The fading figure of the euro

By bne IntelliNews November 1, 2006

Robert Anderson in Prague -

A combination of local politics, enlargement fatigue and simple economics means the new EU member states are pushing back their target dates for adopting the euro from the end of this decade to the middle of next.

Central Europe has fallen out of love with the euro. Partly by choice but largely through necessity, the new member states of the EU are pushing back their target dates for adopting the euro as their currency from the end of this decade to the middle of the next.

Hungary – which once planned to exchange the forint for the euro this year – is now unlikely to make the switchover before 2014, later than Bulgaria, which will not even join the EU until next year.

The Czech Republic and Poland are now looking at 2011 or later, while even the Baltic States have abandoned their initial plans to join shortly after EU accession and are aiming for the end of this decade.

Only Slovenia and Slovakia appear able to keep to their timetables. Slovenia will adopt the euro next January, while Slovakia is still on course to join in January 2009 despite worries over the new left-wing government's spending plans.

Moving Targets

At the same time as the new members redraft their convergence programmes, the existing Eurozone members are becoming less welcoming to potential entrants. Partly this reflects Western Europe's general disillusionment with enlargement, but even more important are the problems of the Eurozone itself. The European Central Bank (ECB) is having quite enough trouble handling existing members of the Eurozone – notably Italy and Portugal – that are breaching the requirements of the stability pact.

Eurozone countries, and the ECB, fear that new members will struggle even more to keep within the rules of the pact. ECB board members have repeatedly emphasised that new entrants must comfortably meet the criteria and be able to continue to do so without difficulties.

This explains the ECB's decision in May to block Lithuania from adopting the euro next January, even though its inflation rate was just 0.07 percentage points above the limit. The ECB's decision was a warning to other entrants that accession to the Eurozone will not be a shoo-in.

All the Baltic States and Slovakia face a serious inflation hurdle to qualify for the euro. Extremely low inflation in several EU countries – including some not even in the Eurozone – has dragged down the average reference rate that new entrants have to keep below.

Meanwhile inflationary pressures in the European economy are growing, particularly in Central Europe, which is experiencing a consumer boom accompanied often by unsustainable wage rises.

Price convergence is inevitable as the economies of the Baltic States and Slovakia grow rapidly towards Eurozone levels. This convergence can come though the exchange rate or inflation, but the Baltic States already operate currency boards that effectively fix the currency rate against the euro, leaving inflation as the main outlet.

For the larger states of Central Europe the main hurdle is keeping their government budget deficits below 3% of gross domestic product (GDP). Poland, the Czech Republic and Hungary have all shirked fundamental reform of the public finances and are now paying the price. Hungary's deficit is forecast to hit 10% of GDP this year and its public debt is around 60% of GDP, another convergence limit.

In recognition of these economic problems, Central Europe has been forced to abandon its overly optimistic adoption target dates. However, the economic problems themselves have also led to a change of mood among the region's political elites.

Reform fatigue

Central European politicians are aware of the public's ebbing support for EU membership and reform in general since accession, and have begun putting their own interests first. They have started acknowledging publicly the difficulties of joining the euro and that, on balance, the costs may outweigh the benefits, at least in the short term. In the Czech Republic, where President Vaclav Klaus was an early opponent, opinion polls now show a majority opposed to the euro.

"Populations are sick of reform and being told to do painful reforms," says Charlie Robertson, chief emerging markets economist at ING Bank. "And politicians are sick of being thrown out at every election. Politicians are turning to populism in order to stay in power."

Political turbulence has reinforced this shift in mood. Governments in the region are often fragile and typically have been thrown out after a single term if they try to implement reforms. In recent months the coalition in Poland collapsed only to re-form, while in Hungary huge demonstrations called for the resignation of the premier for lying over the desperate state of public finances. The Czech Republic has been without a proper government five months after a general election, delaying the crucial decisions necessary to keep to the 2010 timetable.

This political turbulence has encouraged politicians to put off tough economic decisions. Fiscal deficits have ballooned as weak governments give up trying to slash public spending and instead make populist handouts to voters.

None of the Central European governments -- except Slovakia -- is aggressively seeking early euro entry and there are doubts whether Slovak premier Robert Fico is prepared to sacrifice his manifesto promises in return for adopting the euro.

Rightwing parties, lukewarm to the euro and sceptical of the EU in general, have won power in Poland and the Czech Republic, while populists have entered coalitions in Slovakia and Poland. Right across the region former supporters of the euro are having second thoughts.

Premature accession

Once the ability to set interest rates is surrendered to the ECB and exchange rate flexibility is lost through the adoption of the euro, new entrants to the Eurozone can only use fiscal policy to control the pace of economic growth and price convergence.

For the fast growing economies of Central Europe and especially the Baltic States this raises two dangers: either price levels will adjust to Western European levels without a corresponding increase in productivity, making business uncompetitive; or the government has to run a restrictive fiscal policy to control inflation and keep within the stability pact limits, hurting growth and preventing investment in the infrastructure necessary for real convergence with Western Europe.

Politicians are also beginning to realise that their countries have already achieved most of the gains from the convergence process and that the markets won't punish them for taking their time to cross the finishing line.

All many countries have left to gain from euro entry are lower transaction costs and removal of currency risks. The clearest example of this is the Czech Republic, which has already effectively converged with the Eurozone in terms of interest rates and bond spreads.

"The added value of joining the Eurozone is lowest for the Czechs among the new members," reckons Roman Swanton of DWS Investment.

Huge financial flows from convergence funds, which made it easy to issue debt at low interest rates to fund deficits, have given states the benefits of convergence before it has actually been accomplished.

"Convergence trade itself has stopped convergence," says Robertson. "As soon as you start betting on the convergence trade, convergence stops."

Nor will the financial markets punish delay because many foreign investors are benefiting from the appreciation of the Central European currencies and hope it continues for long to come.

However, this could change, especially if the global economic conditions turn unfavourable. "Piling up of problems could create a critical mass and then we could see an over-reaction in the market," warns Lars Christensen, head of New Europe research at Danske Bank.

That is why many believe it's vital that Central Europe continues to prepare for euro entry as if it were about to enter the Eurozone. Governments must reform public spending and improve the competitiveness of labour and industry, because fiscal policy will be the only tool available after entry and competitiveness will determine how well the economy performs inside the Eurozone. If public spending remains bloated by social programmes, it cannot be used for economic fine-tuning; and if the labour market remains inflexible, rising wage costs will lead to unemployment.

"When an economy surrenders interest rate and exchange rate policy tools, it is very important that the other tools function well. Otherwise, when the boat runs into trouble you have no steering wheel," says Viktor Kotlan, chief economist of Ceska Sporitelna in Prague, who argues fiscal and labour market reform must take priority. "We should learn how to play golf before we apply to join the golf club."

The danger is that, by putting off euro entry, Central Europe will also delay reform and it may be many years before the ECB judges they are ready to join. "Delay is a good thing if prudent policies are put in place but that is highly unlikely," says Christensen. "When you abandon euro membership you abandon reform."

Send comments to: Robert Anderson

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