Transcript Sustainable currency regimes in Central and Eastern Europe

Adopting the Euro:
Dilemmas and Tradeoffs
Facing EU Accession
Countries
James W. Dean
Professor
James
W. Dean
Simon Fraser University
[email protected]
State of Play
• 10 countries – Cyprus, Czech Republic, Estonia,
Hungary, Latvia, Lithuania, Malta, Poland, Slovakia
and Slovenia – join EU May 1, 2004
• These countries must join EMU with “derogation”:
this means a grace period before they join ERM II
and then at least 2 years in ERM II before they’re
allowed in to EMU.
• EMU now includes all EU countries except Denmark,
Sweden and the UK. These 3 countries opted out,
but 2004 entrant cannot. [Recall that Norway &
Switzerland are not in the EU].
Conditions for Joining EMU
• To join EU, accession countries had to meet many
economic criteria (eg, creating market economies)
• To join EMU they must join ERM II and then for at
least 2 years maintain:
- Inflation and long term interest rates within 1.5% and
2% respectively of best 3 EMU countries
- Exchange rate within +/- 15% (de jure) or +/- 2.25%
(de facto) band aroung the euro
- Public debt at or below 60% of GDP and budget
deficits at or below 3% of GDP
State of Preparation
• Most of the Maastricht Convergence criteria are
already met by accession countries. In fact they are
much closer to convergence than the current EMU
countries were in 1994!
• Their inflation average is just below the required
reference value ((avg of lowest 3 EU countries plus
1.5%), their long-term interest rates are also below
reference (avg of 3 lowest-inflation EU countries plus
2%), and their average debt/GDP ratio is only 40%.
• However, their fiscal deficits in 2002 averaged 5.1%
of GDP, well above the required 3%.
States of Unpreparedness
• Czech Republic Appreciating nominal exchange rate
• Estonia Central bank independence?
• Hungary Recent currency instability; high inflation; high
budget deficits
• Latvia Privileged access of public sector to financial
institutions
• Lithuania Conflicts of interest among central bank board
members
• Poland High inflation, though now curbed by strong zloty
and high interest rates
• Slovakia High inflation and deficits
• Slovenia High inflation
State of controversy
• 3 best EMU countries or EMU average as reference
level for inflation and long term interest rates?
• +/- 2.25% or +/- 15% band for exchange rate
fluctuations?
• Abandon currency boards?
• Relax inflation ceilings or relax nominal exchange
stabilization to allow real exchange rates to
appreciate as productivity catches up to EU?
• Centralized lender of last resort? Centralized
banking supervision?
• Bad bank debt (CZ, SLK, POL) manageable at
country levels?
Times of Joining EMU
• As declared by accession 10:
• Cyprus: “2007 despite recent fiscal
slippages” (PEP 2003)
• Czech Republic: “as soon as plausible
economic conditions have been
created” (PEP 2003) [More concrete
statements by CZ point to 2009 – 2010]
• Estonia: “as soon as 2006” (PEP 2003)
• Hungary: “1 January 2008” (PEP 2003)
Times of Joining EMU (cont’d)
• Latvia: “earliest … 1 January 2008” (PEP
2003)
• Lithuania: “Realistically … start of 2007”
(Governor Sarkinas, March 2003)
• Malta: “second half of 2007 or Jan 2008
latest” (Governor Bonello, Feb 2004)
• Poland: “only when macro conditions make
it possible … [given projected gov’t deficits]
… 2008 or 2009” (PEP 2003)
Times of Joining EMU (cont’d)
• Slovakia “earliest realistic target 2008”
(Strategy of the Slovak Republic for adoption
of the Euro, June 2003)
• Slovenia “Both the Bank and the
Government … judge … it will be possible at
the beginning of 2007” (Joint programme of
the Slovenian Government and Bank of
Slovenia for ERM II entry and adoption of the
euro, November 2003)
Times of Joining EMU (cont’d)
• In short, declarations of accession
countries range from 2006 (Estonia) to
Jan 2010 (Czech Rep.)
• Most optimistic (2007 or earlier) are
Cyprus, Estonia, Lithuania, Malta, and
Slovenia
• Least optimistic (2008 or later) are
Czech Republic, Hungary, Latvia,
Poland and Slovakia
Current regimes of acceding
countries
• Cyprus: De jure: Peg to euo with +/- 15% band. De facto:
Narrow range of fluctuation
• Czech Republic: Managed float; 2 – 4% inflation target by end
2005
• Estonia: CBA fix to euro since 1992
• Hungary: Peg to euro with +/- 15% band; inflation target of 3 –
5% by end 2005
• Latvia: Peg to SDR with +/- 1% band
• Lithuania: CBA fix to dollar in 1994, then to euro in February
2002.
• Malta: Peg to basket of 70& euro, 30% dollar and pound sterling
• Poland: Free float with inflation target of 1.5 – 3.5%
• Slovakia: Managed float: hybrid strategy; implicit infl. targeting
• Slovenia: Crawling band with monetary, real, external and
financial indicators
Small country peggers
• Small acceding countries already have
hard pegs or currency board
arrangements (CBAs), some to the euro
and some to baskets
• Since they lack feasible exit strategies,
they will likely maintain their present
arrangements, except that those
pegged to baskets will re-peg to the
euro
What will small country peggers
do?
• Estonia and Lithuania will likely maintain
their CBA pegs to the euro
• Cyprus will likely maintain its narrow peg to
the euro
• Latvia and Malta will need to move from their
basket pegs (with euro-weights of 35% and
70%) to sole pegs to the euro.\
• Slovenia will have to from its current gradual
depreciation vs the euro to a peg with
horizontal band
Rationale for SMPs to keeping
current regimes
• The small-country peggers (SMPs) on the preceding
slide:
• have very open economies but very thin foreign
exchange markets.
• Their pegs have served them well in terms of access
to int’l financial markets, low inflation and strong
output growth.
• Moreover they have not needed to intervene or use
interest rates to maintain their pegs. Long term
domestic-currency rates have converged toward
euro-levels.
• To exit and then re-enter their hard pegs would
unnecessarily cost them credibility
Larger accession countries have
more flexible regimes
• Larger countries have actually moved
recently toward more flexibility
• Czech Republic has a managed float with
inflation targeting
• Hungary pegs to the euro but with a +/- 15%
band, and with inflation targeting: ie it runs a
managed float with two targets
• Slovakia also has a managed float with
hybrid targets
• Poland runs a free float with inflation
targeting
Strategy for larger countries
• Larger countries will have to harden their
regimes, but it can be gradual, using ERM II’s
de jure +/- 15% band
• However in mid-2003 Pedro Solbes, EU
monetary affairs commissioner, expressed a
preference for a +/- 2.25% band
• The wider band would be wiser since these
countries still face transition challenges:
Czech Republic’s crown rose by 25% 1999 –
mid-2002 then has fallen by 10% since then;
Hungary’s florint has also been volatile, as
has Poland’s zloty and Slovakia’s crown.
Tradeoffs and Dilemmas 1
Exchange rate flexibility versus stability
• A continued history of volatility vs the euro
suggests that transitional restructuring
and/or volatile capital flows necessitate
continued flexibility for several years (eg,
Czech Rep., Hungary, Latvia, Poland,
Slovakia
Tradeoffs and Dilemmas 2
Fix of central parity now or later?
• Rapid productivity growth relative to the EMU
causes appreciation of real exchange rates.
This can occur via inflation in non-tradeables
prices (Balassa - Samuelson effect) not offset by
deflation in tradeables prices, or via nominal
appreciation
• Hence the central parity consistent with current
account balance may be higher in, say, 2007
than now
Tradeoffs and Dilemmas 3
• Central parity now or later? Cont’d …
• Also, secular growth in capital inflows can cause
real exchange rate appreciation, again via
inflation or via nominal appreciation.
• This can also delay the date to fix parity
• In both cases (catch-up productivity growth and
rapid capital flows), the parity rate consistent
with current account balance is a moving target.
Moreover current account deficits are
appropriate as long as prod. growth and returns
on capital are above EMU and world averages.
Tradeoffs and Dilemmas 4
• The European Central Bank (ECB, Feb 2004, p.
22) regards the two-year participation
requirement in ERM II as a “testing phase” for
both readiness for reduced exch. rate volatility,
and for fixing the correct parity rate.
• In short, continued real and financial
restructuring may warrant continued flexibility;
moreover premature exch. rate stability may
cause excessive current account deficits (in
case of undervaluation), or excessive inflation
(in case of overvaluation).
Convergence
• Most of the Maastricht Convergence criteria are
already met by accession countries. In fact they
are much closer to convergence than the current
EMU countries were in 1994!
• Their inflation average is just below the required
reference value ((avg of lowest 3 EU countries
plus 1.5%), their long-term interest rates are also
below reference (avg of 3 lowest-inflation EU
countries plus 2%), and their average debt/GDP
ratio is only 40%.
• However, their fiscal deficits in 2002 averaged
5.1% of GDP, well above the required 3%.
Fiscal challenges
• In recent years, fiscal deficits have widened in Czech
Rep., Hungary, Poland and Slovakia; also, Cyprus
and Malta’s deficits are above 3%.
• These deficits may prove more intransigent than in
Western Europe given continued pressure for
government spending on both infrastructure and
transfer payments. Moreover. After they join EMU,
the scope for contractionary counter-cyclical fiscal
policy (a la Ireland recently) may be more limited in
the CEECs than in Western Europe given this
reluctance to cut spending; so too the scope for
stimulatory fiscal policy may be limited given the
Growth and Stability Pact’s 3% deficit ceiling.
Next to Adopt the Euro?
• Bulgaria and Romania hope to join the EU in
2007. Croatia may also apply. Hence all three
could officially euroize by 2010.
• In addition, several countries could unofficially
euroize: that is, withdraw local currency and
adopt the euro without permission from Brussels
or Frankfurt. Kosovo and Montenegro have
already done this. Bosnia and Serbia could be
next, especially if they hold out no hope of
joining the EU in the foreseeable future.
Informal Use of the Euro
• Many if not most countries in Eastern Europe
and Central Asia already use the euro or the
dollar informally for transactions and/or store of
value purposes ( For data, see Feige & Dean,
2004).
• However the number of national currencies
Eastern Europe and Central Asia has multiplied
in the last decade with the creation of new nation
states. It is not clear that formal dollarization,
euroization, or currency union is likely in the
near future.
Recent related publications by the
author 1
• Recent related publications by the author:
• “The Economic Case Against the Euro Revisted” In Patrick
Crowley, Before and Beyond EMU. Routledge, 2002.
• “Exchange Rate Regimes in Central and Eastern European
Transition Economies,
• With Lessons for Ukraine” CASE, Kyiv, Ukraine and Warsaw,
Poland, 2002.
• “Monetary Policy in Advanced and Transition Economies:
Illustrations from Canada, Poland and Ukraine” CASE, Kyiv,
Ukraine and Warsaw, Poland, 2002.
• The Dollarization Debate (editor, with Dominick Salvatore and
Thomas Willett). Oxford University Press. March 2003.
• “Should Latin America’s Common Law Marriage to the U.S.
Dollar Be Legalized? Should Canada’s?” In The Dollarization
Debate, op. cit.
Recent related publications by the
author 2
•
“Should Canada Dollarize? Lessons from Europe” In L.-P. Rochon and
M. Seccareccia (eds), Dollarization: Lessons from Europe for the
Americas, London/New York: Routledge, 2003.
•
“Dollarization and Euroization in the Transition Countries: Asset
Substitution, Network Externalities and Irreversibility” (with Edgar
Feige). In Monetary Unions and Hard Pegs: Effects on Trade, Financial
Development, and Stability, George M. Von Furstenberg, Volbert
Alexander and Jacques Melitz, eds., New York: Oxford University
Press, March, 2004.
•
"Distributional Effects of Dollarization: The Latin American
Experience" (With Anil Hira) Third World Quarterly, Vol.25, 3, April
2004.
“Putative Exchange Rate Regimes in Central and Eastern European
Transition Economies” Forthcoming in Journal of Policy Modeling,
2004.
•