Issues

Euro Area Enlargement and Euro Adoption Strategies

Zsolt Darvas and György Szapáry

Workshop on„The First Decade of European Monetary Union”

University of Münster, May 29-30, 2008

This paper was commissioned by DG ECFIN from the EU Commission as part of the "EMU@10" project. The views expressed are those of the authors and do not necessarily reflect the views of the EU Commission.

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies 2

Issues• Given the characteristics and initial conditions of

the NMS, what are the risks and challenges on the road to euro?

• What should be the strategy and timing of euro adoption?

• Explore the real-nominal convergence nexus

• Highlight why keeping the Maastricht inflation criterion unchanged violates the Equal Treatment Principle


GDP per capita at PPS (EA12=100)

30

40

50

60

70

80

90

100

30

40

50

60

70

80

90

100

1996 1998 2000 2002 2004 2006

EA12Czech Rep.HungaryPoland

SlovakiaSloveniaCyprus

30

40

50

60

70

80

90

100

30

40

50

60

70

80

90

100

1996 1998 2000 2002 2004 2006

EA12MaltaEstoniaLatvia

LithuaniaRomaniaBulgaria

25 25 25 25


Price level (EA12=100)

30

40

50

60

70

80

90

100

30

40

50

60

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80

90

100

1996 1998 2000 2002 2004 2006



30

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70

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100

30

40

50

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80

90

100

1996 1998 2000 2002 2004 2006



25 25 25 25


Convergence of Price Levels

• Lowest initial GDP per capita → lowest initial price level → fastest convergence of price level

• The Balassa-Samuelson effect has been declining, but is not the sole factor contributing to price level convergence

• Others factors: shift in consumption to higher quality, higher priced goods, reduction in subsidies (energy, transportation, health care, etc), initial undervaluation


Interest Rates

• Convergence of nominal interest rates

• Low spreads, except Hungary and Romania. Recent increase in Latvia

• Interbank rates: low real interest rate, negative in some NMS

• Housing loans: somewhat larger rates

• Consumer loans: much larger rates


3-month interbank interest rate differential

0

5

10

15

20

25

30

0

5

10

15

20

25

30

96 98 00 02 04 06

Czech Rep.HungaryPoland


0

5

10

15

20

25

30

0

5

10

15

20

25

30

96 98 00 02 04 06

MaltaEstoniaLatvia


Latest observation: April 2008


10-year interest rate differential

-1

0

1

2

3

4

5

6

7

8

-1

0

1

2

3

4

5

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8

99 00 01 02 03 04 05 06 07



-1

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5

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8

-1

0

1

2

3

4

5

6

7

8

99 00 01 02 03 04 05 06 07

MaltaEstoniaLatvia

LithuaniaRomániaBulgária



-4

0

4

8

12

16

-4

0

4

8

12

16

1996 1998 2000 2002 2004 2006

EMU12Czech Rep.HungaryPoland


-4

0

4

8

12

16

-4

0

4

8

12

16

1996 1998 2000 2002 2004 2006

EMU12MaltaEstoniaLatvia


3-month interbank real interest rate


Domestic Credit and Current Account

• Lowest per capita GDP → lowest level of credit and fastest growth of credit

• Credit growth: fuelled by both demand and supply factors

• Fuelled also by low real interest rates in currency board system

• Equilibrium level vs. speed of adjustment

• Dangers: feeds inflation, wage growth, housing prices, consumption, could deteriorate competitiveness, risks financial crisis

• Fastest credit growth → largest current account deficit


Domestic credit / GDP

10

20

30

40

506070

100

200

10

20

30

40

506070

100

200

1996 1998 2000 2002 2004 2006



10

20

30

40

506070

100

200

10

20

30

40

506070

100

200

1996 1998 2000 2002 2004 2006




Current account balance / GDP

-10

-8

-6

-4

-2

0

2

4

-10

-8

-6

-4

-2

0

2

4

1996 1998 2000 2002 2004 2006



-25

-20

-15

-10

-5

0

5

10

-25

-20

-15

-10

-5

0

5

10

1996 1998 2000 2002 2004 2006




Competitiveness

• Export volume growth has been robust and export market shares have increased in most of the NMS

the main cause of the large current account deficits is excessive domestic demand rather than any significant loss of competitiveness


Export market shares in total imports of the world (in percent)

.0

.1

.2

.3

.4

.5

.6

.7

.8

.9

.0

.1

.2

.3

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.9

1996 1998 2000 2002 2004 2006



.00

.05

.10

.15

.20

.25

.30

.00

.05

.10

.15

.20

.25

.30

1996 1998 2000 2002 2004 2006

MaltaEstoniaLatvia



Inflation

• Lowest initial GDP per capita → lowest initial price level → fastest convergence of price level

• Fast credit growth → further boosts domestic demand and inflation


Contribution to GDP Growth, averages of 1997-2001 (left column) and 2002-2006 (right column)

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Est

onia

Latv

ia

Lith

uani

a

Rom

ania

Bul

garia

Slo

vaki

a

Cze

ch R

ep.

Hun

gary

Pol

and

Slo

veni

a

Cyp

rus

Mal

ta

Eur

o ar

ea

Irel

and

Gre

ece

Spa

in

Fin

land

Aus

tria

Por

tuga

l

Net ExportInvestmentGovernment consumptionPrivate consumption


GDP per capita, credit growth, inflation

Credit growth Inflation1995 2007

Cyprus 99.3 93.6 11.8 2.1Malta 87.0 76.3 7.4 2.1Czech Rep. 73.7 81.9 11.6 2.3Slovenia 72.7 91.6 23.8 3.1Hungary 50.7 65.3 13.4 5.6Slovakia 47.8 67.5 17.1 4.1Poland 43.1 55.1 17.5 2.4Estonia 36.0 71.7 35.6 4.6Lithuania 34.5 61.5 42.7 3.4Bulgaria 32.0 38.7 32.2 6.8Romania 31.6 39.3 47.2 8.1Latvia 31.5 60.6 52.9 7.5

EMU12 100.0 100.0 4.0 2.1

GDP per capita at PPSaverage of 2004-2007


An illustrative model for price level convergence 1.

The key determinant of price level is GDP per capita:

20

40

60

80

100

120

140

20

40

60

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100

120

140

20 40 60 80 100 120 140

1995

GDP per capita at PPS (EMU-12=100)

Pri

ce le

vel (

EM

U-1

2=

10

0)

BG

C Z

CY

EE HULV

L T

MT

PL

SK

SI

RO

A T

P T

FI

IE

GR ES

BE

DEFR

I T

NL

DK

20

40

60

80

100

120

140

20

40

60

80

100

120

140

20 40 60 80 100 120 140

2006

BG

C Z

CY

EE

HULVL T

MT

PL

SK

SIRO

A TP T

FI IE

GR ES

BE

DE

FRI T NL

DK



• Indeed, in many cases we could not reject the null hypothesis that the parameter of GDP per capita is one

• Transitory effects also could affect the price level; we found two significant variables:

1. Domestic demand/GDP relative to euro area2. Interest rate differential vs. euro area• Consequently:

itEMUtit

EMUt

it

it

it

EMUt

PPS

it

PPS

EMUt

it iiY

DD

Y

DD

POPY

POPY

P

P,,,2

,

,

,

,10

,

)(

,

)(

,

,



• We also added a dummy for countries with fixed ER regimes: it was significantly positive in 1998-2000 and 2001-2003 but not in 2004-2006

Under fixed exchange rate, the price level convergence takes place via higher inflation and as the real convergence proceeds, this influence diminishes



• Price level convergence projections

• We assume that

– NMS will catch up in GDP per capita at PPS to either 90% of EA12 (=average of Greece, Spain, and Portugal) or 100%

– Catching up is faster in the beginning then slows down: we assume it is described by a logistic function

– Initial speed of GDP catching-up is equivalent to actual average catching-up in 2000-2007

– In the long run the level of domestic demand equals the level of GDP (similarly to recent historical values of EA12) and the speed of convergence depends on the speed of catching-up

– The interest rate differential will converge to zero


Projected annual price level convergence (excess inflation or nominal appreciation in %

point )

2008-2012 2013-2017 2018-2022

Bulgaria 1.2 2.0 2.0

Cyprus 0.4 0.3 0.2

Czech Republic 3.0 1.6 0.8

Estonia 4.3 0.9 0.0

Hungary 3.3 2.2 1.6

Latvia 2.6 1.3 0.5

Lithuania 3.8 1.9 0.9

Malta 0.4 0.4 0.4

Poland 1.9 1.6 1.4

Romania 2.8 2.8 2.5

Slovenia 1.6 0.4 0.1

Slovakia 3.8 2.2 1.2

Catching-up to 100% of EA12


Nominal and Real Exchange Rate

• Nominal exchange rate: among floaters trend appreciation only in Czech Rep. and Slovakia. These two NMS registered low inflation in recent years

• ULC based REER: appreciating trend irrespective of exchange rate regime. More developed countries experienced least appreciation.


Nominal euro exchange rate (1995=100)

60

70

80

90

100

110

120

130

140

60

70

80

90

100

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120

130

140

96 98 00 02 04 06 08



4

8

12

1620

28

40

80

120

160

4

8

12

1620

28

40

80

120

160

96 98 00 02 04 06 08


LithuaniaRomániaBulgária


ULC real effective exchange rate (1995=100)

80

120

160

200

240

280

80

120

160

200

240

280

1996 1998 2000 2002 2004 2006



80

120

160

200

240

280

80

120

160

200

240

280

1996 1998 2000 2002 2004 2006




Fiscal balances

• Fiscal deficit is not a source of imbalance in less developed NMS


General Government Balance / GDP

-12

-10

-8

-6

-4

-2

0

2

4

-12

-10

-8

-6

-4

-2

0

2

4

1996 1998 2000 2002 2004 2006



-12

-10

-8

-6

-4

-2

0

2

4

-12

-10

-8

-6

-4

-2

0

2

4

1996 1998 2000 2002 2004 2006




Summary of Convergence 1

• NMS with lowest initial per capita GDP have:– Lowest per capita GDP → fastest output

growth– Largest price level gap to close → fastest

price convergence– Lowest credit level → fastest credit growth– Lowest real interest rates → procyclicality of

interest rates


Summary of Convergence 2

• Rapid growth of credit to households, particularly mortgage loans.

• Issue: equilibrium level of credit vs speed of adjustment

• Rapid growth of consumption

• Fiscal deficit not source of imbalance in less developed NMS


Choice of Monetary and Exchange Rate Regime 1

• Issue: which regime is best to manage the real and nominal convergence?

• Fixed: price level convergence translates into higher inflation → pushes real interest rates into negative territory → danger of credit boom → adds to inflation and current account deficit → increases debt.

• No immunity against capital flow reversal: example ERM2 member Latvia


Austrian Experience• Real-nominal convergence can be successfully

managed under fixed rate

• Austria has done it, but the price level gap was only 25% when hard currency policy was introduced in early 1970s, not 40% or more remaining for CEEs

• Key to success: social consensus to keep wage growth in line with productivity

• Task was easier: capital market and banking sector liberalization more progressive


70

80

90

100

110

120

60 65 70 75 80 85 90 95 00

GDP per capita in PPP (Germany = 100)Price Level of Consumption (Germany = 100)German mark exchange rate (1960=100)

Catching-up of Austria to Germany


Choice of Monetary and Exchange Rate Regime 2

• Floating: price level convergence can be partly accommodated by nominal appreciation.

• Risks: excessive appreciation, capital flow reversal, excessive exchange rate fluctuations

• Exchange rate more a source of shock than shock absorber. Our new calculations for the CEEs reported in the paper confirm it, using sign restrictions adopted by Farrant and Peersman (2006) based on the theoretical model of Clarida and Gali (1994).


Constraints on Domestic Monetary Policy

• Foreign currency loans and direct external borrowing

• These are difficult to control given strong financial integration.

• Several NMS have applied administrative and regulatory measures, but success is limited. Good only as short term expedients


Share of foreign currency loans (in percent of total loans), 2006

HouseholdsNon-financial corporations Total

Bulgaria 17 n.a. 46Czech Republic 0.2 18.6 10.2Estonia 77.8 75.6 76.7Cyprus n.a. n.a. n.a.Latvia 77.1 77 77Lithuania 43.9 58.2 52.3Hungary 42.7 45.7 44.5Malta 1.4 16.1 9.4Poland 30.9 22.1 27.1Romania 40 n.a. 48Slovenia 43 n.a. 57Slovakia 1.7 33.5 20.1


Standing of NMS Regarding OCA Criteria

• Paper looks at OCA criteria: – business cycle synchronization (BCS)– output volatility– economic structures– labour and product market flexibility– financial integration

• Conclusion: standing improved significantly over years, by now not much of an issue from euro adoption perspective, especially given endogeneity of OCA.

• Important new finding: fiscal discipline (also embodied in EU fiscal rules) is associated with greater BSC


Conclusions 1

• Floating provides more flexibility to manage the real-nominal convergence, but room for manoeuvre should not be overestimated.

• Risks: undue appreciation or excessive ER fluctuations. These militate in favour of earlier rather than later euro adoption where degree of real convergence more advanced.

• Lines are pretty much already drawn it seems, with the Baltic States and Bulgaria having opted for hard pegs.


Conclusions 2• Exiting from pegs?

• Dangers: loss of confidence → depreciation → negative wealth effect on euroized debt → recession

• If well communicated as transition to euro: appreciation → positive wealth effect → adds to CA deficit

• Step appreciation down the road?

• Any change needs careful weighing of pros and cons against accepting a delay in euro adoption


Conclusions 3• Key ingredients to successful real

convergence:

• Productivity growth: what are the best policies to promote productivity?

• Structural reforms: improve flexibility in labour and product markets, ease of doing business (reduce bureaucracy, regulations, corruption)

• Social Pact on incomes policy


Maastricht criteria

• The inflation criterion as currently applied has weak justification on economic grounds

• Violates the Equal Treatment Principle

• Can deny euro adoption by countries which satisfy conditions to function normally in EMU and reap the benefits of membership

Our proposal for modification: euro area inflation + 1.5 percentage points and 2 year compliance


Maastricht criteria, cont’d• Logic:

– euro area inflation influences imported inflation– it is the indicator ECB tries to control – non-euro area countries’ inflation would not affect the

criteria – frees from judging which best performer's inflation is

unsustainable

• Would have minimal impact on euro area inflation (adds 0.05% compared to current practice)


Inflation: Current and Suggested Reference Values

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

1997

m12

1998

m06

1998

m12

1999

m06

1999

m12

2000

m06

2000

m12

2001

m06

2001

m12

2002

m06

2002

m12

2003

m06

2003

m12

2004

m06

2004

m12

2005

m06

2005

m12

2006

m06

2006

m12

2007

m06

2007

m12

Average of three smallest EU members (non-negatives only) Current reference value = Three smallest + 1.5Euro AreaSuggested reference value = Euro area + 1.5



Equal treatment?• During 1970-1990, the three EU countries having the

lowest inflation were Germany (3.8%), the Netherlands (4.8%) and Luxembourg (5.5%)

• By defining the inflation criterion in terms of the 3 best performers, probably convergence to Germany had in mind

• Germany was the most important trading partner of all other old EMU members

• Expansion of EU: the chance that small trading partners constitute the inflation criterion has substantially increased

• E.g. in March 2008 the 3 best performers were: Malta (with 1.5% inflation), the Netherlands (1.7%) and Denmark (2.0%)


Thank you for your attention

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