Making it to the euro

Zdenek Tuma Governor Czech National Bank Project Syndicate

The upcoming enlargement of the European Union in May is a major focus not only for governments in the acceding countries, but also for their central banks. Upon entry, they will become members of the European Central Bank (ECB), which means that the new members are expected to take active steps towards fulfilling the necessary conditions for future admission into the eurozone.

Even though actual enlargement of the eurozone remains in the relatively distant future -- the earliest possible date being January 2007 -- the accession countries must prepare their entry strategies well in advance. This is why in most accession countries last year, central banks and governments stepped up co- operation on defining joint positions on adopting the euro.

Similarly, there were intense debates within the EU, culminating with the adoption of the ECB's Policy Position on Exchange Rate Issues Relating to the Acceding Countries. The Policy Position expressed the ECB Governing Council's stance on membership of the exchange rate mechanism (ERM II), a key precondition for future eurozone entry.

Debate was heated. The accession countries had to decide the optimal timing for eurozone enlargement -- a difficult task, because economic theory gives no clear answers in this respect, and because several accession countries are wrestling with fiscal imbalances well above the Maastricht Treaty's ceiling of 3 percent of GDP.

The EU side, for its part, had to address the problem of how to balance fairness of treatment between old and new eurozone members with ensuring a smooth enlargement. There may be a certain trade-off between these two aspects, since the EU's accession criteria were defined at a time when the eurozone did not exist and when best practices in exchange rate and monetary policy regimes differed from current ones.

Nevertheless, a broad consensus has emerged on a number of issues. First, most people have learned that no universal solution is optimal for all accession countries. There are many country-specific conditions, such as current economic performance, the monetary policy regime, and the fiscal stance.

In this respect, the accession countries can be divided into two broad groups. On one side are small countries -- for example, the Baltic states -- which use devices such as currency boards to peg their exchange rates to the euro. These countries have proven that they can live without their own monetary policies without severe tensions. There is thus no reason to caution them against fast eurozone accession or to force them to change their exchange rate regimes before entry.

So EU institutions are right to acknowledge currency boards as being consistent with the ERM II regime, even though they have at the same time reserved the discretion to assess each country on a case-by-case basis.

On the other hand, it is clear that the roadmap to the eurozone might be completely different for the larger accession countries with floating exchange rates and inflation-targeting monetary policy regimes.

A second area of consensus has emerged from frequent debates on the potential conflict between nominal and real economic convergence between the EU accession countries and the current member states. But most accession countries have already achieved substantial progress in lowering inflation and nominal interest rates. Moreover, many empirical analyses show that real convergence should not be a serious obstacle to enlargement.

Thus the main emphasis has shifted to structural, financial, and cyclical convergence, in line with economic theory on so- called "optimum currency areas." It is typically found that the degree of convergence is very high in terms of foreign trade, capital flows, and banking sector integration, while cyclical convergence and labor mobility have been low so far. Important differences exist, though, among the individual countries even in this respect.

Third, although the Central European countries originally announced different target dates for eurozone accession, their plans have now moved closer together, usually ranging between 2008 and 2010. The biggest practical constraint they face is their public budgets.

Many countries -- including the Czech Republic, Hungary, and Poland -- run large budget deficits and need to implement medium- term reforms to make their pension systems sustainable and to overhaul overly generous social security systems. Given the political sensitivity of these issues, fiscal consolidation will be challenging.

Fourth, it is vital that EU institutions have spoken more openly about the convergence criteria. Most critically, the ECB has de-emphasized in its Policy Position the former 12.25 percent fluctuation band in the ERM II as the criterion for assessing exchange rate stability.

This corresponds to the view shared by many accession countries that such a narrow band would increase the risks in managing the run-up to adopting the euro. Instead, exchange rate stability will be assessed according to economic fundamentals and countries' economic policy mix, rather than by rigidly applying mechanical rules.

Finally, the ECB has proposed a reform of the voting mechanism in its Governing Council, introducing a cap on the number of voting members. Even though many, including myself, do not see it as an optimal final solution, it is an important compromise that will allow eurozone enlargement to start.

The work done during 2003 brought eurozone enlargement much closer. Some countries may proceed faster, especially those with hard pegs against the euro, while for others the years 2008-2010 seem to be a more realistic target. But in most cases, entry strategies have been set, serving as important stabilizers for financial markets and economic agents.