Download Convergence Criteria and New Member States

The Euro and
the New Member States
Natalia Tamirisa
International Monetary Fund
Warsaw, October 29, 2007
Focus

Macroeconomic challenges NMS face as they
prepare to join EMU

Policies that can help overcome these challenges

For details, see Euro Area Policies: Selected
Issues, Country Report No. 07/259, July 31, 2007
www.imf.org/external/pubs/cat/region.asp
Maastricht Treaty



Requires NMS to adopt the euro
But only after they satisfy entry conditions
Timing is left open

EC and ECB review progress annually
(Convergence Reports)

Unilateral euroisation is inconsistent with the
Treaty
Entry Conditions





Inflation should not exceed, on a sustainable basis, by more
than 1.5% that of the three best performing EU countries in
terms of price stability
Exchange rates should be within the “normal” fluctuation
margins provided for by ERM-II; no devaluations
Long-term interest rates should not exceed by more than
2% that of at most the three best performing EU countries
in terms of price stability
The fiscal deficit should not exceed 3% of GDP
Gross government debt should not exceed 60% of GDP
NMS plan to adopt the euro, but for now
have different exchange rate regimes
Exchange Rate Regimes in the NMS and Euro Adoption Plans
Progress in Euro Adoption
IMF Classification 1/
Czech Republic
Hungary
ERM II
Float
Has not joined yet
Intermediate
Has not joined yet
Poland
Slovak Republic
Float
Fixed
Has not joined yet
Joined on November 28, 2005
Estonia
Fixed
Joined on June 28, 2004
Latvia
Fixed
Joined on May 2, 2005
Lithuania
Fixed
Joined on June 28, 2004
Bulgaria
Romania
Fixed
Float
Has not joined yet
Has not joined yet
EMU
No official target date has been set. On current budget plans, 2012 would be the earliest feasible date.
No official target date has been set. The Convergence Program of December 1, 2006 aims at meeting
the Maastricht criteria in 2009.
No official target date
Target date is set for January 1, 2009
The government is committed to adopting the euro at the earliest possible date, which it now estimates
to be 2011, based on current inflation forecasts.
According to the information released by the Ministry of Finance, in 2007 the Government would
discuss a new target for the changeover to the euro, tentatively in 2011-2013.
No official target date has been set. According to the government, Lithuania will aim to join the euro
area as soon as possible and the more favorable period for the country to join the euro area starts in
2010.
Target date is set for January 1, 2010
Target date is set for January 1, 2014
Sources: IMF Annual Report on Exchange Arrangements and Exchange Restrictions and International Financial Statistics ; European Commission; European Central Bank; National
central banks.
1/ "Fixed" includes currency boards, conventional pegs, and narrow bands. "Intermediate" includes tightly managed floats and broad bands. "Float" includes managed and independent
floats.
2/ Information available from European Commission and national authorities, as of end-July, 2007.
Questions relevant for euro adoption

What are benefits and costs of euro adoption for
NMS and the euro area?

Is fulfilling the entry criteria feasible for NMS?

Will NMS economies perform well in the monetary
union?

How much policy adjustment would NMS need to
undertake to fulfill the entry condition?
What are benefits and
costs of NMS euro
adoption for NMS and
the euro area?
Benefits and Costs of Euro Adoption





Elimination of exchange rate risk
More trade and investment
Faster convergence (1% per year)
But loss of a shock absorber
Efficiency gains for the euro area through
outsourcing and competition
Is fulfilling the entry
criteria feasible for NMS?
NMS are converging to the euro area in real
and nominal terms
NMS: GDP per Capita and Prices, 1995-2006
Relative price level
(In percent of EU-25 levels)
80
80
70
70
60
60
50
50
40
40
30
30
BG
CZ
EE
HU
LV
LT
PL
SK
SI
CR
RO
20
20
20
30
40
50
60
70
80
Relative per capita GDP at PPPs
Source: World Economic Outlook, IMF staff estimates.
Note: Countries shown on the chart include Bulgaria (BG), the Czech Republic (CZ), Estonia (EE), Hungary (HU), Latvia (LV), Lithuania
(LT), Slovenia (SI), Poland (PL), Slovak Republic (SK), Romania (RO).
Price convergence results in real appreciation
One of the factors driving real appreciation is
the Balassa-Samuelson effect
Other factors

Persistent equilibrium effects
Quality upgrading of tradables and nontradables
 Shifts in domestic preferences toward services
 EU transfers


Transient equilibrium effects (level adjustment)
Shifts in foreign preferences towards NMS products
 EU accession and adoption of acquis communitaire


Disequilibrium effects

Irrational exuberance, speculative flows, overheating
Uncertainty about equilibrium appreciation
rates contributes to controversy over criteria


Can the built-in margins—1.5% under inflation criterion
and 15% under exchange rate stability criterion—
accommodate equilibrium real appreciation in NMS?
Yes


Real appreciation is largely transient, and Balassa-Samuelson and
other equilibrium effects are small
No


Catching-up euro-area economies posted 3-3.5% inflation in
1999-2006, above the Maastricht reference value
The Maastricht reference value may be driven down by
idiosyncratic factors (administrative and tax changes)
(Choueiri, Ohnsorge, and van Elkan, forthcoming)
Real appreciation is taking place in the
context of convergence-driven booms...
...supported by capital inflows
Rising concerns about overheating and
balance sheet mismatches
80
70
80
Foreign Currency-Denominated Loans, 2005
(in percent of total outstanding loans)
70
10
10
0
0
La
tin
Bu
lg
H
un
ga
r
Po
la
Source: National authorities, Fund staff estimates.
Note: Regional averages for East Asia and Latin America cover emerging market countries.
La
tv
ia
20
Es
to
ni
a
20
Li
th
ua
ni
a
30
R
om
an
ia
30
N
M
S
40
ar
ia
40
Am
er
ic
a
50
y
50
nd
60
Ea
st
As
C
ia
ze
ch
R
ep
ub
Sl
lic
ov
ak
R
ep
ub
W
lic
es
te
rn
Eu
ro
pe
60
Cooling off convergence-driven booms is
difficult

Fiscal tightening


Monetary tightening


Further capital inflows? Sterilization costs?
Capital controls


Significant? Medium-term considerations?
Prohibited under EU rules? Effective?
Prudential regulation

As a macro instrument?
Will NMS economies
perform well in the
monetary union?
Strong productivity growth, may not
be sustainable...
...but significant catch-up potential
remains
90,000
80,000
90,000
GDP PPP per Capita, 2006
(in U.S. dollars)
80,000
70,000
70,000
60,000
60,000
50,000
50,000
United States
40,000
40,000
16
14
30,000
GDP PPP per Capita, 2006
(annual percentage change)
14
12
12
10
10
8
8
Euro area
30,000
16
6
United States
6
Euro area
20,000
20,000
10,000
10,000
4
2
2
0
0
Source: IMF, World Economic Outlook.
Malta
Portugal
Italy
Spain
Cyprus
France
Belgium
Germany
Austria
Netherlands
Luxembourg
Ireland
Greece
Finland
Slovenia
Hungary
Poland
Lithuania
Romania
Czech
Bulgaria
Slovak
Estonia
Latvia
0
Bulgaria
Romania
Poland
Latvia
Lithuania
Slovak
Estonia
Hungary
Malta
Portugal
Czech Republic
Slovenia
Greece
Spain
Cyprus
France
Italy
Germany
Belgium
Finland
Netherlands
Austria
Ireland
Luxembourg
0
4
Measures of labor market flexibility
provide comfort but have not been tested
Product market flexibility is lower
than in the euro area
Significant presence of major foreign banks
should facilitate intertemporal risk-sharing...
...but NMS financial systems are still less
developed and integrated than its peers
Automatic stabilizing properties of NMS
budgets are weaker than in the euro area...
...but variation in expenditures is higher,
especially in discretionary categories
How much policy
adjustment would NMS
need to undertake to
fulfill the entry
conditions?
Dynamic Stochastic General Equilibrium
Model (GIMF by Kumhof and Laxton, 2007)




Fiscal and monetary policy reaction functions
Overlapping generations, open economy monetary
business cycle model Blanchard (1985) and Weil (1989)
Non-Ricardian features: finite planning horizons
and liquidity constrained consumers
Calibration to a representative NMS
Fiscal policy cannot permanently
reduce inflation in NMS with pegs
NMS: Effects of a One-Percent Permanent Decrease in Fiscal Deficit
(In percent or percentage point deviation from the baseline)
Flexible Exchange Rate
Fixed Exchange Rate
4.0
4.0
Real GDP
Inflation
Nominal exchange rate
Real interest rate
Real exchange rate
3.0
4.0
4.0
Real GDP
Inflation
Real interest rate
Real exchange rate
3.0
3.0
2.0
2.0
2.0
2.0
1.0
1.0
1.0
1.0
0.0
0.0
0.0
0.0
-1.0
-1.0
-1.0
-1.0
"+" indicates depreciation
-2.0
"+" indicates depreciation
-2.0
t
t+1
t+2
t+3
Source: IMF staff estimates.
t+4
t+5
3.0
-2.0
-2.0
t
t+1
t+2
t+3
t+4
t+5
Greater wage and price flexibility and lower
nominal rigidities reduce output costs...
NMS with Fixed Exchange Rate Regimes: Effects of a One-Percent Permanent Decrease in Fiscal Deficit
(In percent or percentage point deviation from the baseline)
Base Case
4.0
4.0
Real GDP
Inflation
Real interest rate
Real exchange rate
3.0
Lower Nominal Rigidities
More Flexible Labor and Product Markets
4.0
Real GDP
Inflation
Real interest rate
Real exchange rate
4.0
4.0
3.0
3.0
4.0
Real GDP
Inflation
Real interest rate
Real exchange rate
3.0
3.0
2.0
2.0
2.0
2.0
2.0
2.0
1.0
1.0
1.0
1.0
1.0
1.0
0.0
0.0
0.0
0.0
0.0
0.0
-1.0
-1.0
-1.0
-1.0
-1.0
-1.0
"+" indicates depreciation
-2.0
t+1
t+2
t+3
t+4
t+5
"+" indicates depreciation
"+" indicates depreciation
-2.0
t
-2.0
-2.0
t
t+1
t+2
t+3
t+4
t+5
3.0
-2.0
-2.0
t
t+1
t+2
t+3
t+4
t+5
Source: IMF staff estimates.
...but do not make inflation reduction sustainable
In NMS with flexible exchange rates,
monetary tightening can lower inflation...
NMS with Flexible Exchange Rates: Effects of a One Percent
Interest Rate Increase (In percent or percentage point deviation
from the baseline)
2.0
Real GDP
Inflation
1.5
Real interest rate
Real exchange rate
1.0
Nominal exchange rate
0.5
0.0
-0.5
-1.0
-1.5
"+" indicates depreciation
-2.0
t
t+1
t+2
t+3
t+4
t+5
...but cannot
resolve the
tension between
joint price and
exchange rate
stability
objectives
What margin to use for unanticipated
inflation and fiscal shocks?
Prudent fiscal deficits are estimated
at 1-2 percent of GDP Schadler et al, 2005
What sacrifice ratios to use to quantify
output losses from disinflation?




Euro area: 1.25% of GDP Coffinet, Matheron, Poilly (2007)
EU-15: 0.5% to 3.5% of GDP Bulir and Hurnik (2006)
NMS: 1.5% to 4% of GDP Bulir and Hurnik (2006)
Pegs: short-run multipliers from GIMF
What levels of inflation to use?

Upper limit: Contemporaneous inflation


But could be influenced by transient factors
Lower limit: Long-run equilibrium trend
Average euro area inflation (just under 2 percent)
 Add 1.5% for Balassa-Samuelson effects


Compare to 2.5% “adjusted” reference value
Upper limit on output losses
associated with disinflation
Lower limit is 0.5-1.5 percent of GDP
For fiscal tightening, there is a trade-off
between short- and long-run effects
Conclusion





NMS face considerable macroeconomic
challenges are they prepare for joining EMU
Distinguishing benign appreciation in NMS from
overheating is difficult
Degree of appropriate macroeconomic
adjustment is uncertain, but could be significant
In any event, NMS need to be well prepared
before joining to perform strongly in EMU
Benefits of euro adoption are considerable for
both for NMS and the euro area