BA-CA study: The euro in Eastern Europe – introduction makes sense, but will be partly delayed
- Smaller countries could be members of the euro area as early as 2008.
- Larger countries will probably join the euro at a later date.
"We expect that, despite various difficulties, some of the new EU members will join the euro in 2008", says Stefan Bruckbauer, an economist at Bank Austria Creditanstalt (BA-CA). The larger accession countries will probably introduce the euro at a later date. This is the result of a recent study by the Economics Department of Bank Austria Creditanstalt.
"Despite recent currency turbulence, the majority of the accession countries today have a more stable exchange rate than most of the current euro-area countries had four years before they introduced the euro," says Marianne Kager, BA-CA's Chief Economist. Nevertheless, she adds, this does not guarantee that these countries are already fit for the euro.
In 2003, the inflation rate in the accession countries was the same as in the euro area. But in the medium term, inflation in Central and Eastern Europe is expected to rise. The main reason for this effect is the adjustment of prices to rising wage levels in large sectors of the economy, primarily in manufacturing industry. With euro membership, when nominal exchange rates are fixed, higher inflation than in the "old" euro area will lead to permanent real appreciation. If productivity cannot be increased, this effect may adversely affect competitiveness. According to the BA-CA study, the countries in Central and Eastern Europe (CEE) have sufficient room for productivity increases. GDP per employed person is currently between 20 per cent and 40 per cent of the euro average.
No insurmountable hurdles
Bank Austria Creditanstalt's economists think that neither inflation nor the current account deficits present insurmountable problems for the introduction of the euro. "The difficulty of synchronising price increases and productivity is related not only to nominal exchange rates," says Marianne Kager. The large current account deficits of some CEE countries do not indicate a lack of competitiveness but are due to high levels of investment.
From an economic point of view, despite many doubts, there are few alternatives to a quick introduction of the euro. "The CEE countries would find it difficult to pursue independent exchange rate policies even if they did not join the euro area. They would gain only little room for manoeuvre in their economic policies," says Stefan Bruckbauer.
To join the euro, a country must meet the so-called convergence criteria. The deficit criterion (the public sector deficit must not exceed 3 per cent of GDP) is currently met by the Baltic states and Slovenia, while some of the larger countries significantly exceed this limit. According to current data, all accession countries meet the debt criterion (government debt must not exceed 60 per cent of GDP).
At present the exchange-rate citerion is currently not met by any country because the accession candidates are not members of Exchange Rate Mechanism II (ERM II). "If they were members of ERM II, all new members except Latvia and Poland would currently meet the criterion“, says Marianne Kager.
The inflation criterion (the inflation rate must not exceed the average for the three euro countries with the greatest price stability by more than 1.5 per cent) is currently met by all accession countries except Hungary, Slovakia and Slovenia. In the future it will become more difficult to meet this criterion.
Long-term interest rates must not exceed the average for the three countries with the greatest price stability by more than 2 percentage points. At present only Hungary and Poland exceed this limit.
Stability and Growth Pact
In addition to the Maastricht criteria, meeting the Stability and Growth Pact is also an important requirement. When joining the European Union, and even before introducing the euro, the new members will be required to work towards achieving a balanced budget in the medium term in order not to exceed the deficit limit of 3 per cent in a more difficult economic environment. However, for non-euro members, the consequences of failing to meet this target are significantly less severe.
This means that complying with the requirements of the Stability and Growth Pact in its current form, and independently of the introduction of the euro, will present a challenge to all new EU members. The following calculation illustrates the restrictive effect which the pact might have on CEE countries: if the CEE countries fully met the Stability and Growth Pact from 2004 onwards, their debt ratio would fall from currently 44 per cent of GDP to 34 per cent in 2006 and to below 20 per cent in 2013.
More room for manoeuvre
Bank Austria Creditanstalt's experts think that the higher real and nominal rates of growth in Central and Eastern Europe, in combination with the low debt ratio (CEE: 44 per cent, euro-area average: 70 per cent), would provide more room for interpreting the Stability and Growth Pact. If the old euro countries complied with their zero deficit rule and the new members' deficit did not exceed 3 per cent, the euro area's overall debt ratio would immediately decline by about 1.5 percentage points. The debt ratio would not return to the level currently recorded in the euro area until ten years later.
However, BA-CA's economists doubt that the European Union will make any major concessions. If, and to what extent, concessions are made to the accession candidates will probably depend on how ambitiously the individual countries pursue their plans with regard to the euro. It may be expected that the EU's readiness to make concessions to the countries in meeting the economic-policy targets will be the greater the less ambitious the euro plans of these countries are. "In those countries which will have to make substantial budget consolidation efforts, an excessively ambitious course would impede growth“, Stefan Bruckbauer explains. Bank Austria Creditanstalt's economists think that reasonable targets adjusted to the situation in the CEE countries could put positive "pressure" on some countries, even if they postpone the introduction of the euro, to stabilise their public sector deficits.
Low risks arising from enlargement
According to the recent BA-CA study, the risks arising from enlargement for the current euro area are low. If the new EU member countries had joined the euro in 2003, economic growth in the euro area would have reached 0.7 percent instead of 0,5 per cent. The inflation rate would have remained unchanged, the public sector deficit would have been 0.1 percentage points higher, the debt ratio would have been about one percentage point lower.
Overall, Bank Austria Creditanstalt's economists do not expect the accession countries to join the euro area very soon. "In view of economic reality and the pressure expected to come from the business sector, 2008 may be seen as a realistic date for the introduction of the euro in at least some of the accession countries,“ says Stefan Bruckbauer.
Enquiries: Bank Austria Creditanstalt Economics Department
Stefan Bruckbauer, tel. +43 (0) 5 05 05 ext. 41951