Two major events framed the new millennium from the point
of view of the European Union. These were the introduction of
the euro in eleven member states on January 1st 1999 (Greece became
the twelfth two years later) and the enlargement of the
Union to include ten new countries on May 1st 2004. Eight of the
new members used to be part of the former communist bloc in
Central and Eastern Europe, and two – Cyprus and Malta – are
small but well developed Mediterranean islands. Both events have
been a great success and attention is now focusing on the next
challenge ahead – successfully bringing the new member states inside
the euro area.
Unlike the United Kingdom and Denmark, which negotiated permanent opt-outs
from the obligation to adopt the euro, all the new member states agreed, by signing
the Accession Treaty, to join the euro area when they fulfill the necessary pre-conditions
(as did euro non-member Sweden before them). Until they do so, as member
states with“derogation”, they will continue to use their own currencies and be free to
decide their monetary policies. They are, however, required to treat their exchange
rates as a matter of common concern and should not embark on competitive devaluations,
or introduce the euro outside the legal framework foreseen by the Treaty.
The new members have already
started to participate in the economic
coordination processes that underpin
the single currency, and are also designed
to help applicant countries prepare
for membership in the euro area.
These include fiscal surveillance under
the Stability and Growth Pact and policy
coordination in the framework of the
Broad Economic Policy Guidelines.
Since their accession, the new members
may also participate in the exchange
rate mechanism (ERM II), the successor
of the former European Monetary System
that existed prior to the introduction
of the euro, which links their
exchange rates to the euro. The mechanism
was established in 1999 as a framework
to promote exchange rate stability
among EU member states outside the
euro area, thereby helping them to respect
their commitment to treat their exchange
rate policies as a matter of
common interest.
Greece and Denmark successfully
participated in ERM II from the start of
the mechanism, while Sweden and the
UK have not applied to do so. Subsequently,
Greece adopted the euro in January
2001 and in June 2004 three of the
ten new member states – Estonia,
Lithuania and Slovenia – joined the
mechanism, based on a strong policy
track record and a firm commitment to
preserve macroeconomic and fiscal stability.
The Treaty requires that a member
state participate in ERM II for two years
without severe tensions before it can
adopt the euro. All of the new member
states are, therefore, expected to join the
mechanism at some stage.
In the ERM II framework, a country’s
exchange rate fluctuates around a
central parity against the euro. ERM II is
a flexible system in which realignments
of the central parity are possible and a
currency can fluctuate in bands of up to
15 percent above or below its central rate
without a legal requirement for central
banks to intervene. On the other hand,
interventions at the margins are in principle
automatic and unlimited.
The flexibility of the mechanism accommodates
varying degrees, paces and
strategies of economic convergence. Participation
in such a framework, however,
also implies that the exchange rate matters
in deciding the policy mix of the authorities
and that the central rate
provides an anchor to guide the expectations
of citizens and market participants.
This would not be the case if the exchange
rate moved over a long period in
a wide range and realignments were
common. The difference between the
mechanism and a free float would then
be marginal and the added value of the
mechanism would be low.
Unlike Sweden, all ten new member
states have expressed their willingness to
adopt the euro in the foreseeable future.
The potential benefits for the new member
states from joining a stability-oriented
monetary union include the
reduction of transaction costs, increased
price and cost transparency and the
elimination of exchange rate risks, which
may be relatively high in countries subject
to significant capital flows. Vulnerability
to external shocks would also be
reduced, given that the bulk of external
trade would be conducted within one
currency area.
“Use of a common
currency contributes
to strengthening
a shared ‘European
identity’ within
the Union”
The credibility of the convergence
process has already led to a significant
decline of risk premiums in many countries,
thereby easing their external financing
conditions. Research also suggests
that sharing a common currency could
generate additional trade, even though
EU membership as such already seems to
have boosted trade significantly between
old and new member states. Finally, it
should not be forgotten that EU integration
is also a political project. In this respect,
the use of a common currency
contributes to strengthening a shared
“European identity”within the Union.
The functioning of the euro area is
based on the principle that a stable and
credible macroeconomic framework is a
precondition for achieving a high and
sustainable long-term growth performance.
That is why countries are expected
to have achieved a “high degree of sustainable
convergence” before adopting
the euro, based on a set of formal criteria.
Sustainable convergence, as defined
by the Treaty, requires that a member
state has achieved price and exchange
rate stability; that public finances are
sound and provide room for macroeconomic
management; and that long-term
government bond yield spreads are low.
“Unlike EU enlargement,
the expansion of
the euro area
will not involve
a ‘big bang’ ”
The legal framework foresees that, at
least once every two years, or at the request
of a member state, both the European
Commission and the European
Central Bank prepare a report to the
Council on progress with nominal convergence.
While the criteria presented
above are precisely defined in technical
terms, thereby enhancing transparency
and allowing for equal treatment, they
are not considered in a mechanical way.
The EU institutions have a degree of
freedom in assessing whether a “sustainable”
degree of convergence has been
achieved. Moreover, the assessment also
takes into account the situation and development
of the balance of payments
on current account and the development
of unit labor costs and other price
indices.
The Commission and the ECB presented
their first Convergence Reports
covering the new member states and
Sweden in October 2004. No country has
been identified as ready to adopt the
euro, as none of the countries have participated
in ERM II for the required twoyear
period. Substantial progress has,
nevertheless, been noted in a number of
countries, in particular as regards reducing
inflation.
The question of the appropriate timing
for enlarging the euro area is
complex, and answering it implies caseby-
case considerations of what is optimal
for the member state concerned and
for the macroeconomic stability of the
area as a whole. Consequently, and unlike
EU enlargement, the expansion of
the euro area will not a priori involve a
“big bang,” but rather a sequenced approach.
Exchange rate strategies and
macroeconomic stabilization on the
road to the euro are being designed according
to country-specific circumstances
and taking into account the
preferences of the countries themselves.
In this context, it should be noted that a
number of the new member states have
already for some time tied their currencies
to the euro. Moving toward euro
adoption would not mean a fundamental
regime shift for them.
On the basis of the publicly expressed
intentions and the economic
programs of the new member states, it
appears that Estonia, Lithuania, Slovenia,
Cyprus, Latvia and Malta want to
adopt the euro soon and have set this as
a clear priority for economic policy. The
Czech Republic, Hungary, Poland and
Slovakia intend to give themselves a
somewhat longer preparatory period,
mainly to have more time to bring down
their public finance deficits. Slovakia
aims to adopt the single currency in
2009, while Hungary, Poland and the
Czech Republic are talking about 2009
or 2010.
From a broader perspective, in order
to ensure a smooth transition into the
euro area, the new member states should
also continue to gear their policies towards
fostering real (i.e. income) convergence,
facilitating further integration
into the EU economy, while safeguarding
macroeconomic and financial stability.
Income levels and living standards are
varied, but overall still well below those
enjoyed by the “old” member states. For
the average of the ten new member
states’ GDP per capita amounts, in terms
of purchasing power standards, to just
half that enjoyed by the old member
states, despite a wide degree of dispersion
within the group. Growth rates
(both potential and actual) are generally
higher than in the old member states,
but closing the income gap will remain a
major longer-term policy task.
Real convergence is not an automatic
and linear process, but has to be
underpinned by sound policies. Promoting
real convergence will require continued
broad-based structural reforms of
product, capital and labor markets. Further
progress in this area is key to improving
the flexibility of economies, to
ensuring a growth-conducive business
environment and to bolstering productivity
growth. Research suggests a strong
link between the quality of institutions
and long-term economic performance,
and in many countries there is scope to
enhance the legal and institutional
framework for business activity.
Employment rates tend to be low in
many new member states, and labor
markets are hampered by rigidities such
as low mobility, skill mismatches and
disincentives stemming from tax and
benefit systems. Together with macroeconomic
stability, supportive structural
policies are also important to sustain the
conditions for attracting foreign direct
investment (particularly as privatization
programs move toward completion),
thus alleviating balance-of-payments
concerns.
This is particularly relevant because
many of the new member states run sizable
current account deficits in the context
of their catching-up process. This is
economically sound to the extent that it
reflects an effective allocation of resources
by economic agents that may
bring future benefits. Indeed, relatively
high external deficits may be warranted
in a context of strong investment growth
that is not fully matched by domestic
savings. Also, consumers adjust to improved
long-term income expectations
and release pent-up demand following
better access to credit.
“One of the main
challenges is to bring
public finances onto a
sustainable path”
Current account sustainability is not
a major concern for the new member
states as a group at present, given the
generally high degree of financial and
macroeconomic stability, the significant
share of foreign direct investment in current
account financing and the ongoing
integration into the EU economy. For individual
countries, however, current account
deficits, fueled by credit booms,
have reached levels that need to be monitored
closely. Vigilance is needed to ensure that these imbalances do not become
unsustainable and make the
economies vulnerable to shocks.
One of the main challenges in this
context is to bring public finances onto a
sustainable path and keep them there.
Fiscal performance varies substantially
among the new member states, with six
of them – all except the Baltic countries
and Slovenia – currently running fiscal
deficits above three percent of GDP,
making them subject to an excessive
deficit procedure. In four new member
states, the budgetary situation has worsened
since 2001. At the same time, public
debt levels are generally lower than in
the euro area.
Clearly, fiscal policy will need to
support the new member states in their
catching-up efforts, including through
public investment and by providing incentives
to the private sector via a reformed
tax system. At the same time,
however, in an economic environment
characterized by rising permanent income
expectations, deepening financial
markets, strong domestic credit growth,
high rates of return on investment and
an open capital account, fiscal policy has
to play its role in controlling demand
pressures in the economy. The potential
short term costs of fiscal consolidation
are indeed significantly lower compared
with the costs possibly linked to an interruption,
or reversal, of the real and nominal
convergence process that could
result from a structural mismatch between
domestic demand and supply
conditions.
The set of policies to ensure a
smooth management of the final stretch
towards euro area membership – including,
but not restricted to, meeting the
formal convergence criteria – is therefore
broad-based and includes prudent fiscal
policy, effective financial supervision
and deep-rooted structural reforms. The
new member states still face substantial
challenges on their way to the euro. But
building on the success of EU enlargement
– and provided there is a strong
commitment to undertaking necessary
adjustments and reforms – the conditions
are in place to ensure a successful
gradual expansion of the euro area in the
course of the coming years.
Klaus P. Regling is Director General for Economic and Financial Affairs at the European Commission.
Before joining the Commission in July 2001, he was the Managing Director of Moore
Capital Strategy Group in London. He previously served as Director General for European and International
Financial Relations at the German Ministry of Finance and was a Resident Representative
in Indonesia for the International Monetary Fund.
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