Why the new EU member states should adopt the euro as soon as possible

By: Iulia Traistaru-Siedschlag, ESRI

The new EU countries are facing two major macroeconomic policy challenges. The first is to manage the process of rapid real convergence that comes with high real GDP and productivity growth rates and large capital inflows. The second is to achieve nominal convergence required for the adoption of the euro. These two challenges are related, as rapid real convergence makes it more difficult to achieve nominal convergence. As we argued in a recent paper, for some of these countries, real convergence would be easier to manage if they adopted the euro as soon as possible (von Hagen and Traistaru-Siedschlag[1]). Furthermore, in our view, fiscal policy is likely to play a key role in managing both challenges: first, because fiscal policy can help to absorb part of the demand effects of capital inflows; second, because sustainability of public finances is part of the requirement to adopt the euro. 

 

Like Sweden, and unlike Denmark and the United Kingdom, the new EU countries do not have the right to opt-out from adopting the euro. However, in the absence of a timetable, like Sweden, they can choose when to adopt the single currency.  Slovenia has joined the euro area on 1 January 2007 and Cyprus and Malta are expected to adopt the euro on 1 January 2008 following the favourable assessment of their convergence performance published by the European Commission and European Central Bank on 16 May 2007. By joining the ERM-2, Estonia, Lithuania, Latvia and Slovakia have also signalled their intention to adopt the euro fast. The rest of the new EU countries (the Czech Republic, Hungary, Poland, Bulgaria, and Romania) have chosen to stay for the time being outside the ERM-2 and delay the adoption of the euro. 

 

As shown in Figures 1 and 2, the twelve new EU member states are small open economies. The economic size of the smallest countries (Cyprus, Estonia, Latvia, Lithuania Slovakia, Slovenia, Bulgaria) is comparable to that of Luxembourg; the Czech Republic, Hungary, and Romania are similar in economic size to Ireland and the economic size of Poland is similar to the Netherlands. Trade openness measured  as total export and imports of goods and services as percent of GDP is close to the trade openness of the euro area in Romania and Poland and much higher in the rest of the new EU countries ranging from 97 percent of GDP in Cyprus to around 170 percent of GDP in Slovakia, Malta, and Estonia.

 

 Source: Own calculations based on the AMECO Database, European Commission

 

 

In the absence of capital controls, small open economies are faced with a trade off (known in the theoretical open macroeconomics literature as the “Impossible Trinity”) between reducing currency volatility and running a domestic oriented stabilising monetary policy. To the extent that small open economies have a preference for low exchange variability even if the official exchange regime allows for a high degree of flexibility (“fear of floating”), this implies that in the context of free capital mobility, these countries will have a lower autonomy of monetary policy and will face a low cost of foregoing it. It follows that, although difficult to quantify ex-ante, the benefits of joining the Eurozone in terms of trade and growth gains in these small open economies are likely to outweigh the cost of losing independence over monetary and exchange rate policies for  stabilisation purposes.

 

Over the past decade, the twelve new EU countries (EU-12) have experienced a strong real convergence performance. As shown in Figures 3 and 4, they have grown at much stronger rates than the euro area, with the highest average annual growth rates of real GDP and labour productivity in the three Baltic countries. Significantly, economic growth remained vigorous in the new EU countries even while the economies of the Euro area have slowed down over the past five years.

 

 

 

 

Source: European Commission, Economic Forecast, Spring 2007

 

 

Given the higher marginal product of capital in comparison to the Eurozone  countries, the new EU countries have attracted large capital inflows. Large capital inflows into relatively low-income countries with a well educated labour force are desirable for an efficient international allocation of capital. Furthermore, in the receiving countries capital inflows allow for more investment and consumption at the same time and foster the growth and real convergence process. However, the international experience of emerging economies has shown that large capital inflows create risks, in particular the risk of overheating and sudden stops leading to economic and financial imbalances. 

 

Coping with large capital inflows is a difficult task for macroeconomic policy. Since the underlying reason is real, there is not much monetary policy can do. The obvious response would be to tighten monetary policy to prevent aggregate demand from overheating. With a fixed exchange rate, inflationary pressures result in a real appreciation, a loss in international competitiveness, and a widening current account deficit. With a flexible exchange rate, the central bank may be more successful to keep inflation low, but at the cost of a nominal appreciation of the currency, with the same effect on competitiveness and the current account.  Adopting the euro as soon as possible offers a way out of this dilemma.

 

In our view, fiscal policy is the more appropriate policy instrument for dealing with large capital inflows. Tightening the fiscal stance helps to reduce the risk of an overheating economy. We argue that more effective spending controls and improved budgeting procedures rather than increasing taxes will best promote macroeconomic stability in the new EU countries.

 

The adoption of the euro requires the fulfilment of the Maastricht nominal convergence criteria of low inflation, low long-term interest rates, stable exchange rates against the euro and compliance with two reference values for general government debt and deficits relative to GDP. In addition, the adoption of the euro is conditioned on the compatibility of national legislation with the Treaty and ESCB Statute (legal convergence).

 

The new EU member states have already achieved a substantial degree of nominal convergence. The reference value for price stability is the average of the three lowest inflation rates in the EU plus 1.5 percentage points. In our view, this is not a good yardstick for admitting countries in the Eurozone for at least three reasons. First, since  the EU-27 includes many more small open economies than the EU-15 in 1998, it is clear, that in contrast to frequent declarations by officials from the European Commission and the European Central Bank, applying the same technical criterion to the new EU member states as to the first wave of Eurozone members  does not imply that the new member states are treated in the same way as the incumbent members in 1998.  Furthermore, when the Maastricht criteria were decided, EU member states could still avail themselves of certain capital controls. Second, with 27 members the probability that the three lowest inflation rates are in countries outside the Eurozone is higher. For example, the three lowest inflation rates used for the calculation of the reference value in the latest Convergence Reports for Cyprus and Malta were those of Finland, Poland and Sweden. Since countries joining the Eurozone will have to cope with the Eurozone’s inflation rate, the most sensible thing to do is to change the inflation criterion to 1.5 percentage points above the Eurozone inflation rate. Third, with free capital mobility, achieving exchange rate stability and domestic price stability at the same time depends to a large extent on favourable external conditions and very little on domestic policy. 

 

Nominal convergence in terms of long-term interest rates has been achieved by all new member states except Hungary. This shows that the current inflation trends are perceived as credible by the financial markets. It also implies that, in contrast to many of the incumbent member states of the Eurozone, the new member states cannot expect large fiscal gains from falling interest rates as the adoption of the euro approaches. Most of the credibility gains from adopting the euro have been reigned in already in the process of EU accession. 

 

Most of the new EU member states comply with the 60 percent threshold for the public debt ratio, the exceptions being Hungary, Malta and Cyprus. With the exception of Hungary, the Czech Republic, Slovakia, and Poland the new EU member states comply with the three percent threshold for the budget deficit ratio.

 

The decision about the time for the adoption of the euro is a decision about managing  macroeconomic risks and opportunities: a fast adoption of the euro is likely to foster growth and real convergence in a less risky financial environment. The adoption of the euro at a later date allows the pursuing of structural reforms in a less restrictive macroeconomic environment.

 

 

Iulia Traistaru-Siedschlag is Senior Research Officer and Head of the Center for International Macroeconomic Analysis at the Economic and Social Research Institute in Dublin.

 

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