Report on the European Economy 2004

Executive Summary

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Chapter 1 | Chapter 2 | Chapter 3 | Chapter 4 | Chapter 5 | Summary

Chapter 6

The road to the euro

The ten EU accession countries are supposed to join EMU in the next few years – the third and last phase of accession. Participation in EMU is conditional on satisfying the convergence criteria established in the Maastricht Treaty. When should these countries adopt the new currency? What are the challenges to policymakers in the period between EU accession and the adoption of the euro?

There are clear benefits from participating in EMU. The traditional argument is the credibility of low inflation, which applies to acceding countries as it did to southern European countries in the 1990s.A common currency eliminates currency risk and therefore drastically reduces interest rate differentials. In addition, a common currency is likely to increase trade with other EU countries. In this respect, adopting the euro is equivalent to a drop in transaction costs in cross-border exchanges of goods and services within the EU economic area. Also, by reducing the stock of external debt denominated in foreign currency, adopting the euro will substantially reduce vulnerability to currency and financial instability (although in principle EMU countries could still issue large stocks of dollar-denominated debt). The main and well-known disadvantage of participation in a monetary union is the loss of national monetary policy as an instrument of macroeconomic stabilisation and of the exchange rate as an adjustment mechanism.Whether and under what circumstances the adoption of the euro is a net economic benefit is the subject of an ongoing academic debate and political discussion in present EU countries that are not members of EMU. However, from a political point of view it appears certain that the accession countries will ultimately join EMU, so the relevant policy issue is one of timing.

The road to EMU may be quite difficult. Policy choices on the timing of EMU participation directly impinge on the acceding countries’ ability to use monetary policy to stabilise their economies in the next few years and to build an economic environment that favours high rates of investment and growth, economic integration and financial stability.

Fiscal and monetary authorities in the acceding countries now operate in a regime of high capital mobility. This is the result of a relatively rapid process of liberalisation and deregulation implemented in the last few years. But it is too early to say whether or not the financial and legal systems of these countries can weather volatile capital movements. However, it would be naïve to hope for the better and envision years without large (global or region-specific) shocks.

Our last chapter points at the intrinsic financial and currency fragility of fast-growing emerging markets in a world of liberalised capital flows. Based on the experience of the 1990s, emerging markets may be exposed to highly volatile capital flows, which can be a formidable challenge to macroeconomic stability. In boom periods, large inflows of short-term capital lead to domestic overheating and high rates of domestic credit expansion, causing excessive risk taking. Since debt is usually denominated in foreign currency, these inflows also expose domestic institutions and individuals to severe currency risk. In bust periods, currency devaluation worsens the balance sheets of banks and production firms.

EU accession is likely to increase short-term speculative capital inflows into the acceding countries. These flows may also respond to moral hazard distortions at both domestic and euro-area levels. Vulnerability to crises and contagion emphasises the need for building well-established mechanisms at the EU level to deal with such contingencies.

As discussed in Chapter 5, structural imbalances in the acceding economies may cause acute problems. Deteriorating fiscal conditions could constrain the use of budget policies for stabilisation purposes. Stabilisation is likely to fall disproportionately on monetary and financial authorities, both from a macro perspective and from a financial stability perspective. In such an environment, mandatory adoption of a regime of limited exchange rate flexibility (ERM II) for two years before entering EMU is controversial.

Overall, there is no single strategy that may be recommended to all acceding countries as regards macroeconomic stabilisation on the road to the euro. Arguments in favour of adopting the euro as early as possible includes smaller financial risk due to the elimination of currency mismatch in the balance sheets of banks and firms (which implies the risk of a self-fulfilling run on the country’s debt); interest rate convergence (with the associated gains in terms of the interest bill for the government as well as investment financing by firms); and overall gains in monetary credibility. Arguments for a slower pace to the euro include the need to remove financial distortions creating moral hazard and therefore raising the country’s default risk; easier relative-price adjustment without the need of costly nominal wage and price adjustments; and the need to make fiscal and financial policy sustainable and compatible with a fixed exchange rate before participation in the EMU.

The following recommendations may be made, however:

Countries that are already able to sustain hard pegs should be helped to achieve a smooth and fast transition to the euro. In this set of countries, mainly small ones, priority should be given to institutional reforms and building a policy framework consistent with participation in the euro area without suffering from major macroeconomic imbalance.
Delaying participation in ERM II is a realistic option for countries that are currently unable to sustain hard pegs and have large domestic imbalances. Here the policy priority is achieving a sustainable fiscal stance and stabilising inflation at the correct relative prices.This task requires both institutional and policy reform.
For both groups of countries, the convergence criteria in terms of inflation, interest rates, debt and deficits provide desirable targets to guide policy and should not be relaxed. Though they are not first-best targets, these convergence criteria should be judged relative to existing distortions that could derail the stabilisation efforts.
ERM II allows for large fluctuation bands around the exchange rate parity. Once in the ERM, a country should be able to use the exchange rate flexibility implied by such an arrangement: exchange rate stability should not be mechanically assessed with reference to much narrower bands. Fluctuations in the exchange rate in response to domestic and foreign shocks are not necessarily an indicator of tension in the foreign exchange market, but can be part of an efficient adjustment process. If the dollar suffers further depreciation, it would be reasonable to expect exchange rate fluctuations within ERM II. Declaring that acceding countries will be accepted in the euro area only if they can peg to the euro within narrow bands may raise the possibility of speculative attacks driven by self-fulfilling prophecies. During the transition to the euro, strict domestic stabilisation with some exchange rate flexibility is better than exchange-rate based stabilisation with very limited flexibility.