“Will Central Europe (CEE) Ever Adopt the Euro”?
Dr Katya Kocourek
(Formerly of the Economist Intelligence Unit, now Stroz Friedberg Ltd)
This paper responds to the latest communique released in Brussels on 22 June – the
euro zone’s ―five president’s report‖. Perhaps not surprisingly, this report presents a
plea for greater economic and monetary union and discusses in some detail the
significance of Banking Union for this purpose.
I have tried to answer the central question of my paper, whether the three countries
in CEE currently outside the single currency area will ever adopt the euro, through
the prism of Banking Union. In short − ―no‖ on euro adoption for these countries and
―no‖ on banking union.
I also argue that mechanisms for deeper economic union (like the banking union)
have served to dampen the allure of euro area membership for countries in CEE,
because they challenge, according to prevailing arguments from the region, the very
thing these countries hold dear – monetary independence and the freedom to set
exchange rates.
Background
In the immediate accession period in 2004—06, prior to the financial crisis, CEE was
full of optimism about euro adoption. That optimism has all but gone (and gone are
the 70%-plus popularity ratings for the EU as a whole); not just that, nagging distrust
of the euro area has now set in. This sentiment is underlined by the current climate
of ―secular stagnation‖, which alludes to anaemic growth rates seen in the euro area
since the start of the crisis in 2008.
All three countries in the region - Czech Republic, Hungary and Poland - are bound
to adopt the euro under the conditions of their accession treaties; although in Poland
and Hungary this would require constitutional change first, alongside parliamentary
endorsement. This leaves the Czech Republic free to pass judgement on euro
adoption, separate to any constitutional concerns or quirks.
On paper at least, euro adoption would make sense for these countries, which send
about 30%-40% of their exports to the very core of the old EU, Germany and France.
(Not surprisingly, the Czech Republic and Hungary have high trade to GDP ratios,
over 70%; Poland is lower with around 45%). However, from a currency perspective
there is no immediate benefit from having euros; quite the opposite, despite recent
protestations by the Czech President that the euro is a stable currency.
Precisely when these countries will adopt the euro remains uncertain, as none have
set official entry dates for either the Exchange Rate Mechanism ERM II — the socalled waiting room for euro adoption, founded on the demonstration, by budding
members, of currency stability.
The Czech Republic was originally supposed to adopt the euro in 2010, and Poland
in 2012, but the financial ructions caused by the euro zone crisis have undermined
the allure of a single currency. Since around 2011-12, at the height of the crisis, the
adoption date has been repeatedly pushed backwards, to 2018 in 2012, 2020 in
2014, ―definitely after 2020‖ at the start of 2015, and, more recently, ―decades away‖
as the Greek crisis intensified in recent weeks.
Slovakia and Slovenia are regularly held up as models of why these countries should
not adopt the euro. Sluggish Slovenian GDP growth rates aside, in a lecture
delivered in the UK in 2013, the Czech Central Bank Governor, Miroslav Singer,
explained why euro membership was bad for the Slovaks –

Not only was Slovak recession deeper in 2009, compared with the Czech
economy;

FDI inflows dropped in the immediate period after adoption, followed by a
spike in gross government debt and borrowing; and

Slovakia’s primary budget balance (a key marker of a governments’ ability to
pay back their debt) deteriorated more than in the Czech Republic in the
period after 2009.
In short, so this argument goes, joining the single currency area does not guarantee
economic growth.
The prospect of ―Grexit‖ has soured Czech (and Polish) appetites further; and this is
regularly cited by the Czech finance minister as a reason not to join – this does not
reflect concern about banking sector contagion, however (banking sectors in all three
countries are liquid, and Poland and the Czech Republic in particular have high
capitalisation ratios). This reflects a deeper concern about the will to share financial
burdens across the euro area: the Slovak row over the European Financial Stability
Facility (EFSF) in the autumn of 2011, when euro zone negotiations were almost
brought to a standstill by a Slovak vote against an extended bailout fund, highlighted
this particular problem, which runs deep in CEE.
In Poland, arguments against the euro have focused on the ―boom and bust‖ debt
cycle brought about by single currency membership. The other major flaw, arising
from this, is what it sees as the weakened responsiveness of fiscal policy in dealing
with the sovereign debt burden from the euro zone periphery. Economists at the
National Bank of Poland (NBP, the central bank) have in recent papers argued that
the lack of convergence from a sovereign debt perspective exacerbated the effects
of the financial crisis and the period immediately afterwards, otherwise known as the
―bail out era‖. In short, so this argument goes – euro adoption encourages
unnecessary indebtedness on the road to economic ―convergence‖.
All countries in the region have indicated they will not consider signing up to ERM II
until their economies have reached an adequate point of convergence above and
beyond that stipulated by the EU – differentials in wage growth between the richer
west and poor east is the main informal ―convergence point‖ regularly cited by
Central European politicians. Poland, the Czech Republic and Hungary have at
various points since 2012 indicated that they want to wait until wage growth reaches
a comparable level to that in the western half of the EU so as to avoid the ―Slovak
scenario‖ - a reference to a sudden rise in prices following euro adoption. (This
argument was regularly cited during the recent Polish presidential election, for
instance).
All three countries are nevertheless all doing well in terms of several key
convergence criteria, particularly on the budget deficit — Hungary was the first to exit
the European Commissions’ Excessive Deficit Procedure (EDP), in 2013, followed
by the Czech Republic last year, and most recently Poland has qualified to exit the
EDP — and on long-term interest rates. However, the government debt to GDP ratio
remains a problem for Poland, and public debt remains high by regional comparison
in Hungary, at around 77%.
Question mark hangs over Banking Union
At its very basic level, the Banking Union aims to create a firewall against further
financial and liquidity crises in the single currency area through two financial
mechanisms - a common deposit insurance scheme and a financial resolution
mechanism. One of these, the Single Supervisory Mechanism (SSM), has been in
place November 2014 and is overseen by the European Central Bank.
Critically, banking union also provides a more streamlined path towards euro
convergence via increased banking sector regulation — this is to say banking union
could be used as a ―fast track‖ towards euro adoption. However, this lack of a date
for euro adoption in CEE calls into question their future membership of the Banking
Union, for all countries that adopt the euro in the future will automatically join the
Banking Union — this was the case with Lithuania, the most recent euro member of
the club in January 2015.
As things currently stand, those EU member states currently outside the euro area
have the option to join the Banking Union on a voluntary basis or plump for piecemeal entry, commonly referred to as ―closer co-operation‖ with the ECB. Despite the
obvious perks involved, only Romania and Croatia to-date have expressed serious
interest in the Banking Union. Countries with already strong and liquid banking
systems, those who have seen a minimal amount of deleveraging during the
European crisis, such as Poland and the Czech Republic, have assumed a different
approach.
Reactions to Banking Union
Politicians in CEE have been guarded in their statements about whether or not their
countries are prepared to join the banking union. This is, one could say, a luxury
afforded to them as non-member states of the euro area.
Since 2012, when the European Council announced that Banking Union is a key
priority, politicians from all three countries have been sounding a note of caution. On
the Czech side, after initially opting out of Banking Union in 2012, the emergence of
a new centre-left Social Democratic government in early 2014 brought about a shift
in euro-area semantics. The Czechs have broadly kept their election promises on
Europe: in March 2014, the government approved accession to join the EU’s fiscal
compact (which came into force for 25 members on 1 April 2014), but more recently
leading politicians have gone quiet again on Banking Union.
In June 2014, Miroslav Singer on the Czech side announced that there is ―no
compelling reason‖ for the Czech Republic to join; and in October 2014 his Polish
counterpart, Marek Belka, told newspapers that for the time being he had no
intention for the time of opting into Banking Union.1
Polish and Czech central bank reactions to the Banking Union can be broadly split
into the following overarching themes and viewpoints:

The Banking Union exists to preserve the euro area by larger, richer and older
EU member states like Germany and France; therefore, countries falling
outside the euro area, in the ―east‖ of the EU have no role to play in it.
This perception has fed into arguments made by the NBP’s Marek Belka that
a two-tier European Union, could put non-euro zone members at a serious
disadvantage, as they would not have the same access to liquidity held by the
1
http://www.thebanker.com/Comment/National-Bank-of-Poland-president-eyes-Europe-cautiously
ECB.2 Neither would they have significant powers over decision-making within
the Banking Union, as non-euro zone members.

Banking union as a ―back door‖ to fiscal union.
In the Czech Republic in particular Banking Union has come to be
synonymous with a creeping federalisation or political union.3 Since the EFSF
fiasco in 2011, there has been growing apprehension in CEE about the risks
arising from the pooling of financial resources among existing Banking Union
members. The Czechs in particular are also worried about the fiscal impact of
banking union in the longer run on their own economy.
Furthermore, all three CEE countries are twitchy about the centralisation of
banking regulation, when they believe that have good enough systems in
place themselves. Indeed, as the banking sectors in CEE become more
regulated, concentrated and consolidated at the national level, arguments
against banking union and euro adoption are likely to continue to grow.
Following the UK’s lead in terms of a reformed relationship with the EU, it
appears that the Czechs and the Poles would rather have the option of opting
in and opting out periodically from financial mechanisms run by the Banking
Union (like the SMM), according to recent studies by the Polish Institute of
International Affairs.4

Lacking in financial firepower.
In the summer of 2014, when it looked as though the euro zone was finally
overcoming the worst, concerns were raised from Czech and Polish sides
about whether the banking union would have the financial firepower available
to avert a future crisis.5 Miroslav Singer in particular expressed concern that
―EUR 120 billion‖ may not be enough.6
This argument sees the rationale behind banking union as a short term, rather
than long term, solution.7 This is also tied into a growing consensus in Poland
2
http://www.reuters.com/article/2014/05/21/poland-cenbank-idUSL6N0O72FS20140521 ;
http://www.reuters.com/article/2014/05/21/poland-cenbank-idUSL9N0NY00620140521;
http://www.bruegel.org/nc/blog/detail/article/1372-europe-has-wasted-a-good-crisis/
3
http://www.foreignaffairs.com/articles/139461/nicolas-berggruen-and-nathan-gardels/the-next-Europe
4
http://www.pism.pl/files/?id_plik=18005 http://www.pism.pl/files/?id_plik=18005;
http://www.obserwatorfinansowy.pl/tematyka/in-english/bank-regulations-spell-trouble-for-the-economy/
5
http://www.wsj.com/articles/SB10001424052702303802104579450814068570306
6
http://cib.rbs.com/insight/articles/banking-union.html; http://cib.rbs.com/content/dam/insighthub/Documents/pdfs/banking-union.pdf
7
https://www.cnb.cz/miranda2/export/sites/www.cnb.cz/en/public/media_service/conferences/speeches/do
wnload/frait_20140314_eu_bank_union.pdf
and the Czech Republic that recapitalising banks and pumping liquidity into
weaker economies is not necessarily an effective way to ensure long-term
stability across the EU.

Apprehension about the transfer of powers to the ECB.8
Given the severity of anti-inflationary pressures in the euro zone and in
pockets of CEE, central bankers across the region are defending Quantitative
Easing (QE) and other forms of ―unconventional‖ monetary easing more than
ever. Deflationary conditions make giving up any form of supervisory powers,
by the central banks, even less likely.
The Next Three-Year Horizon
The underlying theme to all of the risks and perceived shortcomings about the
banking union and euro adoption, as outlined above, is the preservation of national
currencies and independent monetary policy.
The Czech Republic has made the case most forcefully that it makes no sense for it
to join the banking union before euro adoption.9 It, like Poland, will continue to
defend the importance of a free-floating exchange rate regime and monetary policy
by independent means in order to try to ensure price stability.
Until inflationary conditions stabilise, the central banks will continue to use a mixture
of conventional and unconventional monetary policy tools to stoke price pressures,
as part of a wider plan to restore a sustainable path of economic growth. In the
Czech Republic, for instance, this means the central bank will continue to manipulate
the value of the currency using foreign exchange/FX levers (which it has been doing
since November 2013).
It is debatable whether Donald Tusk’s presidency as head of the European Council
will bring any significant change on banking union or euro adoption from Poland’s
perspective in a key election year. If anything the recent win by Andrzej Duda from
Law and Justice (PiS) in Poland’s presidential election this May – and the PiS’
expected win this October – is likely to slow the debate over euro adoption.
Conclusion
Existing views on banking union in particular are unlikely to change much at all over
the next three-year period, particularly as these governments continue to avoid
setting a date for euro adoption. What these countries will probably do is to continue
8
http://www.eurointelligence.com/news-details/article/belka-makes-an-obvious-but-important-point-onbanking-union.html?no_cache=1
9
http://www.praguepost.com/finance/40947-the-czechs-and-the-euro
to try to increase their bargaining power with Brussels whilst retaining control over
regulation in the financial sector via their own central banks. This will be a very fine
line to tread.
There are seemingly few financial costs as a consequence of staying out of the
banking union, as these countries attempt to create their own financial firewalls and
capital buffers to avoid financial crisis, which effectively replace the need in the short
run for the resolution mechanisms managed by the Banking Union.
As in the UK, some of it not all Central European countries are expected to put the
issue of euro adoption direct to the public in the form of a referendum. In June 2015
the Czech President announced the country should hold a referendum on euro
adoption before 2020, in response to the UK’s lead as it renegotiates its relationship
with the EU. However, whether it will be a binding referendum or non-binding, or held
in conjunction with the next general election in 2017, remains unclear.
As far as banking union is concerned, Poland and the Czech Republic can effectively
―go it alone‖ for the time being; they are in a financial position to do so. At present,
therefore, it appears that these countries don’t really need a banking union.
Nevertheless, Banking Union highlights a salient point, a warning sign of the future:
perpetual division within the EU and the creation of a two—and three-speed
European Union, between those signed up to banking union and fiscal compact, that
is those for deeper integration, those undecided, and those firmly against.