Nada Choueiri

Eight central European countries—the Czech Republic, Hungary, Poland, the Slovak Republic, Slovenia, Estonia, Latvia, and Lithuania—became members of the European Union (EU) on May 1, 2004. This milestone underscored the end of the transition period, but was also a wake-up call for the substantial effort these countries must still undertake to meet the requirements for euro adoption. This article summarizes recent IMF cross-country research on the first five countries in the above list (CEC5) that helps understand their current economic environment and the challenges they face as they strive for membership in the euro area.

A decade of transition has transformed the economies of the CEC5 into a market-based model. As Weder (2001) points out, their institutions are now similar to those of Western European countries. In the late 1990s, the CEC5 increasingly aligned their financial sector legislation with that of the EU; Wagner and lakova (2001) describe how the countries reinforced their banking systems—which provide the bulk of financial services—through stronger supervision, greater transparency, and foreign participation. According to Morales (2001), the Polish and Czech currencies now seem entirely integrated into global currency markets. Chan-Lau and Morales (2003) even argue that currency derivative markets in both countries seem more efficient than in mature markets.

However, deeper and more liberalized financial markets could yield greater volatility and spillovers across the CEC5 and require tight supervision. According to Kóbor and Székely (2004), the correlation between the Hungarian and Polish currency markets increases in periods of relatively high volatility, and the same holds for the Czech and Slovak Republics. Nevertheless, Bulíř (2004) argues that short-run exchange rate volatility need not raise concerns in liberalized markets as exchange rate deviations from equilibrium could attract stabilizing capital flows. On the other hand, according to Cottarelli, Dell̓ Ariccia, and Vladkova-Hollar (2003), the boom in bank credit to the private sector that coincided with market liberalization could be worrisome. This phenomenon, which should persist with ongoing financial deepening, requires further strengthening of regulations and supervision.

The CEC5 should further consolidate their economic transformation. Allan and Parry (2003) indicate that fiscal transparency must be enhanced and the legal and business environment must be improved to support growth. Perhaps most important, policies are needed to sharply reduce unemployment. Schiff and others (forthcoming) report that enterprise restructuring led to a surge in unemployment. Employment failed to pick up thereafter as productivity was largely driven by growth and as reforms stumbled against labor market obstacles. However, high unemployment, although entrenched, could be reduced through appropriate labor market policies and institutional reforms—including by avoiding high minimum wages and labor tax wedges, improving the business climate to facilitate the development of small and medium-sized enterprises, and encouraging labor mobility.

As new EU members, the CEC5 are committed to eventually adopting the euro, a step that could potentially yield significant long-term gains. Schadler and others (forthcoming) underscore that the gains from joining a currency union in terms of trade and growth opportunities appear certain and could be substantial, while the costs of relinquishing independent monetary policy seem small. Moreover, according to Borghijs and Kuijs (2004), exchange rate variability has been more destabilizing by propagating monetary shocks than stabilizing by absorbing real shocks—additional evidence of the benefits from euro adoption. In addition, Lipschitz, Lane, and Mourmouras (2002) demonstrate that exchange rate flexibility need not protect monetary policy independence when capital markets are open and inflation is targeted. The costs of losing the monetary policy tool are directly related to the degree of synchronization of supply and demand shocks (and associated dynamics) of the entering countries with the euro area members. Frenkel and Nickel (2002) find that while there are differences in this regard between the CEC5 and the euro area, the differences are less important between individual countries—Poland, Hungary, and Slovenia—and some euro area countries.

Notwithstanding these benefits, euro adoption could be delayed by obstacles to the fulfillment of the Maastricht criteria or to successful membership in the Exchange Rate Mechanism (ERM2), both preconditions for euro adoption. Setbacks could come from the lack of strong fiscal adjustment plans and disinflation policies to reduce fiscal deficits and inflation to Maastricht levels. Feldnian and others (2002) and Schadler and others (forthcoming) suggest that the CEC5 will need to exert a substantial fiscal effort—primarily expenditure reducing—to curtail large budgetary imbalances. Structural factors could also jeopardize disinflation. De Broek and Sløk (2001), Feldman and others (2002), and Schadler and others (forthcoming) argue that differing productivity growth between traded and nontraded sectors could raise average inflation by about 1 or 2 percentage points annually. Čihák and Holub (2001) show that the convergence of the price structure in the CEC5 to that of the EU countries will create inflation. Also, if a country’s real exchange rate is far from equilibrium, this would endanger participation in ERM2. Bulíř and Šmídková (forthcoming) note that the Czech, Hungarian, and Polish currencies were significantly overvalued in 2003; hence, converging toward equilibrium could compromise the adherence of these countries’ exchange rates to ERM2 rules. Large and volatile capital flows could also undermine attempts to meet the exchange rate criterion.

IMF research has also helped identify policies that maximize the chances of a successful membership in ERM2 and the euro area. Feldman and others (2002) note that completing price liberalization before joining ERM2 would minimize subsequent inflation shocks, and flexible labor markets would support stabilization and growth objectives given nominal rigidities imposed by ERM2 and euro adoption. Schadler and others (forthcoming) advise countries to enter ERM2 only when the Maastricht criteria are within reach and to limit their stay within that system to the required two-year period. These authors indicate that, while a number of exchange rate regimes would be compatible with ERM2, more rigid systems would be more demanding on other policies to support a country’s goals under ERM2 and euro adoption. They conclude that successful participation in Europe’s Economic and Monetary Union would be ensured if fiscal deficits are well below the 3 percent Maastricht benchmark; fiscal subsidies and transfers are low; wages and prices are flexible; economic activity shows strong linkages across the Union’s member countries; financial market supervision is strong; and competitiveness, as implied by the central parity set within ERM2, is adequate.