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backEUROtalk February, 2005

Central Europe faces rocky road to Euro

The ten countries that acceded to the European Union (EU) on May 1, 2004 are all expected to adopt the euro by 2010–11.

In order to adopt the euro, they must first meet the criteria on inflation, interest rates, fiscal deficits, national debt, and exchange rate stability that were laid out in the 1992 Maastricht Treaty. Inflation must be below the “reference value,” with the rate of consumer price inflation not exceeding the average in the three best-performing EU member states (excluding those countries with negative inflation) by more than 1.5 percentage points.

Likewise, average nominal long-term interest rates must be no higher than 2 percentage points above the three best-performing member states. The public finance deficit must be less than (or in some cases only slightly above) 3% of GDP, while public debt must be below 60% of GDP. Prior to entering the Eurozone, each country must join the Exchange Rate Mechanism-II (ERM-II), which serves as an EMU waiting room.

Upon entry to the ERM-II, a country pegs its currency to the euro, keeping the exchange rate within 15% of its central rate. A country must remain in the ERM-II for two years, without a currency devaluation, before being allowed to adopt the euro.

The EU does not view these criteria symmetrically. Downward movements in the exchange rate are more tolerable than upward movements. One criterion that is somewhat flexible concerns public debt, as countries with debt over the 60% limit have been accepted to the Eurozone in the past, so long as the overall share was declining. In any case, Eurostat data published in September 2004 showed that all eight of the Central and East European (CEE) member states fulfilled the public debt criteria as of 2003, although Hungary's public-debt-to-GDP ratio was uncomfortably close to the limit, at 59.1%.

Three of the new CEE member states entered the ERM-II on June 28, 2004, with Estonia, Slovenia, and Lithuania hoping to adopt the euro in 2007. Although all three countries are expected to successfully complete the ERM-II process, potential pitfalls do exist.

Slovenia is the richest of the three and is in good position to adopt the euro. While the country's fiscal deficit meets the Maastricht criteria, Slovenia's rate of inflation is above the limit, averaging 3.6% in 2004, as measured by the EU's Harmonized Index of Consumer Prices. Nonetheless, Global Insight expects that average annual inflation will fall below 3.0% in 2006 and remain around 2.4–2.5% in 2007–09. Still, there is a risk that inflation will be slightly higher than necessary for Slovenia to leave the ERM-II and adopt the euro by 2007.

Lithuania and Estonia, while much poorer than Slovenia, are in nearly as good a position to succeed with the ERM-II process. Both countries' fiscal deficits are well below 3% of GDP, although inflation, particularly in Estonia, may be slightly above the reference value, depending on inflation trends in the EU's best performers. Moreover, Estonia's high current-account deficit (estimated at more than 11% of GDP in 2004) may be cause for some concern. In contrast, Lithuania's current-account deficit is lower than that in Estonia, below 8% of GDP last year.

The five other CEE countries that joined the EU all have problems that will prevent them from adopting the euro in the near term. While Latvia's accession to the ERM-II is delayed due to high inflation, for Poland, Hungary, the Czech Republic, and Slovakia the biggest obstacles relate to public finances. Slovakia is now on track to reduce the deficit to the 3.0% level by 2006–07; in the other three countries, additional reforms will be required before that target is reached. We expect that Latvia will join the Eurozone in 2008, followed by Slovakia in 2009.

The fiscal situation is particularly worrisome in Hungary, as the government has consistently overshot its budget deficit targets. Poland will also have a difficult time bringing its finances into accordance with the convergence program requirements.

According to ESA-95 methodology, Poland's general government deficit has been estimated at 5.4% in 2004, and a gradual reduction to 3.2% is envisaged by 2006. The Polish government plans to comply with the Maastricht budget criterion for the first time in 2007, with Eurozone membership as early as 2009. But in its latest assessment of the EU member states' convergence programs, released on February 2, the European Commission (EC) pointed to several risks in meeting that goal.

For one, the EC criticized the Polish government's decision to relax its budget-deficit target for 2007, raising it from 1.5% of GDP in the original version of the convergence program issued in May last year to 2.2% in the December update. The deficit target was increased even though the cabinet projects that GDP growth will rebound to 5.6% in 2007, after reaching 5.0% in 2005 and 4.6% in 2006.

Moreover, the EC has argued that keeping the semi-private, open-ended pension funds (OPF) within government accounts is not compatible with fiscal accounting required by the Maastricht convergence criteria. Removing the OPF from the fiscal budget would immediately raise Poland's deficit by 1.5% of GDP each year, thus making the fulfillment of the Maastricht criterion quite unlikely any time soon unless stricter reform efforts are enacted. But in contrast, the Polish parliament recently voted against full enactment of key measures of a plan for fiscal reform, thereby reducing the scope of saving gains for the budget to about half of the original target. Poland's target year of 2009 for euro adoption seems increasingly unlikely to be realized. Global Insight sees 2010–11 as a more realistic scenario.

Similarly, Hungary and the Czech Republic are equally unlikely to accede to the EMU until 2010–11, and that date may be pushed back even further for political reasons. While it makes sense for small countries such as the Baltic states and Slovenia to accede to the Eurozone as soon as possible, some politicians and economic analysts in the Central European countries are more hesitant.

In the Czech Republic, for example, a victory for the opposition Civic Democrats (ODS) in the 2006 parliamentary elections would likely lead the country to meet the Maastricht budget deficit criteria more quickly than under the current leadership, although the euroskeptic approach of the party may nevertheless contribute to further delays in joining the EMU.

Source: GlobalInsight - GAI

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