Forthcoming in Journal of Policy Modeling, special issue on adoption of the euro by
new members of the EU.
Abstract
The ten countries that acceded to the European Union on May 1, 2004, must now
decide how and when to adopt the euro. All do so eventually, and their self-declared
deadlines range from 2006 to 2010. This paper analyzes tradeoffs, controversies and
dilemmas that are likely to face such countries over the next six years, and in closing
offers brief conjectures about future adoption of the euro by countries still outside the
EU.
Adopting the Euro: Dilemmas and Tradeoffs Facing EU Accession Countries
James W. Dean
Simon Fraser University
jdean@sfu.ca
The ten countries that acceded to the European Union on May 1, 2004 must now
decide how and when to accede to European Monetary Union. All must join EMU1
eventually, and their self-declared deadlines for accession range from 2006 to 2010.
This paper analyzes tradeoffs, controversies and dilemmas that are likely to face
such countries over the next six years, and in closing offers brief conjectures about
future adoption of the euro by countries still outside the EU.
State of play
On May 1, 2004, ten countries – Cyprus, Czech Republic, Estonia, Hungary, Latvia,
Lithuania, Malta, Poland, Slovakia and Slovenia – joined the European Union (EU).
Unlike their predecessors in the EU, these countries must adopt the euro, but not
immediately. That is, they must join European Monetary Union (EMU), but with
“derogation”. In euro-speak this means a grace period before they join the
hardening-up process of Exchange Rate Mechanism (so-called “ERM II”), and then
at least two years in ERM II before they’re allowed into EMU. Recall that EMU
now includes all EU countries except Denmark, Sweden and the UK. These three

Parts of this manuscript draw from Dean (2002a,b). I am grateful to Elinor Johansen and Inna
Golodniuk for comments, and in particular to Maria Silgoner of the National Bank of Austria for
drawing my attention to a variety of facts that I got wrong in an earlier draft.
1
Throughout this paper I use the term EMU to mean European Monetary Union, by which I mean
countries that have withdrawn their national currencies and adopted the euro as their sole official
currency. Usage in the European bureaucracies is different: EMU means Economic and Monetary
Union, to which all 25 EU members belong. I prefer the vernacular and use the phrase “accession to
EMU” interchangeably with “adopt the euro”.
1
countries opted out2, but 2004 entrants cannot. Recall also that Norway and
Switzerland are not in the EU.
Box 1 is a “wish list”: it contains recent statements from the accession countries
about their intended dates of accession to EMU. These dates range from Estonia’s
2006 to Czech Republic’s 2009 – 2010.
INSERT BOX 1
Conditions for joining EMU
-
To join the EU, accession countries had to meet many economic criteria, the
most basic of which was to create market economies. Before adopting the
euro they must join ERM II and commit to maintaining exchange rates
within +/- 15% (de jure) or +/- 2.25% (de facto) bands around a parity peg to
the euro for at least two years. In addition, they must have met the following
“Maastricht criteria” during the year before they want to adopt the euro
(i.e., at the earliest, during the second year of their period in ERM II):
-
Inflation and long term interest rates within 1.5% and 2% respectively of the
three EU countries3 with the lowest inflation rates
Public debt at or below 60% of GDP, and budget deficits at or below 3% of
GDP
-
States of preparation
Most of these criteria are already met by the new member states. In fact they are
much closer to convergence than the current EMU countries were in 1994. Their
inflation average is just below the required reference value, their long-term interest
rates are also below reference, and their average debt/GDP ratio is only 40%.
However for several, their Achilles heal is fiscal deficits: in 2002 and 2003 these
averaged over 5% of GDP, well above the required 3%.
While fiscal deficits are perhaps the most fundamental challenge to adoption of the
euro, there are others:
•
The Czech Republic, as a by-product of rapid productivity growth and
strong investment inflows, has until recently faced a rapidly appreciating
nominal exchange rate, and may experience further increases that could
push the limits allowed under ERM II.
2
Technically, only Denmark and Britain have been granted opting out, but it would seem unlikely
that Sweden will ever be expelled from the EU or even penalized for repeatedly voting against
adopting the euro.
3
Note that in this context “EU countries” means all 25 existing members, including all 10 new
members as well as the 3 old members that have not adopted the euro.
2
•
Hungary until mid-2003 experienced currency instability, and still suffers
from inflation that exceeds ERM II criteria, not to mention high budget
deficits (5.6% of GDP in 2003). Also, net FDI outflows in 2003 forced
increased reliance on financing the substantial current account deficit via
debt.
•
Latvia has made the slowest transition from central planning and will be
under pressure from Brussels and Frankfurt to reduce privileged access of
the public sector to financial institutions.
•
Lithuania maintains conflicts of interest among central bank board
members.
•
Poland has successfully reduced inflation to less than 2%, but at the cost of
a strong zloty and high interest rates, policies that have exacerbated
unemployment.
•
Slovakia suffers from both high inflation and high deficits.
•
Slovenia suffers from high inflation.
In these contexts it should be noted that “high” (inflation, deficits, etc.) means
simply “too high to meet Maastricht criteria”, not necessarily too high for the good
of the country. Indeed, even in countries that are in the late stages of transition to
market systems, there may be good grounds for tolerating stable but relatively high
inflation and deficits. To impose prematurely low inflation and deficits may reduce
real growth, increase unemployment, and exacerbate income differentials. This is
partly because structural rigidities take time to break down, and partly because
productivity growth in these Central and Eastern European Countries is typically
well above the Western European average. In short, some ERM II and Maastricht
conditions may be too onerous.
States of controversy
Indeed, several aspects of the route to adoption of the euro are currently
controversial in Warsaw, Prague, Budapest, Bratislava, Ljubljana etc., and even,
soto voce, in Brussels and Frankfurt. Here are six of the most controversial:
•
Should the three best EU countries or the over-all EU average dictate
inflation reference levels for inflation and long term interest rates? If the
latter, reference levels would, of course, be higher.
•
Should +/- 2.25% or +/- 15% be allowable as a band for exchange rate
fluctuations? The band was officially widened to +/- 15% after the Western
European currency crises of 1992/93, but in mid-2003 Pedro Solbes, the EU
3
Monetary Affairs Commissioner, startled putative accession countries by
proclaiming that de facto the band expected within ERM II will be +/- 2.25%.
•
More generally, should ERM II relax its inflation ceilings and/or relax
nominal exchange stabilization to allow real exchange rates to appreciate as
productivity catches up to the EU?
•
Does the European Central Bank ever contemplate acting as a centralized
lender of last resort? If so, might it not also want to centralize banking
supervision?
•
Bad bank debt is particularly problematic in the Czech Republic, in Slovakia
and in Poland. Is it manageable at country levels?
•
Should the new member states with currency boards abandon them before
joining ERM II? This would seem pointless unless re-alignment of parity
with the euro is contemplated.
This last controversy raises a broader issue. How do countries that already fix to the
euro or to baskets – these countries are relatively small - “loosen up”, or will that be
necessary? And how do the countries that currently float – these countries are
relatively large – “tighten up”?
Current currency regimes of the ten acceding countries are described in Box 2. The
ten divide neatly into six “small country peggers” and four “large country floaters”.
INSERT BOX 2
Small peggers
Slovenia, which is small in size and population (albeit top of the ten in terms of per
capita GDP), will have to move from its current peg with a downward sloping band
(i.e. gradual depreciation versus the euro), to a peg with a horizontal band. This is a
potential problem for trade competitiveness if inflation persists above the EU
average.
The smallest five - Cyprus, Estonia, Lithuania, Latvia and Malta - all have hard
pegs to external currencies: the first three to the euro, Latvia to the SDR, and Malta
to a basket that is 70% euro-weighted. It makes no sense for the euro-peggers to
loosen up unless their pegs are seriously misaligned: in any case they lack feasible
exit strategies. But the other two must make an explicit decision about whether to
maintain the parity rate with the euro that is implicit in their baskets. Moreover
they face the problem that their new pegs – to the euro – will conform less to their
trade patterns to the extent that their current baskets are de facto trade weighted.
This is not likely to be a problem for Latvia, whose trade is overwhelming with
euro-land. Malta, however, still does considerable trade with Britain, its former
4
colonial master: tourism in particular may suffer slightly from increased exchange
rate uncertainty.
But the previous problems are minor by comparison with the benefits likely to be
reaped from tighter integration with euro-denominated capital markets. Indeed,
many of these benefits have already been reaped. The small-country peggers have
very open economies but very thin foreign exchange markets. Their pegs have
served them well in terms of access to international financial markets, low inflation
and strong output growth. Moreover they have not needed to intervene or use
interest rates to maintain the pegs. Long term domestic-currency rates have
converged toward euro-levels; to exit and then re-enter their hard pegs would
unnecessarily cost them credibility.
In short, Estonia and Lithuania will likely maintain their currency board pegs to the
euro and Cyprus will likely maintain its narrow peg to the euro, whereas Latvia and
Malta will need to move from their basket pegs (with euro-weights of 35% and
70%) toward sole pegs to the euro.
Large floaters
The larger new member states have moved recently toward more flexibility. The
Czech Republic has a managed float with inflation targeting; Hungary pegs to the
euro but with a +/- 15% band, and also inflation-targets: i.e. it runs a managed float
with two targets; Slovakia has a managed float with hybrid targets; Poland runs a
free float with inflation targeting.
Larger countries will have to harden their regimes, but they should be permitted to
harden gradually. Under ERM II, de jure they can fluctuate within a +/- 15% band.
But as already mentioned, in mid-2003 Pedro Solbes, the EU Monetary Affairs
Commissioner, expressed preference for the much narrower, traditional +/- 2.25%
band. The wider band would be wiser since these countries still face transition
challenges: Czech Republic’s koruna rose by 25% 1999 – mid-2002, and since then
has fallen by more than 10%; Hungary’s forint has also been volatile, as has
Poland’s zloty and Slovakia’s koruna. This volatility reflects both BalassaSamuelson effects due to rapid productivity growth, and large changes in capital
inflows.
Exchange rate flexibility versus stability is one of several tradeoffs and even
dilemmas that will face new member states in the transition process toward
adopting the euro.
Tradeoffs, dilemmas and challenges
How much flexibility? As suggested, among the large floaters a continued history of
volatility against the euro suggests that transitional restructuring and/or volatile
capital flows may necessitate continued flexibility for several years. The Czech
5
Republic, Hungary, Poland, and Slovakia have already been mentioned. Latvia
might be added to the list. As the poorest of the new member states it has the longest
way to go to catch up to EU productivity levels; moreover, capital inflows are likely
to increase sharply. Recall that Latvia pegs to the SDR; hence unlike other small
floaters, flexibility against the euro can be introduced without abandoning a preexisting fixed parity.
What central parity, and when? A second challenge facing new member states that do
not already fix to the euro is whether to lock in to a central parity rate now or later.
Rapid productivity growth relative to the EMU causes appreciation of real exchange
rates. This can occur via inflation in non-tradeables prices (the Balassa - Samuelson
effect) that is not offset by deflation in tradeables prices, or via appreciation of the
nominal exchange rate: in short via inflation that is higher than the EU average, or
via increases in the nominal exchange rate. In any case, the central parity consistent
with current account balance may be higher in, say, 2007, than now, especially if
new member states are constrained by the Maastricht criteria to inflation rates no
higher than the lowest three EMU countries. The EU Commissioner’s declaration
last year of a de facto ERM II exchange rate band of only +/- 2.25% could force
countries to make a premature choice of parity.
An additional consideration in the choice between fixing parity now or later is that
secular growth in capital inflows can cause real exchange rate appreciation, again
via inflation or via nominal appreciation. This can also delay the date for fixing
parity.
In both cases (catch-up productivity growth and rapid capital flows), the parity rate
consistent with current account balance is a moving target. A final complication is
that the medium term parity rate is not necessarily one that is consistent with
current account balance. On the contrary, continuing current account deficits are
appropriate as long as productivity growth and returns on capital are above EMU
and world averages.
The European Central Bank itself (ECB, Feb 2004, p. 22) regards the two-year
participation requirement in ERM II as a “testing phase”, both for readiness for
reduced exchange rate volatility, and for fixing the correct parity rate. However in
practice the ECB is likely to confront tradeoffs and dilemmas. Continued real and
financial restructuring may warrant continued flexibility; moreover premature
exchange rate stability may cause excessive current account deficits (in case of
undervaluation), or excessive inflation (in case of overvaluation).
Fiscal challenges A third set of challenges is fiscal. First, in recent years fiscal
deficits have widened in Czech Republic, Hungary, Poland and Slovakia. Even in
Cyprus and Malta, deficits are above 3% of GDP. These deficits may prove more
intransigent than in Western Europe, given long socialist traditions and the
consequent likelihood of continued pressure for government spending on both
infrastructure and transfer payments. Second, given a reluctance to cut spending,
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the scope for contractionary counter-cyclical fiscal policy may be more limited in
the Central and Eastern European Countries than in Western European countries
like Ireland; so too the scope for stimulatory fiscal policy will be limited if the
Growth and Stability Pact’s 3% deficit ceiling is enforced.
Next to adopt the euro?
Bulgaria and Romania hope to join the EU in 2007. Croatia has just applied, and
Macedonia may do so soon. All four could, in principle, officially euroize by 2010,
although Croatia and Macedonia are likely to accede to both the EU and EMU later
than Bulgaria and Romania. Turkey has had official EU-candidate status since
1999, but is not expected to be admitted until at least 2015.
Several countries could unofficially euroize: that is, withdraw their domestic
currency and adopt the euro without permission from Brussels or Frankfurt.
Kosovo and Montenegro have already done so. Bosnia and Serbia could be next,
especially if they hold out no hope to join the EU in the foreseeable future and
therefore have no particular incentive to jump through hoops devised by Brussels
and Frankfurt.
It is not, however, crystal clear that abandonment of local currencies is typically
immanent. Although many if not most countries in Eastern Europe and Central
Asia already use the euro or the dollar informally for transactions and/or store of
value purposes (Feige & Dean, 2004), the number of national currencies in the
region has multiplied over the last decade with the creation of new nation states
(Pomfret, 2003). It is not clear that widespread formal dollarization, euroization, or
currency union is likely in the near future except in countries that accede to the EU.
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BOX 1
Self-declared Intentions to Join European Monetary Union
•
•
•
•
•
•
•
•
•
•
Cyprus: “2007 despite recent fiscal slippages” (Pre-Accession Economic
Programme [PEP] 2003)
Czech Republic: “as soon as plausible economic conditions have been
created” (PEP 2003) [More concrete statements by CZ point to 2009 – 2010]
Estonia: “as soon as 2006” (PEP 2003)
Hungary: “1 January 2008” (PEP 2003)
Latvia: “earliest … 1 January 2008” (PEP 2003)
Lithuania: “Realistically … start of 2007” (Governor Sarkinas, March 2003)
Malta: “second half of 2007 or Jan 2008 latest” (Governor Bonello, Feb 2004)
Poland: “only when macro conditions make it possible … [given projected
gov’t deficits] … 2008 or 2009” (PEP 2003)
Slovakia “earliest realistic target 2008” (Strategy of the Slovak Republic for
adoption of the euro, June 2003)
Slovenia “Both the Bank and the Government … judge … it will be possible
at the beginning of 2007” (Joint programme of the Slovenian Government and
Bank of Slovenia for ERM II entry and adoption of the euro, November 2003)
•
In short, declarations of the new member states range from 2006 (Estonia) to
Jan 2010 (Czech Rep.)
• Most optimistic (2007 or earlier) are Cyprus, Estonia, Lithuania, Malta, and
Slovenia
• Least optimistic (2008 or later) are Czech Republic, Hungary, Latvia, Poland
and Slovakia
Source: European Central Bank (2004), pp. 7 – 8.
BOX 2
•
Cyprus: De jure: Peg to euro with +/- 15% band. De facto: Narrow range of
fluctuation
• Czech Republic: Managed float; 2 – 4% inflation target by end 2005
• Estonia: CBA fix to euro since 1992
• Hungary: Peg to euro with +/- 15% band; inflation target of 3 – 5% by end
2005
• Latvia: Peg to SDR with +/- 1% band
• Lithuania: CBA fix to dollar in 1994, then to euro in February 2002.
• Malta: Peg to basket of 70& euro, 30% dollar and pound sterling
• Poland: Free float with inflation target of 1.5 – 3.5%
• Slovakia: Managed float: hybrid strategy; implicit infl. targeting
• Slovenia: Crawling band with monetary, real, external and financial
indicators
Source: European Central Bank (2004), pp.14 – 15.
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REFERENCES
Dean, James W. (2002a) “The Economic Case Against the Euro Revisited” In
Patrick Crowley, Before and Beyond EMU. Routledge.
Dean, James W. (2002b) “Exchange Rate Regimes in Central and Eastern European
Transition Economies, with Lessons for Ukraine” CASE, Kyiv, Ukraine and
Warsaw, Poland.
European Central Bank (2004), “The Acceding Countries’ Strategies Towards ERM
II and the Adoption of the Euro: An Analytical Review”, Occasional Paper Series
No. 10, February. http://www.ecb.int.
Feige, Edgar and James W. Dean (2004) “Dollarization and Euroization in the
Transition Countries: Asset Substitution, Network Externalities and Irreversibility”
In Monetary Unions and Hard Pegs: Effects on Trade, Financial Development, and
Stability, George M. Von Furstenberg, Volbert Alexander and Jacques Melitz, eds.,
New York: Oxford University Press, March, 2004.
Oesterreichische Nationalbank (2002) Focus on Transition 2. http://www.oenb.at
Pomfret, Richard (2003) “Currency Areas in Theory and Practice” Working Paper,
School of Economics, University of Adelaide.
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