Monetary aspects of enlargement - Central and Eastern Europe, EMU and the ERM-2

Table of Content

Introduction

1. THE GROUNDWORKS
1.1 The EMU-accession procedure
1.2 The ERM-II
1.3 Exchange rate regimes in the CEEC
1.4 The macroeconomic situation of the CEEC
1.5 EMU-accession strategies and timeframes

2. PHASE 2 – THE CEEC AND THE ERM
2.1 A common problem structure – goals of exchange rate regimes in
transition countries
2.2 Which exchange rate regime for the CEEC?
2.3 Excurse: Currency crises
2.4 Adjustment capacity
2.4.1 Institutional capabilities
2.4.2 Fiscal policy
2.5 Which entry-rate?

3. PHASE 3 – THE CEEC AND THE EURO
3.1 Is an enlarged EMU an Optimum Currency Area?
3.2 How fit are the candidates?
3.3 Do the Maastricht Criteria still make sense?
3.4 Problem areas and possible dangers
3.4.1 Fiscal discipline and public investment
3.4.2 “Stability Culture” and the ECB
3.4.1 Dangers of premature entry
3.4.2 Political costs to the CEEC

Conclusion – How should they enter?

References

INTRODUCTION

A rough 50 years after its foundation, the European Union (EU) is preparing for the probably most ambitious challenge of its existence, the binding-back into the West of the once centrally-planned economies of Central and Eastern Europe (CEEC). Together with political and general economic efforts, European monetary integration also gains speed with as many as twelve CEEC queuing up for entry into the EU (not including Turkey, which has not yet officially begun entry negotiations), the first of them most likely joining the Union already two years after the physical introduction of the single currency, i.e. in 2004. Many of these countries are eager to also join Monetary Union (EMU) and show their ability to be ‘good Europeans’ by adopting the Euro as soon as possible. Various statements by both CEEC-government officials and monetary authorities exemplify this very vividly.

This implies that the enlargement of EMU is already a relevant issue. By the time it becomes acute, positions and perspectives of both applicants and current members should be clear, if unnecessary delays and political irritations are to be avoided. The body of literature on the subject is thus as large as the questions of when, how and on what terms CEEC-accession will take place are pressing, and becoming more so as time progresses.

This study attempts to coherently examine the core issues related to EMU-enlargement, equally synthesising the various segmented approaches of the academic debate, and deduce normative conclusions as to what strategic outlook should seem appropriate to both CEEC and the current EMU-12: In what timeframe should accession most sensibly take place? How appropriate are the mechanics leading up to EMU, most prominently the Exchange Rate Mechanism (ERM-II) and the Maastricht criteria, and how should they be dealt with? What are the most likely problem areas and deficits that need to be confronted? Since there appears to exist a more or less stable consensus regarding the basic desirability of EMU for the CEEC, the paper will concentrate more on the run-up to full EMU, equally the road to the euro, and place special emphasis on the CEEC’s attitude towards the ERM-II.

I shall proceed in three distinct steps to address these issues. In the first section, I shall lay the foundations for the following discussion by summarising the procedural basics of EMU-accession and giving a short overview of the applicants’ situation in the relevant policy and structural areas, as well as comment on their prospective entry-strategies. The main discussion is divided into two chapters. In the first, I shall discuss how appropriate the ERM-II appears to be for the CEEC, if, when and on what terms they should join it and what monetary and exchange rate policies seem advisable. Also, policy areas and issues that may pose problems for the smooth functioning of the system are examined. The second chapter deals in an equal manner with the transition from ERM-II to full monetary integration, i.e. the adoption of the single currency, and summarises some common objections as well as likely problem areas and central institutional, structural and monetary implications. I shall conclude with a summary of the most salient points.

1. GROUNDWORKS

1.1 THE EMU-ACCESSION PROCEDURE

Roughly two years before their effective accession, it appears very likely that the new entrants to the EU will not be allowed “opt-out” clauses for Economic and Monetary Union, as were used by Denmark and the United Kingdom. This means that all future entrants into the EU are supposed eventually to become members of the common currency area, which became a reality with the introduction of the euro in eleven (later twelve) of the 15 European Union member states in January 1999. This follows from the Amsterdam Treaty, which declares that all future member countries “shall adhere to the goals of EMU”. It was spelled out more explicitly by the general commitments in the pre-accession agreements signed by the new entrants with the European Commission. However, they will not from the start transfer their monetary authority but rather enter the Union as “member states with a derogation” to full EMU-membership.^[1] In its 1998 Composite Paper on the progress of applicant countries in meeting the Copenhagen criteria, the European Commission also presents its views on the phasing of EMU integration for the future member countries. The Commission envisages a three-phased process^[2]: The first phase is the pre-accession phase, during which the accession states shall fulfil the general EU membership criteria. The second is the accession stage, in which the accession countries are already in the EU but still outside the euro area. In this phase they shall treat “exchange policy as a matter of common interest”^[3] and (eventually) co-ordinate exchange rate policy through the ERM-II mechanism. The third and final phase is the actual euro phase.

Contrary to the view of some of the accession countries, the European Commission makes it thus very clear now, that there should be a distinct second phase on the road to full integration into EMU. The Commission states explicitly that “new member states are not expected to adopt the single currency upon accession, even though they will be taking part in EMU. EMU implies a gradual development of the economies of candidate countries leading to the final adoption of the single currency, as ultimately all member states must introduce the euro”.^[4] This timeframe thus excludes a simultaneous accession to the European Union and to the common currency framework, the so-called third phase of EMU. This de jure impossibility of a ‘simultaneous entry’ is further strengthened by the EMU convergence criteria themselves. The third Maastricht criterion is the so-called “ERM criterion”, which states that the currency of any future EMU member should have been in the ERM without devaluation or revaluation for at least two years. Since only EU member countries can integrate into the ERM-mechanism (or, rather ERM-II, which has replaced the old ERM with the introduction of the euro)^[5], an EMU accession could only happen at least two years after EU accession, bar major changes in both the current enlargement and monetary integration institutional and legal frameworks.

During the accession phase, i.e. during their first years within the EU, the new members will have to adopt the monetary and exchange rate policy-related provisions of the Acquis Communautaire. These include:

- to regard their economic policies as a matter of common concern^[6]
- to exclude all central bank credits to the government and ensure an acceptable degree of central bank independence^[7]
- to avoid excessive deficits^[8]
- to treat exchange rate policy as a matter of common interest^[9]
- to submit regular convergence programmes^[10]

The exact monetary policy stance of the accession countries in the second phase was left rather vague in “Agenda 2000”. In its 1998 Composite Paper the European Commission clarified its position somewhat: It suggests that the ERM-II framework is the preferred pre-Euro framework for the accession countries in this phase.^[11] Whether ERM-II should start immediately at the moment of accession into the EU, is, however, still a matter of discussion. Remarks made by former euro-commissioner De Silguy in 1998 seem to suggest that the Commission was at that time thinking about a crawling peg regime immediately after EU accession to be followed by ERM-II.^[12] The rationale of course would be that the first mechanism would be conducive to monetary stability, but not as restricting for the accession countries as immediate ERM-membership. This approach, however, is almost nowhere being referred to anymore, in more recent statements. Exchange rate policy in the accession phase shall be extensively discussed in later chapters. It is important to realise that phase 2 would possibly comprise an as yet undefined ‘pre-ERM’ part and an ERM-II part with duration of a minimum of two years, in the Commission’s view. The duration of the accession countries’ stay in this second phase could thus possibly last much longer than two years if it is deemed appropriate for their economies or for the stability of the euro area.

The possibility of a duration of phase 2 shorter than two years should, however, not be totally ruled out. On the exchange rate stability criterion, derogations were given in 1998 upon entry into the euro area for Italy and Finland. Moreover, the President of the ECB has, in several public statements, indicated that the view of the ECB on this point is that a plurality of approaches should be feasible without compromising equality of treatment.^[13] It has been suggested by accession countries that two years of nominal exchange rate stability outside ERM-II, but equal in performance to that within the ERM, would qualify them on the exchange rate stability criterion as described in the Maastricht Treaty.

For entry into the third phase, full participation in the euro area currency union, the new EU member states will only have to comply with the Maastricht criteria. These criteria are convergence criteria in the fiscal and monetary sphere. Once in the euro area, the new members will also have to adhere to all the budgetary rules of the Stability and Growth Pact, like all other euro area members. It is important to note here that no additional transition-type requirements are to be applied for full EMU membership. In principal, these will all have been covered by fulfillment of the Acquis conditions for entry into the Union. Once a member state adopts the euro, its NCB automatically becomes a component of the Eurosystem.

1.2 THE ERM-II

The ERM-II part of phase 2 aims to ensure that the new member states will “orient their policies towards stability and convergence, and help them in their efforts to adopt the euro”.^[14] The operating procedures for the new ERM have been defined by the European Central Bank (ECB) and the non-euro area national central banks (NCBs): The currency of each member state participating in the ERM-II will have a central rate against the euro and fluctuation bands of ±15 per cent. After a political decision-making process, initiated by either the ECB or individual NCBs, these parities in the ERM-II exchange rate grid can be adjusted to new levels. The Commission has suggested on various occasions that realignments could become a regular occurrence in ERM-II for those new member states that are still finding their real exchange rate equilibrium versus the euro area.^[15] Even though this is left rather unclear in the ERM-agreement, it is widely assumed that the ERM-entry parity will at the same time constitute a ceiling for future adjustments.^[16] Member currencies could, effectively and bar any possible speculative crises, only appreciate during their stay in the system. If parities should be changed, recourse to the prior performance of a currency could then only ever result in a re-valuation of the central rate.^[17]

The fluctuation bands are supported by automatic, unlimited intervention at the margins. This access to the unlimited short-term intervention credits of the ECB (“very short-term financing”^[18] ) presents the CEEC’ main advantage over the previous situation: It strengthens the NCBs in the event of a speculative attack. However, as all intervention credits have to be paid back in foreign exchange reserves by the country that used them, the support by such credit lines is in reality probably more limited than the wording of the arrangement suggests.^[19] In addition, the ECB reserves the right to unilaterally suspend intervention if it deems that a continuation would endanger price stability within the Eurozone. Questions of time-consistency with regard to the ECB’s resolve to defend the mechanism thus arise – even though, given the enormous difference in size, some authors express doubts that even unlimited intervention on its behalf in defence of any one CEEC-currency could ever realistically endanger Eurozone-price stability.^[20] If this was true and the markets understood it, they would most likely never test the system. However, as it is the ERM-II is thus massively asymmetric and non-euro member states bear the, de facto if not de jure, responsibility for maintaining the stability of their currencies relative to the euro – in fact a unilateral peg.^[21]

This notwithstanding, “exchange rate co-operation may be further strengthened”, i.e. fluctuation bands narrowed, where this is judged appropriate between the ECB and the respective NCB.^[22]

On the whole, the ERM-II retains much the same features that rendered its predecessor ERM-I unable to deal with the ‘inconsistent triangle’ of quasi-fixed exchange rates, full capital mobility and potentially diverging fundamentals, i.e. the need for independent monetary policies – so much so, in fact, that it all but collapsed in 1992/93. I shall come back to this vital issue when discussing the costs and benefits of the accession countries’ exchange rate strategies in the run-up to full EMU-membership in later chapters.

1.3 EXCHANGE RATE REGIMES IN THE CEEC

Even though their economic tasks and problems on the outset of transition in the late 1980s/early 1990s were similar to a substantial degree, the CEEC have chosen a large variety of exchange rate regimes to deal with them. Following the liberalisation of wages, prices and external trade, a sharp depreciation (overshooting) of the exchange rate ensued in many countries. In order to curb inflation and faced with insufficiently developed indirect macroeconomic policy instruments, a number of them chose to anchor their currencies with a fixed exchange rate regime and thus to equally import stability.^[23] Only a minority, starting from a position closer to perceived macroeconomic equilibrium, opted for more flexible arrangements.^[24] Such exchange rate-based stabilisation programmes contributed to restoring some sort of domestic equilibrium, though in some cases at the cost of widening current account imbalances. Further down the line, a number of countries chose or were forced to abandon their fixed regimes.^[25]

Assessing the evolution of the exchange rate arrangements in the CEEC-10 (excluding Malta and Cyprus) since the opening-up, a clear trend towards the corners of fixed and flexible options emerges. At the same time, as is shown in figure 1, this movement has been asymmetric. More flexible arrangements have become - relatively speaking - more popular than fixed hard pegs. Even so, the range of exchange rate regimes currently followed still covers the whole spectrum of possibilities from free floating to currency board arrangements (CBAs), as depicted in table 1.

In most countries, exchange rate policy has been increasingly governed by the twin objectives of exchange rate stability and external competitiveness and, more generally, by the need to strengthen the credibility of macroeconomic policies.

illustration not visible in this excerpt

From this point of view, both Hungary and Poland have managed to restore competitiveness and to achieve credibility in the fundamentals. Unlike Hungary, Poland had earlier resorted to both one-off de- and re-valuations and later moved aggressively to reduce the rate of depreciation and the width of the bands of its pre-announced crawling peg arrangement. More recently, Poland abandoned the peg altogether. However, evidence of increased credibility can be found for both countries in the rapid convergence of exchange rates in the forward markets to the pre-announced rates (prior to Poland’s floating), as well as the decline in domestic interest rates, reflecting a decrease in country-specific risk premiums.^[26] The Czech regime as well seems to have been able to restore credibility after the currency crisis a few years ago. The case of Estonia has been particularly remarkable in achieving both high growth and low inflation during its prolonged adherence to the CBA.^[27]

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In sum, it can thus be stated that a large number of regimes and very different exchange rate policy strategies seem to be generally compatible with economic transition processes. The literature puts such differences down to a variety of factors that will be touched on in later chapters.^[28]

1.4 THE MACROECONOMIC SITUATION OF THE CEEC

In contrast to the widely differing exchange rate arrangements, the current macroeconomic situation in most CEEC is broadly characterised by robust growth, underpinned with rapidly increasing labour productivity, by massive decelerations in inflation rates to single-digit or low double-digit figures (see figure 2) and, by and large, a decent external current account balance.^[29] Thus, convergence with the EU is being achieved both on the real and nominal level. Another common feature has been a trend real appreciation. Such a trend would be consistent with what could be expected in a catching-up transition economy subject to the Balassa-Samuelson effect, something that will be more closely examined in later chapters.^[30]

illustration not visible in this excerpt

The CEEC have also moved swiftly and quite uniformly (despite remaining differences) to liberalise capital account transactions. This is in sharp contrast to the policies followed in western European countries after the Second World War, where capital account liberalisation was only completed (more or less) in 1991. Practically all CEE-countries have become members of the World Trade Organisation (WTO). Their trade figures with the EU, expressed in percentage terms of overall trade, are already high, as depicted in figure 3, and likely to rise further.^[31]

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In terms of broad indicators of economic structures it is difficult to find strong systematic differences between the candidates and the poorer member countries. The share of agriculture in GDP is already rather low both in most CEEC.^[32] Nor is the share of industry in GDP notably different from that of some current EMU members. In terms of employment the differences in economic structures would appear to be larger, particularly with respect to Romania, Bulgaria and Poland, where a huge part of the labour force is still officially employed in agriculture.^[33] However, since value added in this sector is a rather small part of total GDP, it seems less relevant for the issue of EMU membership than, for example, for the conduct of any future Common Agricultural Policy. At a broader level, according to a recent IMF-study, all CEEC appear to more or less “share a high degree of openness as well as similar trade and output structures with the EU”.^[34]

However, the (non-PPP-corrected!) per-capita levels of GDP of the large majority of accession candidates are still quite some way below those of the current EU-15, as shown in figure 4. The Commission rightly takes this as a symptom of unfinished transition, which, in its view, warrants a considerable delay in EMU-accession of these countries.^[35] Whether or not largely diverging levels of economic development constitute a sufficient obstacle to a currency union is, however, hotly debated.^[36]

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1.5 EMU-ACCESSION STRATEGIES AND TIMEFRAMES

A number of CEEC have already voiced their basic attitudes on how and when they plan to join EMU. Among those, a phased but relatively short-term approach seems to be the prevalent attitude.^[37]

- Poland plans to enter the ERM as soon as possible and considers the current floating of the Zloty as a short-term strategy to allow the currency to find an appropriate entry-level. The Polish government states that the country would hope to fully join at the latest three years after EU-accession.
- The Czech Republic plans to move from its current ‘dirty float’ to the ERM within an estimated two-year horizon, and to meet the Maastricht criteria three to four years after accession.
- Hungary intends to join EMU some two to three years after its accession to the Union and is (politically) willing to subordinate its exchange rate policy to this eventual goal.
- Slovenia expects to be able to meet all criteria by the end of this year. However, the EMU-entry date is a matter of relatively open domestic dissent, ranging from the minimum period of two years after accession (governmental position) to an open-ended non-commitment (Slovenian central bank in 1999). Earlier, the country had even voiced the request of obtaining an ERM opt-out clause and being able to join EMU together with the European Union.
- Estonia intends to keep its proven CBA and switch directly to the single currency upon fulfilment of the Maastricht criteria. Again, the country is considering trying to skip the two-year ERM-period.

[...]

^[1] European Central Bank (2000), p. 46

^[2] see European Commission (1998)

^[3] Article 99 of the Treaty (ex 103); numbering refers to the Amsterdam version

^[4] European Commission (1998)

^[5] for reasons of simplicity, I shall use the terms „ERM“ and „ERM-II“ interchangeably in this paper. The ‚old’ ERM-I effectively ceased to exist in 1999 and was replaced by the ERM-II. Whenever referring to „the ERM“, I shall therefore intend to speak about the ‚new’ ERM-II mechanism, unless explicitly stated otherwise.

^[6] Article 99 of the Treaty

^[7] Article101; European Central Bank (2000), p.47

^[8] Article 104

^[9] Article 124

^[10] Article 7, Stability and Growth Pact

^[11] European Parliament (1999), p. 10

^[12] European Parliament (1999), p. 10

^[13] Angeloni and Dedola (1999)

^[14] European Parliament (1999), p. 12

^[15] European Parliament (1999) p. 14

^[16] see for example Coricelli (2001), p. 14

^[17] Coricelli (2001), pp. 7/14

^[18] Bofinger and Wollmershäuser (1999), p. 27

^[19] European Central Bank (2002), Article 7

^[20] see for example Gros et al. (2000), p. 117

^[21] Masson (1999), p. 11; Gros et al. (2000), pp. 118

^[22] European Central Bank (2002), p. 479

^[23] Kopits (1999), p. 9

^[24] Masson (1999), p. 1

^[25] Poland, the Czech Republic, Hungary, see Kopits (1999), pp. 9 for an overview of developments and reasons

^[26] Kopits (1999), p.13

^[27] Kopits (1999), P. 13

^[28] Coricelli (2001), p.6

^[29] Kopits (1999), p. 11, some countries, such as Estonia, stand out with diverging developments

^[30] Masson (1999), pp. 4

^[31] Coricelli (2001), p.6

^[32] Gros et al. (2000), pp. 102

^[33] Gros et al. (2000), pp. 102

^[34] see Corker et al. (2000); see also European Central Bank (2000), p. 40

^[35] European Parliament (1999)

^[36] see, for example, Gros et al. (2000) and Schweickert (2001a) for the exact opposite result of the analysis

^[37] the following taken from European Parliament (1999), pp. 55