The perils of convergence

Date: 05/04/03

Countries joining the EU next year face a tricky path to the euro

EVEN as they try to persuade their citizens to vote for membership of the European Union, the governments of the ten, mostly ex-communist, countries invited to join the EU in May 2004 are preparing for their next big challenge: adopting the euro. Many are eager to join, so as to reap the benefits of eliminating currency risk, lower interest rates than they now enjoy and (they fondly hope) faster economic growth.

In theory, the question is not if, but when, these countries will join the euro: unlike Britain and Denmark, which are in the EU but not the single currency, they have no Maastricht treaty “opt-out”. They are supposed to meet the same entry conditions as those set for the 12 current members of the euro area. As well as low inflation and long-term interest rates, budget deficits below 3% of GDP and government debt below 60% of GDP, that means they should spend at least two years in the EU's exchange-rate mechanism, ERM2, keeping their currencies within a 15% band either side of a central rate against the euro.

In practice, things may prove a lot fuzzier. The entry conditions, notably on debt and exchange rates, were fudged for some of the existing members. Several have since proved unable to keep their budget deficits below 3% of GDP. Few expect Britain, should it decide to join, to spend a preparatory two years in ERM2. Accession countries may thus be cut some slack. And should the EU's new members become reluctant to join, they cannot be forced to. Sweden, an EU member with no opt-out, has stayed out, though it will hold a referendum this September.

Financial markets expect the new members to join, although not before 2007. Spreads over German government-bond yields have tumbled. On some entry criteria, the hopefuls are in good shape: for instance, inflation is lower, in most of them, than it was in Italy, Spain or Greece a few years before they entered the euro. Against that, many have big budget deficits: over 5% of GDP in Poland, more in Hungary. Pressing too fast towards 3% might reduce the growth of national incomes that are still far below EU levels.

The European Commission and the European Central Bank (ECB) have urged the candidates not to rush into the euro, but to concentrate on structural reforms. They also think it essential that the EU's new members spend the prescribed minimum of two years in ERM2. Some policymakers in the region, and some academics, disagree. They see the regime as an outdated, booby-trapped framework that could trigger a currency crisis in central and eastern Europe. The turmoil in January in Hungary's exchange-rate system - in which the forint moves in the same band as it would in ERM2 - bears this out. The central bank had to cut interest rates, at some cost to its inflation-fighting credentials, to stop the forint bursting through its upper limit.

Among ERM2's critics are the authors of a report*, originally written for the commission but published last month by the Centre for Economic Policy Research in London. The authors claim that the obligation to participate in ERM2 after the dismantling of all remaining capital controls on entering the EU will plunge the candidates into “an interim period [of] enhanced vulnerability before the safety of monetary union.” They rattle off a list of the currency crises of the 1990s, from upheavals in the forerunner of ERM2 to later crises in East Asia and Latin America. These forced several countries to jettison soft exchange-rate pegs, of which ERM2 is an example, in favour of either harder pegs (monetary union or currency boards) or fully floating exchange rates. If ERM2 came unstuck, it might not make countries ready for the euro, but rather delay their entry indefinitely.

Fighting Balassa-Samuelson

One problem is that accession countries can expect large capital inflows as investors bet on their convergence with the rest of Europe. This is likely to put upward pressure on exchange rates. But the inflows might then be reversed, sending the exchange rate down again. There is also the Balassa-Samuelson effect, which causes the real exchange rates of fast-growing countries to appreciate. Faster productivity growth in the tradable-goods sector leads to higher wages. Wages in the non-tradable sector then increase too, pushing up prices. The result is either a rising exchange rate - testing the limits of ERM2 - or rising inflation, which would conflict with another condition of euro membership. The authors say that the Balassa-Samuelson effect has raised real exchange rates by perhaps 2% a year. These rates have strengthened, on average, in recent years, but have also fluctuated.

Granted, once inside ERM2 applicants may call on the firepower of the ECB to fend off speculative attacks and keep their exchange rates inside the set limits. But rather than test ERM2's robustness, the authors suggest that unilateral adoption of the euro (euroisation), without joining the euro area, might be a better bet. Many “closet unilateralists” in the region's central banks deride the ERM2 requirement, given the special treatment accorded to Italy and Finland, which were allowed to join the euro before spending two years in ERM2's predecessor. Both the commission and the ECB dislike the idea of euroisation, but the authors think their objections are overstated.

For some countries, such as Estonia, which has a currency board backed by the euro, such a quick transition may make sense. For others, ERM2 may be an invitation for markets to make mischief - especially if they believe that the central parity is not sustainable. Given the capital inflows (and maybe outflows) that these countries can expect, and given the likely upward pressure on their real exchange rates as they get richer, the best course for some might be neither unilateral euroisation nor ERM2, but to let the exchange rate float - ie, to wait and see.

* “Sustainable Regimes of Capital Movements in Accession Countries”, by D. Begg, B. Eichengreen, L. Halpern, J. von Hagen and C. Wyplosz. Centre for Economic Policy Research, Policy Paper No.10.

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