The Euro and The Euro and the New Member the New Member

StatesStatesNatalia TamirisaNatalia Tamirisa

International Monetary FundInternational Monetary Fund

Warsaw, October 29, 2007Warsaw, October 29, 2007

FocusFocus Macroeconomic challenges NMS face as Macroeconomic challenges NMS face as

they prepare to join EMUthey prepare to join EMU

Policies that can help overcome these Policies that can help overcome these challenges challenges

For details, see For details, see Euro Area Policies: Selected Issues , , Country Report No. 07/259, July 31, 2007 Country Report No. 07/259, July 31, 2007 www.imf.org/external/pubs/cat/region.aspwww.imf.org/external/pubs/cat/region.asp

Maastricht TreatyMaastricht Treaty

Requires NMS to adopt the euroRequires NMS to adopt the euro But only after they satisfy entry But only after they satisfy entry

conditionsconditions Timing is left openTiming is left open

EC and ECB review progress annually EC and ECB review progress annually (Convergence Reports)(Convergence Reports)

Unilateral euroisation is inconsistent Unilateral euroisation is inconsistent with the Treatywith the Treaty

Entry ConditionsEntry Conditions

InflationInflation should not exceed, on a sustainable should not exceed, on a sustainable basis, by more than 1.5% that of the three best basis, by more than 1.5% that of the three best performing EU countries in terms of price stabilityperforming EU countries in terms of price stability

Exchange ratesExchange rates should be within the “normal” should be within the “normal” fluctuation margins provided for by ERM-II; no fluctuation margins provided for by ERM-II; no devaluationsdevaluations

Long-term interest ratesLong-term interest rates should not exceed by should not exceed by more than 2% that of at most the three best more than 2% that of at most the three best performing EU countries in terms of price stabilityperforming EU countries in terms of price stability

The fiscal deficitThe fiscal deficit should not exceed 3% of GDP should not exceed 3% of GDP Gross government debtGross government debt should not exceed 60% should not exceed 60%

of GDPof GDP

NMS plan to adopt the euro, but NMS plan to adopt the euro, but for now have different exchange for now have different exchange

rate regimesrate regimes

IMF Classification 1/ ERM II EMU

Czech Republic Float Has not joined yet No official target date has been set. On current budget plans, 2012 would be the earliest feasible date.

Hungary Intermediate Has not joined yetNo official target date has been set. The Convergence Program of December 1, 2006 aims at meeting the Maastricht criteria in 2009.

Poland Float Has not joined yet No official target dateSlovak Republic Fixed Joined on November 28, 2005 Target date is set for January 1, 2009

Estonia Fixed Joined on June 28, 2004The government is committed to adopting the euro at the earliest possible date, which it now estimates to be 2011, based on current inflation forecasts.

Latvia Fixed Joined on May 2, 2005According to the information released by the Ministry of Finance, in 2007 the Government would discuss a new target for the changeover to the euro, tentatively in 2011-2013.

Lithuania Fixed Joined on June 28, 2004No official target date has been set. According to the government, Lithuania will aim to join the euro area as soon as possible and the more favorable period for the country to join the euro area starts in 2010.

Bulgaria Fixed Has not joined yet Target date is set for January 1, 2010Romania Float Has not joined yet Target date is set for January 1, 2014

2/ Information available from European Commission and national authorities, as of end-July, 2007.

Sources: IMF Annual Report on Exchange Arrangements and Exchange Restrictions and International Financial Statistics ; European Commission; European Central Bank; National central banks.1/ "Fixed" includes currency boards, conventional pegs, and narrow bands. "Intermediate" includes tightly managed floats and broad bands. "Float" includes managed and independent floats.

Exchange Rate Regimes in the NMS and Euro Adoption Plans

Progress in Euro Adoption

Questions relevant for euro Questions relevant for euro adoptionadoption

What are benefits and costs of euro What are benefits and costs of euro adoption for NMS and the euro area?adoption for NMS and the euro area?

Is fulfilling the entry criteria feasible for Is fulfilling the entry criteria feasible for NMS?NMS?

Will NMS economies perform well in the Will NMS economies perform well in the monetary union?monetary union?

How much policy adjustment would NMS How much policy adjustment would NMS need to undertake to fulfill the entry need to undertake to fulfill the entry condition?condition?

What are benefits What are benefits and costs of NMS and costs of NMS euro adoption for euro adoption for NMS and the euro NMS and the euro

area?area?

Benefits and Costs of Euro Benefits and Costs of Euro AdoptionAdoption

Elimination of exchange rate riskElimination of exchange rate risk More trade and investmentMore trade and investment Faster convergence (1% per year)Faster convergence (1% per year) But loss of a shock absorberBut loss of a shock absorber

Efficiency gains for the euro area Efficiency gains for the euro area through outsourcing and competitionthrough outsourcing and competition

Is fulfilling the Is fulfilling the entry criteria entry criteria

feasible for NMS?feasible for NMS?

NMS are converging to the euro NMS are converging to the euro area in real and nominal termsarea in real and nominal terms

20

30

40

50

60

70

80

20 30 40 50 60 70 80

Relative per capita GDP at PPPs

Rel

ativ

e pr

ice

leve

l

20

30

40

50

60

70

80

BG CZ EE HU

LV LT PL SK

SI CR RO

NMS: GDP per Capita and Prices, 1995-2006(In percent of EU-25 levels)

Source: World Economic Outlook, IMF staff estimates.Note: Countries shown on the chart include Bulgaria (BG), the Czech Republic (CZ), Estonia (EE), Hungary (HU), Latvia (LV), Lithuania (LT), Slovenia (SI), Poland (PL), Slovak Republic (SK), Romania (RO).

Price convergence results in real appreciation

One of the factors driving real One of the factors driving real appreciation is the Balassa-appreciation is the Balassa-

Samuelson effectSamuelson effect

Other factorsOther factors Persistent equilibrium effectsPersistent equilibrium effects

Quality upgrading of tradables and nontradablesQuality upgrading of tradables and nontradables Shifts in domestic preferences toward servicesShifts in domestic preferences toward services EU transfersEU transfers

Transient equilibrium effects (level Transient equilibrium effects (level adjustment)adjustment) Shifts in foreign preferences towards NMS Shifts in foreign preferences towards NMS

productsproducts EU accession and adoption of EU accession and adoption of acquis communitaireacquis communitaire

Disequilibrium effects Disequilibrium effects Irrational exuberance, speculative flows, Irrational exuberance, speculative flows,

overheatingoverheating

Uncertainty about equilibrium Uncertainty about equilibrium appreciation rates contributes to appreciation rates contributes to

controversy over criteriacontroversy over criteria Can the built-in margins—1.5% under inflation Can the built-in margins—1.5% under inflation

criterion and 15% under exchange rate stability criterion and 15% under exchange rate stability criterion—accommodate equilibrium real criterion—accommodate equilibrium real appreciation in NMS? appreciation in NMS?

YesYes Real appreciation is largely transient, and Balassa-Real appreciation is largely transient, and Balassa-

Samuelson and other equilibrium effects are smallSamuelson and other equilibrium effects are small NoNo

Catching-up euro-area economies posted 3-3.5% Catching-up euro-area economies posted 3-3.5% inflation in 1999-2006, above the Maastricht inflation in 1999-2006, above the Maastricht reference value reference value

The Maastricht reference value may be driven down The Maastricht reference value may be driven down by idiosyncratic factors (administrative and tax by idiosyncratic factors (administrative and tax changes)changes)

((Choueiri, Ohnsorge, and van Elkan, forthcomingChoueiri, Ohnsorge, and van Elkan, forthcoming))

Real appreciation is taking Real appreciation is taking place in the context of place in the context of

convergence-driven booms...convergence-driven booms...

...supported by capital ...supported by capital inflowsinflows

Rising concerns about Rising concerns about overheating and balance sheet overheating and balance sheet

mismatchesmismatches

Source: National authorities, Fund staff estimates.Note: Regional averages for East Asia and Latin America cover emerging market countries.

0

10

20

30

40

50

60

70

80

East A

sia

Czech

Rep

ublic

Slovak

Rep

ublic

Wes

tern

Eur

ope

Poland

Hunga

ry

Latin

Am

erica

Bulgar

iaNM

S

Roman

ia

Lithu

ania

Estonia

Latvi

a

0

10

20

30

40

50

60

70

80

Foreign Currency-Denominated Loans, 2005(in percent of total outstanding loans)

Cooling off convergence-driven Cooling off convergence-driven booms is difficultbooms is difficult

Fiscal tighteningFiscal tightening Significant? Medium-term considerations?Significant? Medium-term considerations?

Monetary tighteningMonetary tightening Further capital inflows? Sterilization Further capital inflows? Sterilization

costs?costs? Capital controlsCapital controls

Prohibited under EU rules? Effective?Prohibited under EU rules? Effective? Prudential regulationPrudential regulation

As a macro instrument?As a macro instrument?

Will NMS Will NMS economies perform economies perform

well in the well in the monetary union?monetary union?

Strong productivity growth, Strong productivity growth, may not be sustainable... may not be sustainable...

...but significant catch-up ...but significant catch-up potential remainspotential remains

Source: IMF, World Economic Outlook.

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000B

ulga

riaR

oman

iaP

olan

dLa

tvia

Lith

uani

aS

lova

kE

ston

iaH

unga

ryM

alta

Por

tuga

lC

zech

Rep

ublic

Slo

veni

aG

reec

eS

pain

Cyp

rus

Fra

nce

Ital

yG

erm

any

Bel

gium

Fin

land

Net

herla

nds

Aus

tria

Irel

and

Luxe

mbo

urg

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

GDP PPP per Capita, 2006(in U.S. dollars)

United States

Euro area

0

2

4

6

8

10

12

14

16

Mal

taP

ortu

gal

Ital

yS

pain

Cyp

rus

Fra

nce

Bel

gium

Ger

man

yA

ustr

iaN

ethe

rland

sLu

xem

bour

gIr

elan

dG

reec

eF

inla

ndS

love

nia

Hun

gary

Pol

and

Lith

uani

aR

oman

iaC

zech

Bul

garia

Slo

vak

Est

onia

Latv

ia

0

2

4

6

8

10

12

14

16

GDP PPP per Capita, 2006(annual percentage change)

United States

Euro area

Measures of labor market Measures of labor market flexibility provide comfort but flexibility provide comfort but

have not been testedhave not been tested

Product market flexibility is Product market flexibility is lower than in the euro arealower than in the euro area

Significant presence of major Significant presence of major foreign banks should facilitate foreign banks should facilitate intertemporal risk-sharing...intertemporal risk-sharing...

...but NMS financial systems ...but NMS financial systems are still less developed and are still less developed and integrated than its peersintegrated than its peers

Automatic stabilizing properties Automatic stabilizing properties of NMS budgets are weaker than of NMS budgets are weaker than

in the euro area...in the euro area...

...but variation in expenditures ...but variation in expenditures is higher, especially in is higher, especially in

discretionary categoriesdiscretionary categories

How much policy How much policy adjustment would adjustment would

NMS need to NMS need to undertake to fulfill undertake to fulfill

the entry the entry conditions?conditions?

Dynamic Stochastic General Dynamic Stochastic General Equilibrium Model (Equilibrium Model (GIMF by GIMF by

Kumhof and Laxton, 2007Kumhof and Laxton, 2007)) Fiscal and monetary policy reaction Fiscal and monetary policy reaction

functionsfunctions Overlapping generations, open Overlapping generations, open

economy monetary business cycle economy monetary business cycle model model Blanchard (1985) and Weil (1989)Blanchard (1985) and Weil (1989)

Non-Ricardian features: finite planning Non-Ricardian features: finite planning horizons and liquidity constrained horizons and liquidity constrained consumersconsumers

Calibration to a representative NMSCalibration to a representative NMS

Fiscal policy cannot Fiscal policy cannot permanently reduce permanently reduce

inflation in NMS with pegsinflation in NMS with pegs NMS: Effects of a One-Percent Permanent Decrease in Fiscal Deficit

(In percent or percentage point deviation from the baseline)

Source: IMF staff estimates.

Flexible Exchange Rate

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

t t+1 t+2 t+3 t+4 t+5

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0Real GDPInflationNominal exchange rateReal interest rateReal exchange rate

Fixed Exchange Rate

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

t t+1 t+2 t+3 t+4 t+5

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0Real GDPInflationReal interest rateReal exchange rate

"+" indicates depreciation "+" indicates depreciation

Greater wage and price flexibility Greater wage and price flexibility and lower nominal rigidities and lower nominal rigidities

reduce output costs...reduce output costs... NMS with Fixed Exchange Rate Regimes: Effects of a One-Percent Permanent Decrease in Fiscal Deficit

(In percent or percentage point deviation from the baseline)

Source: IMF staff estimates.

Lower Nominal Rigidities

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

t t+1 t+2 t+3 t+4 t+5

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0Real GDPInflationReal interest rateReal exchange rate

"+" indicates depreciation

More Flexible Labor and Product Markets

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

t t+1 t+2 t+3 t+4 t+5

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0Real GDPInflationReal interest rateReal exchange rate

"+" indicates depreciation "+" indicates depreciation

Base Case

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

t t+1 t+2 t+3 t+4 t+5

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

Real GDPInflationReal interest rateReal exchange rate

...but do not make inflation reduction sustainable

In NMS with flexible exchange In NMS with flexible exchange rates, monetary tightening can rates, monetary tightening can

lower inflation...lower inflation...

...but cannot ...but cannot resolve the resolve the tension tension between joint between joint price and price and exchange exchange rate stability rate stability objectivesobjectives

NMS with Flexible Exchange Rates: Effects of a One Percent Interest Rate Increase (In percent or percentage point deviation

from the baseline)

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

t t+1 t+2 t+3 t+4 t+5

Real GDP

Inflation

Real interest rate

Real exchange rate

Nominal exchange rate

"+" indicates depreciation

What margin to use for What margin to use for unanticipated inflation and unanticipated inflation and

fiscal shocks?fiscal shocks?

Prudent fiscal deficits are estimated at 1-2 percent of

GDP Schadler et al, 2005

What sacrifice ratios to use to What sacrifice ratios to use to quantify output losses from quantify output losses from

disinflation?disinflation?

Euro area: 1.25% of GDP Euro area: 1.25% of GDP Coffinet, Coffinet, Matheron, Poilly (2007)Matheron, Poilly (2007)

EU-15: 0.5% to 3.5% of GDP EU-15: 0.5% to 3.5% of GDP Bulir and Bulir and Hurnik (2006)Hurnik (2006)

NMS: 1.5% to 4% of GDP NMS: 1.5% to 4% of GDP Bulir and Hurnik Bulir and Hurnik (2006)(2006)

Pegs: short-run multipliers from GIMF

What levels of inflation What levels of inflation to use?to use?

Upper limitUpper limit: Contemporaneous inflation: Contemporaneous inflation But could be influenced by transient factorsBut could be influenced by transient factors

Lower limitLower limit: Long-run equilibrium trend : Long-run equilibrium trend Average euro area inflation (just under 2 Average euro area inflation (just under 2

percent)percent) Add 1.5% for Balassa-Samuelson effectsAdd 1.5% for Balassa-Samuelson effects

Compare to 2.5% “adjusted” reference Compare to 2.5% “adjusted” reference valuevalue

Upper limit on output Upper limit on output losses associated with losses associated with

disinflationdisinflation

Lower limit is 0.5-1.5 percent of GDP

For fiscal tightening, there is For fiscal tightening, there is a trade-off between short- and a trade-off between short- and

long-run effectslong-run effects

ConclusionConclusion NMS face considerable macroeconomic NMS face considerable macroeconomic

challenges are they prepare for joining EMUchallenges are they prepare for joining EMU Distinguishing benign appreciation in NMS Distinguishing benign appreciation in NMS

from overheating is difficultfrom overheating is difficult Degree of appropriate macroeconomic Degree of appropriate macroeconomic

adjustment is uncertain, but could be adjustment is uncertain, but could be significantsignificant

In any event, NMS need to be well prepared In any event, NMS need to be well prepared before joining to perform strongly in EMU before joining to perform strongly in EMU

Benefits of euro adoption are considerable Benefits of euro adoption are considerable for both for NMS and the euro areafor both for NMS and the euro area