COMMENT: Euro entrant Slovakia well positioned due to sound policies

By bne IntelliNews August 11, 2008

Gunter Deuber of Deutsche Bank Research -

Slovakia made the grade to join the euro as of January 2009 on a performance that was comfortably within all Maastricht criteria. However, euro adoption will be just another step on the long road to catching up with core Eurozone members, as EMU membership is no carte blanche for smooth economic development. Portugal suffered a prolonged crisis as EMU member. In Slovenia, inflation picked up strongly. In Slovakia's case, the sustainability of inflation convergence is less in question, although the need for future price adjustments is substantial.

Slovakia is the poorest EMU entrant to date. However, the competitive environment should contain inflationary pressure stemming from price level convergence. Following an economic crisis at the end of the 1990s, the country has become the leading reformer in the region. In a comparison of recent EMU entrants, Slovakia has the best competitiveness indicators. Labour costs are lower than in all other Central and Western European countries. Productivity gains have constantly been larger than wage gains. Moreover, the overall market orientation is high, as reflected in a low level of state interference. Government expenditure totals 36.9% of GDP, a reading below that of all EMU peers. Moreover, Slovakia had its own well-balanced growth dynamics before its bid for EMU entry. As Slovakia displayed a meagre interest rate differential vis-à-vis Eurozone rates in recent years, there was no exceptional (mortgage) credit boom due to a drastic fall in real interest rates driven by overly optimistic EMU expectations (which in the case of Portugal turned into negative real interest rates). Furthermore, Slovakia will most likely enter EMU at a more favourable juncture than Slovenia did. The latter joined EMU in a period of elevated global inflationary pressure due to jumping energy and food prices. Considering the deteriorating global growth outlook, inflationary pressures should be easing until Slovakia adopts the euro.

Nevertheless, a slight uptick in Slovak inflation will be inevitable after EMU entry. The exchange rate will be fixed, while the price level of final household consumption is 63% of the EU27 average. In recent years the appreciation of the Slovak korun, which has continued within the Exchange Rate Mechanism II (ERM II), has averted inflationary strains deriving from the price-level catch-up. According to the Slovak National Bank, a 1% appreciation vis-à-vis the euro has lowered inflation by 0.1 to 0.2 percentage points in recent years - with the annual appreciation amounting to 6% on average since the year 2000. Thus, the strong koruna revaluation (including the recent parity change) within the ERM II representing gains of around 20% will provide a cushion. The koruna recorded the strongest-ever revaluation within the ERM II. In Slovenia's case, the central parity remained unchanged. For Greece and Ireland, revaluations within the ERM stood at 3.5% and 3% respectively. The European Central Bank (ECB), which was rather critical early this year in its assessment of the sustainability of inflation convergence in Slovakia, advocated a koruna revaluation of the given magnitude. In reality, the state of the Slovak economy will not concern the ECB much with respect to monetary policy. The GDP-based contribution to Eurozone aggregates will be around 0.7%. However, as all EMU outsiders in CEE are unlikely to make it into the club soon, there are some interesting points to learn from Slovakia's smooth entry:

* Firstly, reforms pay off. Euro adoption is not only a political issue but a vote for market reforms. Nevertheless, a coherent euro strategy helps to keep euro adoption politically on track. This holds true at both the domestic and the European level. Conflicts among national elites regarding EU integration or the use of EU issues as scapegoat are not supportive at either level.

* Secondly, EMU entry is possible despite a reluctant assessment by the ECB. However, such a scenario is only feasible if the candidate has a reform track record as well as viable political support at the EU level.

* Thirdly, the EU is always inclined to stick to "old" procedures as long as possible. Thus, only one or two realignments of the central parity within ERM II look feasible, while the second realignment will set the final conversion rate. Therefore, the timing of ERM II entry should be well chosen.

* Finally, Slovakia's EMU entry was well timed "by chance", as it can be considered a pro-European decision. In view of the unexpected Irish "No" on the Lisbon Treaty as well as evidence that other member states (eg. Poland) are reconsidering their ratification, a rejection of the Slovak EMU bid at the very last moment would have dealt a blow to European integration and the EU's image in CEE. This is where the political component comes back into play, as the ECB has no formal say in enlarging the euro club.

Although Slovakia's euro entry contains a political element, it seems completely justified from an economic point of view. The overall competitive environment should prevent inflation from skyrocketing and protect the country from a loss in competitiveness after euro adoption.

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