Preparing for euro adoption Anatoli Annenkov Principal Economist Directorate Economic Developments 12 October 2006 The views expressed in this presentation are solely those of the presenter and do not necessarily reflect those of the European Central Bank

2 Benefits of adopting the euro Risks related to premature euro adoption ERM II The formal enlargement process The convergence criteria State of convergence Some policy challenges Price and exchange rate stability Outline

3 Benefits of euro adoption a) For the individual country: - stable exchange rates in relation to most important trading partners; - credible framework for monetary policy and price stability = low risk premia and low long-term interest rates; - reduced transaction and information costs; - higher protection against financial disturbances. b) For the euro area: - completion of the internal market, providing price and cost transparency; - economies of scale and more efficient allocation of production factors.

4 Risks related to premature euro adoption a) For the individual country: - differences in business cycles may lead to suboptimal interest rates in the national context and the emergence of local bubbles/crises; - unless convergence is sustainable, a country can run into competitiveness problems, with no resort to exchange rate changes; - without sufficient flexibility to adjust to changes in competitiveness - risks of protracted economic losses. b) For the euro area: - less cohesion in the euro area may complicate the single monetary policy; - lack of convergence and flexibility may affect the credibility of EMU.

5 The road to the euro Accession to the EU Entry into ERM II Assessment of convergence, formal decision on entry and conversion rate Adoption of the euro ERM II membership Optional: Pre-ERM II phase (as stipulated in the Treaty) ERM II membership Technical preparations

6 Exchange Rate Mechanism II ERM II membership voluntary but expected Main features of ERM II –Fixed but adjustable exchange rates vis-à-vis the euro –Standard fluctuation band ±15% –Central parity and fluctuation bands mutually agreed –Both the ECB and the Member State concerned can trigger a review of the central parity

7 Exchange Rate Mechanism II (contd) Entry is not subject to legal criteria –Case-by-case assessment based on equal treatment –Major policy adjustments (e.g. price liberalisation and fiscal reforms) to be undertaken prior to entry –Need to follow credible fiscal consolidation path Length of participation –Minimum two-years prior to examination of convergence –No restrictions on length of participation beyond minimum period –Should be assessed on the basis of what is most helpful to accompany the convergence process

8 Formal enlargement process - role of the ECB Every second year, or at the request of a country, the ECB and the European Commission report on the state of convergence in their Convergence Reports. Case-by-case examination based on the convergence criteria and the principle of equal treatment. Based on these examinations and on a proposal by the Commission, the (ECOFIN) Council will decide which countries fulfil the necessary conditions for adopting the euro. The Council will also decide the conversion rate at which the national currency will be replaced by the euro.

9 Convergence criteria The criterion on price stability the achievement of a high degree of price stability; this will be apparent from a rate of inflation which is close to that of, at most, the three best performing Member States in terms of price stability –Reference value: average HICP inflation rate of, at most, three best performing EU Member States percentage points.

10 Convergence criteria The criterion on the government budgetary position the sustainability of the government financial position…will be apparent from having achieved a budgetary position without a deficit that is excessive… –Reference value: the ratio of the government deficit to GDP should not exceed 3%. (unless the ratio has declined substantially and come close to the reference value) –Reference value: the ratio of government debt to GDP should not exceed 60%. (unless the ratio is sufficiently diminishing and approaching the reference value)

11 Convergence criteria The exchange rate criterion The observance of the normal fluctuation margins provided for the exchange–rate mechanism of the EMS, for at least two years, without devaluing… –The ECB examines whether a Member State has participated in ERM II for at least two years prior to the examination without severe tensions, in particular, without devaluing its currency against the euro. –Focus is put on the exchange rate being close to the central rate against the euro, while also taking into account factors that may have lead to an appreciation.

12 Convergence criteria The long-term interest rate criterion The durability of convergence achieved by the Member State and of its participation in the exchange–rate mechanism of the EMS being reflected in the long-term interest rate levels –Reference value: average of long-term interest rates in the three best performing EU Member States in terms of price stability + 2 percentage points.

13 State of convergence – price stability Denmark and the UK are not shown as they have a special status and are presently not candidates for joining the euro area

14 State of convergence – government balances in 2005

15 State of convergence – g overnment debt in 2005

16 State of convergence – exchange rate criterion Estonia, Lithuania and Slovenia joined end-June Cyprus, Latvia and Malta joined in early May Slovakia joined in end-November 2005.

17 State of convergence – long term interest rates N.B. No comparable long-term interest rates are currently available for Estonia, Bulgaria and Romania.

18 Policy challenges in the run-up to euro adoption Achieve sustainable price stability and fiscal prudence Complete all transition related reforms (price liberalisation, administered prices, indirect tax harmonisation etc.) Interaction between structural and cyclical factors: - Price level convergence and inflation; - Strong domestic demand, fuelled by low interest rates, credit and house price expansion; - large current account deficits raises questions on sustainability.

19 The relation between price and exchange rate stability The process of real convergence can make it difficult to combine price and exchange rate stability. Ultimately, price stability is the primary objective in all EU Member States, irrespective of the chosen monetary policy strategy. Before fixing the exchange rate, it is important that: –major policy adjustments (e.g. price liberalisation and fiscal consolidation) are undertaken; –the economy is flexible and has well-functioning markets, so that shocks are easily absorbed without resorting to the exchange rate; –the central rate against the euro is chosen close to the equilibrium value.

20 Economic characteristics euro area – Bulgaria and Romania in 2005

21 Thank you for your attention!