## _cr1597 - INTRODUCTION

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### INTRODUCTION — progress, challenges, and policy context
- New Member States (NMS) progress and divergence:
  - Significant progress on EU integration and income convergence since mid-1990s; first group of Central and Eastern European countries joined the EU in 2004.
  - Pace of convergence varied across NMS; significant differences remain in real and financial integration with the EU and the euro area.
- Macro-financial cycles and post-crisis context:
  - Most NMS experienced credit booms that led to a build-up of macroeconomic imbalances; following the global financial crisis of 2008/09, most NMS went through deep recessions, bringing convergence to a halt.
  - Recovery is fragile amid sluggish euro area growth; in some NMS growth is held back by private sector balance-sheet weaknesses, including high debt burdens.
  - Disinflation driven by falling global food and energy prices, and disinflationary spillovers from the euro area, may exacerbate difficulties faced by overleveraged firms and households.
- Policy space and institutional reshaping:
  - Few NMS-6 have full monetary policy flexibility due to lack of monetary autonomy or significant currency mismatches.
  - Fiscal space is limited, reflecting crisis-related burdens; adjustment is needed to meet medium-term objectives under the EU fiscal rules.
  - Prudential policy scope is being re-defined by European financial architecture reforms.
- 2014 NMS Policy Forum themes (November-December 2014 staff discussions):
  - Euro adoption and its changing calculus for NMS-6.
  - Opting into the Banking Union prior to euro adoption.
  - The EU’s fiscal framework and pension reform (focus on incentives for structural reform).
  - Making the most of the EU single market: structural reform priorities and the role of services exports given the EU Services Directive.

### EURO ADOPTION — regimes, implications, and new evidence
- Adoption history and current regimes:
  - Since 2004, five NMS have adopted the euro: Slovenia, the Slovak Republic, and the Baltics.
  - Bulgaria and Croatia tie their currencies to the euro (Bulgarian lev via currency board; Croatian kuna via tightly managed quasi-peg).
  - Czech Republic, Hungary, Poland, and Romania target inflation and generally allow exchange rates to float.
- What euro adoption now entails:
  - Adoption implies joining the common currency area and the common regulatory area (Banking Union).
  - After joining the euro:
    - Monetary policy functions shift to the ECB (Eurosystem).
    - Bank supervision and resolution for systemic institutions come under the Single Supervisory Mechanism (SSM) and Single Resolution Mechanism (SRM).
  - Policy responsibilities change:
    - Monetary policy: Local (+ some coordination with ECB) → Centralized (Eurosystem)
    - Fiscal policy: Local (+ EU fiscal rules) → Local (+stricter enforcement of EU fiscal rules)
    - Macroprudential policy: Local (+ ESRB monitoring) → Mainly local (+ESRB monitoring and greater role of the ECB)
    - Microprudential supervision: Local → Mainly centralized (Banking Union)
- Key considerations for NMS regarding euro adoption:
  - Impact on growth prospects and competitiveness.
  - Likelihood, nature and impact of shocks (common with euro area or idiosyncratic).
  - Policy space required to manage cycles and respond to shocks.
  - Requirements for successful participation: sufficient similarity (business cycle synchronization, financial integration, real income levels) and economic flexibility (labor and product market flexibility).
- New empirical insights since 2004:
  - Trade and growth effects smaller than earlier expectations:
    - Recent estimates of additional GDP growth from euro adoption range from nil (Havranek, 2010) to 2-3 percent of GDP (Baldwin, 2006).
    - Earlier anticipated real GDP gains were 10 to 25 percent over 20 years (Frankel and Rose, 1998; Rose et al., 2000).
    - Increased trade is now thought to be associated more with EU membership than with euro adoption per se.
  - Euro premium diminished after the euro crisis:
    - Pre-crisis adopters could expect reputational boost up to two sovereign debt ratings notches, or about 9 IIR points; this premium has mostly vanished post-crisis.
    - A positive premium may return if institutional reforms succeed.
  - Eliminating FX mismatches via euro adoption can enhance perceived creditworthiness:
    - For highly euroized economies, elimination of currency mismatches can enhance perceived creditworthiness by almost two ratings notches, or 10 IIR points.
  - Monetary autonomy proved valuable in the past decade:
    - 2003–07: nominal exchange rate appreciation aided tighter monetary conditions and helped dampen domestic demand and contain inflation and credit growth (notably Czech Republic and Poland, to a lesser degree Hungary).
    - 2008/09 downturn: monetary easing and exchange rate depreciation helped prevent excessive contractions in domestic demand (particularly Poland and Romania).
    - Inflation-targeting central banks had some success containing pass-through of euro area disinflation into core inflation by offsetting spillovers with domestic monetary stance.
  - Monetary autonomy is difficult to fully replace for shocks of the past decade’s magnitude:
    - NMS-6 compare favorably with the euro area on many economic flexibility indicators, but real income gaps and lower cross-border asset-holding risk-sharing imply longer and more intense fluctuations when ceding monetary autonomy.
    - Bulgaria and Croatia used macro-prudential measures and fiscal buffers with some success, but these did not fully substitute for monetary autonomy given past shock sizes.
- Practical initiation of euro adoption:
  - NMS-6 committed in accession treaties to adopt the euro “once the necessary conditions are fulfilled.”
  - ERM2 participation has no clear-cut criteria; EC and ECB convergence reports indicate no NMS-6 fulfills all adoption criteria at this juncture, mainly due to lack of legal harmonization or prerequisite participation in ERM2.

### SELECTED DATA POINTS AND INDICATORS (as presented)
- Timeframes and dates referenced:
  - Mid-1990s; 1995-2011; 2004; 2008/09; 2010, 2011; 2013; November-December 2014; 2003–07; 2008-14.
- NMS groupings:
  - NMS-6: Bulgaria, Croatia, Czech Republic, Hungary, Poland, Romania.
  - NMS-EA: Estonia, Latvia, Lithuania, Slovakia, Slovenia.
- Euro premium and literature estimates:
  - Earlier reputational boost for euro adopters up to two sovereign debt ratings notches, or about 9 IIR points.
  - Eliminating currency mismatches via euro adoption can enhance perceived creditworthiness by almost two ratings notches, or 10 IIR points.
  - Additional GDP growth estimates from euro adoption: nil (Havranek, 2010) to 2-3 percent of GDP (Baldwin, 2006); earlier anticipated gains 10 to 25 percent of real GDP over 20 years (Frankel and Rose, 1998; Rose et al., 2000).

### Consequences for macroeconomic policy frameworks (paragraph 17)
- For economies with monetary autonomy (Czech Republic, Hungary, Poland and Romania):
  - Euro adoption would constrain macro-policy options, especially for economies with large income gaps and less synchronized business cycles vis-à-vis the euro area.
  - Greater reliance would fall on other instruments: counter-cyclical fiscal policy (which requires fiscal space) and macro-prudential policies.
  - Structural reforms to boost growth potential and facilitate internal adjustment (notably adaptable labor markets) would be key.
  - Ongoing EU fiscal and financial governance reforms will affect countries’ policy space in the euro area.
- For economies that use the euro as monetary anchor (Bulgaria and Croatia):
  - They have already ceded monetary autonomy and exchange rate flexibility.
  - A key issue is the extent to which ongoing reforms will constrain the use of macro-prudential instruments.
- On the euro adoption process:
  - Specific and — to the extent possible and suitable — measurable criteria for ERM2 accession could render the process more structured.
  - Such criteria would usefully emphasize real income convergence and structural preparedness — notably adaptable labor markets — as prerequisites for adoption.

### Authorities’ views and country perspectives (paragraph 18)
- Pegged/euroized countries generally see merits in adoption:
  - Those with pegged currencies argued lack of monetary autonomy could be compensated by fiscal policy and regulatory measures.
  - EC emphasized overall policy mix mattered more than exchange rate regime.
  - Some NMS — notably Romania — viewed euro adoption as a reform anchor.
- Floating-currency countries value monetary autonomy:
  - Most countries with floating currencies value monetary autonomy and exchange rate flexibility for absorbing shocks and supporting real convergence.
  - European institutions noted Hungary and Romania (flexible regimes) requested international financial assistance during 2008/09.
  - ECB noted limits to monetary autonomy for non-euro area EU members: the treaty specifies exchange rate policy is a matter of common concern.
- Common concerns:
  - Whether ongoing reforms will fix euro area architecture (slow progress on fiscal union and insufficient common backstops).
  - Whether the euro area’s institutional framework grants sufficient fiscal and macro-prudential policy space to manage convergence and asymmetric shocks.
- Preference emphasis:
  - Most NMS-6 authorities viewed real convergence in income levels and/or structural features as more important than nominal convergence (contrasting with nominal adoption criteria).

### Opting into the Banking Union (BU) prior to euro adoption (paragraphs 19–26)
- BU background and expected benefits:
  - European System of Financial Supervision established in 2011; Single Rulebook developed (CRD IV and CRR adopted mid-2013; BRRD adopted mid-2014).
  - BU centralizes supervision and resolution via SSM and SRM; open to non-euro area EU countries.
  - Motivations: reverse financial fragmentation; raise credibility and quality of supervision; unify resolution; provide common, industry-funded backstop.
  - Expected outcomes: lower compliance costs, removal of cross-border barriers, lower resolution/restructuring costs, and ultimately lower bank funding costs.
- Elements needed for full BU benefits:
  - An effective common fiscal backstop to break sovereign-bank links (ESM currently acting as de facto backstop).
  - Allowing the Single Resolution Fund (SRF) to borrow against future industry levies (SRF fully funded and mutualized only by 2024).
  - Progress toward a pan-European deposit guarantee scheme (DGS).
- What opting into the BU entails for non-euro members:
  - Participation in both SSM and SRM; requires close cooperation with ECB and amending national legislation to enable national authorities to work with ECB and SRB.
  - ECB can request further information and carry out its own comprehensive assessment.
  - For countries targeting euro adoption (Romania), joining BU prior to adoption phases in institutional adjustments.
- Differences in treatment for non-euro opt-ins (paragraph 23):
  - (i) Role in the SSM: non-euro countries are not members of the ECB’s Governing Council that adopts SB-drafted decisions.
  - (ii) Fiscal backstop: non-euro opt-ins are not eligible for direct bank recapitalization from the ESM.
  - (iii) Liquidity support: non-euro opt-ins would not automatically have access to ECB liquidity facilities.
  - Safeguards: reasoned disagreement procedure and exit clause; non-euro countries can terminate participation (ECB can also take such decision).
- Specific sensitivities for the NMS-6:
  - Ability to influence SSM decisions related to parent banks is critical given dominance of euro area bank subsidiaries.
  - Removal of cross-border transfer barriers could reduce buffers at subsidiary level but also reduce local authorities’ ability to ring-fence.
  - Direct participation in the SSM would allow opt-ins to vote in the Supervisory Board on issues currently beyond local supervisors’ purview.
  - Access to common liquidity and fiscal backstops matters because:
    - (i) NMS-6 still have large external liabilities.
    - (ii) Banks in NMS-6 typically hold less bail-inable funds (other than uninsured deposits) than eurozone banking groups operating in the region.
  - NMS-6 are therefore more likely to benefit from SRF risk-sharing or other common backstops.
- Macroprudential implications:
  - Asymmetry: both ECB and national authorities can tighten standards beyond the other regulator’s level, but cannot compel loosening except by reversing their own decisions.
  - Some macroprudential tools remain under full national control (subject to notification to and non-binding scrutiny by the ESRB); SSM can impose Pillar II measures only on directly supervised banks.
  - Liquidity coverage ratio and leverage ratio can be modified by the SSM only after harmonization in 2015 and 2018, respectively.
- Evolution-dependent benefits:
  - Benefits for NMS-6 depend on how supervision and financial systems evolve: potential greater financial stability, simpler home-host interactions, and reduced funding costs if parent banks provide more or cheaper funding or if NMS banks borrow directly at lower costs.
  - Realization of lower non-deposit funding costs depends on supervisory preferences and evolving bank funding models.
  - Lack of clarity on implementation of structural measures at EU and national levels adds uncertainty about future cross-border banking model.

### Staff’s position and decision considerations on BU opt-in (paragraphs 27–28)
- Overarching view:
  - BU is still evolving; opt-in decision has many moving parts and must consider country characteristics, policy preferences, and evolving BU modalities.
- Observations on when opting into the BU makes sense:
  - BU design asymmetries and lack of equal treatment of euro area and non-euro members tilt decision against early opt-in and in favor of waiting until euro adoption.
    - Addressing SSM governance, liquidity support, and fiscal backstop issues would make BU opt-in before euro adoption more attractive.
  - Lack of clarity and operational experience is another reason to wait (coordination between SSM and local supervisors; interaction between prudential policies and national monetary policies).
  - Some may still opt in if BU participation addresses specific challenges that outweigh shortcomings:
    - Examples: enhancing quality and credibility of bank supervision; access to larger industry-funded backstops; political economy reasons (distancing supervision from local vested interests); concerns about being “left behind” if other NMS-6 join first.

### Banking Union (BU) opt-in: NMS-6 concerns (section 29)
- Key concerns from NMS-6:
  - Insufficient influence on SSM decisions regarding parent banks.
  - Loss of local power to set liquidity requirements for local subsidiaries; ring-fencing local liquidity “tops the list of concerns.”
  - Exiting the BU not seen as a sufficient safeguard due to reputational costs.
  - Misalignment between decision powers (centralized) and burden-sharing (costs borne by individual member states in near term).
  - Desire to explore ways euro area institutions could extend support to opt-ins “(on par with other BU members)” in financial instability.
  - Difficulty assessing balance between future benefits and immediate drawbacks due to limited operational experience.
  - Uncertainty on how BU membership would affect ability to conduct monetary and macro-prudential policies.
  - Unclear systemic effects on European financial system evolution depending on opt-in choices.

### Banking Union: ECB and EC perspective (advantages of early opt-in)
- Benefits highlighted:
  - Having a seat at the table in SSM.
  - Access to a common industry-funded backstop.
  - Early opt-in allows participation in shaping BU operational modalities.
- Design and safeguards:
  - BU design seen as balanced within Treaty framework; exact parity with euro area treatment not possible for non-euro members.
  - Safeguards: reasoned disagreement procedure and exit clause.
  - Ongoing discussions on common fiscal backstop aim to achieve better symmetry between euro area and non-euro BU members.
- Emphasis on member state decision and need for thorough preparation.

### The EU fiscal framework and pension reform — changes, reversals, and implications
- NMS pension reform history and outcomes:
  - NMS were early pension reformers; parametric reforms in late 1990s and early 2000s rendered PAYG systems technically sustainable but reduced future benefit replacement ratios “often as low as 20 percent (compared to an average of about 40 percent today).”
  - Most NMS introduced a second, mandatory, funded pension pillar: Hungary (1998), Poland (1999), Bulgaria and Croatia (2002), Romania (2007). Czech Republic is an exception (strengthened tax incentives for voluntary third pillar).
  - Second pillars showed mixed results — modest returns, little diversification, and relatively high (albeit falling) administrative costs; assessment complicated by investment losses during the global financial crisis.
- Reversals after 2008/09:
  - Many second pillar reforms were reversed after 2008/09 to varying degrees: Hungary, Poland, Slovakia, and Baltics redirected contributions to the first pillar; Romania delayed built-up of its second pillar.
  - Baltic states are in process of restoring or have restored pillar II; Poland and Slovakia partially reversed; Hungary reversed in full.
- Role of EU fiscal framework in reversals:
  - Transition cost: Since 2004 Eurostat reclassified pillar II schemes from public to private sector, so contributions to the second pillar no longer counted as government revenue while PAYG obligations remained, increasing reported headline deficits until PAYG obligations fall.
  - 2005 framework reform granted limited EDP exemptions: limited adjustment “as long as it remains ‘close to the reference value’ and for a maximum of five years (on a digressive linear scale).” The exemption did not capture the full transition cost “more than 1 percent of GDP a year in countries with large second pillars (Poland, Hungary, Slovakia)” nor the full transition period “(40–50 years).”
  - Patterns: Countries with the largest second pillars enacted the largest reversals; staff finds no link between reversals and low returns or high fees.
- Recent changes and remaining bias:
  - Reforms reduce the anti-pillar II bias but do not eliminate it.
  - MTOs: a portion of systemic pension reform costs can be recognized in defining a country’s MTO, but in practice little link between MTO and existence/size of second pillar.
  - EDP: five-year restriction during which pension reform can be taken into account has been eliminated (applies to deficit, not debt criterion); exemption remains limited in size.
  - ESA 2010 accounting framework (effective 2014) changed treatment but “does not eliminate the incentive entirely.”
  - Overall, rules and exemptions are “complex and nontransparent,” leaving the European Commission considerable discretion.
- Fiscal comparisons:
  - Germany’s headline balance is “4 percentage points of GDP stronger than Poland’s,” but Poland had a stronger pension-adjusted balance in 2013 (pension-adjusted balance concept from FAD (2012)).
  - Staff: “The gap between the EU’s fiscal framework and fiscally neutral treatment of a country’s pension regime remains sizeable.”
- Staff’s policy recommendations on pensions:
  - Core challenge: securing fiscally and socially sustainable pension systems; currently legislated parameters imply most NMS-6 PAYG systems will pay much lower pensions, risking old-age poverty and social conflict.
  - Ways to avoid undesirable outcomes: accept higher fiscal burdens in future, or increase savings ahead of time to generate additional income for pensions.
  - Role of Pillar II:
    - Pillar II reforms are one means to generate higher savings but not the only one.
    - Countries that have maintained pillar II should strengthen them to reduce the offset between higher private and lower public savings.
    - Countries that abolished second pillars should strengthen fiscal stance and limit debt accumulation to create fiscal space when PAYG obligations fall due; strengthen incentives for participation in the voluntary third pillar.
  - EU fiscal framework recommendation: make the framework more neutral toward a country’s choice of pension regime; recent reforms have moved in that direction, but further steps would be helpful.
- Authorities’ views:
  - NMS-6: dealing with ageing costs without excessively constraining future fiscal space is a major challenge; several authorities view recent/planned reforms (e.g., increases in effective retirement age) as addressing the issue.
  - European Commission staff: recent reforms largely eliminate incentives to abolish second Pillar funds and the framework adequately highlights implicit liability challenges.
  - Divergent country views: some seek more flexibility to make the corrective arm of SGP neutral to pension regime choice; others want stronger consideration of ageing-related fiscal costs under the preventive arm. Polish authorities suggested expenditure ceilings rather than deficit rules.

### Making the most of the EU Single Market — findings and reform priorities
- Benefits of EU membership:
  - Access to larger market; catalyst for growth and convergence; stronger competition incentivizes productivity improvements; open trade and investment facilitates technology transfer, raising export quality and quantity.
- Structural reforms critical for export performance (2003–11 staff analysis of 10 NMS):
  - Significant explained variation in value added exports to the EU from: higher education; continuous vocational training and skills upgrade; incentives to work and hire; restrictions on foreign investment and ownership.
  - In relative importance: vocational training and skills upgrade strongest, followed by incentives to work (inactivity trap), foreign investment and ownership environment, higher education, and relative minimum wage.
  - Integration with supply chains shows a strong positive impact, larger than most structural variables.
- Country-specific priorities:
  - Czech Republic: above-average performance from continuous vocational training, lower restriction on foreign investment/ownership, and strong integration with regional supply chains.
  - Hungary: wage competitiveness, supply chain links and foreign investment environment contributed to above-average performance; contribution from foreign investment environment has declined recently.
  - Poland: room to improve integration with supply chains and foreign investment environment to boost exports to the EU single market.
  - Bulgaria and Romania: persistent below-average performance, need broad-based structural reforms (higher education and foreign investment environment); Bulgaria has lost some export advantage from relatively low minimum wage.
- Export quality:
  - Most NMS-6 have considerable room for quality improvement in current export products to the EU.
  - Romania and Bulgaria: about 40 percent of exports to the EU fall in the bottom quartile of quality.
  - Czech Republic and Hungary: exports to the EU concentrated in the two middle quality quartiles.
  - Structural reforms that increase exports (human capital, institutional quality, foreign investment) also tend to improve export quality over time.
- Services trade and the Services Directive (SD):
  - The EU single market is less effective for services than for goods; many export restrictions persist.
  - SD introduced in 2006 to improve access for services exports.
  - Most services exports (70 percent) from the region belong to sectors covered under the SD.
  - SD implementation reduced overall import restrictions on services by about 30 percent relative to pre-SD levels, with variation across countries and products.
  - Progress has fallen short of expectations as many EU members only partially reduced or kept some restrictions.
  - Further liberalization of services would boost NMS-6 exports to the EU; success depends on actions by EU trading partners and NMS themselves.
- Revealed Comparative Advantage (RCA) in professional and technical services (relative to total services gross exports):
  - Bulgaria: RCA 0.61; % of services exports under SD 5.9
  - Croatia: RCA 0.4; % of services exports under SD 8.1
  - Czech Republic: RCA 1.1; % of services exports under SD 29.6
  - Hungary: RCA 1.1; % of services exports under SD 31.3
  - Poland: RCA 1.1; % of services exports under SD 35.7
  - Romania: RCA 1.1; % of services exports under SD 39.6
  - Estonia: RCA 0.8; % of services exports under SD 26.5
  - Latvia: RCA 0.7; % of services exports under SD 30.8
  - Lithuania: RCA 0.4; % of services exports under SD 22.7
  - Slovak Republic: RCA 0.8; % of services exports under SD 20.4
  - Slovenia: RCA 0.5; % of services exports under SD 16.4
- Staff’s structural reform priorities:
  - Improve higher education, vocational training and skills.
  - Strengthen incentives to work and hire.
  - Improve foreign investment environment.
  - Increase links with supply chains.
  - For highly integrated countries (Czech Republic, Hungary): diversify exports outside the EU.
  - Quality-improvement sequencing: low-quality exporters prioritize foreign investment and supply-chain links; medium-level exporters prioritize skills, higher education, and R&D.

### Staff appraisal: integration, euro adoption, banking union, pension and EU framework
- Overall staff view:
  - NMS-6 should enhance competitiveness and economic flexibility via structural reforms, while boosting fiscal and macroprudential policy space to gain full benefits from EU integration and ensure eventual euro adoption is a success.
- Euro adoption:
  - Advantages and drawbacks exist.
  - A once sizeable country risk premium associated with adoption has vanished with the euro crisis.
  - Joining the euro implies giving up monetary autonomy, which has been valuable for absorbing shocks and containing macroeconomic imbalances.
  - Euro adoption benefits highly euroized countries by eliminating currency mismatches.
  - For flexible-exchange-rate NMS-6, consideration is whether monetary autonomy can be replaced by other policy instruments and support from euro area institutions.
  - For peggers, an issue is the extent to which they can continue to use macroprudential tools after adopting the euro.
  - Progress with real convergence and structural preparedness are key prerequisites.
- Banking Union opt-in:
  - Early opt-in may phase in institutional changes for countries targeting euro adoption (Romania).
  - Opt-in decision requires careful consideration of country characteristics, policy preferences and BU modalities.
  - Two factors tilt against early opt-in:
    - Lack of equal (or fully equivalent) treatment of euro area and non-euro BU members.
    - Lack of clarity on and experience with BU operational modalities.
  - Some NMS-6 may still see net benefits (enhanced supervision credibility; distancing supervision from local vested interests; access to common industry-funded backstops).
- EU fiscal framework and pensions:
  - EU fiscal framework arguably contributed to pressures triggering unwinding of many second pension pillars after 2008/09.
  - Recent reforms render the framework more flexible, but it continues to fall short of neutrality toward a country’s pension regime choice.
  - Pillar II reforms are one, but not the only, way to strengthen pension systems.
  - Countries that have maintained a second pillar should reduce the offset between higher private and lower public savings.
  - Countries that abolished second pillars should generate additional fiscal space and consider strengthening incentives for the voluntary third pillar.

### Policy recommendations for EU and euro area institutions
- Ensure governance reforms consider impacts on NMS-6 economies and policy frameworks.
- Specific actions recommended:
  - Define more specific criteria for admission to ERM2; emphasize institutional, structural, and real convergence.
  - Protect interests of non-euro BU members:
    - SSM should establish a strong track record and clarify operational modalities as early as possible.
    - Continue discussions on the common fiscal backstop to achieve better symmetry between euro area and non-euro BU members.
    - Consider extending liquidity support to BU opt-ins in the event of financial stress.
  - Establish mechanisms for effective policy coordination between local central banks, the ECB, the SSM/SRM and the EC to address potential tensions between prudential, growth and price stability objectives.
  - Ensure the EU framework (e.g., fiscal rules) does not create disincentives for structural reforms needed by NMS-6.
  - Consider further efforts to lift intra-EU restrictions on services trade, building on experience with the EU Services Directive.

### Box 3. How Do NMS-6 See Potential Benefits and Drawbacks of Euro Adoption? (staff survey)
- Survey design and respondents:
  - Respondents: five central banks (CBs) and four ministries of finance (MoFs).
  - Importance scale: 4 – High Importance; 2 – Moderate; 0 – Negligible Importance.
  - Responses display considerable heterogeneity across countries and institutions.
- Perceived high-importance benefits:
  - Access to euro liquidity facilities.
  - Enhanced country reputation potentially lowering risk spreads.
  - Reduction of FX mismatches.
- Perceived lower-importance benefits:
  - Euro-driven trade effects.
  - Euro-driven growth effects.
  - Boost to inward FDI.
  - Euro adoption not generally expected to increase business cycle synchronization with the euro area.
- Perceived concerns (moderate to high):
  - Euro area’s unfinished reform agenda.
  - Potential reductions in fiscal and macro-prudential policy space.
  - Importance of sufficient income level convergence prior to adoption.
  - Uncertainty about evolving euro area institutions.
- Survey summary emphasis:
  - High importance: access to ECB liquidity; lower country risk premium; reduced FX mismatches; enhanced reputation.
  - Moderate to high concern: income convergence prior to adoption; uncertainty about evolving euro area institutions; potential reductions in fiscal and macro-prudential policy space.
  - Lower importance: increases in trade with the euro area; boost to inward FDI; alignment of business cycle with the euro area.

*International Monetary Fund — sections “INTRODUCTION,” “EURO ADOPTION,” “The timing of euro adoption is ultimately an issue of preferences that can differ,” and related boxes from the provided content.*

### INTRODUCTION _________________________________________________________________________________ 3

### _cr1597 - INTRODUCTION

### INTRODUCTION — progress, challenges, and policy context
- The New Member States (NMS) have made significant progress on EU integration and income convergence since mid-1990s; first group of Central and Eastern European countries joined the EU in 2004.
- Pace of convergence varied across NMS; significant differences remain in real and financial integration with the EU and the euro area.
- Most NMS experienced credit booms that led to a build-up of macroeconomic imbalances; following the global financial crisis of 2008/09, most NMS went through deep recessions, bringing convergence to a halt.
- Recovery in NMS is fragile amid sluggish euro area growth; in some NMS growth is held back by private sector balance-sheet weaknesses, including high debt burdens.
- Disinflation driven by falling global food and energy prices, and disinflationary spillovers from the euro area, may exacerbate difficulties faced by overleveraged firms and households.
- Policy space in NMS-6 is constrained post-crisis and is being reshaped by institutional reforms in the EU and the euro area:
  - Few NMS-6 have full monetary policy flexibility due to lack of monetary autonomy or significant currency mismatches.
  - Fiscal space is limited, reflecting crisis-related burdens; adjustment is needed to meet medium-term objectives under the EU fiscal rules.
  - Prudential policy scope is being re-defined by European financial architecture reforms.
- The 2014 NMS Policy Forum (staff discussions with NMS-6 authorities, European Commission and ECB during November-December 2014) covered four broad policy issues:
  - Euro adoption: Has the calculus of euro adoption changed for the NMS-6 in light of the recent crisis experience and evolving European financial architecture?
  - Opting into the Banking Union prior to euro adoption: What are pros and cons of joining the Banking Union before euro adoption?
  - The EU’s fiscal framework and pension reform: Are the EU fiscal rules providing the “right” incentives for the NMS to carry out structural reforms? (Question discussed with a focus on pension reform.)
  - Making the most of the EU single market: How can the NMS-6 take full advantage of being part of the EU single market? What are structural reform priorities and the role of services exports given the EU Services Directive?

### EURO ADOPTION — regimes, implications, and new evidence
- Adoption history and current regimes:
  - Since 2004, five NMS have adopted the euro: Slovenia, the Slovak Republic, and the Baltics.
  - The Baltics adopted after many years of unilateral hard pegs; Slovenia and the Slovak Republic maintained monetary autonomy until shortly before adoption.
  - Among NMS that have not adopted the euro:
    - Bulgaria and Croatia have tied their currencies to the euro (Bulgarian lev via currency board; Croatian kuna via tightly managed quasi-peg), mimicking many features of euro adoption.
    - Czech Republic, Hungary, Poland, and Romania target inflation and generally allow exchange rates to float.
- What euro adoption now entails:
  - Following institutional reforms, euro adoption implies joining the common currency area and the common regulatory area (Banking Union).
  - After joining the euro:
    - Monetary policy functions shift to the ECB (Eurosystem).
    - Bank supervision and resolution for systemic institutions come under the Single Supervisory Mechanism (SSM) and Single Resolution Mechanism (SRM).
  - Policy responsibilities change:
    - Monetary policy: Local (+ some coordination with ECB) → Centralized (Eurosystem)
    - Fiscal policy: Local (+ EU fiscal rules) → Local (+stricter enforcement of EU fiscal rules)
    - Macroprudential policy: Local (+ ESRB monitoring) → Mainly local (+ESRB monitoring and greater role of the ECB)
    - Microprudential supervision: Local → Mainly centralized (Banking Union)
- Key considerations for NMS regarding euro adoption:
  - Impact on growth prospects and competitiveness.
  - Likelihood, nature and impact of shocks (common with euro area or idiosyncratic).
  - Policy space required to manage cycles and respond to shocks.
  - Successful participation in a common currency area requires sufficient similarity (business cycle synchronization, financial integration, real income levels) and economic flexibility (labor and product market flexibility).
- How the calculus looked circa 2004:
  - Benefits identified in 2004 included trade generation leading to higher growth, and enhanced perception of policy credibility that could lower financing costs.
  - Risks identified included greater difficulty coping with asymmetric demand shocks without independent monetary policy, large and volatile capital inflows and lending booms, and higher inflation via Balassa/Samuelson effects.
  - These risks were seen as manageable with low growth volatility, synchronization with the euro area, sufficient fiscal space, wage flexibility, structural reforms, and strong financial supervision.
- New insights from the past decade:
  - Trade and growth generation from euro adoption remained far below earlier expectations:
    - Recent estimates for additional GDP growth from euro adoption range from nil (Havranek, 2010) to 2-3 percent of GDP (Baldwin, 2006), versus earlier anticipated real GDP gains of 10 to 25 percent over 20 years (based on Frankel and Rose, 1998 and Rose et al., 2000).
    - Increased trade now thought to be associated more with EU membership than with euro adoption per se.
  - Euro premium (impact of euro membership on perceived credit risk) has diminished after the euro crisis:
    - Countries adopting the euro in the 2000s (e.g., Slovenia 2007, Slovakia 2009) could earlier expect a reputational boost equivalent to as much as two sovereign debt ratings notches, or about 9 points with the survey-based Institutional Investor Rating (IIR).
    - The euro premium has mostly vanished in the wake of the crisis; a positive premium may return if ongoing institutional reforms succeed.
  - Eliminating FX mismatches via euro adoption can bring significant benefits:
    - For highly euroized economies, eliminating currency mismatches through euro adoption can enhance perceived creditworthiness by almost two ratings notches, or 10 IIR ratings points.
    - Liability euroization remains high in several NMS-6; hedging and macro-prudential measures have not fully eliminated FX-mismatch risks.
  - Monetary autonomy proved valuable over the past decade for absorbing shocks and containing imbalances:
    - 2003–07: nominal exchange rate appreciation aided tighter monetary conditions and helped dampen domestic demand and contain inflation and credit growth—notably in the Czech Republic and Poland, and to a lesser degree Hungary.
    - 2008/09 downturn: monetary easing and exchange rate depreciation helped prevent excessive contractions in domestic demand—particularly in Poland and Romania.
    - Inflation-targeting central banks had some success containing pass-through of euro area disinflation into core inflation by offsetting spillovers with domestic monetary stance.
  - Monetary autonomy is difficult to fully replace with other instruments for shocks of the magnitude seen in the past decade:
    - High labor market flexibility can help via wage adjustment, and on many economic flexibility indicators the NMS-6 compare favorably with the euro area.
    - However, real income gaps vis-à-vis the euro area remain substantial and cross-border asset-holding risk-sharing is much lower than euro area averages; even in flexible economies longer and more intense fluctuations should be expected when ceding monetary autonomy.
    - Bulgaria and Croatia have used macro-prudential measures and fiscal buffers with some success, but these have not fully substituted for monetary autonomy given past shock sizes.
- Practical initiation of euro adoption:
  - NMS-6 committed in accession treaties to adopt the euro “once the necessary conditions are fulfilled.”
  - Accession involves discretion by euro area institutions; ERM2 participation has no clear-cut criteria.
  - According to EC and ECB convergence reports, no NMS-6 fulfills all adoption criteria at this juncture, mainly due to lack of legal harmonization or prerequisite participation in ERM2.

### SELECTED DATA POINTS AND INDICATORS (as presented)
- Timeframes and dates referenced:
  - Mid-1990s; 1995-2011 (Gross Exports of Goods and Services to EU; GDP per Capita at PPP)
  - 2004 (first group joined EU)
  - 2008/09 (global financial crisis)
  - 2010, 2011 (euro area crisis years)
  - 2013 (Private Sector Indebtedness data; Fiscal Deficit and Medium-Term Objective chart year)
  - November-December 2014 (staff discussions)
  - 2003–07 and 2008-14 (monetary conditions and domestic demand comparisons)
- NMS groupings:
  - NMS-6: Bulgaria, Croatia, Czech Republic, Hungary, Poland, Romania.
  - NMS-EA: Estonia, Latvia, Lithuania, Slovakia, Slovenia.
- Euro premium and rating evidence:
  - Earlier reputational boost for euro adopters (2000s) up to two sovereign debt ratings notches, or about 9 IIR points.
  - For highly euroized economies, eliminating currency mismatches via euro adoption can enhance perceived creditworthiness by almost two ratings notches, or 10 IIR points.
- Literature estimates:
  - Recent estimates of additional GDP growth from euro adoption: nil (Havranek, 2010) to 2-3 percent of GDP (Baldwin, 2006).
  - Earlier anticipated gains: 10 to 25 percent of real GDP over 20 years (Frankel and Rose, 1998; Rose et al., 2000).

*Source: CEE New Member States Policy Forum—INTERNATIONAL MONETARY FUND (sections “INTRODUCTION” and “EURO ADOPTION” from provided content).*

### 16.      The timing of euro adoption is ultimately an issue of preferences that can differ

### 16.      The timing of euro adoption is ultimately an issue of preferences that can differ

### Consequences for macroeconomic policy frameworks (paragraph 17)
- For economies with monetary autonomy (Czech Republic, Hungary, Poland and Romania):
  - Euro adoption would constrain macro-policy options, especially for economies with large income gaps and less synchronized business cycles vis-à-vis the euro area.
  - A larger burden would fall on other policy instruments to safeguard balanced growth, notably counter-cyclical fiscal policy — which requires fiscal space — and macro-prudential policies.
  - Structural reforms to boost growth potential and facilitate internal adjustment (notably adaptable labor markets) would be key.
  - Ongoing EU fiscal and financial governance reforms will affect countries’ policy space in the euro area.
- For economies that use the euro as monetary anchor (Bulgaria and Croatia):
  - They have already ceded monetary autonomy and exchange rate flexibility to benefit from the euro as monetary anchor.
  - A key issue is the extent to which ongoing reforms will constrain the use of macro-prudential instruments.
- On the euro adoption process:
  - Specific and — to the extent possible and suitable — measurable criteria for ERM2 accession could render the process more structured.
  - Such criteria would usefully emphasize real income convergence and structural preparedness — notably adaptable labor markets — as prerequisites for adoption.

### Authorities’ views and country perspectives (paragraph 18 and related bullets)
- Countries with currencies pegged to the euro and/or highly euroized NMS generally continued to see merits in euro adoption.
  - Those with pegged currencies argued the lack of monetary autonomy could be compensated by other instruments, notably fiscal policy and regulatory measures.
  - The EC emphasized that the overall policy mix mattered more than the exchange rate regime.
  - Some NMS — notably Romania — viewed euro adoption as a reform anchor.
- Most countries with floating currencies continued to value monetary autonomy and exchange rate flexibility for absorbing shocks and supporting real convergence.
  - The European institutions noted Hungary and Romania (both with flexible exchange rate regimes) requested international financial assistance during the 2008/09 crisis.
  - The ECB noted limits to monetary autonomy for non-euro area EU members: the treaty on the functioning of the EU specifies each Member State shall treat its exchange rate policy as a matter of common concern.
- Several authorities warned a large, positive “euro premium” could be a double-edged sword, potentially provoking over-confidence as before the euro crisis; current circumstances may allow a more sober assessment than the pre-crisis period up to 2009.
- Most NMS-6 authorities viewed real convergence in income levels and/or structural features as more important than nominal convergence — in contrast to adoption criteria formulated in nominal terms.
  - The EC underscored that economic integration and business cycle synchronization with the euro area varied considerably across countries, requiring a differentiated view.
  - European Institutions and some country authorities emphasized that even if adoption is not envisaged short-term, countries should prepare through structural reforms.
- Common concerns:
  - Whether ongoing reforms are sufficient to fix the euro area architecture — noting slow progress on fiscal union and insufficient common backstops.
  - Whether the euro area’s institutional framework grants sufficient fiscal and macro-prudential policy space to manage convergence and asymmetric shocks.

### Opting into the Banking Union (BU) prior to euro adoption (paragraphs 19–26)
- Background on BU and Single Rulebook:
  - The European System of Financial Supervision was set up in 2011, followed by the development of the Single Rulebook, including CRD IV and CRR (adopted mid-2013) and BRRD (adopted mid-2014).
  - The BU centralizes bank supervision and resolution via the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM); BU is open to non-euro area EU countries.
- Main motivations and expected benefits:
  - Reverse financial fragmentation, raise credibility and quality of banking supervision, eliminate home-host supervisor distinctions, unify bank resolution and restructuring, and provide a common, industry-funded backstop.
  - Expected outcomes: lower bank compliance costs, removal of barriers to cross-border banking activity, lower resolution and restructuring costs, and ultimately lower bank funding costs.
- Elements still needed for full BU benefits:
  - An effective common fiscal backstop to break sovereign-bank links (the ESM is currently acting as de facto common fiscal backstop).
  - Allowing the Single Resolution Fund (SRF) (which will be fully funded and mutualized only by 2024) to borrow against future industry levies.
  - Working towards a pan-European deposit guarantee scheme (DGS).
- What opting into the BU entails:
  - BU membership refers to participation in both the SSM and SRM; for non-euro area economies, it means close cooperation with the ECB and amending national legislation to enable national authorities to work with the ECB and the Single Resolution Board (SRB).
  - The ECB can request further information and carry out its own comprehensive assessment during the process.
  - For countries that have announced a target date for euro adoption (Romania), joining the BU prior to adoption effectively phases in necessary institutional and operational adjustments.
- Differences in treatment for non-euro area opt-ins (paragraph 23):
  - (i) Role in the SSM: non-euro countries are not members of the ECB’s Governing Council that adopts decisions drafted by the Supervisory Board (SB).
  - (ii) Fiscal backstop: non-euro area opt-ins are not eligible for direct bank recapitalization from the ESM (acting as de facto common fiscal backstop).
  - (iii) Liquidity support: non-euro area opt-ins would not automatically have access to the ECB liquidity facilities.
  - Safeguards for non-euro opt-ins include the reasoned disagreement procedure and the exit clause; non-euro area countries can terminate participation in the BU (though the ECB can take such decision as well).
- Specific sensitivities for the NMS-6:
  - Ability to influence decisions related to parent banks is critical because banking systems are dominated by euro area bank subsidiaries that are often more important locally than to parent groups.
  - Removal of barriers to cross-border transfers could reduce required buffers at subsidiary level but also reduce local authorities’ ability to ring-fence.
  - Direct participation in the SSM would allow opt-ins to vote in the Supervisory Board on issues currently beyond local supervisors’ purview.
  - Access to common liquidity and fiscal backstops matters because:
    - (i) NMS-6 still have large external liabilities.
    - (ii) Banks in NMS-6 typically hold less bail-inable funds (other than uninsured deposits) than eurozone banking groups operating in the region.
  - NMS-6 are therefore more likely to benefit from the risk-sharing aspect of the SRF or other common backstops.
- Macroprudential policy implications:
  - Under BU rules there is asymmetry: both the ECB and national authorities can tighten standards beyond the other regulator’s level, but cannot compel loosening except by reversing their own decisions.
  - Some macroprudential tools will remain under full national control (subject to notification to and non-binding scrutiny by the ESRB); SSM can impose Pillar II measures only on directly supervised banks.
  - Liquidity coverage ratio and leverage ratio can be modified by the SSM only after harmonization in 2015 and 2018, respectively.
- Evolution-dependent benefits:
  - Indirect and direct benefits from the BU for NMS-6 will depend on how supervision and financial systems evolve.
  - Potential benefits: greater financial stability in the euro area, simpler home-host interactions, and reduced funding costs if parent banks provide more or cheaper funding or if NMS banks borrow directly at lower costs.
  - Realization of lower non-deposit funding costs depends on supervisory preferences and evolving bank funding models.
  - Lack of clarity on implementation of structural measures at EU and national levels adds uncertainty about the future cross-border banking model.

### Staff’s position and decision considerations on BU opt-in (paragraphs 27–28)
- Overarching view:
  - The BU is still evolving; the opt-in decision has many moving parts and must consider country characteristics, policy preferences, and evolving BU modalities.
- Observations on when opting into the BU makes sense:
  - BU design: Lack of equal (or fully equivalent) treatment of euro area and non-euro area members tilts the decision against early BU opt-in and in favor of waiting until euro adoption.
    - Addressing SSM governance, liquidity support, and fiscal backstop issues would make BU opt-in before euro adoption more attractive.
  - BU modalities: Lack of clarity and operational experience is another reason to wait, particularly for coordination between SSM and local supervisors and between prudential policies at national and BU levels and national monetary policies.
  - Some may still opt in if BU participation addresses specific challenges that outweigh shortcomings:
    - Examples: enhancing quality and credibility of bank supervision or access to larger industry-funded common backstops.
    - Political economy considerations (e.g., distancing supervision from local vested interests) or concerns about being “left behind” if other NMS-6 join first may also drive opt-in decisions.

*IMF staff analysis as presented in the chapter titled "16.      The timing of euro adoption is ultimately an issue of preferences that can differ."*

### 29.      While acknowledging that once fully established the Banking Union would

### _cr1597 - 29.      While acknowledging that once fully established the Banking Union would

### Banking Union (BU) opt-in: NMS-6 concerns
- Protection of NMS interests vis-à-vis euro area parent banks:
  - Most NMS-6 concerned they would not have sufficient influence on SSM decisions regarding parent banks.
  - Concern that local supervisors would lose the power to set liquidity requirements for local subsidiaries; losing the ability to ring-fence local liquidity “tops the list of concerns” in the NMS-6 survey.
  - The option of exiting the BU was not viewed as a sufficient safeguard, seen as unlikely to be used due to negative reputational effects.
- Misalignment between decision powers and burden-sharing:
  - Decisions on liquidity provision and bank resolution of significant banks would be taken at the BU-level, while costs would largely be borne by individual member states in the near term.
  - NMS-6 interested in exploring ways euro area institutions could extend support to opt-ins “(on par with other BU members)” in the event of financial instability.
- Lack of clarity and limited operational experience:
  - Most NMS-6 found it difficult to assess the balance between potential future benefits and more immediate drawbacks.
- Policy space and coordination:
  - Uncertainty on how BU membership would affect non-euro area NMS ability to conduct monetary and macro-prudential policies.
- Uncertainty about systemic effects:
  - Unclear how the European financial system will evolve under the BU and how one or more NMS-6 opting in might affect those that stay out; unclear whether supervisors, parent banks and investors would view opt-ins and non-opt-ins differently.

### Banking Union: ECB and EC perspective (advantages of early opt-in)
- Benefits highlighted for NMS-6:
  - Having a seat at the table in the SSM.
  - Access to a common industry-funded backstop.
  - Early opt-in would allow participation in shaping BU operational modalities.
- Design and safeguards:
  - BU design presented as a balanced solution within the Treaty framework; non-euro area countries cannot be treated exactly the same as euro area countries.
  - Safeguards for non-euro area opt-ins cited: a reasoned disagreement procedure and exit clause.
  - Discussions on a common fiscal backstop are ongoing “with the view to achieving a better symmetry between euro area and non-euro area BU members.”
- Emphasis that close co-operation is a member state decision requiring thorough preparation.

### The EU fiscal framework and pension reform — summary of changes and context
- Framework changes aim:
  - Enhance traction and better align fiscal incentives with cyclical and country-specific circumstances.
  - Accommodating pension reform is a key element; framework specifies exemptions to reward structural reforms.
- NMS pension reform history:
  - NMS were early pension reformers; parametric reforms in late 1990s and early 2000s rendered PAYG systems technically sustainable but reduced future benefit replacement ratios “often as low as 20 percent (compared to an average of about 40 percent today).”
  - Most NMS introduced a second, mandatory, funded pension pillar: Hungary (1998), Poland (1999), Bulgaria and Croatia (2002), Romania (2007). Czech Republic is an exception (strengthened tax incentives for voluntary third pillar instead).
  - Staff background analysis: second pillars showed mixed results — typically modest returns, little diversification, and relatively high (albeit falling) administrative costs; assessment complicated by investment losses during the global financial crisis.

### Reversals of Pillar II after 2008/09 and drivers
- Reversals:
  - Many second pillar reforms were reversed after 2008/09 to varying degrees: Hungary, Poland, Slovakia, and Baltics redirected contributions to the first pillar; Romania delayed built-up of its second pillar.
  - Baltic states are in process of restoring or have restored pillar II; Poland and Slovakia partially reversed; Hungary reversed in full.
- Role of the EU fiscal framework in reversals:
  - Transition cost: Since 2004 Eurostat reclassified pillar II schemes from public to private sector, so contributions to the second pillar no longer counted as government revenue while PAYG obligations remained, increasing reported headline deficits until PAYG obligations fall—this “transition cost” persists until PAYG obligations are replaced by pillar II pensions.
  - Framework up to 2005 focused on headline fiscal balance with no offset for transition costs; 2005 reform granted very limited exemptions within the Excessive Deficit Procedure (EDP): limited adjustment “as long as it remains ‘close to the reference value’ and for a maximum of five years (on a digressive linear scale).” The exemption did not capture the full transition cost “more than 1 percent of GDP a year in countries with large second pillars (Poland, Hungary, Slovakia)” nor the full transition period “(40–50 years).”
  - Patterns: Countries with the largest second pillars enacted the largest reversals; staff finds no link between reform reversals and low returns or high fees—“if anything, the more profitable second pillar funds were dissolved.”
- Recent changes:
  - Reforms reduce the anti-pillar II bias but do not eliminate it.
  - MTOs: a portion of systemic pension reform costs can be recognized in defining a country’s medium-term fiscal objective (MTO), but in practice little link between MTO and existence/size of second pillar.
  - Excessive Deficit Procedure: the five-year restriction during which pension reform can be taken into account has been eliminated, but this applies only to the deficit and not to the debt criterion. The EDP exemption remains limited in size, penalizing countries with large second pillars.
  - ESA 2010 accounting framework (effective 2014) changed treatment but “does not eliminate the incentive entirely,” because (i) resulting future increases in social security contributions still count toward the fiscal deficit, (ii) pillar II asset transfers continue to reduce recorded government debt, and (iii) interest savings from debt reduction lower the recorded overall deficit.
  - Overall, rules and exemptions are “complex and nontransparent,” leaving the European Commission considerable discretion.

### Fiscal comparisons and indicators
- Poland vs. Germany:
  - Germany’s headline balance is “4 percentage points of GDP stronger than Poland’s,” but Poland had a stronger pension-adjusted balance in 2013 (pension-adjusted balance concept from FAD (2012)).
- Staff’s finding on gap:
  - “The gap between the EU’s fiscal framework and fiscally neutral treatment of a country’s pension regime remains sizeable.”

### Staff’s position and policy recommendations on pensions
- Core challenge:
  - Securing fiscally and socially sustainable pension systems remains a challenge; with currently legislated parameters, most NMS-6 PAYG systems will pay much lower pensions in future, risking old-age poverty and social conflict.
- Ways to avoid undesirable outcomes:
  - Accept higher fiscal burdens in future, or increase savings ahead of time to generate additional income for pensions.
- Role of Pillar II:
  - Pillar II reforms are one means of generating higher savings but not the only one.
  - Countries that have maintained pillar II should strengthen them to reduce the offset between higher private and lower public savings.
  - Countries that abolished second pillars should cope by: strengthening fiscal stance and limiting debt accumulation to create fiscal space when PAYG obligations fall due; and strengthening incentives for participation in the voluntary third pillar.
- EU fiscal framework recommendation:
  - The framework should be more neutral toward a country’s choice of pension regime; recent reforms have moved in that direction, but further steps would be helpful.

### Authorities’ views (NMS-6 and EC staff)
- NMS-6 authorities:
  - Dealing with the cost of ageing without excessively constraining future fiscal space is a major challenge.
  - Several authorities believe recent and planned reforms (notably increases in effective retirement age) address the issue.
- European Commission staff:
  - Viewed recent reforms as largely eliminating incentives to abolish second Pillar pension funds and that the framework adequately highlights implicit liability challenges.
- Divergent country views:
  - Some authorities argued for more flexibility to make the corrective arm of the SGP neutral to pension regime choice; others advocate stronger consideration of ageing-related fiscal costs under the preventive arm.
  - The Polish authorities suggested expenditure ceilings rather than deficit rules to address shortcomings of the EU fiscal framework.

### Making the most of the EU Single Market — findings and reform priorities
- Benefits of EU membership:
  - Access to larger market, catalyst for growth and convergence; stronger competition incentivizes productivity improvements; open trade and investment regime facilitates technology transfer, raising export quality and quantity.
- Structural reforms critical for export performance:
  - Staff’s analysis (experience of 10 NMS during post-accession years) finds significant explained variation in value added exports to the EU from: higher education, continuous participation in vocational training and skills upgrade, incentives to work and hire, and restrictions on foreign investment and ownership.
  - In relative importance: vocational training and skills upgrade have the strongest impact, followed by incentives to work (inactivity trap), foreign investment and ownership environment, higher education, and relative minimum wage. Integration with supply chains shows a strong positive impact, larger than most structural variables.
- Country-specific priorities (2003–11 analysis):
  - Czech Republic: above-average performance largely from continuous vocational training, lower restriction on foreign investment/ownership, and strong integration with regional supply chains.
  - Hungary: wage competitiveness, supply chain links and foreign investment environment contributed to above-average performance; contribution from foreign investment environment has declined recently.
  - Poland: room to improve integration with supply chains and foreign investment environment to boost exports to the EU single market.
  - Bulgaria and Romania: persistent below-average performance indicating need for broad-based structural reforms, particularly in higher education and foreign investment environment; Bulgaria has lost some export advantage from relatively low minimum wage, indicating waning wage competitiveness at low-skill segment.
- Export quality:
  - Most NMS-6 have considerable room for quality improvement in current export products, particularly in the EU market.
  - Romania and Bulgaria: about 40 percent of exports to the EU fall in the bottom quartile of quality.
  - Czech Republic and Hungary: exports to the EU concentrated in the two middle quality quartiles.
- Structural reforms and quality:
  - Reforms that increase exports (human capital, institutional quality, foreign investment) also tend to improve export quality over time.

*Source: _cr1597 - 29.*

### 46.      Reform priorities depend on initial conditions. For countries exporting relatively low

### _cr1597 - 46.      Reform priorities depend on initial conditions. For countries exporting relatively low

### Reform priorities and export quality
- Reform priorities depend on initial conditions of export quality.
- For countries exporting relatively low quality products:
  - Accessing technology through foreign investment and higher links with supply chains are more important than other reforms (see EBRD 2014).
- For countries with lesser room for quality improvement:
  - Further progression in the quality ladder requires significant scaling up of higher education, skills match and R&D.
- Example: Czech Republic and Hungary, highly integrated with the EU and standing taller in the quality ladder, need to catch up with some of the most competitive economies in the world; diversification of exports including through new product lines or partners would be helpful given persistent weaknesses in the post-crisis euro area.

### Market access, services trade, and the Services Directive (SD)
- Better market access is important for enhancing exports from NMS-6.
- The EU single market is less effective for services than for goods; countries face numerous export restrictions.
- The EU introduced the Services Directive (SD) in 2006 to improve access for services exports.
- Most services exports (70 percent) from the region belong to sectors covered under the SD.
- Implementation of the SD has reduced overall import restrictions on services by about 30 percent relative to the pre-SD levels, with considerable variation across countries and products.
- Progress has fallen short of expectations as many EU member states have opted to only partially reduce or even keep some restrictions.
- Staff’s analysis shows that further liberalization of the services sector would boost the NMS-6’ exports to the EU.
- NMS-6 have a comparative advantage in various services products that fall under the SD, including in professional services (Czech Republic, Hungary, Poland and Romania) which remain most protected.
- Further dismantling of restrictions by EU members, both advanced and emerging market economies, will help boost services exports to the EU.

### Revealed Comparative Advantage (RCA) in professional and technical services (relative to total services gross exports)
- Bulgaria: RCA 0.61; % of services exports under SD 5.9
- Croatia: RCA 0.4; % of services exports under SD 8.1
- Czech Republic: RCA 1.1; % of services exports under SD 29.6
- Hungary: RCA 1.1; % of services exports under SD 31.3
- Poland: RCA 1.1; % of services exports under SD 35.7
- Romania: RCA 1.1; % of services exports under SD 39.6
- Estonia: RCA 0.8; % of services exports under SD 26.5
- Latvia: RCA 0.7; % of services exports under SD 30.8
- Lithuania: RCA 0.4; % of services exports under SD 22.7
- Slovak Republic: RCA 0.8; % of services exports under SD 20.4
- Slovenia: RCA 0.5; % of services exports under SD 16.4

### Staff’s position on structural reforms
- Structural reforms are important for strengthening export integration with the EU and improving export quality.
- Main policy priorities to enhance exports to the EU:
  - Improving higher education, vocational training and skills
  - Incentives to work and hire
  - Foreign investment environment
  - Reforms to increase links with supply chains
- For countries already highly integrated with the EU market (e.g., Czech Republic and Hungary), diversification outside the EU would be beneficial.
- For quality improvement, reforms should be mindful of a country’s existing quality level:
  - Countries producing products at the lower end of quality spectrum: prioritize improved foreign investment environment and greater links with supply chains to access technology.
  - Countries at the medium-level of quality spectrum: benefit from improving skills and higher education, and innovation through higher R&D spending.
- Further liberalization of trade in sectors covered by the SD will be particularly beneficial for the NMS-6 given comparative advantages in specific services; success will strongly depend on actions by EU trading partners.

### Authorities’ views
- NMS-6 view the EU single market as key to strengthening export growth and convergence.
- Authorities agreed reforms to improve the foreign investment environment, higher education, labor market flexibility and links with supply chains are needed to maximize benefits from the single market, especially given that low wages are unlikely to remain a source of comparative advantage.
- Authorities viewed progress in reduction of barriers under the EU Services Directive as modest so far and saw significant room for growth in services exports from further liberalization, including by NMS themselves.
- Authorities acknowledged exports outside the EU have been an important source of growth since the crisis and looking outside the EU will help boost export performance.
- EU and ECB representatives agreed with staff’s findings on country-specific structural reform priorities and the importance of a well-functioning single market.
  - ECB staff noted the single market is important to tackle the apparent deceleration in the convergence process in some of the NMS-6.
  - ECB staff highlighted potential risks of cross-border supply chain participation: lock-in into low value-added activities and skill mismatches when participation is not sufficiently diversified across sectors.

### Staff appraisal: integration, euro adoption, banking union, pension and EU framework
- NMS-6 should enhance competitiveness and economic flexibility through structural reforms, while boosting fiscal and macroprudential policy space to gain full benefits from EU integration and ensure eventual euro adoption is a success.
- Euro adoption:
  - Advantages and drawbacks exist.
  - A once sizeable country risk premium associated with adoption has vanished with the euro crisis.
  - Joining the euro area implies giving up monetary autonomy, which has been valuable for absorbing shocks and containing macroeconomic imbalances.
  - Euro adoption holds advantages for highly euroized countries by eliminating currency mismatches.
  - For NMS-6 with flexible exchange rate regimes, consideration is the extent monetary autonomy can be replaced by other policy instruments and support from euro area institutions.
  - For NMS-6 peggers, an issue is the extent to which they can continue to use macroprudential tools after adopting the euro.
  - Progress with real convergence and structural preparedness are key prerequisites for making eventual euro adoption a success.
- Opting into the Banking Union (BU):
  - For countries targeting euro adoption (Romania), early opt-in may phase-in necessary institutional changes.
  - BU opt-in decision requires careful consideration of country characteristics, policy preferences and BU’s modalities.
  - Two factors tilt against early BU opt-in at this stage:
    - Lack of equal (or fully equivalent) treatment of euro area and non-euro area BU members.
    - Lack of clarity on and experience with BU operational modalities.
  - Some NMS-6 may still see net benefits from BU participation (enhanced quality and credibility of bank supervision; distancing local supervision from local vested interests; gaining access to common industry-funded backstops).
- EU fiscal framework and pension reform:
  - The EU’s fiscal framework arguably contributed to pressures triggering the unwinding of many second pension pillars after the 2008/09 crisis.
  - Recent reforms render the framework more flexible, but it continues to fall short of neutrality toward a country’s choice of pension regime.
  - Pillar II reforms are one, but not the only, way to strengthen pension systems.
  - Countries that have maintained a second pillar should reduce the offset between higher private and lower public savings.
  - Countries that have abolished second pillars should generate additional fiscal space and consider strengthening incentives for participation in the third, voluntary pillar.

### Policy recommendations for EU and euro area institutions
- Ensure ongoing governance reforms are mindful of their impact on NMS-6 economies and policy frameworks.
- Specific actions:
  - Define more specific criteria for admission to ERM2 to help guide the reform agenda in the NMS-6, and emphasize the importance of institutional, structural, and real convergence.
  - Ensure interests of non-euro area members of the BU are adequately protected:
    - SSM should establish a strong track record and clarify operational modalities as early as possible.
    - Continue discussions on the common fiscal backstop to achieve better symmetry between euro area and non-euro area BU members.
    - Consider extending liquidity support to BU opt-ins in the event of financial stress.
  - Establish mechanisms for effective policy coordination between local central banks, the ECB, the SSM/SRM and the EC to address potential tensions between prudential, growth and price stability objectives at national and supranational levels.
  - Ensure the EU framework (e.g., fiscal rules) does not create disincentives for structural reforms the NMS-6 need to increase economic flexibility and growth potential.
  - Consider further efforts to lift intra-EU restrictions on services trade, building on experience with the EU Services Directive.

*International Monetary Fund.*

### Box 3. How Do NMS-6 See Potential Benefits and Drawbacks of Euro Adoption?

### Box 3. How Do NMS-6 See Potential Benefits and Drawbacks of Euro Adoption?

### Summary of staff survey (NMS-6 central banks and ministries of finance)
- Survey objective: capture authorities’ views on potential benefits and drawbacks of euro adoption.
- Respondents: five responses from central banks (CBs) and four from ministries of finance (MoFs).
- Importance scale used in survey: 4 – High Importance; 2 – Moderate; 0 – Negligible Importance.
- Responses display considerable heterogeneity across countries and institutions.

### Perceived benefits (authorities’ views)
- Access to euro liquidity facilities is highly valued.
- Enhanced country reputation as a result of membership, potentially giving rise to lower risk spreads.
- Reduction of FX mismatches is an important benefit.
- Other potential benefits viewed as less important:
  - Euro-adoption-driven trade effects.
  - Euro-adoption-driven growth effects.
  - Boost to inward direct investment (FDI).
- Euro adoption is generally not expected to increase countries’ business cycle synchronization with the euro area.

### Perceived concerns (authorities’ views)
- Primary concerns relate to the euro area’s unfinished reform agenda.
- Related concern about whether the euro area governance framework will reduce fiscal and macro-prudential policy space, including:
  - Reduced fiscal space.
  - Reduced macro-prudential space.
- Many respondents emphasized the importance of reaching sufficient income level convergence with the euro area prior to adoption.
- Other concerns cited in responses include uncertainty about evolving euro area institutions.

### NMS-6 survey results (notes)
- The survey employed a numeric importance scale (4, 2, 0) and reported the balance of opinion across the nine responses (five CBs, four MoFs).
- Key items emphasized in written summary and survey output:
  - High importance: access to ECB’s liquidity facilities; lower country’s risk premium; reduce vulnerability from FX mismatches; enhance country’s reputation.
  - Moderate to high concern: income level convergence prior to euro adoption; uncertainty about evolving euro area institutions; potential reductions in fiscal and macro-prudential policy space.
  - Lower importance: increases in trade with the euro area, boost to inward FDI, and alignment of business cycle with the euro area.

*International Monetary Fund — Box 3, “How Do NMS-6 See Potential Benefits and Drawbacks of Euro Adoption?”*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr1597.pdf_