1

 Bank-based systems
 Market-based systems
 Financial systems in Eastern Europe
2

•
•
transaction costs
Institutions take deposits and channel funds to individuals and firms; evaluating assets gives rise to fixed costs that intermediaries can share, thereby giving them an advantage over individuals.
asymmetric information
As a rule, borrowers have better information about the riskiness of their financial situation and repayment prospects than do their lenders, and managers know more about the profitability of their firm than shareholders and lenders. Financial institutions have a comparative advantage in screening and monitoring borrowers.
3

•
•
•
Banks started securitising loans in searching for a way not to keep all the money they lend on their balance sheets, companies developed their asset management capabilities beyond their core competences and began widening their activities to the financial realm, most trading of financial instruments takes place among financial institutions without any customers involved at all.
4

For example, although recent advances in information technology have substantially reduced information costs and asymmetries, the need for financial services has not declined to a similar extent – direct lending is still the exception and not the rule.
Another unresolved puzzle is the large share of trades among intermediaries.
5

Financial intermediaries transact at near zero cost and can create a large number of synthetic assets through dynamic trading strategies, allowing them to create products with very safe payoffs and/or with varying degrees of complexity according to their own needs and those of their customers.
6

Synthetics are securities that allow combinations of assets to be obtained with low transaction costs.
Examples:
•
•
•
•
Synthetic stocks can be constructed by buying a stock index future contract and a riskless security.
Synthetic securities – assets or liabilities – denominated in one currency can be constructed by combining a security denominated in another currency with a forward foreign exchange contract of similar maturity and a spot contract.
A forward foreign exchange contract that does not exist can be replicated by using a spot contract combined with borrowing and lending in the two currencies involved.
A synthetic option is built from a set of transactions replicating a portfolio of the traditional financial claims it corresponds to.
7

Common to all synthetic assets is that they are so-called redundant securities:
Their cash payoffs may be replicated by a set of transactions in other financial instruments.
Synthetic assets mimic the payoffs, but not necessarily the risk profile of the desired product.
The latter refers to the underlying distribution of returns for various instruments and also to the assumption of continuous price movements and liquid markets that is usually made.
8

Table 3.14: World Financial Markets in Figures
*
Volume of estimated daily global foreign exchange turnover in April
2001
Foreign consolidated bank claims worldwide, first quarter 2001
Domestic equity markets, world total of market value, August 2001
Outstanding value of world bonds markets, June 2001
In comparison: world annual merchandise exports for 2001
* In trillions of US dollars.
Sources: BIS, IFSL, WTO.
1.2
11.3
27.1
> 29.3
6.0
9

In Europe, much of this and other financial activity takes place in London:
Table 3.15: European Financial Markets in Comparison
1
UK France Ge rmany
Branches and subsidiaries of foreign banks (March 2003)
287 179 129
Cross-border bank lending (March
2003)
Foreign equities turnover (January-
September 2003)
19
45
6
-
11
3
Foreign exchange dealing (April 2001)
Derivatives turnover
2
- exchange-traded (January-August
2003)
- OTC (April 2001)
31
6
36
3
3
9
5
13
13
International bonds (2002)
- primary market
- secondary market
60
70
1 If not otherwise stated, as percentage share of world total.
2 Based on the volume of contracts.
Source: IFSL.
...
...
...
...
US
224
Japan
84
9 9
32 -
16
27
18
...
...
3
3
...
...
9
10

• by far the highest number of foreign banks
• the highest share of equity turnover, foreign exchange dealing and OTC derivatives trading
• it is the most important centre of international bond trading in both primary and secondary markets
• there are more corporate headquarters in London than in any other European centre: one-third of Fortune Global 500 companies have their European headquarters there, compared with 9% in Paris, 6% in Brussels, 3% in
Düsseldorf and 3% in Frankfurt.
• Over 65% of the Fortune Global 500 companies are represented in London
– more than in any other European city.
11

and in some market segments are even taking the lead:
• exchange-traded derivatives are primarily traded in Frankfurt
• the world's second-largest market behind the US of mutual fund management is in France
• the insurance industry is largely concentrated in Munich where total premium income exceeds those in both New York and
London, the Numbers Two and Three respectively
• money and government bond trading is not concentrated in one place
• sales teams for non-government bonds and equity sales and
M&A, too, are decentralised across the euro area.
12

Traditionally, a distinction is made between bank-based financial systems and market-based systems.
In Europe, both can be found:
Anglo-Saxon countries have market-based system, while France and Germany are examples of bank-based systems.
13

Financial systems
Table 3.16: Bank-based versus Market-based Syste ms
*
Equities
Bonds
Bank Assets
Germany
1990 2001
9 15
27
64
30
55
US
1990 2001
25 38
51
24
46
16
100 100 Total
* In percent.
100 100
Source: Milken Institute.
A look at the relative importance of banks and securities markets in the US and Germany shows the difference:
In the US, banks are relatively unimportant compared to equities and, in particular, bonds, which play by far the largest role. In Germany, the contrary holds: here, apparently, banks are relatively important and bond and equity markets less so.
14

Financial systems
The data also show that, in the 1990s the importance of bank finance has declined in both systems, while the share of equities has risen markedly.
This indicates a worldwide structural change in financial markets rather than an adjustment or convergence of systems.
15

Bank-based Systems
In countries with bank-based systems, firms' external financial funds are primarily provided by banks with which they have long-term relationships.
As a rule, banks are universal banks allowed to offer a wide range of financial services.
Banks take deposits and lend directly to firms and individuals and, at the same time, trade in equities and provide underwriting services.
The latter is in contrast to market-based systems where more or less strict "firewalls" separating different kinds of financial services such as taking deposits and granting loans on the one hand and underwriting and trading equities on the other exist.
16

Bank-based Systems
However, the lines are not clear-cut and the limit of what is allowed or forbidden varies from country to country:
17

Table 3.17a: Permissible Banking Activities in Europe, the United
States and Japan*I
Se curitie s Insurance Re al Estate Comme rcial
Bank
Inve stme nt
Very Wide Powers
Austria
Switzerland
United Kingdom
France
Netherlands
Wide Powers
Denmark
UR
UR
UR
UR
UR
UR
PM
PM
PM
PM
PM
PM
UR
UR
UR
PM
PM
PM
UR
UR
UR
UR
UR
RS
Nonfinancial
Firm
Inve stme nt
UR
UR
UR
UR
UR
UR
Finland
Germany
Ireland
Luxembourg
Portugal
Spain
UR
UR
UR
UR
UR
UR
RS
RS
PH
PM
PM
PM
PM
PM
UR
UR
RS
RS
UR
UR
UR
UR
PM
UR
UR
UR
UR
RS
UR
PM
* As of 1995.
Definitions:
Securities activities include underwriting, dealing and brokering all kinds of securities and all aspects of mutual funds business.
Insurance activities include underwriting and selling of insurance products/servic es as principal and as agent.
Real estate activities include investment, development and management.
Unrestricted (UR): The full range of activities can be conducted directly in the bank.
Permitted (PM): The full range of activities can be conducted, but s ome or all only through subsidiaries.
Restricted (RS): Less than the full range can be conducted in the bank or its subsidiaries.
Prohibited (PH): The activities cannot be conducted at all.
18

Table 3.17b: Permissible Banking Activities in Europe, the United
States and Japan*II
Somewhat Restricted
Powers
Italy UR
Sweden
Belgium
Greece
Restricted Powers
UR
PM
PM
PM
PM
PM
RS
RS
RS
RS
RS
RS
RS
RS
UR
RS
RS
UR
UR
Japan
United States
* As of 1995.
RS
RS
PH
RS
RS
RS
RS
RS
RS
RS
Definitions:
Securities activities include underwriting, dealing and brokering all kinds of securities and all aspects of mutual funds business.
Insurance activities include underwriting and selling of in surance products/services as principal and as agent.
Real estate activities include investment, development and management.
Unrestricted (UR): The full range of activities can be conducted directly in the bank.
Permitted (PM): The full range of activities can be conducted, but some or all only through subsidiaries.
Restricted (RS): Less than the full range can be conducted in the bank or its subsidiaries.
Prohibited (PH): The activities cannot be conducted at all.
Source: International Monetary Fund (1997): International Capital Markets – Developments,
Prospects and Key Policy Issues, Washington, DC, Table 44.
19

Differences in financial systems
As the Table demonstrates, in the mid-1990s the differences in various areas of financial business in and outside of Europe have been considerable.
Many of these differences still persist, although, over recent years, European countries have experienced some convergence in the course of the implementation of the single market program.
• Among all bank activities, the most sensitive cases seem to be involvement in real estate business, which is restricted in a large number of countries, ...
• and mutual investments, both of banks in nonbank financial firms and vice versa.
• For European banks, in contrast to those in the US and Japan, securities trading is widely unrestricted.
•
Although overall restrictions on insurance are low, they exist among others in the country with some of the largest insurers worldwide, Germany.
20

Bank-based systems
A practice which is widespread in bank-based systems – but is not exclusive to them – has become known as relationship pricing: banks offering credit to investment-grade companies tend to charge very little in the hope of being rewarded later with more lucrative work such as underwriting securities.
Often banks use this instrument to survive in an ever increasing investment banking competition worldwide.
Many of these commitments are based on the assumption that the related costs are low because companies would rather sell commercial paper than draw down credit lines, which are more expensive. However, this way of competing contains a systemic risk: under changing economic conditions, companies may become unable to raise funds in the markets and the demand for credit may rise. In such a situation, repricing - which would be a normal reaction - may be prevented just because the banks find themselves too close to the firms.
21

Bank-based systems
Relationship finance many advantages:
•
It promotes cooperative behaviour
A firm that defaults on a bank loan risks being excluded from further credit in the future.
•
Systems risks can be contained by intertemporal smoothing:
In accumulating low-risk, liquid assets, banks reduce the need for cross sectional risk sharing through markets.
In a market-based system, competition from financial markets where risks are actively managed and traded would rule out this possibility.
• Banks standing in long-term relationships with their customers are necessarily better informed than stock market investors.
22

Bank-based systems
However, these arguments have to be put into perspective:
The overall efficiency of a bank-based system depends on the extent to which the advantages are realised.
In international debates on investor relations and shareholder value, bankbased systems are usually equated with financial backwardness.
By most measures financial markets in the US and UK are more developed than in France, and far more developed than in Germany, raising concerns about corporate governance and control.
One example - the German hausbank system:
23

Bank-based systems
The German hausbank system: there are three kinds of activities not reflected in banks' balance sheets:
• control of equity voting rights by the banks which allows them to considerably influence the outcome of shareholder meetings. The banks derive their strategic advantage in these meetings not only from direct holdings of equity but also from proxy votes from client shareholders.
• banks' representation on firms' supervisory boards
• the underwriting of new share issues of large listed stock corporations.
In Germany, this is often concentrated in the hands of few big banks that have an informational advantage over potential competitors with no relationships whatsoever to the companies.
24

Bank-based systems
The abuse of these and other instruments of power in bank-based systems is widely held responsible for
• outdated structures,
• high costs
• a great deal of red tape that deter investment and make venture capital scarcely available, thereby adding considerably to the structural weaknesses of the economy.
In bank-based systems, corporate governance and control is largely exerted behind closed doors; for example, changes through a stock-market takeover, as in Anglo-
Saxon countries, are rare.
25

Market-based systems
... in general, their superiority is reflected in performance:
Table 3.18: Profitability of Major Banks in International Comparison
*
US (10)
UK (4)
France (4)
Germany (4)
Italy (6)
Spain (4)
Sweden (4)
Switzerland (2)
Pre -tax Profits
1.66
1.11
0.58
0.05
0.48
0.93
0.70
0.08
Net Interest Margin
3.11
2.02
1.03
0.80
2.16
2.66
1.48
0.84
* In 2002, as percentage of total average assets
Number of banks included in parentheses
Source: BIS.
26

Market-based systems
However, again, these arguments have to be put into perspective:
Even in market-based systems, shareholders' rights rarely go beyond electing directors, and no mechanism ensures that managers do not pursue their own interests.
27

Market-based systems
Both bank-based and market-based systems have advantages and disadvantages:
28

Table 3.19: Bank-based versus Market-based Systems
Bank-based Systems
Relationship Finance
Advantages:




Cooperative behaviour
Intertemporal smoothing
Information
Long-term planning horizons
Disadvantages:




Intransparency
Inefficient corporate governance
Inefficient pricing
Low competition
Market-based Systems
Arm's-length Finance
Advantages:

Transparency

Efficient pricing

Efficient risk allocation

High competition
Disadvantages:

Short-sightedness

Dependence on fads and fashions

Dependence on analysts

Low management liability
29

Bank-based and market-based systems
Inefficiencies are found in both of them:
30

Table 3.20a: Sources of Inefficiencies in Bank-based and Market-based Systems I
Feature
Asymmetric
Information
Adverse Selection
General Description In Bank-based
Systems
One person or one group of people knows more than another.
Borrowers know more about the repayment prospects for a loan than the banks.
With imperfect information, discrimination between underperforming and overperforming actors is not possible.
Average conditions favour the former and put the latter at a disadvantage. Result: underperformers will dominate.
Bad borrowers take out loans, good borrowers will find them too expensive.
Result: The overall riskiness of banks' credit portfolios is too high compared to returns.
In Market-based
Systems
Management knows more about the firm's performance than analysts and shareholders.
Badly performing firms face a higher demand for their shares, higher liquidity and better financing conditions than justified under full information.
Better performing companies face worse conditions than expected and thus are driven out of the market.
31

Table 3.20b: Sources of Inefficiencies in Bank-based and Market-based Systems II
Feature
Moral Hazard
General Description In Bank-based
Systems
Initially, a market failure associated with the provision of insurance: someone who has insurance or enjoys another form of protection against bearing the full consequences of a decision may take greater risks than otherwise.
Agency Cost Whenever a person (the principal) hires somebody else (the agent) to carry out a task, conflicts of interests may arise for the latter. This is a principal-agent-problem where costs arise for the principal from the agent acting selfishly.
In a system with deposit insurance, or central banks willing to act as lender-oflast-resort, banks may be more willing to take risks than otherwise in search of higher returns.
Under insufficient monitoring dealers may become tempted to take more risks than justified in search of profits and promotion.
In Market-based
Systems
Managers not wholly liable for the consequences of their decisions may be more willing to take risks than otherwise.
A principal-agentproblem may arise in the relationship between shareholders or firm owners and managers if owners want managers to run the firm maximising share values, while managers' priorities are elsewhere.
32

Financial systems
33

Financial systems
34

Financial systems
35

Financial systems
36

Financial systems
They differ from other market participants above all in two respects:
•
They are answerable not only to shareholders, but
– as they are not as anonymous as other private shareholders – also in a sense potentially to public opinion.
• In contrast to other shareholders exit is rarely an option.
• As a consequence, they have begun to cultivate a constant dialogue with the companies (capitalism of voice).
37

Financial systems
In these countries, the nature of the financial system is less important than the overall economic and institutional environment allowing generation of profits that may be used for this purpose.
However, studies have shown that this does not necessarily hold true for emerging economies ...
38

Financial systems
39

Financial systems
Malta
Cyprus
Poland the Czech Republic
Estonia
Hungary
Latvia
Lithuania
Slovakia
Slovenia
Bulgaria and Romania are expected to follow in 2007.
40

CEEC financial systems
Their membership will alter rules and regulations in these countries and intensify competition and structural transformations with repercussions on western markets and systems.
41

CEEC financial systems
42

Table 3.21a: Comparison of Financial Systems in "Old" and "New"
EU Member States I
Banking

Historic experience

Role of banks

Foreign ownership
Equity Markets

Stage of development

Privatisation

Market capitalisation

Market dynamism
CEEC
Single-tiered system, planned economy, monobanks providing loans based on decisions
EU
Two-tiered structure of central bank and commercial banks, market economy. in planning bureaux.
Low degree of monetisation, low High degree of monetisation/bank bank penetration. penetration.
High penetration of foreign banks. Low penetration of foreign banks.
Highly developed. Underdeveloped, delistings in favour of listings abroad not uncommon.
Vouchers, management and employee buy-outs, initial public offerings.
Initial public offerings, mergers and acquisitions.
Low. High.
High at first. Low.
43

Table 3.21b: Comparison of Financial Systems in "Old" and "New"
EU Member States II
Bond Markets

Government debt

Corporate debt
Common Institutions
CEEC
Low level of available securities.
Negligible, crowded out by banks, preferences for listing abroad.
Developing with EU integration.
EU
Deep and liquid internal and external markets.
Growing internal and external markets.
Monetary Policy

Main transmission channel of monetary policy

Monetary regime
Exchange-rate channel
Hard and soft currency pegs, floating
Common regulatory framework,
Single-Market Program, FSAP.
Interest-rate channel
Exchange-Rate Mechanism, common currency
44

CEEC financial systems
• transformed from a single-tiered system under the communist rule of the late 1980s, where the state bank had a quasi-monopoly on banking and credit, to a two-tiered one.
•
Bank legislation along the lines of the EU rules has been implemented everywhere.
• In all countries, except Slovenia, major banks have been privatised.
•
Foreign banks have entered the region's markets, buying domestic banks and stepping up retail networks where these already existed.
• In Hungary, Bulgaria and the Czech Republic, foreign banks hold a share of between 60 and 70 percent of total bank assets; in Slovakia the share is even higher.
45

CEEC financial systems
•
The degree of monetisation in these countries is low compared to EU standards. In 2002, money in circulation plus deposits in the CEEC as a percentage of GDP was only about two-thirds the EU level.
•
Bank intermediation, measured as bank claims on the domestic sector as a percentage of GDP, is about one third of the respective
EU measure.
• The use of bank accounts is less widespread than in western Europe.
This is the case for Bulgaria and Romania in particular, where less than 10 percent of the population have bank accounts; even in
Poland the share is only 34 percent, while in Slovenia it is close to 80 percent.
•
The difference between old and new member states is even greater for the total of bank assets. While in the euro area, bank assets amount to 265 percent of GDP, in the CEEC they range from 30 to 100 percent.
46

CEEC financial systems
•
In contrast to many other countries, in the CEEC, foreign investors control a large part of the banking sectors.
•
Advantages: import of capital and know-how,
• assistance in establishing best practices in bank business,
• strengthening of competition,
• enhancing of financial sector restructuring and adjustment to international standards.
• Disadvantages: in many cases, foreign-owned institutions in these countries have lost important functions in recent years as trading and other key activities were shifted to the investors' headquarters,
• danger of disinvestment as a result of a worsening domestic environment or a change in the owner's commercial strategy, as has already occurred in a few cases.
47

CEEC financial systems
• In the first few years of their existence exchanges in eastern Europe showed high market dynamics,
• measured as growth in market capitalisation, traded value and number of listed companies they clearly outperformed not only those in developing countries outside Europe but also western European exchanges:
48

Table 3.22: Stock Market Dynamics in Eastern and Western Europe in International
Comparison
1
Rank in
Europe
1
15
16
17
18
19
20
2
3
4
5
6
11
12
13
14
7
8
9
10
Market
Capitalisation
United Kingdom
(3)
France (4)
Germany (5)
Italy (7)
Romania (2)
Belgium (5)
Latvia (6)
Switzerland (9)
Spain (11)
Slovenia (9)
Greece (12)
Netherlands (12) Poland (15)
Sweden (15) Finland (16)
Finland (18) Iceland (17)
Belgium (20) Malta (18)
Denmark (26)
Greece (27)
Ireland (29)
Norway (32)
Portugal (29)
Cyprus (19)
Ireland (25)
Italy (27)
Turkey (34)
Portugal (35)
Poland (39)
2
Highest Growth in
Market
Capitalisation
3
Bulgaria (1)
France (29)
Hungary (31)
Spain (33)
Austria (40) Portugal (34)
Luxembourg (42) Germany (38)
Hungary (47) n.a.
Highest Growth in
Value Traded
3
Romania (2)
Iceland (4)
Latvia (5)
Finland (6)
Cyprus (8)
Bulgaria (12)
4
Italy (13)
Greece (15)
Lithuania (16)
France (19)
Portugal (20)
Malta (23)
Spain (24)
United Kingdom
Highest Growth in
Number of Listed
Companies
3
Romania (1)
Bulgaria (2)
Spain (4)
Cyprus (5)
Poland (9)
Finland (13)
Malta (14)
Iceland (16)
Latvia (17)
Slovenia (19)
Greece (27)
Germany (29)
Turkey (31)
Hungary (37)
(26)
Netherlands (28) Sweden (41)
Hungary (30)
Sweden (37)
Turkey (38)
Denmark (41)
Slovenia (42)
Switzerland (42) n.a. n.a. n.a. n.a.
1 World rank in parantheses.
2 End of 2001.
3 In dollar terms, percentage increase
1996-2001.
4 1998-2001.
Source: The
Economist (2004):
Pocket World in
Figures, London.
49

CEEC financial systems
However, market capitalisation in the CEEC remained low.
The combined annual turnover on the stock exchanges of Prague,
Budapest and Warsaw is said to equal that on the Frankfurt stock market in ten trading days.
In an international context, only the markets of Poland and, to a lesser extent, the Czech Republic and Hungary, play some role.
The dire state of the exchanges makes it easy to forget that before
World War II some countries had vibrant financial markets and a long tradition of stock trading: in Warsaw, the first exchange was established in 1817, in Budapest in 1864.
50

CEEC stock markets
51

CEEC stock markets
Table 3.23: Privatisation in Central and Eastern European Countries
Country
Bulgaria
Czech Republic
Estonia
Hungary
Latvia
Privatisation Strate gy
Mass privatisation
Mass privatisation
Initial public offerings
Initial public offerings
Initial public offerings
Lithuania
Poland
Romania
Slovakia
Mass privatisation
Initial public offerings
Mass privatisation
Mass privatisation
Slovenia Initial public offerings
Source: Caviglia, Giacomo, Krause, Gerhard and Christian Thimann (2002): Key Features of the Financial
Sectors in EU Accession Countries, in: Christian Thimann (ed.) (2002): Financial Sectors in EU Accession
Countries, Table 1, http://www.ecb.int/pub/pdf/other/financialsectorseuaccessionen.pdf
52

CEEC stock markets
• voucher privatisation,
• management and employee buy-outs and
• initial public offerings including direct sales to strategic investors.
In countries with mass privatisation schemes, such as Bulgaria, the
Czech Republic, Lithuania, Romania and Slovakia, at first a large number of companies were listed rapidly, but liquidity remained low and corporate governance structures were insufficient as the result of widespread ownership. The consequence was an equally rapid delisting.
In countries where privatisation took place in the form of initial public offerings, such as Estonia, Hungary, Latvia, Poland and Slovenia, firms were only listed after a framework for securities trading had been established.
53

CEEC bond markets
• are dominated by government bonds and
• still small, accounting for between five and 20 percent of GDP, compared to an average of 50 per cent in the euro zone.
Even in the Czech Republic, where the non-government bond market is larger than the government market, liquidity is higher in the latter.
• In many countries, government bonds are mostly bought and held until maturity.
Liquid secondary markets exist only in the Czech Republic, Hungary and
Poland.
• In recent years, foreign currency-denominated bonds have gained significance.
Spreads on these instruments have fallen considerably against the background of reforms and the prospects of EU accession.
54

CEEC foreign exchange markets
This particularly holds true for countries with a currency board arrangement:
55

CEEC foreign exchange markets
Currency Board Arrangements
•
• exist in countries as diverse as Argentina, Hong Kong and Estonia; widely regarded as a strategy to prevent or withstand foreign exchange market speculation;
• strongly limit the scope of monetary policy.
• A currency board is a constitutional guarantee of a currency's foreign value which goes beyond a mere fixing of the exchange rate and comprises explicit restrictions on the government's ability to print money.
• Currency can be issued only in exchange for the foreign currency against which its rate had been fixed – which may be another currency such as the euro or the US dollar, or a basket of currencies.
• The advantage of such a system is credibility: the central bank can no longer provide free liquidity to banks; financial sector reforms which are otherwise difficult to implement will be forced and discretion will be removed from corrupt and incompetent economic managers.
56

CEEC foreign exchange markets
Table 3.24: Currency Regimes in Central and Eastern Europe
Country
Bulgaria
Czech
Republic
Curre ncy Re gime
Lev
(BGL)
Koruna
Currency board arrangement based on the euro
Managed float
Estonia
(CZK)
Kroon
(EEK)
Currency board arrangement based on the euro
Hungary Crawling peg based on the euro
Latvia
Lithuania
Poland
Romania
Forint
(HUF)
Lats
(LVL)
Litas
(LTL)
Zloty
(PLN)
Lei
(ROL)
Currency peg based on SDR (39% US dollar, 32% euro,
18% yen, 11% pound sterling)
Currency board arrangement based on the US dollar
Floating
Managed float, segmented foreign exchange market
Slovakia
Slovenia
Koruna
(SKK)
Tolar
(SIT)
Managed float
Managed float
57

CEEC foreign exchange markets
After EU entry, the countries are obliged to wait for a transition period of two years before joining the euro.
So far, Poland and Slovakia are planning to adopt the common currency in 2008, while the Czech Republic and Hungary are aiming for 2009/10; during this period, their currencies will be exposed to a heightened risk of speculative attacks.
58

CEEC foreign exchange markets
when in December 1991 the leaders of the 12 EC countries met at
Maastricht in the Netherlands to negotiate a treaty on the European
Union, they not only set out a detailed timetable for economic and monetary union (EMU) but also convergence criteria for economies wanting to join in EMU:
59

CEEC foreign exchange markets
The convergence criteria are five conditions countries must meet before taking part in full economic and monetary union. These are:
• Inflation must stay below 1.5 percent above the average inflation rate of the lowest three inflation countries in the EU.
•
Their long-term interest rate should be no more than two percent above the average of the three countries with the lowest inflation rates.
•
Budget deficits must not exceed three percent of GDP.
• National debt must not exceed 60 percent of GDP.
•
Exchange rates should have been within the 15-percent fluctuation range from parity of the Exchange Rate Mechanism (ERM) without realignments for at least two years.
60

CEEC foreign exchange markets
Experience with former enlargements demonstrates that crises need not occur despite major weaknesses in accession countries' economic performance before entry. A look at the performance of old and new member countries shows that large deviations from the criteria before the beginning of the transition period were not unusual:
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CEEC foreign exchange markets
Table 3.25: Budget Deficits and Debt before EMU
1
Country
Italy
Spain
Portugal
Greece
Czech Republic
2
Estonia
2
Hungary
2
Latvia
2
Lithuania
2
2
Poland
Slovakia
2
Slovenia
2
1 As percentage of GDP.
2 Preliminary.
Year
1994
1994
1994
1994
2002
2002
2002
2002
2002
2002
2002
2002
Budget Deficit
-9.1
-6.6
-6.0
-7.4
-3.9
+1.3
-9.2
-3.0
-2.0
-4.1
-7.2
-2.6
Source: The Economist, country data.
Public Debt
124
66
64
111
27
6
56
15
23
42
43
28
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CEEC foreign exchange markets
The prospect of joining the common currency may help to force governments into fiscal discipline, as happened in Spain,
Portugal and Italy.
On the other hand, much depends on the nature of the budget deficits: in Portugal and Italy, for example, these were mainly caused by high interest payments on public debt whose reduction was easy to justify and to achieve with the prospects of declining interest rates in the course of monetary unification.
CEEC deficits are largely due to high social spending, investment and tax reductions, which are much harder to reduce.
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• In recent years, the rationale for the existence of financial institutions has altered with a greater emphasis on the ability to distribute risks.
•
Traditionally, a distinction is made between bank-based and market-based financial systems.
• Bank-based systems are characterised by relationship finance and cooperative behaviour between borrowers and lenders.
•
Market-based systems provide arm's length finance with bond and equity markets playing an important role.
•
Financial systems in the "new" EU member states from Central and Eastern Europe are characterised by a low degree of monetisation and underdeveloped banking sectors.
• Equity markets in CEEC countries showed high dynamism in the first years of their existence but market capitalisation remains low.
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