Euro Adoption by Accession Countries - Macroeconomic Aspects of the Economic and Monetary Union

TABLE OF CONTENTS

1. Introduction
1.1 Disagreement in the New EU Member States
1.2 Goals and Approach of This Study
1.3 Definition of Key Terms

2. Fundamentals of the Euro Adoption by Accession Countries
2.1 History of the Euro
2.2 Enlargement of the EU
2.3 Economic and Monetary Union

3. Accession Countries in the Third Stage of Economic and Monetary Union
3.1 Convergence Criteria
3.2 Current Strategies for Euro Adoption
3.3 Fulfillment of the Convergence Criteria
3.4 Directly vs. Steady Euro Adoption
3.5 Balassa-Samuelson Effect

4. Completion of the Third Stage of the EMU and its Macroeconomic Effects
4.1 Is the Enlarged EU an Optimum Currency Area?
4.2 Expected Macroeconomic Effects of the Single Currency
4.2.1 Exchange Rate Risk
4.2.2 Financial Markets
4.2.3 Price Parity
4.2.4 Macroeconomic Stability
4.2.5 Less-specific Monetary Policy
4.3 The Euro Area In the World Economy

5. Conclusion

APPENDIX

REFERENCES

1. Introduction

1.1 Disagreement in the New EU Member States

On 1st May 2004 ten new member states joined the European Union (EU), e.g. Estonia, Poland and Slovenia. The countries won’t adopt the euro as their new currency immediately, because they first have to show that their economies have converged with the economy of the euro zone.

Presently, the efforts and opinions of the new members differ about the adoption of the single currency. For instance, the Slovenian Prime Minister Janez Jansa told the press in February 2006 that there “is nothing on the path ahead” that could endanger the euro adoption in 2007. The government pursues a tight fiscal policy to meet all entry requirements. Recently, it introduced a dual pricing – that means all prices of goods and services are marked in tolars as well as euros – to raise consumer awareness in the preparation for the euro adoption.^[1] Contrarily, other countries are skeptical. The leader of the Polish conservative party Jaroslaw Kaczynski said during a campaign that he “doesn’t see any benefits in adopting the euro. Euro adoption would lead to lower exports, lower national income and higher unemployment.” The Estonian Sirje Karu said in an interview, that “Estonians are scared. We heard that when Finland adopted the euro, it took them quite a while to get used to it and prices increased. The poorest suffered.”

Using this situation as a background, it is interesting to analyze the euro adoption by accession states. How does the adoption process work? When should the euro be introduced and what macroeconomic effects does it have?

1.2 Goals and Approach of This Study

The goals of this research are to point out the actual stage of the Euro Adoption in the new EU member states and to investigate the effects of the introduction of a single currency.

The paper proceeds as follows: First, the process of the Economic and Monetary Union (EMU) associated with the enlargement of the EU will briefly be explained. Afterwards, the requirements for the euro adoption will be described and the new member states will be investigated about how far they meet them. Finally, the macroeconomic effects of the adoption of a single currency will be discussed.

1.3 Definition of Key Terms

Accession of new member states to the EU is provided in Article 49 of the EU Treaty. Article 49 states that “any European State which respects the principles set out in Article 6(1) may apply to become a member of the Union”. The principles of Article 6(1) are “liberty, democracy, respect for human rights and fundamental freedoms, and the rule of law”. New member states that fulfill these criteria and join the EU are basically called accession countries.^[2]

Once the accession countries have achieved economic and budgetary results which prove that their economies have converged with the economy of the eurozone, they will join the single currency in accordance with the procedures laid down in the EU Treaty (=Euro Adoption).

2. Fundamentals of the Euro Adoption by Accession Countries

2.1 History of the Euro

The euro was established by the provisions in the Maastricht Treaty on EU and is the official and single currency of the eurozone.^[3] In 1999, the euro was introduced to the financial markets and in 2002 launched as a currency. It is managed and administered by the independent European Central Bank (ECB) – that is responsible for the monetary currency – and the European System of Central Banks – that is responsible for printing, minting and distributing notes and coins.

2.2 Enlargement of the EU

Since the establishment of the euro, new countries have joined the EU. The original EU consisted of six members and has expanded into a union of 25 countries. Enlargement now refers to the last wave of accessions culminating in the simultaneous membership of ten countries to the EU from Central and Eastern Europe on 1st May 2004: the Czech Republic, Estonia, Cyprus, Latvia, Lithuania, Hungary, Malta, Poland, Slovenia and Slovakia.

2.3 Economic and Monetary Union

The EMU is the process of harmonizing the economic and monetary policies of the member states of the EU with a view to the introduction of a single currency, the euro. EMU consists of three stages (Figure 2): The first stage was to introduce free movement of capital, closer coordination of economic policies and cooperation between central banks. The second stage contained convergence of the economic and monetary policies and the establishment of the European Monetary Institute and of the European Central Bank (ECB). Since 1st January 1999 the third stage of the EMU is in progress. Exchange rates are irrevocably fixed and the single currency is introduced on the foreign-exchange markets and for electronic payments, followed by the introduction of euro notes and coins on 1st January 2002.

At the beginning of the third stage, eleven member states adopted the euro and they were joined two years later by Greece. Some members have not adopted the single currency: the UK and Denmark, both of which benefit from the opt-out clause, and Sweden, which doesn’t at present meet all of the criteria regarding the independence of its central bank.^[4] Under the accession treaty the ten new member states went straight into stage three on 1st May 2004. They have the status of “member state with derogation” according to Article 122 (1) of the EC Treaty and must adopt the euro as soon as they meet the criteria. They were not granted an opt-out clause.

Figure 2: Stages of the EMU

Abbildung in dieser Leseprobe nicht enthalten

3. Accession Countries in the Third Stage of Economic and Monetary Union

3.1 Convergence Criteria

The “member states with derogation” - that are the accession states - have to meet the convergence criteria, also known as the Maastricht criteria, to adopt the euro. The four main criteria, based on Article 121 (1) of the EC Treaty, are the following:

- Inflation Rate: Price stability is measured according to the rate of inflation in the three best performing member states. The inflation rate must not be more than 1.5% above the benchmark states.
- Long-term Interest Rates: The nominal long-term interest rate must not be more than 2% higher than the three best-performing member states.
- Government Finance: The government finance criterion covers the annual government deficit and the government dept. The ratio of the annual government deficit to gross domestic product (GDP) must not exceed 3% at the end of the preceding fiscal year. If not, it is at least required to reach a level close to 3%. Only exceptional and temporary excesses would be granted for exceptional cases. The ratio of gross government dept to GDP must not exceed 60% at the end of the preceding fiscal year. Even if the target cannot be achieved due to the specific conditions, the ratio must have sufficiently diminished and must be approaching the reference value at a satisfactory pace.
- Exchange Rate: Accession countries should have joined the exchange-rate mechanism (ERM II) of the European Monetary System for two consecutive years and should not have devaluated its currency during this period. The purpose of the ERM II is to reduce exchange rate variability and achieve monetary stability. The ERM II is based on the concept of fixed currency exchange margins, but with exchange rate variability within those margins. Currencies in the ERM II are allowed to float within a range of Abbildung in dieser Leseprobe nicht enthaltenwith respect to a central rate against the euro. The national currencies of the ten new member states will become part of the ERM II at different dates.

The purpose of setting these criteria is to maintain the price stability within the eurozone even with the inclusion of the new member states.

3.2 Current Strategies for Euro Adoption

The new member states have set target dates for the adoption of the euro by themselves. Estonia, Lithuania and Slovenia aspire to adopt the euro on 1st January 2007. They joined ERM II on 28th June 2004. Cyprus, Latvia and Malta want to follow no later than 1st January 2008. They entered ERM II on 2nd May 2005. Slovakia, that joined the ERM II on 25th November 2005, aims to adopt the euro on 1st January 2009 and the Czech Republic as well as Hungary have as the target year 2010. Poland has no target date for the time being yet. The period of dual circulation – euro and national currency – will be very short, generally only two weeks.

If current plans are materialized, the euro area will enlarge with nine more countries in four successive steps between 2007 and 2010. Its population will enlarge from 309 million people to 345 million, and its aggregate GDP will increase by around 3.7%.

3.3 Fulfillment of the Convergence Criteria

In this section the current status regarding to the fulfillment of the convergence criteria by each new member states will be pointed out. To see how far the countries can meet their target dates the focus will be on Estonia, Lithuania and Slovenia, since they aim to adopt the euro as the first countries from Central and Eastern Europe on 1st January 2007.

Using the data from Table 1, presently all three countries meet the criteria for the long-term interest rate, government finance and will meet the exchange rate criterion until the 1st January 2007. Slovenia also meets the interest rate criterion. Lithuania exceeds the maximum interest rate by 0.2% and Estonia exceeds it with 1.6% by far. In 2004, Estonia had an inflation rate of 2% and met this criterion. This raise in inflation is, as the EC states, a result of the rapidly growth in oil and electricity prices. The outlook for 2006 is that the inflation rate will fall again.

The following Table 1 provides an overview of the status quo regarding to the fulfillment of the convergence criteria (dark fields mark fulfilled criteria by each country):

Table 1: Fulfillment of the Convergence Criteria by Accession Countries

Abbildung in dieser Leseprobe nicht enthalten

[Data reference: *Wikipedia, Convergence Criteria, 2006; **ECB, Convergence Report 2004 – all data is based on figures of 2006, except of the long-term interest rate (2004)]

3.4 Directly vs. Steady Euro Adoption

Since the accession states have different target dates, reasons pro and contra for a fast or slow eurozone entry will be weighed up in this section. Rapid entry could be beneficial for a country that does not have an established tradition of domestic monetary policy or for a country that has made significant progress with real convergence. More slow timing for eurozone entry would be better for a country that has a credible monetary policy, still differs significantly according to the real convergence and does not have a very flexible economy, e.g. the Czech Republic.

Empirical analysis found that slower and gradual eurozone enlargement would also be more beneficial from the European perspective. If the eurozone countries are too diverse, there will be a problem with internal stability – even after implementing institutional reforms, which should change the principle of decision-making on European rates over to the majority principle.

Therefore, the eurozone entry must be assessed separately for each accession state according to its conditions, whereby a slower entry will be favored regarding to stability in the EU.

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^[1] Tolars (SIT) is the national currency of Slovenia.

^[2] Since this research refers to the enlargement of the EU in 2004, the term accession states will be used for the ten new EU member states.

^[3] The eurozone is the subset of EU member states which have adopted the euro, creating a currency union (Figure 1, Appendix).

^[4] Opting out is an exemption granted to a country that doesn’t wish to join the other members in a particular area of community cooperation, for instance taking part in the third stage of the EMU to avoid a general stalemate.