Dr. Gunther Schnabl, Tübingen University1 The Emergence of the Euro Zone An Informal Euro Standard as a First Step for EMU Membership of the CEE Countries Gunther Schnabl Universität Tübingen & Katholieke Universiteit Leuven Observatoire Français des Conjonctures Èconomique Paris, February

Dr. Gunther Schnabl, Tübingen University2 Table of Content 1.Introduction 2.A Shift towards more Exchange Rate Flexibility in Central and Eastern Europe (CEE)? 3.The Shift towards a Euro Zone in Central and Eastern Europe 4.An Informal Euro Standard as an Optimal Exchange Rate Strategy 5.Conclusion

Dr. Gunther Schnabl, Tübingen University3 1. Introduction The exchange rate strategies in Central and Eastern Europe are currently (officially) very heterogeneous: –(tight) pegs to the euro: Bulgaria, Estonia, Hungary, Lithuania –currency basket arrangement: Latvia (€, $, ¥) –crawling peg: Romania –(officially) floating: Czech Republic, Poland, Slovak Republic, Slovenia Is a more homogenous exchange rate strategy the better choice?

Dr. Gunther Schnabl, Tübingen University4 De jure IMF Classification of CEE Exchange Rate Arrangements

Dr. Gunther Schnabl, Tübingen University5 Exchange Rate Policies in Central and Eastern Europe (€) (1993:01=100)

Dr. Gunther Schnabl, Tübingen University6 Exchange Rate Policies in East Asia ($) (1993:01=100)

Dr. Gunther Schnabl, Tübingen University7 2. More Exchange Rate Flexibility in Central and Eastern Europe? Soft pegs in emerging markets open to international capital flows are prone to crisis (Fischer 2001). The IMF recommends that emerging markets open to international capital flows should pursue (more) flexible exchange rate regimes. Since 1997 three CEE countries have moved towards (more) exchange rate flexibility: Czech Republic (1997), the Slovak Republic (1999), and Poland (2001). Romania and Slovenia were (official) free floaters even before The flexible exchange rate strategies are not sustainable in emerging markets in general (McKinnon/Schnabl 2002) and in Central and Eastern Europe in specific (ECOFIN 2000).

Dr. Gunther Schnabl, Tübingen University8 Reasons for the „Fear of Floating“ in Emerging Markets macroeconomic stabilization –inflation –government expenditure foreign exchange risk for international trade –trade of emerging markets is invoiced in $, € or ¥ original sin (Eichengreen and Hausmann 1999) –international debt denominated in foreign currency depreciations and exchange rate fluctuations put balance sheets at risk –foreign exchange risk of short-term international payment flows (McKinnon and Schnabl 2002)

Dr. Gunther Schnabl, Tübingen University9 Reasons for Exchange Rate Stabilization with Respect to EU Accession macroeconomic stabilization is a prerequisite for EU, ERM2 and EMU membership –monetary convergence (inflation, interest rates) –fiscal discipline further growing trade integration after EU accession –euro invoicing accelerated integration into the euro capital markets –foreign exchange risk of (inter-)national (euro denominated) debt vanishes –foreign exchange risk of short-term international capital flows disappears expected ERM2 membership adds an additional need to redirect exchange rates to the euro

Dr. Gunther Schnabl, Tübingen University10 Monetary Convergence

Dr. Gunther Schnabl, Tübingen University11 Trade Integration

Dr. Gunther Schnabl, Tübingen University12 Convergence of Interest Rates (Money Market)

Dr. Gunther Schnabl, Tübingen University13 3. The Shift towards a Euro Zone in Central and Eastern Europe The euro bloc is continuously growing. Formal tests: –Calvo-Reinhart criteria –standard deviations of daily exchange rate returns Estonia (1992), Bulgaria (1997), Hungary (2000) and Lithuania (2002) form the core of the euro zone. Informally, the Czech Republic and Slovenia have also joined the euro club. Poland, the Slovak Republic, Romania and partially Latvia (still) remain outside.

Dr. Gunther Schnabl, Tübingen University14 Calvo-Reinhart Criteria (1999: :07)

Dr. Gunther Schnabl, Tübingen University15 Standard Deviations of Daily Exchange Rate Changes (1999: :07)

Dr. Gunther Schnabl, Tübingen University16 Central and Eastern Europe: Daily Exchange Rate Volatilities against the Euro

Dr. Gunther Schnabl, Tübingen University17 The Emergence of the Euro Zone (arithmetic average)

Dr. Gunther Schnabl, Tübingen University18 4. An Informal Euro Standard as an Optimal Exchange Rate Strategy Latvia, Poland, the Slovak Republic and Romania should join the euro zone. The case against the currency basket (Latvia): –A trade weighted currency basket reduces risk against all basket currencies, but does not eliminate it. –A hard peg to the euro eliminates the risk against the most important currency for trade and payment transactions and allows hedging against all other currencies via the euro capital markets—at low cost. –A hard peg to the euro further prepares Latvia for ERM2 and EMU membership.

Dr. Gunther Schnabl, Tübingen University19 The merits of an Informal Euro Standard with Respect to EMU Accession Poland, the Slovak Republic and Romania should the exchange rate towards the euro to enhance macroeconomic stability in the region. The common nominal anchor would –favour macroeconomic convergence with the Euro Area and among the CEE countries, –reduce risk for international trade with the Euro Area and among the CEE countries (competitive depreciations), –accelerate the integration of the CEE countries in the euro capital markets. Economic stability by both macroeconomic stabilization and growing intra-regional trade and capital linkages would also reduce the risk of speculative attacks.

Dr. Gunther Schnabl, Tübingen University20 Estonia Exchange Rate Volatility against Euro and Polish Zloty

Dr. Gunther Schnabl, Tübingen University21 5. Conclusion The exchange rate policies of the CEE countries are still rather heterogeneous. As the EU accession and the intended ERM2 and EMU accession require macroeconomic convergence, Central and Eastern Europe are drifting toward a euro zone. The informal euro zone enhances economic stability, economic integration and—to this end—real convergence. Thus, it facilitates EMR2 and EMU accession. The informal euro standard does not necessitate a strictly unified hard peg to the euro but allows adjustments—for instance gradual appreciations in response to relative productivity gains (Balassa-Samuelson effect).