In September 2007, Slawomir Skrzypek, president of the National Bank of Poland, suggested the minimum two-year adherence to the ERM-II exchange rate band prior to full Eurozone entry should be shortened. In the same month, Fitch Ratings issued a report warning that, aside from in Slovakia, the prospect of euro adoption was proving an increasingly weak anchor for prudent economic policies in central and eastern Europe (CEE).
Perhaps existing Eurozone members are not providing much of an example. Within months of taking office in May 2007, president Nicolas Sarkozy’s government was slammed by the EU for proposing a round of tax cuts that put France’s compliance with the Maastricht budget deficit ceiling of 3% of GDP in doubt. Paris’s response was to suggest the need for greater flexibility, because the measures were part of wider structural reform that would boost growth and bring the deficit down in the long run.
It is left to the European Central Bank (ECB) to hold the line, and Jurgen Stark, the executive board member for economics, is determined to make his view crystal clear. “Fiscal rules under the Stability and Growth Pact were clarified in 2005, but now we appear to be confronted again with the problem that not all states of the euro-area seem to respect the reformed pact,” he tells Emerging Markets.
Historical experience shows that there is no need for a trade-off between structural reforms and fiscal consolidation, he argues, and it is not for the ECB to take either of these into account. “This is the responsibility of the national governments, and it is in their own interest to adjust their economies, make them more flexible, less vulnerable to external shocks, and to bring the fiscal deficits down, which is also necessary in view of the challenge of aging populations.”
And the same rules apply, firmly but fairly, to Eurozone applicants. “The doors are open, they will remain open, and this was demonstrated by the fact that Slovenia joined in January this year.” In mid-2007, European governments also agreed to allow Malta and Cyprus to become the fourteenth and fifteenth members in January 2008. Stark adds that no new member-state has an opt-out clause, so all are obliged to join the euro “once the convergence criteria are met on a sustainable basis”.
Convergence challenge
It is this last point that seems to be turning into a bone of contention among aspiring Eurozone members, especially since Lithuania was rejected in 2006 after missing the inflation target by a fraction of a percent. The Harmonized Index of Consumer Prices (HICP) criteria is a moving target, calculated from an average of inflation rates in selected euro-area countries. There were complaints that the selection of countries for the reference rate means the criteria is subjective, but Stark refutes this.
“I see the risk that governments regard the fulfilment of the criteria too much as a short-term policy objective. They have not only to be observed at a given point in time, but also on a lasting basis,” says Stark. He notes that the sustainability clause is not an interpretation of Maastricht, but was spelt out explicitly in the treaty, and reaffirmed in the first convergence reports in 1998. “We have not invented new rules or new interpretations; we do not change the rules of the game,” he concludes forcefully.
Skrzypek’s comments in September demonstrate growing concern that this objective may conflict with another criteria, the requirement to lock national currency into a narrow exchange-rate band against the euro for at least two years before entry, the system known as ERM-II. So the argument goes, a fixed exchange rate prevents the possibility of currency appreciation acting to curb economic overheating. Lithuania, which is already in ERM-II and has a currency peg to the euro, is not even the most severe example. Neighbouring Latvia saw inflation surge into double-digits in August 2007, amidst credit rating downgrades and a speculative attack on the currency peg itself.
But Stark emphasizes that ERM-II is there for a reason. Countries need to demonstrate that they can live for an extended period under the pre-conditions for euro-area entry without large exchange rate deviations or volatile HICP, to ensure that stability is maintained once they join the Eurozone. “In our understanding, membership of ERM-II should not just be like a waiting room, to stay in for two years and then adopt the euro. It is an exercise room.”
And for Leszek Balcerowicz, former president of the National Bank of Poland (NBP) and now a visiting professor at Brown University in the US, the whole question is academic. “As a former policy-maker, I know that this is not really useful. At the end of the day, the inflation criteria has to be fulfilled in order for these countries to enter the Eurozone. So the question is what policies they have at their disposal to do it, and that is fiscal policy.”
Consequently, the real dilemma is similar for most Eurozone applicants, says Balcerowicz, whether they have fixed or floating exchange rates: to bring down the fiscal deficit. “The question of when to join the euro can therefore be reduced to the question of when they can put their fiscal house in order. I would say: the sooner, the better.”
Party games
Of course, Balcerowicz’s own commitment to fiscal discipline was well demonstrated during his own time as Polish finance minister, and by his criticism of budgetary weakness when at the NBP. Today, the priorities have changed for many CEE governments, says Pavel Mertlik, the Czech Republic’s finance minister from 1999 to 2001 and now RZB’s chief economist in Prague. Delivering a catch-up in living standards to the rest of the EU, as promised before the new members joined, is where the votes lie. Mertlik points out that Slovenia is not necessarily a useful precedent, because its consumer prices – a proxy for the population’s spending power – were already almost in line with those in neighbouring Eurozone member Austria even before the Balkan state adopted the euro. By contrast, prices in the Czech and Slovak republics are less than 60% of the levels in Euroland.
“There is a general belief, not only among political but also among economic elites, that the country is benefiting from real and nominal economic convergence, with the economy growing faster than the Eurozone, and inflation is being kept low by an appreciating currency,” Mertlik tells Emerging Markets. Policy-makers are likely to be reluctant to jeopardize this benign combination, especially in a context where many CEE governments are fragile and politically-divided coalitions that find it difficult to agree on far-reaching reforms. Poland was forced into early elections on October 21 after the collapse of its ruling coalition, and the Czech Republic has had no single-party majority government in more than a decade.
As a result, Mertlik believes that the acid test will be the experience of the Slovak Republic, which looks set to become the first of the four central European economies to meet the convergence criteria, possibly next year. In its report, Fitch warned that even Slovakia could find entry delayed, “particularly if the EU authorities adopt a harsh interpretation of a ‘sustainable’ price performance or Exchange Rate Mechanism (ERM) membership without ‘severe tensions’.” If it does adopt the euro in January 2009, Fitch still expects a pause of at least three years before any other country follows through the open door. Mertlik shares this downbeat assessment, arguing that it is harder to achieve consensus for fiscal tightening among coalition governments without the perception of a “national goal” that accompanied EU enlargement.
By contrast, Balcerowicz questions the notion of “reform fatigue” in the region. “This is a biological metaphor, but there are various factors and explanations in different countries; it is only a convenient shorthand as we are not dealing with the same situation in each country.” Still, he acknowledges, the drive for euro adoption will require more political mobilization from existing and aspiring Eurozone members. “You need to say that this is a domestic issue, that it is in the interest of these countries to pursue fiscal reforms.”