April 24, 2004
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MS. LOTZE: Welcome to this briefing on euro-adoption with Susan Schadler, Deputy Director of the European Department and one of the authors of the IMF study "Adopting the Euro in Central Europe". An advance copy of the study is available outside the room, and a final version will be published as an Occasional Paper this summer.
Before I turn the floor over to Ms. Schadler, I wanted to point out two IMF events in relation to the study and EU enlargement. The first is an economic forum on the issue of euro adoption on May 4 at 2:30 p.m. at the IMF Auditorium. The event is open to the public. The second is the June issue of the IMF publication Finance&Development, which will focus on EU enlargement and discuss such topics as the economic challenges facing the new members; Europe's lagging economic performance compared with the United States; the future of the Stability and Growth Pact; and immigration policy, among other issues.
So on this note, I will turn it over to Ms. Schadler.
MS. SCHADLER: Good afternoon. Thank you, Conny.
A little over a year ago when the timing of enlargement was firming up, an IMF staff team started a study on the major macroeconomic issues in the course of the next step of European integration, that is, adopting the euro in the new member states. In the study, we looked principally at the macroeconomic benefits and challenges of euro adoption.
We focused on five Central European countries: Poland, Hungary, Czech Republic, Slovak Republic, and Slovenia. This is not the full 10 that are the new member states who are eventually all going to adopt the Euro, but we focused on these five because they are the five where the largest issues in terms of a change in their policy regime from a largely flexible exchange rate regime to a fixed exchange rate regime presents the greatest challenges.
We have not, however, looked at any of the specific paths that these countries should take from where they are now to adopting the euro; rather, what we're searching for is generalizations about the problems and the opportunities and the possible solutions to problems that these countries will face.
What I'm going to do today is just summarize a few of the brief points. In very broad terms, the study reaches three conclusions: that the potential for euro adoption to significantly accelerate the income catch-up in these countries is large; that the policy requirements for achieving that acceleration and catch-up are quite demanding; second, that each country needs a strategy to prepare for euro adoption, and the specific strategies that the countries adopt will make a difference, both in terms of the gains that they realize from adopting the Euro and from the potential risks that they face during this major policy regime change. And finally, the strategies need to be crafted around the particular country of these countries and what I would say are the vulnerabilities that stem from these characteristics.
Now, let me first say a few words about costs and benefits of euro adoption for these countries. On the benefit side, several years ago, Andy Rose did a study of the gains for countries joining currency unions, the gains for trade, and his conclusion was that being a member of a currency union stood to increase your trade vis-à-vis other members of the currency union threefold. And that's a very, very large estimate and suggests that countries joining the currency union would see a 300 percent increase in their trade with other currency union members, quite a startling conclusion.
Subsequently, there has been a flowering of research around this issue, and most of it has discredited those very, very high estimates. But still, the overwhelming conclusion from the literature is that there are substantial advantages to be had from joining a currency union, but the range of estimates is very wide.
We have looked at these fairly carefully for the Central European countries and have concluded that something in the range of an increase in trade with other countries in the currency union of 10 to 85 percent could occur.
Alongside this benefit and the benefits that that would bring for growth that these countries would enjoy an elimination of the interest rate risk premium; as they eliminate exchange rates, the risk that is inherent in investing in those countries would be diminished. They will also benefit from the discipline of the Euro area macroeconomic policy framework.
All in all, we come to a conclusion, again, very wide estimates, that countries could stand to gain very substantially, even by as much as 20 percent increase in GDP over a 20-year period or relatively little, as little as 1 percent over the 20-year period. But from these various benefits, they are almost sure to realize gains.
But there will be costs, and the chief cost of joining the currency union is the potential for increase in economic volatility. Why could these countries face additional volatility? Well, economic shocks differ among different countries; different countries are affected differently by the same shock, and different countries experience different shocks, and an independent monetary policy is one of the chief ways that a country uses to smooth over those shocks. Without an independent monetary policy, it must rely on other mechanisms, principally wage and price flexibility but also flexibility that would come from the operation of fiscal stabilizers.
Now, how much additional volatility a country could experience from joining the euro area depends a lot on how large the shocks are, how different the shocks are from those in the euro area to which euro area monetary policy is anyway attuned and how frequent those shocks would be. Our conclusion from examining the various arguments and data fairly carefully is that properly prepared, the new member states should experience substantial gains from adopting the euro.
Let me turn briefly now to the question that most of the study is devoted to, and that is how to prepare and position the countries to maximize gains and minimize risks of disruption from the process of adopting the euro.
Most of the study is devoted to three broad efforts. One is to identify the key characteristics that exist in the Central European countries and from that to see what kinds of vulnerabilities they would face during the euro adoption process; and third, to look at potential strategies that countries might consider in order to minimize those risks and maximize the gains.
I'm going to focus on a few characteristics of vulnerabilities here just to pick out the ones that I think are most important. First of all, macroeconomic features and policies: in each of these countries, inflation has fallen quite sharply over the last several years. But several of them still have inflation rates that are above euro area inflation rates by a substantial margin, as you can see here: Hungary, Slovak Republic, and Slovenia all still have fairly high inflation rates, whereas Poland and the Czech Republic have inflation rates that are even below those in the euro area.
Second, fiscal deficits are large. Mostly, they exceed the maximum SGP limit of 3 percent of GDP. In many cases, they are even rising between 1999, the section in blue and 2003, the section in black.
In addition, these countries have still moderate debt ratios, but their debt ratios are also rising. These two characteristics, the inflation and the fiscal positions, lead us to the conclusion that still, further considerable efforts are needed to align macroeconomic policies in the euro--in the CECs with those in the euro area.
Why is this important? Well, without inflation being low enough, being close to the inflation rate in the euro area, fixed exchange rates will erode competitiveness. The fiscal side, even in the currency union, fiscal deficits, large fiscal deficits and high debt can crowd out private investment; and the third area, which is more difficult to quantify, but I think at least as important as the first two, labor and product market flexibility will be very important in order to maximize the trade gains and to absorb shocks.
I want to point to three other issues on the financial sector side that will be very important: first, choosing central parities. This is obviously an important part of the Euro adoption process. We devote quite a bit of attention to looking at the considerations that should go into the choice of central parities, and I think I could basically summarize our conclusions in three broad statements.
First of all, we are advocating the countries aim for choosing a true equilibrium rate. We are not suggesting that there are any gimmicks to over- or under-valuing that could better position the country for the tasks ahead, but we also put some emphasis on looking at how countries will go about choosing central parities. How do you choose an equilibrium rate? And we certainly agree with what is found in many other studies, that the range of equilibrium rates is very, very large, so it's not going to be easy to pinpoint where in the range of estimates of equilibrium countries should necessarily be.
This leads to the third conclusion, that we believe strongly that the risks of overvaluing are probably greater than the risks of undervaluing. So that will be an important consideration in deciding where within this range of equilibrium estimates countries want to be.
A second issue that commanded a lot of our attention was the risks of very rapid bank credit growth during or even after countries adopt the euro. This is just a quick picture to show you quickly how different the ratios of bank credit to the private sector are in the Central European countries compared to the euro area. As you can see, in most of these countries, bank credit through the private sector relative to GDP is about half the level that it is in the euro area. This suggests that there is substantial scope for a very rapid expansion of bank credit, as these countries catch up to euro area rates of bank credit relative to GDP.
As you can see, it has already started. This light blue line is the ratio for 1999; the darker line is that for 2002, and you can see that already, that increase has started. The question in our minds is how quickly will it continue?
There, we turn to some of the existing non-core euro area countries to see just how fast, in similar sorts of circumstances, their bank credit to the private sector picked up immediately before and just after their Euro adoption. And as you can see, the experience was very wide.
In some cases, here, the black line is the actual euro area bank credit to the private sector, and the blue line is the actual bank credit to the private sector in each individual country. The red line is a fitted trend. So you can see that in several of the countries, notably Greece, Ireland, and Portugal, the situation was also--it was also the case that bank credit to the private sector was substantially below the euro area average in the early 1990s, and in the case of Portugal, where there has been quite rapid credit growth, there has been even an increase beyond the euro area level, whereas in Greece, the increase has been very moderate, and they actually remain below the euro area level.
So where in this range are the Central European countries likely to fall? Well, our estimates suggest that in fact, the Central European countries could well experience rapid credit growth well beyond that of Greece, maybe looking something more like Ireland and Portugal. And in fact, some of the near term annual estimates are likely to be worrisomely high, but there are a few things that reassure us in this picture.
First of all, these adjustments, as I said before, will be toward a sustainable equilibrium in general, so unless it overshoots, as perhaps some people think it might have in Portugal, they should still be in fairly safe territory. Also, in each of the non-core euro area countries, these rapid credit growth episodes have occurred without any major incidents for the banking sector, and third, we have recommended a variety of measures the countries should consider to restrain credit growth if it begins to look too rapid.
Why don't we turn now to the last issue I'd like to raise, and that is the balance sheet risks for countries with large capital inflows. I want to point to a couple of things. First of all, net capital inflows to these countries have been, over the last several years to these countries have been, over the last several years, substantially higher than any of the countries that we've seen in the euro area. This is a comparison, on the top, of net capital inflows to the Central European countries. The blue line is the total net capital inflow. The components, other inflows, portfolio investment and direct foreign investment are the various colored segments of those lines.
And you can see that they are, relative to GDP, about twice or even in some cases higher than twice the inflows that the southern EU members faced during--before and even subsequent to euro adoption. So in a sense, in these countries, we are really in rather new territory in terms of just the sheer size of the inflows, and because inflows are very large, the potential for volatility in those inflows, a potential for the leveling off of the inflow or even of a reduction in the inflow.
Now, we are somewhat reassured by the very large black segment in these Central European country pictures. That's direct foreign investment. The direct foreign investment component of these inflows is very large, and that leads us to the belief that these are relatively more stable inflows than in some of the other countries that we've seen.
At the same time, what we see in these countries are relatively high interest rates compared to those in the euro area. In the euro area, and several of the countries in the euro area, are shown in blue. The Central European countries are shown in red here. And you can see that, with the exception of the Czech Republic, each of these countries has interest rates that are now several hundred basis points higher than in the euro area.
This means that there is a real temptation in each of these countries for borrowers to borrow in foreign currency and not to hedge. This is what we call the balance sheet problem. If a company is going out and borrowing in euros, it has an exposed position in euros, and should there have to be, for example, devaluation or a depreciation in one of these countries, that would impact heavily upon the companies and potentially on banks. This is a problem to which, of course, in the Fund, we are highly attuned, because we have seen these circumstances arising in a number of countries, some of which managed the process quite well and some of which have landed in balance of payments crises.
But we have essentially three recommendations that come out of this picture for the Central European countries. First, we believe strongly that they should stick to what we call the corner solutions for exchange rate policies. By that, I mean that exchange rate policies should aim either at a hard peg, which effectively eliminates the exchange rate risk; that's one corner of the solution. The other corner is a flexible exchange rate framework, in which the risk is explicitly shifted, the risk of open balance sheet positions is explicitly shifted to the private sector.
The second component of the strategy would be to set clear monetary policy frameworks so that countries' authorities communicate clearly to markets how they plan to respond in policy terms to any shocks that could arise. And third, we recommend that countries make their plans and form their strategies for adopting the euro around one of getting in place the key requirements, particularly on inflation and fiscal deficit sides, before they go into the ERM2 so that they can be in the ERM2 for a relatively short period. The rules, of course, are that they must stay in the ERM2 for two years, and we certainly are not contesting that notion, but we are saying that countries should not plan to have an indefinite stay in the ERM2.
So, to conclude, potentially, we see very large net gains from euro adoption in the Central European countries, but there are several risk factors in the Central European countries: the not yet aligned macroeconomic policies, the potential for credit booms, capital flow volatility, that call for three-prong strategies: low fiscal deficits and inflation, strong financial sector oversight to ensure against the risk of credit booms; and clear monetary policy frameworks.
Thank you.
QUESTIONER: Do you think it's a wise thing for these countries to actually strive for the euro area? They are so financially poor compared to the present euro countries. Is a euro area monetary policy good for them, because they are so poor?
MS. SCHADLER: You know, I think there are two parts of my reply to that question. First of all, because we think the potential for major increases in trade and potentially GDP from adopting the euro, we do strongly believe that countries could benefit significantly if they're prepared properly from adopting the euro.
Is euro area monetary policy right for the Central European countries? Well, I pointed out that certainly, there are circumstances in which one could imagine it could be wrong. When something happens, some shock occurs in these countries, I mean, take just 1998, the Russia shock. The Russia shock affected the Central European countries considerably more than it did the Western European countries. And as a result, you could have seen monetary policy adjusting in the euro area in a way that was not appropriate for the Central European countries.
In fact, what we find in the study--we do quite a bit of work looking at the degree to which the economic cycles and the scope for shocks in these countries to differ from those in the euro area, and we find that these countries are, in fact, rather closely aligned, in fact, in many cases, more closely aligned than the Southern European countries are even now with the euro area. So we aren't very concerned from that side.
I should say one third thing, too. You are talking about whether relatively low-income countries compared to the euro area should be having the euro area monetary policy, and I would say there I also don't think that there is any reason to think that there is a problem. I think that lack of convergence of cycles or shocks that occur to these countries that then occur to the euro area are the more serious concern, but actual disparities in per capita GDP, for example, are not necessarily a reason to have a different monetary policy.
QUESTIONER: With the actual pace of the fiscal reforms in the Central European countries, when do you believe that these countries will be prepared to adopt the euro, is the first question? And which one of these countries is right now best prepared for all--is closest to adopting the euro?
MS. SCHADLER: Well, I think that the countries all have a number of issues that they can address before they should adopt the euro. I think that this is not so much a question of even when they will be allowed to adopt the euro, but they, themselves, looking at their own considerations of the benefits of adopting the euro, it is very much in their interest that these conditions be right before they adopt the euro. Otherwise, these kinds of problems with the euro area monetary policy not being right are going to be serious problems.
Now, in terms of when do I think they're going to be ready? You know, I think this is very much a process that needs to unfold in these countries. You know, there needs to be the public support for euro adoption that leads to the fiscal consolidation and very strong monetary policy frameworks that get inflation low and keep inflation low.
That process needs to take place, and in some countries, let's face it, I showed you the picture of the fiscal deficits; they are substantially out of line with what they would need to be to have a country be successful in the euro area.
So it's a question of political consensus: when will these countries get the political consensus to undertake the fiscal reforms that they need? That's true for four of the countries. Slovenia is the one that stands out, in the sense that it already has a fiscal position that is well within, both in terms of its deficit and in terms of its debt ratio, well within the parameters of the euro area countries, and--Slovenia. The Czech Republic has a--still, as you saw from the--the black line is substantially in excess of the 3 percent of GDP. There is a lot of work to be done there before they could really feel ready to adopt the euro.
So I think it's less a question of someone from the outside saying when it could happen than people on the inside wanting it to happen and making it happen.
QUESTIONER: Of course, we don't agree with you, but we do admire your expertise. And I haven't any argument with that. However, the idea of setting exchange rates to the end of the solar system is surely something which the IMF has learned from experience, for example, in Argentina, which makes no sense.
Is the implication of what you're saying that the IMF actually supports the wholesale collectivization of currencies, or are you just presenting a technical approach, and you're not jumping on either side of the fence? Because if the IMF supports fixed exchange rates, one could argue that you haven't learned anything since the founding of the Bretton Woods organizations at all.
MS. SCHADLER: Well, that's a big question, so I don't want to answer on behalf of the entire Fund. I should probably have said at the beginning that this study reflects the views of the author, not the views of the Fund. It has been discussed in the Executive Board, and you'll see the views that they had on it. I believe it's in the published version.
Well, let me bite off a few smaller pieces of that very big question. First of all, this is a study of five Central European countries. It's not a question of whether we believe that all countries in the world should fix their exchange rates, and there should be one currency. It's a question of whether these five countries, which are obliged in the Acquis Communitaire to adopt the euro.
But it's a question of whether they should see this as a near-term goal or a long-term distant goal. And there, I would say one really does need to look at the very substantial amount of work that's been done on the advantages of being a member of a currency union. I don't think anybody is in a position to argue that there are not significant advantages to trade and output from being in a currency union so--
QUESTIONER: Then why is Britain doing better than the rest of Europe?
MS. SCHADLER: Well, these studies are all long-term studies. We're talking about gains that take place over 20 to 30 years. We are certainly not going to get involved in a discussion of, you know, cycles over the last five years. That's a completely different issue. There are going to be cycles in all countries, and that's largely independent of this currency union question.
But the studies that are coming out of EMU are finding indeed that EMU has conferred substantial benefits in terms of increased trade. And this is not trade diversion; it's trade creation, that is, additional trade to trade that already takes place outside the borders of EMU and therefore presumably on to output.
So I think the first thing you have to look at is those very substantial gains from trade. I think the second point is that, you know, in this what we call corner solution or bipolar view of exchange rate policy, one of the poles is hard pegs.
Now, a currency union is the quintessential hard peg. It must be recognized that the policy conditions to make a hard peg work are rigorous, and that is one of the things that I have been trying to emphasize this afternoon and have certainly emphasized ad nauseam, I would say, in the study; that these countries need to prepare carefully to go into the currency union.
They cannot go in with policies vaguely aligned or temporarily aligned. They need to make a commitment to having policies aligned with the euro area. But once that condition holds, I don't think that there's anything in what I might call conventional view of the IMF that suggests that a currency union is not a viable exchange rate arrangement.
QUESTIONER: Prices across the EU have not converged; I mean, my wife bought a property in France, and we found that the same property was selling at a completely different price in Germany. And of course, you've got varying long-term interest rates as well. That's the other factor. So in fact, you know, the system doesn't work in key respects.
MS. SCHADLER: Well, I don't know whether I would consider either of those things being evidence of the system not working. If you look in the United States, which I think we would all have to say is a fairly successful currency union, I can promise you that the things that I buy in Washington, D.C., my kids, who live in New England, are not buying for the same price. Do I think that's not working? No, I think it's regional disparities and tastes and, you know, sales that occur in some places at some time and not at some places in another time. So no, I don't think there's any reason to judge the operational efficiency of a currency union simply by whether prices of similar goods are the same in two different place.
On interest rates, actually, I would completely differ with you. Long-term interest rates, we hope, are going to remain sensitive to the debt positions of various countries. I mean, this is one of the remaining disciplining devices that we hope continues in a currency union, and a country that has very large debts has higher interest rates than a country that has very small debt. You know, I think the evidence is that indeed, those differential risk premia do exist on long-term interest rates, and I would say that's the market working rather well in a currency union.
MS. LOTZE: Okay; if we have no more questions, we thank everyone for coming, and that concludes the press conference.
Thank you.
[Whereupon, the press conference was concluded.]
