Euro Area Enlargement and Euro Adoption Strategies Zsolt Darvas and György Szapáry Workshop on „The First Decade of European Monetary Union” University of Münster, May 29-30, 2008 This paper was commissioned by DG ECFIN from the EU Commission as part of the project. The views expressed are those of the authors and do not necessarily reflect the views of the EU Commission.

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies2 Issues Given the characteristics and initial conditions of the NMS, what are the risks and challenges on the road to euro? What should be the strategy and timing of euro adoption? Explore the real-nominal convergence nexus Highlight why keeping the Maastricht inflation criterion unchanged violates the Equal Treatment Principle

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies3 GDP per capita at PPS (EA12=100)

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies4 Price level (EA12=100)

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies5 Convergence of Price Levels Lowest initial GDP per capita → lowest initial price level → fastest convergence of price level The Balassa-Samuelson effect has been declining, but is not the sole factor contributing to price level convergence Others factors: shift in consumption to higher quality, higher priced goods, reduction in subsidies (energy, transportation, health care, etc), initial undervaluation

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies6 Interest Rates Convergence of nominal interest rates Low spreads, except Hungary and Romania. Recent increase in Latvia Interbank rates: low real interest rate, negative in some NMS Housing loans: somewhat larger rates Consumer loans: much larger rates

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies7 3-month interbank interest rate differential

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies8 10-year interest rate differential

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies9 3-month interbank real interest rate

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies10 Domestic Credit and Current Account Lowest per capita GDP → lowest level of credit and fastest growth of credit Credit growth: fuelled by both demand and supply factors Fuelled also by low real interest rates in currency board system Equilibrium level vs. speed of adjustment Dangers: feeds inflation, wage growth, housing prices, consumption, could deteriorate competitiveness, risks financial crisis Fastest credit growth → largest current account deficit

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies11 Domestic credit / GDP

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies12 Current account balance / GDP

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies13 Competitiveness Export volume growth has been robust and export market shares have increased in most of the NMS  the main cause of the large current account deficits is excessive domestic demand rather than any significant loss of competitiveness

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies14 Export market shares in total imports of the world (in percent)

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies15 Inflation Lowest initial GDP per capita → lowest initial price level → fastest convergence of price level Fast credit growth → further boosts domestic demand and inflation

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies16 Contribution to GDP Growth, averages of (left column) and (right column)

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies17 GDP per capita, credit growth, inflation

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies18 An illustrative model for price level convergence 1. The key determinant of price level is GDP per capita:

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies19 An illustrative model for price level convergence 2. Indeed, in many cases we could not reject the null hypothesis that the parameter of GDP per capita is one Transitory effects also could affect the price level; we found two significant variables: 1.Domestic demand/GDP relative to euro area 2.Interest rate differential vs. euro area Consequently:

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies20 An illustrative model for price level convergence 3. We also added a dummy for countries with fixed ER regimes: it was significantly positive in and but not in  Under fixed exchange rate, the price level convergence takes place via higher inflation and as the real convergence proceeds, this influence diminishes

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies21 An illustrative model for price level convergence 4. Price level convergence projections We assume that –NMS will catch up in GDP per capita at PPS to either 90% of EA12 (=average of Greece, Spain, and Portugal) or 100% –Catching up is faster in the beginning then slows down: we assume it is described by a logistic function –Initial speed of GDP catching-up is equivalent to actual average catching-up in –In the long run the level of domestic demand equals the level of GDP (similarly to recent historical values of EA12) and the speed of convergence depends on the speed of catching-up –The interest rate differential will converge to zero

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies22 Projected annual price level convergence (excess inflation or nominal appreciation in % point )

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies23 Nominal and Real Exchange Rate Nominal exchange rate: among floaters trend appreciation only in Czech Rep. and Slovakia. These two NMS registered low inflation in recent years ULC based REER: appreciating trend irrespective of exchange rate regime. More developed countries experienced least appreciation.

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies24 Nominal euro exchange rate (1995=100)

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies25 ULC real effective exchange rate (1995=100)

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies26 Fiscal balances Fiscal deficit is not a source of imbalance in less developed NMS

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies27 General Government Balance / GDP

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies28 Summary of Convergence 1 NMS with lowest initial per capita GDP have: –Lowest per capita GDP → fastest output growth –Largest price level gap to close → fastest price convergence –Lowest credit level → fastest credit growth –Lowest real interest rates → procyclicality of interest rates

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies29 Summary of Convergence 2 Rapid growth of credit to households, particularly mortgage loans. Issue: equilibrium level of credit vs speed of adjustment Rapid growth of consumption Fiscal deficit not source of imbalance in less developed NMS

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies30 Choice of Monetary and Exchange Rate Regime 1 Issue: which regime is best to manage the real and nominal convergence? Fixed: price level convergence translates into higher inflation → pushes real interest rates into negative territory → danger of credit boom → adds to inflation and current account deficit → increases debt. No immunity against capital flow reversal: example ERM2 member Latvia

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies31 Austrian Experience Real-nominal convergence can be successfully managed under fixed rate Austria has done it, but the price level gap was only 25% when hard currency policy was introduced in early 1970s, not 40% or more remaining for CEEs Key to success: social consensus to keep wage growth in line with productivity Task was easier: capital market and banking sector liberalization more progressive

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies32 Catching-up of Austria to Germany

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies33 Choice of Monetary and Exchange Rate Regime 2 Floating: price level convergence can be partly accommodated by nominal appreciation. Risks: excessive appreciation, capital flow reversal, excessive exchange rate fluctuations Exchange rate more a source of shock than shock absorber. Our new calculations for the CEEs reported in the paper confirm it, using sign restrictions adopted by Farrant and Peersman (2006) based on the theoretical model of Clarida and Gali (1994).

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies34 Constraints on Domestic Monetary Policy Foreign currency loans and direct external borrowing These are difficult to control given strong financial integration. Several NMS have applied administrative and regulatory measures, but success is limited. Good only as short term expedients

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies35 Share of foreign currency loans (in percent of total loans), 2006

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies36 Standing of NMS Regarding OCA Criteria Paper looks at OCA criteria: –business cycle synchronization (BCS) –output volatility –economic structures –labour and product market flexibility –financial integration Conclusion: standing improved significantly over years, by now not much of an issue from euro adoption perspective, especially given endogeneity of OCA. Important new finding: fiscal discipline (also embodied in EU fiscal rules) is associated with greater BSC

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies37 Conclusions 1 Floating provides more flexibility to manage the real-nominal convergence, but room for manoeuvre should not be overestimated. Risks: undue appreciation or excessive ER fluctuations. These militate in favour of earlier rather than later euro adoption where degree of real convergence more advanced. Lines are pretty much already drawn it seems, with the Baltic States and Bulgaria having opted for hard pegs.

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies38 Conclusions 2 Exiting from pegs? Dangers: loss of confidence → depreciation → negative wealth effect on euroized debt → recession If well communicated as transition to euro: appreciation → positive wealth effect → adds to CA deficit Step appreciation down the road? Any change needs careful weighing of pros and cons against accepting a delay in euro adoption

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies39 Conclusions 3 Key ingredients to successful real convergence: Productivity growth: what are the best policies to promote productivity? Structural reforms: improve flexibility in labour and product markets, ease of doing business (reduce bureaucracy, regulations, corruption) Social Pact on incomes policy

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies40 Maastricht criteria The inflation criterion as currently applied has weak justification on economic grounds Violates the Equal Treatment Principle Can deny euro adoption by countries which satisfy conditions to function normally in EMU and reap the benefits of membership  Our proposal for modification: euro area inflation percentage points and 2 year compliance

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies41 Maastricht criteria, cont’d Logic: –euro area inflation influences imported inflation –it is the indicator ECB tries to control –non-euro area countries’ inflation would not affect the criteria –frees from judging which best performer's inflation is unsustainable Would have minimal impact on euro area inflation (adds 0.05% compared to current practice)

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies42 Inflation: Current and Suggested Reference Values

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies43 Equal treatment? During , the three EU countries having the lowest inflation were Germany (3.8%), the Netherlands (4.8%) and Luxembourg (5.5%) By defining the inflation criterion in terms of the 3 best performers, probably convergence to Germany had in mind Germany was the most important trading partner of all other old EMU members Expansion of EU: the chance that small trading partners constitute the inflation criterion has substantially increased E.g. in March 2008 the 3 best performers were: Malta (with 1.5% inflation), the Netherlands (1.7%) and Denmark (2.0%)

Darvas and Szapáry: Euro Area Enlargement and Euro Adoption Strategies44 Thank you for your attention