Adopting the euro: an introduction to four country studies.

Watson, C. Maxwell

INTRODUCTION

Country by country; issue by issue ... The four studies that follow--in which authors from Croatia, Estonia, Hungary and Poland discuss the adoption of the euro in their economies--could carry this common caption. The question they address is one of the most momentous in the post-transition economic history of their countries: abandoning monetary autonomy in the interests of ever fuller integration in the European Union economy.

It is an issue that some studies have dealt with in generic terms across the region. By contrast, the particular merit of the studies presented here is that--while sharing many elements of a common analytic framework--they probe issues which the authors identify as particularly germane in their own economy.

How important is the fiscal issue in Hungary, and what lessons emerge from financial markets' recent judgments on this? Does de facto euroisation tilt the balance of the arguments, down the road, for Croatia? Could overheating be a worry even with Estonia's balanced budget and flexible labour market? Are cyclical risks in Poland significant, and how do they measure against long-run gains from adopting the euro? These are among the issues that these authors come to grips with in their analyses.

Three of these countries will, of course, join the European Union in May 2004, and for them, in principle, the adoption of the euro is not a choice but an obligation. All four authors, indeed, see strong attractions in euro area membership. But timing remains an issue. And in arriving at their judgements on timing, they surface important qualifications in terms of policy prerequisites to be fulfilled--and of economic and financial risks along the road. Advocates and opponents of early euro area membership alike will find challenging points of view, and an encouragement to look at the issues in terms of specifics not generalities ...

COSTS OF ABANDONING MONETARY AUTONOMY

The Optimal Currency Area (OCA) literature is a natural starting point, as these authors weigh the costs of losing monetary autonomy against long-run gains from euro adoption. They all touch on the issues of asymmetric shocks and real sector adjustment mechanisms, which are of key importance where national monetary autonomy has been surrendered. They note on the favourable side the extent of existing integration with the euro area--and the likelihood of a further, endogenous increase after joining monetary union. But they also surface some significant qualifications on these real sector issues:

* Ross and Lattemae report a strong positive correlation between shocks affecting Estonia and the euro area--as well as high flexibility in the labour market and the real economy generally. This leads them to view the costs of euro adoption--in OCA terms--as not really relevant for Estonia. But they warn against overestimating the degree of integration of the new members as a group with the euro area, noting differences among their economies.

* Vujcic recalls that business cycle analyses have typically been static, and based on limited data--qualifying their relevance to the future. Indeed, he points out, the ECB's current monetary policy would hardly meet Croatia's needs at a time of buoyant economic activity and rapid credit growth. Borowski, meanwhile, notes that for Poland intra-industry trade--which would underpin the durability of business cycle convergence--is still relatively modest.

* Borowski also mentions that the amplitude of business cycles has been much wider in Poland than in the euro area--raising a question whether the stance of the ECB would be adequate to address such swings. His study concludes that there would indeed be a likelihood of wider output swings, but that this involves relatively modest costs for the Polish economy.

* The studies on Croatia, Hungary and Poland consider their national labour markets to be less flexible than could be desired, reflecting mainly rigidities in wage bargaining--and this injects a cautionary note as regards the smoothness of real economy adjustment under the euro.

The balance of these considerations is reflected in the authors' overall judgements on real sector factors. If the counterfactual of existing constraints on monetary policy were ignored, then all the studies except that on Estonia would see distinct costs in abandoning monetary autonomy in terms of exposure to shocks, the risks of wider output swings, or labour market rigidities.

This said, the four countries' present exchange regimes and environments substantially affect the authors' assessments of opportunity cost. The studies on Estonia and Croatia underscore existing constraints on policy:

* Ross and Lattemae consider that, given the present CBA arrangement, there would be no opportunity costs in adopting the euro: the economy has already adjusted to a rigid regime.

* Vujcic reports that, in Croatia, the high degree of euroisation leaves monetary policy heavily circumscribed. Exchange rate fluctuations have major effects on corporate balance sheets, and thus on banks--who have transformed currency into credit risk. From a stability perspective, large prudential overheads result; and the required high level of banks' liquid exchange reserves leads to wide spreads. The chance to reduce these costs is argued to support strongly the case for early euroisation--real sector rigidities notwithstanding.

In the case of Estonia, Ross and Lattemae's arguments on real sector flexibility--and the adaptation of the economy to a rigid regime--are clearly of fundamental importance. In Croatia, monetary policy is not claimed by Vujcic to be wholly immobilised, however: it is circumscribed to the extent that it is almost too potent. In terms of achieving low inflation monetary policy has so far been very effective--even if heterodox measures have at times been needed. As regards prudential issues, these will remain crucial in all circumstances--perhaps particularly under the hypothesis of monetary union, when the external current account constraint transforms into a more subtle financial sector constraint.

Turning to Hungary and Poland, the existing regimes are obviously very different from Estonia and Croatia. They enjoy substantial and full exchange rate flexibility, respectively, under their present frameworks. However, the two studies diverge in assessing opportunity costs:

* The Hungarian study expresses concern that moving from the present wide band towards and into ERM2 could increase existing risks of volatility in capital flows. Csermely sees a risk that markets might abruptly re-evaluate fiscal policy in a country, leading to exchange rate pressures. She would favour moving quickly into ERM2, in order to tap the long-run benefits of euro adoption, if credible fiscal consolidation could be assured--and she also mentions in this connection the importance of commitment to a sound financial system. But absent firm policy resolve, she sees if anything a case for shifting in the opposite direction--to a free float.

* The study on Poland takes a different and more pessimistic view of floating. It sees the exchange rate flexibility of the present inflation targeting regime as a source of instability, particularly given an alleged need for more time to build the credibility of monetary policy. In Borowski's view, Poland has low opportunity costs in losing monetary autonomy--despite rigidities in the labour market and some concerns about output swings. Moving to adopt the euro would, in his view, enhance stability by cutting short the process of credibility.

The balance of Borowski's arguments on this point is challengeable. Many observers would see fiscal tensions as contributing substantially to instability--and share the view of Csermely that such tensions argue for a flexible exchange rate. One can argue that the situation should engender fear of fiscal tensions more than fear of floating! Meanwhile, Csermely's view of the euro--as something of a safe haven in a volatile world--is one that needs to be considered more fully, below, in connection with the evolving financial market environment.

RISK PREMIA, CAPITAL FLOWS AND THE FINANCIAL SECTOR

All the studies anticipate that euro adoption would trigger further declines in risk premia. This would reflect elimination of currency risk and improved liquidity. It would reflect the mitigation of external current account risks both in a mechanical sense, under monetary union, and in the more fundamental sense of reducing country risk as monetary autonomy is abandoned and fiscal policy-makers commit to the Stability and Growth Pact.

Borowski analyses the impact of lower risk premia on output in Poland. This is indeed the main driver of his conclusion about the long-run net gains from adopting the euro. He suggests a total long-run output gain, illustratively, of perhaps 4-14 percent of GDP. Within this, the long-run impact of transactions cost savings is put at only some 0.3 percent of GDP. All of the remaining impact is attributed to interest rate/risk premia effects. Borowski concludes, however, with an important word of caution: 'It must be remembered ... that potential costs of the euro adoption in Poland may be incurred shortly after the EMU accession, whereas it would take decades for the benefits to fully accrue. Hence, the euro is a project which seems appealing to long-distance runners, rather than those for whom the choice between waiting or being impatient rarely tilts towards the former.' This raise en garde appears wholly justified.

The other authors also expect that a decline in risk premia will further stimulate the inflow of capital--increasing available savings. However, Ross and Lattemae point out the need for vigilance as regards financial stability. The credibility-enhancing effects of EH accession are 'vast' for the candidate countries, they note, and this may result in overly optimistic market expectations concerning economic growth and the rate of return on invested assets--bringing about changes in the structure and volume of capital flows or in resource allocation in the economy. The latter, they are concerned, could lead to 'outright overheating' or 'an uneasy mix of policies.'

Csermely, too, discusses capital market exuberance. In Hungary, she suggests, markets have tended to overestimate policy-makers' fiscal resolve. Hence strong capital inflows may be punctuated by sharp reversals. But if fiscal policy is robust, then, as already noted, she urges taking the risks of a leap into ERM2, in order to reach the shore of the euro-safe haven. Two elements in Csermely's prescription need to be separated out, however: awareness of the policy and market rigours of the passage up to and through ERM2; and confidence that euro area membership will shield the economy to some extent from financial market vicissitudes.

On this second point, one should enter a word of caution. Eliminating the exchange rate thermometer does not entail immunity against economic fever. To an important extent, the capital market variability that concerns Csermely and the other authors relates to fluctuating perceptions of domestic risk. These fluctuations will not disappear when the euro is adopted. Rather, risks will be transformed. Over time, the premium demanded by market participants will continue to fluctuate--as will capital inflows--reflecting both policy fundamentals and market imperfections such as bubbles and overshooting.

When explicit variability in the exchange rate ceases, the risk premium may well decline initially in a response, as these studies assume. But as real activity then accelerates, the path of the risk premium--and of the real exchange rate--over the medium term is harder to foresee. There is a strong possibility that capital inflows, together with rapidly growing domestic credit, could lead over the medium term to substantial appreciation of the implicit real effective exchange rate. If that occurred, and left the implicit rate misaligned under monetary union, then the unwinding of this through price and wage adjustment (given asymmetries in wage flexibility) could lead to an extended period of slow growth.

This perspective highlights the fact that the existence of a risk premium in the acceding countries is not inherently problematic. To a degree, it can exert a dampening influence on the inflow of capital--in conditions where the high real returns available might otherwise lead to a pace of capital inflow that would exacerbate risks of overheating. In sum, caution is needed in featuring the early adoption of the euro as a form of safe haven in a world of high real returns, fluctuating risk premia, and perfectly mobile capital. To the extent there is protection to be found in this capital market setting, it is for the most part more basic--lying in efforts to achieve a benign policy mix and to foster increased flexibility in the real economy.

Ross and Lattemae have an important message, in other words, when they note the potential for exuberant market expectations in connection with EU accession, with the credibility of policy regimes such as Estonia's, and also with euro area membership in the future. This financial market setting is one of the major challenges they see on the road ahead, and it leads them to urge the importance of fostering domestic saving, strengthening the financial sector, and continuing to enhance real sector flexibility in the economies where this is needed.

MEETING THE MAASTRICHT CRITERIA

The arguments discussed so far relate to the benefits and costs of early euro adoption. But some of the authors also discuss the feasibility of this, in terms of meeting the Maastricht Criteria. On the positive side, they cite impressive achievements to date in containing fiscal imbalances and reducing inflation.

On the more cautious side, they note three issues:

* First, there is an inherent tension in reconciling nominal exchange rate stability with the impact of productivity differentials on consumer prices (the Balassa-Samuelson effect). Ross and Lattemae consider that this has the potential to be an important issue--even though the magnitude of the effect was likely overstated in some early analyses, which did not distinguish other transition-related price adjustments. On the one hand, they stress that rapid productivity growth is a sign of economic strength, not weakness. On the other hand, they wonder out loud how credibility would be affected, respectively, by meeting the criterion due to cyclical good luck, or by policy creativity--or alternatively delaying adoption of the euro, or temporarily slowing real convergence. Overall, they view meeting the formal rules of the euro club as a major issue on the road ahead. (One should also bear in mind that heavy inflows--or strong price convergence influences--could lead to a relative rate of CPI increase/real appreciation that is larger than the magnitude of the strict Balassa-Samuelson effect.)

* A second issue is fiscal discipline. Csermely cautions that the last few years witnessed a less disciplined fiscal policy in Hungary, which set back the disinflation calendar. It remains to be established that current consolidation plans will be successfully carried through--'a major uncertainty to meeting the Maastricht criteria on time.' Vujcic observes that Croatia has made important progress with fiscal consolidation, though he acknowledges some inevitable uncertainty about the future. Ross and Lattemae note Estonia's very strong fiscal track record, which has kept it 'well within the intellectual framework of the Stability and Growth Pact.'

* A third issue relates to the interest rate criterion, where Ross and Lattemae observe that there are no domestic rates fulfilling the required maturity band, given the absence of a government bond market in Estonia; but this does not appear to them a fundamental problem. Csermely notes the strong performance, over time, of Hungarian government bonds.

A fiscal question that does not surface directly in these studies is a more normative one. Csermely, and also Ross and Lattemae, note that over the past decade there was no conflict between real and nominal convergence. Indeed, fiscal consolidation and disinflation were good for growth. But the papers do not ask about the opportunity costs of meeting the Maastricht fiscal criterion at an early date, and going on to achieve a position close to balance under the Stability and Growth Pact. Given expenditure pressures in areas such as infrastructure, and the level of taxes on labour income in some countries, this deserves serious study.

CHALLENGES AND TENSIONS

Should the scale tilt--in Borowski's phrase--toward waiting or towards impatience? These papers contribute in a lively and candid manner to the debate. Inevitably, their conclusions differ--sometimes reflecting differences in economic structure, sometimes more profoundly:

* Borowski and Csermely are not in agreement, clearly, on the extent to which flexible exchange regimes are a source of instability, or a safety valve to help handle it, in contexts where elements of policy credibility are not fully established. (For this commenter, it has to be said, history sides with the latter--safety valve--view.)

* Csermely sees capital flow volatility at its worst in connection with ERM2 entry, but then abating with the passage toward the euro. But Ross and Lattemae warn--surely with some justification--that credible nonflexible regimes (such as Estonia's currency board, or, by extension, euro area membership) may actually contribute to the emergence of overoptimism among market participants about risk-adjusted real returns. Far from a safe haven, this would feature euro adoption as a setting which will have financial market as well as institutional rigours--placing strong demands on policy and on the flexibility of the real economy.

* The stress that Ross and Lattemae lay in their study on the fundamental importance of real sector flexibility and fiscal discipline recall that these factors, along with financial sector robustness, must weigh very heavily in the balance when contemplating monetary union. This emphasis contrasts with some views in the other studies--including the preponderant weight given to the monetary and prudential costs of currency substitution in Vujcic's paper.

* Finally, the Estonia study takes very seriously the potential difficulty of observing the 'rules of the game' in time for early euro area entry, and raises a question about the credibility costs of trying to finesse these rules, for example, by creativity in managing the path of inflation. Where Csermely is concerned mainly about policy assignment problems, the Estonia study sees a more fundamental tension between real convergence, nominal convergence, and stability in the nominal exchange rate. Thus it concludes that 'there are questions about ... ability to fit into the club rules that cannot be overlooked.'

These differences of perspective should stimulate further research on the technical and policy-related dimensions of euro adoption. Certainly, policymakers will find much to reflect on as they digest these four different renderings of the opportunities and challenges ahead.

C. MAXWELL WATSON

Wolfson College, University of Oxford, Linton Road, Oxford OX2 6UD, UK. E-mail: [email protected]