations.

Institutional Considerations

EMU is going to be part of the EU acquis communautaire.16 The ability of CEE countries to adhere to the aims of EMU has been explicitly mentioned as one of the criteria for EU membership. Consequently, the economic policies of prospective EU members could be expected to be influenced by the design of EMU.

In this perspective, the macroeconomic policy framework, and macroeconomic policies themselves, of future EU members would be likely to take into consideration the following features of EMU: the provisions on central bank independence; the prohibition on central bank financing of the government; the procedure used to assess eligibility to adopt the common currency, including the criteria on fiscal deficit of the general government, public debt, and stability of the exchange rate over a period of two years; the fiscal rules at the heart of the Stability and Growth Pact; and the design of the new Exchange Rate Mechanism (ERM II) for EU countries with a derogation or with an exemption.

While not directly a consequence of EMU, but of immediate relevance for the design and conduct of macroeconomic policy, it can be noted that the acquis communautaire also includes a commitment to an open capital account, not only among EU members but also between the EU and the rest of the world. Europe Agreements between the EU and CEE countries already contain provisions for the liberalization of capital movements.

Structural Impact of EMU on Trade Flows

The launch of EMU will lower transactions costs for intra-euro-area transactions. As noted above, it could also reduce the average cost of exports from non-EU countries to the euro area, as it should be easier and less costly to export to one single market using one currency than to many markets using many currencies. Thus, EMU may add to existing processes that are already inducing—or are expected to induce—increases in trade flows between CEE and MB countries and the EU.

Trade links between the EU and CEE countries have been steadily growing since the start of the lat-ter’s transition to market economies. Such growth was facilitated by the Trade and Cooperation Agreements and later the Europe Agreements signed between the EU and a number of CEE countries. Recent studies tend to indicate that, in proportion to GDP or to total trade flows, this process may be coming to an end for a number of CEE countries, including Visegrad (Czech Republic, Hungary, Poland, and Slovakia) and Baltic countries.17 For other CEE countries, which may have experienced delays and setbacks in the transition process, this process may, however, be far from complete, and costs of trade remain unnecessarily high. A reduction in the cost of exports to the euro area could offer these countries’ firms an additional incentive to accelerate the development of new relations with euro-area markets. In MB countries, the implementation of Association Agreements with the European Union, which contain provisions for a significant reduction in MB countries* trade protection, should induce a progressive transfer of resources in areas where these countries enjoy a comparative advantage and, ultimately, lead to increased trade between MB countries and the EU. Moreover, the launch of EMU could offer an incentive to speed up this process of transition. In all cases, the gains appear potentially large in the agricultural area; however, capturing these gains would require a reform of the CAP, which currently imposes significant barriers to trade.

Effect of EMU on Capital Flows

The impact of EMU on foreign direct investment in CEE and MB countries has been an object of debate. One can argue that EMU, which puts the final touch on the creation of a single, large market, in combination with Europe or Association Agreements, which guarantee access to this large market at least for industrial goods, can only spur investment in neighboring countries. To support this point of view, a parallel can be drawn with the situation in North America where investment in Canada or Mexico is made more attractive by the proximity of the United States and the access to that market guaranteed by the North American Free Trade Association (NAFTA). One could also argue that the EMU-induced reduction in trading costs between euro-area countries will lead to a diversion of foreign direct investment from non-euro-area members to euro-area members, unless the nonmembers are also liberalizing trade among themselves and with the rest of the world.18 Whether foreign direct investment creation will dominate foreign direct investment diversion or not is a question that cannot be settled for certain. However, if EMU is successful, that is, if it spurs growth within the euro area, it is generally predicted that the ensuing benefits that will accrue to neighboring countries would extend to higher foreign direct investment. Of course, as mentioned above in relation to external trade and economic activity, such a positive outcome depends on the measures taken by the prospective recipient countries to maintain macroeconomic stability and to create a climate favorable to private sector growth.

EMU could also have an influence on portfolio investment and other financial (lows, particularly for the countries of Central and Eastern Europe that aspire to join the European Union. By bringing about convergence of interest rates in a number of countries and eliminating financial instruments denominated in a number of currencies, EMU may spur portfolio capital flows into non-euro-denominated instruments of CEE countries from investors intent on maintaining a diversified portfolio containing assets with different yield/risk combinations. First, financial markets of some CEE countries are already well integrated with world financial markets. Second, with EMU as part of the acquis communautaire of the EU, macroeconomic policies of future members would be expected to be geared to consolidation of macroeconomic stability. Third, EU members are obliged under the Maastricht Treaty to maintain free capital movements not only between themselves but also vis-à-vis third countries. Similarly, EU Association Agreements with Jordan, Morocco, and Tunisia contain references to capital account liberalization between the EU and the associate country. Thus, prospective EU members would be expected to continue liberalizing their capital account transactions.

EMU may also lead to increased reliance on euro-area financial markets by non-EU residents. By fostering larger, more liquid, and more efficient financial markets, EMU is likely to increase competition in the markets for the underwriting of bond issues and syndication of bank loans. In addition, a larger euro-denominated government bond market would reduce the costs of hedging euro-denominated liabilities. Thus, overall, borrowing by non-EU countries in euros is likely to become more attractive. In addition, if EMU contributes to increasing the efficiency of euro-area equity markets, equity issues by non-EU countries in these markets may increase.

Finally, in the short run, EMU could also pose some risks to some countries’ capital flows. As discussed above, commentators have generally noted that the period following introduction of the euro might be one of great uncertainly regarding interest and exchange rate developments. The section on economic activity showed that movements in euro-area interest rates or euro’s exchange rate against other major currencies could have a significant impact on euro-area outsiders. Thus, in the event of a sharp rise of short-term euro interest rates or swift changes in the euro’s level, a country that was already financing a large current account deficit with substantial foreign portfolio investment and short-term capital inflows could be at serious risk of losing market confidence. In addition, experience has shown that such capital flows can be extremely sensitive to shifts in monetary policy of major industrial countries that profoundly modify expectations about future returns on their domestic assets.

Effect of EMU on Financial Systems

Introduction of the euro is likely to put the financial systems of some non-EU countries—primarily those with a large degree of integration with EU financial markets—under great competitive pressures.

Banking systems in some non-EU countries could be particularly affected by two factors discussed above. First, a large number of their higher-quality customers may be tempted to bypass local financial markets and directly access euro-area financial markets. Second, euro-area banks, which are themselves under strong pressure to restructure, could become fiercer competitors in the foreign markets in which they have an active presence. This latter development may help strengthen non-EU banking systems. Nevertheless, given that domestic banks would be expected to continue to dominate retail banking activities in non-EU countries, it is significant that non-EU banks may find themselves facing increased competitive pressures following introduction of the euro.

The development of capital markets, for instance stock exchanges, in certain non-EU countries may also be affected by the consolidation of such markets in the euro area. The recent listing of a few of the largest international companies of non-EU countries on EU stock exchanges may be an indicator of future developments in this domain.19

Implications for IMF Surveillance

Analysis of the impact of EMU on selected non-EU countries has implications for IMF surveillance over both future euro-area members and non-EU countries.

The fiscal and structural policies of euro-area members following introduction of the euro will affect the impact of EMU on countries outside the EU. It will be incumbent upon the IMF to assess such spillover effects more explicitly when pressing euro-area members to address structural rigidities promptly—particularly in labor markets—and to maintain appropriate fiscal policies, as these policies are central to ensuring EMU’s success for both members and nonmembers.

The first implication of EMU on the IMF’s surveillance activities over selected non-EU countries follows from the discussion of the challenges to integration. Greater attention to the implications for non-EU countries of global changes in economic and financial conditions in the euro area and to financial sector issues will be necessary. In addition, in certain cases, increased integration in the world economy may mean a need to revisit the appropriateness of current exchange arrangements with a view to increasing their flexibility. This may be the case, in particular, when existing arrangements fit poorly with the geographical composition of international trade and financial relations.

The second implication follows from the earlier consideration of institutional aspects of EMU, particularly as concerns future EU members. Jointly, EMU and accession to the EU will put constraints on the framework, design, and implementation of macroeconomic policies. In its surveillance activities, the IMF should take into account these future constraints and help prepare its members to face them with appropriate recommendations on complementary macroeconomic and structural reforms. For instance, certain CEE countries may eventually be expected to tie their currency more closely to the euro, either as participants in the ERM II after becoming an EU member or in anticipation of such a participation. Choosing such a course would imply progressively giving up any remaining independence of their monetary policy. To ensure maintenance of sound fundamentals and the possibility of reacting to various shocks, it would then be necessary to create more room for maneuver for fiscal policy, which may entail not only aiming at ambitious fiscal targets but also tackling with great determination structural problems, such as underfunded pension systems or loss-making public enterprises.

Statistical Appendix

The four tables that follow set out general, macro-economic, trade, and financial indicators for the countries of Central and Eastern Europe, the Mediterranean Basin, and the CFA franc zone (Tables (1.6 to 1.9).

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See Masson, Krueger, and Turtelboom (1997); and IMF (1997b, 1997c). Also, IMF (1997a) provides a summary of the IMF-sponsored Conference on EMU and the International Monetary System held on March 17–18, 1997.

Some of the relevant issues have been discussed elsewhere: see, for example, Lax ton and Prasad (1997).

In addition to the publications cited above, sec, for example, Alogoskoufis and Portes; Benassy-Quere, Mojon, and Pisani-Ferry; Berysien; Bryant; Kawai: McCauley and White; Patat; and Prati and Schinasi—all in Masson, Krueger, and Turtelboom (1997). See also Eichengreen (1996,); and Frankel and Rose (1996).

The 13 Central and Eastern European countries selected for this study are Albania, Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Former Yugoslav Republic of Macedonia, Poland, Romania, the Slovak Republic, and Slovenia.

Mediterranean Basin countries included in this study are Algeria. Cyprus, Egypt, Israel, Jordan, Lebanon, Libya, Malta, Morocco, the Syrian Arab Republic, Tunisia, and Turkey.

The CFA franc zone members included in this study are Benin, Burkina Faso, Cameroon, the Central African Republic, Chad, Congo, Côte d’lvoire, Equatorial Guinea, Gabon, Guinea Bissau. Mali, Niger, Senegal, and Togo. Comoros is also a member of the French franc zone, but its currency (the Comorian franc, introduced in 1981) is issued by the Bank of Comoros at a fixed rate against the CFA franc.

See IMF (1997b), Chapter 3, p. 77. These two scenarios were entitled “EMU with Additional Fiscal Consolidation and Labor Market Reforms” and “EMU with Neither Additional Fiscal Consolidation nor Labor Market Reforms.”

For CEE countries and CFA franc zone members, these figures are based on the results of a survey of country economists. For MB countries, they are based on econometric estimates (see Chapter 3, “Impact on Economic Activity in the MENA Region”). The CEE chapter also contains numerical estimates of the impact of euro-area GDP on exports and GDP in Central and Eastern European countries. In general, these estimates are a little lower than the figures presented here (see Chapter 2. “Linkages Through External Trade” and “Financial Linkages”).

For a detailed discussion of the integration of CEE financial markets with EU financial markets, see Chapter 2.

Financial Sector Issues” in Chapter 3. Other studies, such as Calmfors (1997), suggest much lower estimates.

This is the right comparison as, keeping input use constant, a 1 percent average GDP increase in the euro area is the logical counterpart to the derived 1 percent average reduction in production cost in the euro area.

The multiplication is as follows: 0.8 = 0.5 (change in net exports) X 1.5 (export multiplier) x 0 35 (half of ratio of trade to GDP) x 3 (appreciation of REER).

Financial Linkages” in Chapter 2 and “Currency Composition of External Debt” in Chapter 3.

The acquis communautaire is the set of policies, laws, and rules that have been jointly adopted by current EU members and that future members undertake to follow, During the process of accession to EU membership, it can be negotiated that certain aspects of the acquis communautaire will be phased in over a certain transition period. For a detailed discussion of the EMU and the acquis communautaire. see Temprano-Arroyo and Feldman (1998).

Financial Linkages” in Chapter 2 and “Impact on Economic Activity in the MENA Region” in Chapter 3.

financial Linkages” in Chapter 2.

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