European Affairs

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.

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.

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.

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.


This article was published in European Affairs: Volume number 6, Issue number 1-2 in the Winter/Spring of 2005.