1. IMPACT OF THE MONETARY INTEGRATION PROCESS UPON INFLATION IN THE CZECH REPUBLIC AND OTHER SELECTED COUNTRIES ACCEDING THE EUROZONE Economic and Monetary Union: 10 Years of Success? Brno, 27-28 November 2008 Petr Rozmahel Research Centre Faculty of Business and Economics Mendel University in Brno Czech Republic rozi@mendelu.cz

2. Selected CEE Countries Acceding the Eurozone Slovenia January 2007 Slovakia January 2009 Czech Republic? Euro-pessimists: „…consider the risk of the inflation shock after joining the Eurozone too early..“

3. Will adoption of the Euro increase prices sharply in the CR and other CEECs? Is there a risk of galloping inflation after the Euro adoption in the CEECs? What are the factors determining inflation rate during the process of economic and monetary integration in the candidate countries?

4. Inflation rate in the Eurozone countries in the period 1996 - 2007 Source: Eurostat

5. Actual national inflation rates vs. Eurozone average Source: Eurostat

6. Inflation factors of the monetary integration process in the CEECs Formal factors (Maastricht criteria, etc.) One-off factors Loss of autonomous national monetary policy Low comparative price level relative to GDP per capita Catching up process – channels of the price convergence Balassa-Samuelsson effect

7. Formal Inflation Factors Maastricht criteria Stability and Growth Pact Tax harmonization Actual inflation rates and convergence criteria in selected CEECs Czech EstoniaHungaryLatviaPolandSlovakia Republic 20042,636,86,23,67,5 20051,64,13,56,92,22,8 20062,24,33,56,71,24,3 Reference value 2,8 Source: Convergence Report, ECB, December 2006

8. One-Off Inflation Factors Rounding, psychological effects, perceived inflation Source: Eurostat Inflation rate in Austria, Germany and Italy in the period 1992-8/2007

9. Loss of national autonomous monetary policy: inflation targeting by the CNB Source: Czech National Bank Actual inflation rates and inflation targets of the Czech National Bank

10. GDP per capita (in PPS) and CPL in the Eurozone and selected acceding countries in 2006 Source: Eurostat, author´s calculations Low CPL relative to GDP per capita

11. Catching up process of the CEECs towads the Eurozone Annual GDP growth rates in selected CEE countries and the Eurozone Source: Eurostat

12. Convergence in GDP per capita of the acceding countries towards the Eurozone Source: Eurostat Catching up process… 199920002001200220032004200520062007 Eurozone (12)100 Czech Republic60,860,161,962,565,767,968,870,774 Hungary46,849,251,854,656,657,157,758,757,5 Poland42,542,441,942,943,745,746,147,348,6 Slovakia44,244464849,651,654,557,662,2 Slovenia69,56969,371,973,476,978,179,480,5

13. Price convergence (CPL of the private consumption of households) of the CEECs the Eurozone Source: Eurostat Two channels of price convergence Inflation differential Exchange rate appreciation Catching up process price convergence 199920002001200220032004200520062007 Eurozone (12)100 Czech Republic45,447,849,456,452,652,956,559,161,3 Hungary4648,952,356,756,259,361,558,458,8 Poland50,757,66460,552,551,36061,260,8 Slovakia39,644,142,944,348,952,954,356,757,1 Slovenia72,472,57373,573,672,673,573,8

14. Inflation channel of the price convergence: Similarity in Czech and Eurozone Inflation rates Source: Eurostat Actual inflation rates in the Czech Republic and the Eurozone in 1996 – 8/2007

15. Exchange rate channel of the price convergence: nominal appreciation Source: CNB, MF CR Exchange rate CZK/EUR, exponential trend, prediction

16. Balassa-Samuelson Effect Annual growth rate [%] of labour productivity in converging CEE countries relative to EU-15 Source: Eurostat BS average estimations for CEECs: 1-2% of BS effect contribution to the total CPI; Schadler et al. (2005)

17. Inflation in the Czech Republic after joining the Eurozone: Three Scenarios Realistic scenario Pessimist scenario Note: Ceteris Paribus Assumption

18. Realistic scenario: long-lasting higher domestic inflation resulted from the real convergence process Positive inflation differential (% units) appropriate to higher GDP and productivity growth rates in the catching-up economies. Severity and duration of the higher inflation period dependent on the level of reached convergence in the very moment of acceding the Eurozone.

19. Pessimist scenario: higher inflation, negative impact upon economic growth, unsure future Pessimist inflation expectations fixation, wage claims exceeding the productivity growth Loss of competitiveness of domestic production, negative impact upon economic growth

20. Pessimist scenario… Inflation rates in the Eurozone, Ireland and Spain in the period 2001 – 8/2007 Source: Eurostat

21. Pessimist scenario… Labour productivity growth rate in the Eurozone, Ireland and Spain in years 2001-2005 Source: Eurostat

22. Inflation factors after joining the Eurozone Inflation factor Direction rise (+)/decline (-) Duration Period Price transparence improvement - Long-term Exchange rate risk elimination - Long-term Stability and Growth Pact - Long-term Purpose-built increase in prices by firms + Short-term Rounding effect + Short-term Autonomous monetary policy loss + Long-term Low CPL relative to GDP per head + Long-term Closing Exchange rate channel + Long-term Balassa-Samuelson effect + Long-term

23. Conclusions /1 It is difficult to separate the direct impacts of Euro adoption and the convergence processes upon inflation rate in the candidate catching-up countries. Indicated deep gap between Czech and Eurozone comparative price levels. Low comparative price level relative to GDP and closed exchange rate channel of the price convergence process could produce long- lasting inflation differentials after joining the Eurozone. Such inflation does not have to be harmful provided that it is in line with rising productivity and GDP growth differentials.

24. Arguments for sharp and immediate increase in inflation after joining the Eurozone are weak. Risk of galloping inflation is low, dependently on incomes policy of government and positive inflation expectations fixation. Running catching-up process, closing exchange rate channel and low initial CPL are likely the most important factors of long lasting positive differentials after joining the Eurozone in the forthcoming future. Conclusions /2

25. Thank you for your attention.