COMMENT: Euro enlargement proceeding at snail's pace

By bne IntelliNews July 25, 2008

Werner Becker of Deutsche Bank Research -

From the start, European monetary union (EMU) was conceived with the idea that as far as possible, all EU member states would participate if they met the convergence criteria and had the political will to take this step.

Under the "acquis communautaire," the 12 new EU member states have committed to adopt the euro once they meet the convergence criteria. So, unlike the UK and Denmark, they have no exemption status. Even though the new EU countries can expect a significant growth boost from monetary participation, apart from the four countries mentioned there are no further entrants in the offing in the foreseeable future. This is because the convergence criteria have as yet not been met and/or there is little political interest in introducing the euro.

As far as convergence is concerned, an important factor for the countries that joined the EU in May 2004 is first of all the exchange rate criterion that stipulates the currency's tension-free participation in ERM II for at least two years. Thus, 2007 was the earliest date for EMU participation by the new EU member states. Joining ERM II can thus be seen as a sign of the political will to adopt the euro. Leaving aside the exchange rate criterion, since 2007 the Achilles heel for the convergence test has been primarily inflation (for all countries except Poland and Slovakia) and the budget deficit (for Hungary). Hungary is still some way from meeting most of the convergence criteria. While the higher inflation rate is an entry hurdle for the three Baltic states (and for Bulgaria and Romania), Poland and the Czech Republic lack the political will at present. An argument for the hesitancy is the fact that in the economic catch-up process, in full swing for some years, there is still the need for an autonomous monetary and exchange rate policy as an adjustment instrument.

New controversial debate over convergence criteria

Future EMU entry has also sparked a controversial debate about whether the admission of the new EU member states would necessitate a modification of the convergence criteria of low inflation rates, interest rate convergence, budgetary discipline and exchange rate stability. So far the principle of equal treatment of all candidate countries, necessary for political reasons, has been applied. Nonetheless, it should be permissible to consider what can or needs to be improved in light of the experiences over the past 10 years, whereby the focus is on the inflation and budget criteria.

The trigger for this debate was Lithuania which, together with Slovenia, had applied in 2006 for EMU membership in 2007, but whose application was rejected on the inflation criterion, which it only just failed to meet. However, in Lithuania's case it would have been short of the mark if, in 2006, the inflation rate for the previous 12 months had been compared purely mechanistically with the reference value (ie. the average inflation rate of the three most price-stable EU member states plus 1.5%). The low inflation rates must also be sustainable. This was not the case, however, as the rise in inflation to 5.8% in 2007 subsequently indicated. In this connection it was argued that in the convergence test for the new EU countries one should depart from the relative definition of the inflation criterion and take the ECB's inflation definition as the benchmark. The relative definition of the inflation criterion has the drawback that the three EU member states with the lowest inflation rates do not even have to be EMU participants and the average of the best three countries is systemically lower today than it was 10 years ago. This objection is justified. The inflation criterion should therefore be reviewed.

It makes sense to take the Eurozone's established benchmark and use the ECB's definition of price stability - inflation rate below but close to 2% − as the basis for the reference inflation rate. However, a problem is that the reference value (just below 2% plus 1.5 percentage points) would be over 3% and would no longer be compatible with price stability. But if the benchmark were defined as just below 2% plus a margin, eg. of one percentage point, then the inflation criterion could be adequately considered. At the same time, the Balassa-Samuelson effect, which explains the structurally higher inflation in the new EU member states, could be taken into account. It should be possible politically to reach a consensus on such an adjustment and modify the rules in a similar way as with the adoption of the rotation principle for the ECB. However, if it requires a revision of the EU Treaty with all the associated ratification procedures, this would probably mean that the inflation criterion will stay as it is.

There has also been criticism of the budget criterion. It has been argued that the new EU countries need a fiscal policy that could be managed more flexibly than provided for in the reformed stability pact, which retains the 3% of GDP deficit limit. It has even been demanded that the 3% limit should be lifted altogether for the new EU countries. However, this would be a massive breach of the principle of equal treatment. Moreover, it should not be forgotten that in the fast-growing new EU countries an expansive fiscal policy would tend to lead to higher inflation rates rather than higher growth rates. Finally, most of these countries have demographic problems that require a forward-looking, solid fiscal policy. The goal conflicts between nominal and real convergence have also been a subject of controversial debate. The convergence criteria are based on nominal convergence. Real convergence, on the other hand, is understood as the catch-up process in the new EU countries that, through higher growth, brings them closer into line with per capita income in the old EU member states. This process has been intact for years. However, there is occasional criticism that nominal convergence and real convergence are not compatible, for instance because the necessary price stabilisation would have to be bought at the expense of growth. Real convergence should therefore have priority. In the short term this can cause a goal conflict. Given the wide gap in per capita income, which in the new EU countries was between 40% and 90% of the EU average in 2007, such an approach would push EMU participation into the distant future for quite a few new EU countries. The call for real convergence should not be allowed to place an added obstacle in the way of the new EU countries' accession to EMU. Moreover, the rules require that the progress in single market integration, the current account position and trend, the development of unit labour costs and other price indices are considered in the convergence review process. Finally, structural reforms and deregulation should be undertaken during the catch-up process in order to dismantle price distortions and to strengthen growth and the resilience to asymmetric shocks within EMU. Nominal and real convergence should proceed in parallel despite possible tensions.

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