Thinking the unthinkable
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Emerging Markets

Thinking the unthinkable

The vision of an enlarged eurozone is coming unstuck. Amid signs of overheating, many eastern European economies look less likely than ever to meet their targets for joining the single currency

By Philip Alexander


The vision of an enlarged eurozone is coming unstuck. Amid signs of overheating, many eastern European economies look less likely than ever to meet their targets for joining the single currency


Overheating domestic demand and property markets, central banks intervening to beat back currency speculators, and widening current account deficits. This may sound like the disintegration of the European Exchange Rate Mechanism (ERM) in the early 1990s, but it’s actually the unsettling situation facing several new EU members.


Prospects for enlarging the eurozone – the institutional successor to those ill-fated attempts at monetary coordination two decades ago – are looking increasingly shaky.


Analysts at Danske Bank caused a stir in February 2007 by publishing an “overheating index” for the region, in which the three Baltic states, Bulgaria, Romania and, to a lesser extent, Slovakia, were all flashing red warning signs.


Since then, Latvia and Lithuania have unveiled policy packages designed to engineer a soft landing for their economies. The situation in Lithuania is less extreme, and Lars Rasmussen, one of the authors of the original Danske report, believes the policy response is credible. He is unconvinced, however, by the proposals outlined by the Latvian authorities. “The Latvian government have put forward a plan to fight inflation, as they call it, but they have not changed their inflation forecasts,” Rasmussen says. “So it was more like communicating that they are doing something, without really doing anything.”


He expects greater fiscal tightening within the next few months, either by cutting expenditures or by hiking taxes, but with a current account deficit running at more than 20% of GDP and accelerating inflation, time is running out to avoid a hard landing.


Politicians in Latvia may be reluctant to take the blame for shutting down the domestic demand party, but where does this leave policy-makers in Bulgaria? They have won IMF and EU praises for running budget surpluses in excess of 3% of GDP, but are still witnessing inflation of around 6.5% and a current account deficit that approached 15.8% of GDP in 2006. What they also have in common with the Baltic states is a fixed exchange rate.


No short cut?


At first sight, this might look like a short cut to eurozone membership: if the currency is already pegged to the euro, how difficult can it be to adopt the euro outright? The problem is that the inflexible monetary regime has robbed these countries of an extra tool to fight inflation, at a time when the rapid catch-up with the rest of the EU is posing particular risks.


“If you look at the other eastern European economies that have floating exchange rates, the currency has appreciated during the transition while they’ve grown, and that has put a dampener on inflation, cooled the economy, and allowed a gradual adjustment to more sustainable growth,” says Rasmussen.


Even among the floating-rate regimes, however, there are some overheating candidates, notably Romania and Slovakia. According to Zsolt Papp, head of EMEA economics at ABN Amro, these countries are suffering from confused monetary policy objectives, with both central banks cutting interest rates sharply this year, even as labour markets tighten and inflation picks up.


The reason for the cuts is concern over precisely the exchange rate appreciation process that could cool the economy, given the chance. There is political pressure in both countries to protect the competitiveness of exporters, whose performance could suffer if their goods become more expensive in foreign currency terms. 


“They have a difficult balance to strike, but I think these countries have to permit a certain degree of currency appreciation,” Papp says. “If you look at what is happening in the Baltic states due to fixed exchange rates, then it is playing with fire a little to try to stop appreciation with interest rate cuts.”


He believes that it is better for monetary policy to put less emphasis on exchange rate trends, as is the case in the Czech Republic, where the National Bank accepted its limited power to stop the koruna’s FDI-driven appreciation, and now faces fewer inflation risks.


The waiting room


This raises a serious question about the eurozone accession process, which includes a stint in the ERM-II “waiting room”, when applicants must target both price and exchange rate stability simultaneously.


“The European Central Bank has not spelt this out, but the underlying idea behind ERM-II is to join only when you have practically met all the other targets, so that keeping inflation down is not going to be a problem any more,” observes Papp. “Joining ERM-II at an early stage when inflation is still a long way from the target just exacerbates the problems and creates more imbalances.”


Slovakia joined relatively early, however, just 18 months after its May 2004 EU entry, but in the process may have undermined efforts to meet the Maastricht inflation target to qualify for eurozone membership. “Obviously, you are also much more exposed to currency speculation, because if you have an exchange rate target, there is something to speculate against,” says Papp.


So far, the Latvian central bank has successfully defended speculation against the lat’s exchange rate peg to the euro, which provoked the three-month currency forward market to jump by 80 points in March-April 2007. However, the wider issue behind both the peg pressures and Slovakia’s misplaced enthusiasm for ERM-II is that, although policy responses have varied, the whole region is facing inflationary pressures resulting from the process of real convergence with standards of living in the rest of the EU.


The spending habits and expectations of its populace are not necessarily within the powers of each government to control, a point recognized by Andres Trink, head of group risk management at Hansabank, the largest retail bank in the Baltic states.


“We have a role to play to get the Baltic economies back to more sustainable growth levels,” he tells Emerging Markets. “We are in active dialogue with governments and central banks in all Baltic countries, and generally we support their strategy of putting the economy back to more sustainable growth rates.” In particular, buoyant sentiment and high economic growth in the wake of EU membership have encouraged consumers to borrow heavily to finance property and durable goods purchases.


“While the main focus is on Latvia, we have revised our growth targets and generally become more selective about the credit risk we are taking in Estonia and Lithuania as well. We are also widening risk margins to reflect the different risk profile of our clients,” says Trink.  


Convention vs Maastricht


Nevertheless, Papp believes that there is more that governments can do. In particular, he suggests it would make more sense to manage the catch-up pressures in a conventional way through a generally accepted package of fiscal and monetary policy targets, rather than the less tailored Maastricht criteria.


“Once you have eliminated or minimized external imbalances, then it makes sense to target eurozone entry. Hungary has already learnt that lesson, and I think the Baltic states are coming round to the view that thinking they were going to join the euro two years after joining the EU was just too ambitious,” he says.


Papp points out that the states that have enjoyed the smoothest path to the eurozone, namely Malta, Cyprus and Slovenia, started from much higher levels of real economic convergence.


This argument is reinforced by Trink at Hansabank, who comments on the challenges facing the Baltic states. “One of the main concerns has been rapid wage growth above productivity growth that hurts competitiveness of export industries,” he says.


Demands for higher wages should not surprise us, says Julie Smith, specialist on European integration at London-based international affairs think-tank Chatham House. “The goal of EU membership was used to maintain support among the public for tough budget cuts and lay-offs during the transition process. The case made by the governments was that, after entry, the countries would benefit, so that created high expectations,” she tells Emerging Markets.


The very rapid growth rates at present will partly meet those aspirations, but this makes politicians in the region anxious about trying to persuade voters to sacrifice a little economic growth in the short term to achieve stability in the long term. “Politicians say it’s just part of the transition, it’s just catching up. That is of course true, but you cannot catch up too fast; you will get overheating situations because of bottlenecks in different sectors,” observes Rasmussen at Danske. “There is a speed limit to transitions, and if you go too fast you will just hurt yourself and have to drive slower for a while.”


That case might be easier to put to the public, says Smith, if the existing EU15 had focused more on a strategy for integrating the new members fully, rather than just relying on eurozone entry plans to maintain the momentum. “Politicians in all the EU states find it easy to blame the European institutions for things that go wrong, but for the new members, it is especially important to show clearly what the benefits are,” she notes.


In the rhetoric vacuum that exists as the 15 pre-2004 members turn in on themselves amid disputes over economic reform and European budget allocations, more eurosceptic parties have fared well in the Czech Republic, and especially in Poland. Smith fears that the newest entrants, Bulgaria and Romania, could suffer even worse doubts about deeper integration. “For the 10 countries that joined in 2004, free movement of labour has had genuine benefits for the population. But because of the immigration debate, even this advantage of EU membership has been restricted for the 2007 wave.”


Expect further delays on the increasingly rocky road to eurozone enlargement.

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