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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