EASTERN EUROPE/EU: Rush to euro carries risks

Analysis

Two macroeconomic issues that dominated the meeting of the Council of Ministers of Economics and Finance (ECOFIN) in Brussels on January 19 are critical to the Central and East European (CEE) countries that will join the EU in May:

• First, the highly public dispute in the EU over the Stability and Growth Pact (SGP) raises serious questions about the management of fiscal policy in the euro-area.
• Second, the appreciation of the euro, whose rise against the dollar threatens the global competitiveness of EU exporters struggling to rebound from the economic downturn, creates important spillover effects in the trade-dependent CEE economies whose national currencies are closely tied to the euro, and creates a disincentive for the others to establish closer links.

SGP clash. The European Commission has lodged a complaint with the European Court of Justice (ECJ) challenging the legality of the decision in November of ECOFIN to allow France and Germany additional time to meet their obligations under the excessive deficit procedure of the SGP (see EUROPEAN UNION: High stakes in SGP challenge - January 19, 2004). While the Commission requested fast track treatment from the ECJ, the case could require up to two years to adjudicate -- meaning that unanswered questions will remain over the future of the SGP during the initial phase of EU enlargement. However, even if the Commission loses its case, it is unclear that this would result either in a tendency towards greater fiscal laxity on the part of existing member states, or a willingness to relax the requirements for euro-area entry for new members. Indeed, the track record of negotiations would appear to suggest that the Commission and member states are likely to be strict with the new members.

Fiscal importance. In their discussions of SGP reform, European Commission authorities stress the increased importance of national-level fiscal stabilisers in the single currency area. The 3% deficit threshold was intended to preserve a degree of fiscal flexibility for euro-area countries, which could not use the exchange rate as an adjustment mechanism once they entered the common currency area. The unavailability of the exchange rate as a macroeconomic tool was not a salient issue in the two years following the euro's introduction in 1999, when the new currency fell from 1.17 dollars to 0.82 dollars. However, during the ensuing period, the euro has appreciated some 57% against the dollar, peaking at 1.29 dollars on January 12.

The IMF argued yesterday that the accession states should be better prepared in fiscal terms than existing members were before entering the euro-area. The Fund sees a need for the new members to have deficits well below the Maastricht criterion's ceiling of 3% of GDP, preferably around 1-2%. It also believes that euro-area aspirants should meet the criteria before they even join ERM II. A credible harmonisation of macroeconomic policies with the euro-area entry requirements in advance of ERM II entry would lessen the risk of speculative attacks during these countries' stay in ERM II (see EASTERN EUROPE: ERM II has dangers for EU joiners - June 19, 2003), but would prevent any possibility of early entry to the euro-area.

Euro appreciation. For the accession countries, euro appreciation creates further reservations about the wisdom of early integration into the common currency area (see EASTERN EUROPE: Enthusiasm for early euro entry waning - January 14, 2004). Aspirants will be required, during their membership of ERM II, to hold currency fluctuations to a +/- 2.25% trading band against a fixed parity to the euro for two years prior to entering the euro-area itself. Combined with the disinflation requirements established at Maastricht, the rigid exchange rate structure of ERM II places applicant countries at risk of real currency appreciation -- a serious liability to trade-dependent countries seeking robust growth rates.

Even accession states that have opted out of early ERM II/euro-area entry will be vulnerable to the competitive effects of euro appreciation. CEE countries that are fully indexed to the euro (Hungary, Estonia and Lithuania) are subject to the euro's appreciation against the dollar and other global currencies. Euro-driven real currency appreciation has already occurred in some accession countries (notably Hungary). This will not affect these countries' trade with the euro-area -- which predominates for most of them (see EASTERN EUROPE: CEE trade is strongly dependent on EU - January 7, 2004) -- as it is driven by appreciation of the euro. The damage would be limited to their trade with the rest of the world. In these highly trade dependent economies, this still constitutes a large enough share of trade (around a quarter in the case of Hungary) to exert a major impact on overall trade performance.

Of the other CEE accession states, the Czech Republic, Slovakia and Slovenia have managed floats, Latvia's currency is pegged to the SDR basket, and Poland's zloty is in a free float. These countries do not therefore currently suffer from a competitive disadvantage due to the strong euro, but will have to shift to a trading band against the euro upon ERM II entry. A strong euro might therefore act as a disincentive for rapid ERM II entry (unless it aids the establishment of a parity rate that will ensure competitiveness). This appears to be the view of the Polish authorities, who are hedging their euro-integration strategy. The zloty is relatively insulated from euro appreciation, and has indeed declined against the euro and other major currencies since 2002. The National Bank of Poland, which is statutorily required to lower inflation, reserves use of the exchange rate for inflation targeting purposes. Moreover, Polish central bankers prefer a flexible exchange rate regime to allow the zloty (which is already encountering upward pressure from large inflows of foreign capital) to reach an equilibrium exchange rate in the run up to euro membership. For Poland to hold an overvalued currency when the zloty/euro conversion rate is locked in would burden local enterprises with a permanently uncompetitive exchange rate.

Halfway house. Coincident with EU accession on May 1, the new member states will join the European System of Central Banks under the 'derogation' principle. This will provide them with the political benefits of access to the EMU decision-making process. However, it will deny them the economic and commercial advantages of full membership of the euro-area, notably the removal of foreign exchange risk from trade and investment activities. The new states' membership of this 'halfway house', with the attendant risks, may prove prolonged.