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Transcript of an IMF Economic Forum
Adopting the Euro in the New Member states: the next step in European integration

Washington DC, May 4, 2004

Participants:

Susan Schadler (Moderator)
Deputy Director, European Department
International Monetary Fund

Lajos Bokros
Director for Financial Advisory Services
World Bank (& former Minister of Finance of Hungary)

Peter Kenen
Professor of Economics and International Finance
Princeton University

Hari Vittas
Alternate Executive Director (Albania, Greece, Italy, Malta, Portugal, San Marino and Timor-Leste)
International Monetary Fund

J. Onno de Beaufort Wijnholds
Permanent Representative, USA
European Central Bank

View a webcast of this Economic Forum using Windows Media Player.

MS. SCHADLER: Thank you for coming today. We're delighted to have this opportunity to discuss what I think is one of the most interesting items on the European agenda for the next few years, and that is after the enlargement, how do the new member states approach the major question of how and when to adopt the euro as their national currency?

Today we have a panel of four people who will each do a very short presentation. I'll then try to sum up and pose some of the main questions that were raised or at least occurred to me in the course of these presentations. Following this we'll open the floor to questions and have an exchange of views among the panelists.

Let's start with Onno Wijnholds, who is the Permanent Representative of the ECB, and the ECB's observer at the IMF. This is after many years of being the Dutch Executive Director at the IMF's Executive Board.

Onno?

See Mr. Wijnholds' presentation (209 kb PDF file)

MR. WIJNHOLDS: Thank you, Susan.

Let me start with a question. There's something wrong with the slide. I wonder who sees it?

Well, I will tell you, there is a big chunk missing and those are the new member states. So we are missing a big part of territory to the east and 75 million people, and of course, also the islands of Cyprus and Malta are not in there. So I've asked my colleagues at the ECB in Frankfurt to get their draftsmen working on the new situation.

We're here to talk about adopting the euro in the new member states, and, well, I'm hitting the button. There we are. Technologically challenged.

Well, the new EU member states have an obligation to adopt the euro or in the jargon, they have a derogation. Because there's no indication of a time path, they can take their time doing it, but they are expected to adopt the euro at some point or other. This is different from, for instance, the United Kingdom and Denmark, who have a so-called opt-out option, but the new member states have all accepted this situation.

Now, euro adoption requires a number of things. First of all, meeting the Maastricht criteria, the convergence criteria. Those criteria were formulated at the time of the Treaty of Maastricht 12 years ago, and I will come back to the situation as regards the criteria a little later.

This also includes a requirement for a stay of minimally two years in the exchange rate mechanism, ERM-II, and they will of course have to be in agreement on an entry exchange rate level. This is something that is a collective decision and I will also mention it a little later.

The compliance with the Maastricht criteria is assessed by the Council of European Finance Ministers on the basis of reports by the European Commission and the ECB. So there are large numbers of economists busily working already on all these matters.

Let's have a look at the present situation. We have here the 10 countries plus the two so-called accession countries who will hopefully join the European Union in 2007, Bulgaria and Romania. And I have listed the various currency regimes in order of let's say the hardness of the peg, beginning with the two Currency Board cases, Estonia and Lithuania. Then the pegs to a basket, Latvia and Malta. And then there are two countries that peg to the euro, Cyprus and Hungary, with Hungary having--and I put it in parentheses--some form of inflation target. I won't go into details I might get it wrong too, and make people unhappy, but there is an inflation targeting approach there.

Slovenia, the Czech Republic and Slovakia all have a form of managed float, and they either have a monetary policy framework in this (?) of monetary targeting or inflation targeting.

Finally, Poland is a freely floating country. I've just been assured that there will be no intervention, and the country operates on an inflation target, whereas Bulgaria has a Currency Board and Romania a crawling band with a monetary target.

Let's talk a little about the ERM-II. Joining the ERM-II is something that countries can do without going through any particular process. There are no formal requirements. But of course it's necessary to go into the ERM-II before you can adopt the euro. And an immediate joining of the ERM-II implies euro adoption in two years time at the earliest. In other words, if countries will soon--and there will probably be a number who will soon ask for joining up in the ERM-II--they come now, the earliest realistic date for them to adopt the euro is January 1, 2007 I would say.

Some countries have indicated that they want to move fast. There were some press reports in the last few days about this, mention of the two Currency Board cases in the Baltic States, and a little later perhaps Slovenia and Cyprus. And other countries have been pondering the question and there seems to be an indication that some of them feel they need a little more time on this.

Now, the acceding countries are rather heterogeneous in terms of their economic development and structure, which would point to a case-by-case approach. So there's no question of all countries going there together, but we will see them come according to a certain sequence.

There's also a view, and this is a view shared, for instance, by the European Central Bank and IMF staff, that it is wise to do major adjustments that still have to be done in the new member states and reforms, to do them before joining ERM-II.

Now let's look at the so-called convergence criteria. Moving toward Maastricht. I have listed only three of the four criteria. I have not included the long-term interest rates. I think that's perhaps not the most problematic one. Not that the situation is all that problematic, but as you will see, in terms of the inflation criterion which is a somewhat complicated criterion, namely not more than 1.5 percentage points above the three best-performing countries, at most. That is the official language. And what that will mean in practical terms is a little difficult to say right now, but what one can say is that inflation in a few of these countries is clearly too high, Slovakia being I think the most obvious case.

Now, as regards budget balance, where the Maastricht criterion is 3 percent of GDP deficit, we see even a surplus case, Estonia, but we see some quite large deficits. I hasten to add that in the Czech Republic that seems to be a bit of a snapshot of an unusual situation, and the underlying position I understand is certainly not as bad. But nevertheless, a number of countries have quite a way to go towards meeting the budget deficit criterion. Then there's also the debt ratio criterion. This is a 60 percent of GDP criterion. However, there is also a qualifier in the sense that countries that see their debt ratio fall and are still above 60 percent, well, they should be okay, to put it in colloquial terms.

So I think on the debt ratio things don't look so bad as long as, of course, countries do adjust their fiscal deficits to bring them down to lower levels so that the debt ratios can also come down where required.

Now, as to ERM-II, the question has often been put forward how wide is this band going to be? The countries have to join this exchange rate mechanism with respect to the euro, and there was an impression at some point that the so-called narrow band of 2-1/4 percent, which had been applied in the early days of ERM-I, would also apply here, but this is not the interpretation that is now I think commonly accepted. It is going to be the wide band of plus/minus 15 percent. However, and I have quoted here a sentence exactly to get it right. "However, the assessment of exchange rate stability against the euro will focus on the exchange rate being close to the central rate while also taking into account factors that may have led to appreciation."

What this says is really we don't want you to devalue at your initiative when you are in ERM-II. It's okay if you appreciate. After all, this is not uncommon for countries in a catch-up process, as you will see, but we do want you to show that you can keep your exchange rate pretty stable and not fluctuate too far away from the central rate.

There are two views that one can see with respect to ERM-II. One is the view that it is going to be merely a waiting room and you have to get over it as quickly as possible, or the other one, which says you have to see this as a workout group and where you build up muscle for being strong when you enter the euro zone as a full-fledged member. So the waiting room view is, let's get it over as quickly as possible because particularly during a period you might be subject to capital flows which could be quite disruptive. The workout view, however, says you have to see the period of ERM-II participation as one where you can fully prepare yourself for adoption, and which would allow you to take those measures still needed to enter the euro zone in a robust fashion. And, yes, as I hinted, you can gain experience functioning with an exchange rate anchor.

Then I come to my final slide. I want to very much emphasize that the new member countries are embarking on a very important historical process, which should be seen as an irreversible step. And joining the European Union is both an economic and political act. I cannot emphasize enough that while there are very important economic benefits to be gained, the political aspects of it are at least as important.

Furthermore, joining the European Monetary Union and adopting the euro implies even more investment of economic and political capital. Therefore, adopting the euro should be seen as an irreversible step. In my view the new member states are well on their way towards adopting the euro, but some will need more time than others to get there, as we all could see from the graph on the convergence criteria.

The European Central Bank is very much looking forward to working closely, even more closely than they do already now, with the new member states, with the central banks, and there will be a time, of course, when they adopt the euro that their governors will be part of the Governing Council of the European Central Bank, which will be enlarged at that time.

Thank you.

MS. SCHADLER: Thank you, Onno.

Next I will ask Lajos Bokros to speak. Lajos is currently the Director of Financial Advisory Services at the World Bank and was formerly Finance Minister in Hungary, now still very engaged, obviously, from his own country's perspective, with questions surrounding euro adoption.

MR. BOKROS: Thank you very much, Susan.

Before elaborating on the subject, ladies and gentlemen, I have to make two introductory remarks. The first one is that I was invited to this panel only a few days ago, and returned from mission on Sunday only, so I haven't had time to read the IMF paper, which is a must for everybody to read, by the way. So that I will not comment on the paper.

The second comment is that as a citizen of a new EU member country, which hardly meets any of the Maastricht criteria laid down for EMU accession, obviously I will not talk about the need to change those criteria, because that will not be credible at all.

Rather, I will talk about what the 8 new EU members should do to put their house in order, their own house in order, in order to benefit from eventual EMU accession, which is likely to enhance their growth potential and very much contribute to their financial stability through better discipline and more prudent fiscal policy, and consequently also enhance competitiveness.

If we make a small very sketchy analysis of the growth pattern of the Baltic countries, on the one hand, and the Vishegrad countries, on the other hand, we can see that these patterns are very, very different. In the Baltics there was a kind of recession in 1999 as a consequence of the Russian financial crisis and meltdown. But then from 2000 onwards what we can see is very rapid growth.

The Vishegrad countries in a sense it is different. In Poland and Hungary we had quite rapid growth until 2000, but then we have experienced marked slowdown ever since. Slovenia is pretty similar to that. In the Czech Republic and Slovakia, 1998 was also a kind of turning point because that was the time when both countries really started real structure reforms in the corporate and banking sector, both restructuring and privatization, and as a consequence you also have slow growth and higher unemployment.

If we put one further element into this picture, like for example, the general government deficit. As a former Finance Minister, obviously I have to talk about fiscal issues. You will see that in the Baltics, 1999, there was a shooting up of the deficit, but then between 2000 and 2003 the deficit was small, deficit is small even today, well below 3 percent. The Vishegrad countries, in Poland and Hungary, fiscal deficit was, let me say, manageable until 2000, but then there was rapid growth. There has been rapid growth ever since. In the Czech Republic there was constant growth in the deficit from 1998 to 2003. In Slovakia the deficit grew until 2000 and then stagnated more or less at that level.

Now, if you introduce one more element into this picture, namely the size of the fiscal sector on the economy, which I think is even more important in the long run, compared to deficit, we can see an even more marked difference between the Baltic countries and the Vishegrad countries. In the Baltic countries we see a constant reduction of the size of the fiscal sector and now it is below 40 percent of GDP, while in the Vishegrad countries there was a constant growth of the size of the fiscal sector and it is well above 40 percent, Hungary being an outlier, which has about 50 percent fiscal sector compared to GDP. Slovenia is a kind of a middle of the road situation because the size of fiscal sector remained largely constant over this period of time.

Obviously, I have no time to enrich this very short and sketchy analysis by adding the other important variables, like inflation monitoring policy, foreign direct investment, consistency or inconsistency of monitoring fiscal policy, the existence or lack of structural reform.

But in any case, by and large, we see the following dichotomy in patterns of recent development. In the Baltics we have high growth, a small fiscal sector, low deficits, prudent fiscal policies. In the Vishegrad countries we have markedly slower grower, a big fiscal sector, high deficits, and much less prudence in managing fiscal affairs.

It's no surprise as a consequence that Estonia, Lithuania, Slovenia also to a certain extent, mentioned already that they could go and will go to ERM-II very soon. And the Vishegrad four countries are likely to follow them only later, and only if they undertake very serious public finance reforms, like taxation which was already started in Slovakia, like pension reform, which was started in Poland and Hungary, but these reforms have to be started in the Czech Republic and Slovenia too, and complemented by other reforms like health care, education, public administration, social policy, local government finance, you name it.

I wrote a book which was published in Hungary two weeks ago, exactly two weeks ago, entitled Competitiveness and Solidarity. Some people say even here in the Fund that its message is relevant to all Vishegrad countries, not just like Hungary. In this book I argue that in order to speed up real convergence we need to enhance growth by significantly improving our international competitiveness, because there is a dichotomy within our countries. While manufacturing in most countries, energy, in all countries banking, trade, and other services have been largely restructured, privatized, and thus these sectors have already realized huge productivity and efficiency gains. Unfortunately, the agriculture, and even more so, the so-called state sector, have largely avoided any major systemic change or systemic transformation. The state sector, as we can see, is large, costly, represents a huge burden on the already-reformed and restructured and privatized part of the economy, which is the real economy. But even more important, the services of the state sector, the quality of services, is constantly deteriorating, especially in health care and education, which in turn affects very negatively the future quality of labor in these countries, and as a consequence, competitiveness.

So I would argue very shortly that we need comprehensive public finance reforms in all Vishegrad countries in order to reduce the size of the fiscal sector, the size of deficit, but also the size of public debt, no matter what we feel about the 60 percent criteria. For some countries 60 is too much. For others maybe it is too low.

We need to improve the quality of services, especially in human infrastructure. That's the only way to enhance the quality for labor.

And finally, last but not least, we have to improve social cohesion by better targeting social transfers. We have to distribute much less but then target those social transfers and funds to really needy people. Middle class people, richer people need lower taxes, not more subsidies, and we have to target those subsidies really to those who have no choice but to get them.

Thank you very much.

MS. SCHADLER: Thank you, Lajos.

Next we'll hear from Hari Vittas, who is the Alternate Executive Director from Greece on the IMF's Executive Board, and he's going to speak a bit on Greece's experience, which in many respects parallels some of what we can expect in some of the new member states.

See Mr. Vittas' presentation (110 kb PDF file)

MR. VITTAS: Thank you, Susan.

Good afternoon, ladies and gentlemen. I will need some help to put my slides on the screen.

Let me begin by saying that my task is mainly to explore whether Greece's experience in joining the ERM offers any clues to the new member states as they try to develop their own strategies for adopting the common currency.

Greece's experience may be of interest because it is the only country that was not there--so far that was not a founding member of EMU. It joined EMU three years after it was created. Arguably, also there are some similarities between Greece's experience, Greece's economic structure and stage of economic development with that in the new member states, but I would hasten to add that there are some major differences. It would be wrong to assume that any of the new member states would have to follow a similar path to the adoption of the euro as Greece followed.

[Technical interruption.]

MR. VITTAS: Here we are. The first issue that I would like to explore relates to the potential benefits and costs of economic integration. A lot of research has been done on this issue and the main findings can be summarized as follows. The economic benefits of integration are potentially very large, perhaps as large as 20 percent of GDP. However, there are also significant costs, the most important of which are the loss of monetary autonomy, which implies that the range of instruments that countries may have available at their disposal to deal with adverse extraordinary developments would be reduced. This may lead to some increased volatility over time.

One issue that is not clear from the research that has been done so far is how quickly these economic benefits accrue. Do they begin accruing when a country joins the European Union or even before, or do they have to wait for the largest part until the country also becomes a member of the Monetary Union?

To try to see if Greece's experience offers any insights on this issue, I have prepared two graphs. The first one which is now on the screen shows how the standard of living in Greece has evolved since Greece became a member of the European Union in the early '80s. There are two measures of the standard of living, but both give the same picture, so I will not spend any time explaining what are the differences between them.

The important thing is to see that for the first 15 years or so after Greece became a member of the European Union, there was not evidence of a convergence. In fact, the standard of living in Greece declined, relative to the average in the EU. However, after the late 1990s, the situation has changed quite a lot. There has been a significant improvement in the relative performance of Greece. By the start of the present century Greece was more or less back where it started when it became a member of the European Union.

Before I draw any conclusion from this picture, I'll show you the second chart, which tries to explain why Greece's performance in the first 15 years after it became a member of EU, was so poor. This was a period that was marked by very high budget deficits in Greece, lack of wage discipline. Nominal wage increases were very high. Inflation was very high. There was a need to devalue the currency every now and then to restore competitiveness. The economic performance was very poor. Again, things changed in the mid '90s when Greece adopted unilaterally her currency policy. It gave up its monetary independence.

Now, a lot on these two charts and the general information is available on Greece's performance. I'd like to draw the following benefits. First that the potential benefits may be large, but they are not automatic. They can easily be wasted in the absence of good supportive policies. The monetary integration process may help to realize the benefits of integration in large part by providing very strong incentives for a country to pursue disciplined macroeconomic policies, and the final conclusion is that for Greece, the loss of monetary autonomy was more a blessing than a curse.

Of course, I would not suggest that this conclusion applies to all countries in general, but it may have some significance for at least a few of the new member states.

The next issue that I would like to say a few things about is the timing of ERM entry or the adoption of the euro. The typical advice that is given to new member states includes three elements. First, do not rush into entering the ERM. It's important to achieve an adequate or a sufficient degree of nominal convergence before you do it. Second, avoid to the extent possible a prolonged stay in the ERM, as this could be very risky. And third, it may be useful to have a clear target for the adoption of the euro.

I could anticipate my convergence by saying that Greece's experience supports the first, and perhaps to a lesser extent the third element of this advice, but not the second. The first part of the advice, Greece adopted this hard currency, hard drachma policy in 1994, but it did not enter the ERM until March '98, more or less four years later. I think in '94 it would have been very unwise for Greece to enter the ERM. Still at that time Greece was experiencing very large budget deficits in excess of 10 percent of GDP. The inflation rate was also in double digits, and Greece would have asked for trouble I guess if it had this idea at that time to enter ERM.

By '98, however, the situation had changed quite dramatically. Both the budget deficit and the inflation rate were closer to the Maastricht criteria although not quite there. In addition, the credibility of the government's commitment to stay the course had increased. It was indeed possible for Greece to enter the ERM.

In general, the new member states, as you have already heard, have a much lower (?) than Greece experienced in 1994, but some of them may not yet be ready for entry into the ERM.

Is ERM too risky? Greece stayed in the ERM certainly longer than the minimum two years requirement, and I think it is important to stress that significant tensions emerged only in the early part of that period. The whole period was marked by a series of international financial crises, so it was by no means a quiet period in currency markets. The tensions that Greece experienced in the early part of its stay in the ERM were significant, but certainly manageable. The authorities were able to address them through a combination of both orthodox and unorthodox economic measures, and by using the margin of fluctuation that is provided by the ERM-II.

Tensions subsided quite markedly as progress was made in further reducing the financial imbalances, and as the credibility of the final goal was further enhanced. Hence, my conclusion is that the consent about the riskiness of staying in ERM for any length of time is certainly exaggerated, at least judging from the experience of Greece.

Setting a clear target for the adoption of the euro certainly helps. It provides an anchor to stabilize market expectations, and it also helps to martial the support, both political and popular, that is needed to implement the policies required to meet the qualification criteria.

Greece was very fortunate in that respect in that it had a very clear target date to choose. It had missed the opportunity to be among the founding members of the EU area, and it was determined not to miss the second most significant event in the history of EMU, which was the introduction of the euro notes and coins, so that I think helped to achieve the objective.

It's not clear to me for the choice of a target date will be equally simple for many of the new member states. This may give rise to some difficulties. If the authorities themselves do not announce any target date, the markets will try to guess, so there may be some difficulties if the market's guess has to be revised or if the authorities announce a target and then for some reason they feel that they need to change it. But I would say that any tensions again that might arise should be manageable given the flexibility that is inherent in the exchange rate mechanism, the second version of this, the present version.

Finally, I would like to touch a little very quickly on the challenges that the countries face after they achieve the goal of adopting the euro. One of the main challenges that is discussed is that of a credit boom, which may lead to excess demand pressures or asset price bubbles. Greece didn't experience a credit boom, not as pronounced as some of the other so-called non-core countries in the euro area. But certainly so far there has not been any evidence of a bubble, and I think this is certainly encouraging. If the bubble emerges in the future, there would have been a lot of time for the authorities and the financial institutions to prepare themselves to deal with such an event. I mean the probability of a significant crisis arising as a result of credit expansion is not very high.

A more significant risk is complacency, adjustment fatigue, which may lead to a relaxation of fiscal policy. Greece tried to guard against this risk by adopting a new objective, a national objective. This was to achieve a real convergence, full convergence with the average standard of living in the rest of the euro area by the year 2010. Unfortunately, this goal was not--did not invite a lot of popular support. It was not terribly meaningful, so it has by not being forgotten. There is certainly a risk of relaxation of financial policies. I would say that the stability and growth pact that is still in existence despite all the problems that it has experienced provides some assurance that any slippages would be contained.

Finally, there is a risk of arithmetic shocks or loss of competitiveness related to excessive wage developments at home. This is again a significant risk. It increases the desirability of increasing the flexibility of the economy, providing also room for fiscal maneuver to use in the case of an arithmetic shock, and in general it makes it desirable to strengthen the incentives that we have in the European Union in general to pursue structural reforms.

I'll end at this point. Thank you very much.

MS. SCHADLER: Thank you, Hari.

Now as our last speaker, I would like to introduce Peter Kenen, who is the Walker Professor of Economics and International Finance at Princeton University, and also authored a paper that came out last summer I believe, for the Institute for International Economics on the topic of euro adoption in the new member states.

Peter?

See Mr. Kenenīs slides (148 kb PDF file)

MR. KENEN: Thank you for letting me go last because I was then able to discover, looking at Onno's slides, that the numbers I was going to show you were wrong, and so I'm not going to show you my second slide. That comes of what happens when your research assistant follows your instructions faithfully even though the instructions were wrong.

[Laughter.]

MR. KENEN: I want to dwell on the convergence criteria, which are now I think emerging on the slide. The first thing to note about the first of these criteria, the price stability criteria, is the rather odd formulation. It refers to the inflation rate in the three EU countries with the lowest inflation rates. That was the standard. In fact, it was even tighter than that, but I won't go into that detail. That's odd. Why?

Because there was no EMU when these convergence criteria were drafted. These were drafted with the first round of countries in mind, and one had to find an inflation test then that did not involve a logical circularity, choosing the EMU countries, considering their inflation rate, and they said, "No, you aren't the EMU countries because you don't satisfy the criterion." You had to have an external criterion, and that's what was used. In fact, at the time, as I recall, the UK inflation rate was one of the lowest, and of course the UK is not even now a member of the euro area.

The same odd thing happens in connection with the interest rate criterion, which is the fourth one there, where once again the criterion is based upon the interest rates of the three countries, the lowest three EU countries with the lowest inflation rates.

The exchange rate criterion is the oddest of all because it refers to an institutional arrangement that no longer exists. The exchange rate mechanism of the European Monetary System at the time that the Maastricht Treaty was written, prescribed adherence to very narrow exchange rate margins, 2-1/4 percent. In fact, those are the old Breton Woods margins. But those margins were widened temporarily in 1993 to 15 percent during the exchange rate crisis of 92-93, and they were never narrowed again thereafter. In 1998, however, when the Commission evaluated the eligibility of existing EU countries for EMU, it based its assessment on the old normal 2-1/4 percent margins because those were the ones referred to explicitly in the Treaty not by number but by name.

In 1999, however, the European Monetary System was replaced by a new exchange rate mechanism for the EU countries that had not yet entered EMU. That's the one we've been referring to as ERM-II. It is based upon bilateral agreements between those countries and the European Central Banks, and on the 15 percent margins that had been adopted temporarily and de facto either in the exchange rate crisis of '93, and they are now described as the standard margins of ERM-II to avoid confusion with the normal margins of ERM-I.

There is incidentally, only one such agreement now in force and that's the one between the ECB and Denmark, and it uses the old narrow margins by mutual agreement between the two institutions, between the Danish Government and the ECB.

In the old Cold War days it used to be said that NATO was meant to keep the Russians out, the Americans in and the Germans down. The cynics have suggested that these convergence criteria were meant to lure the Germans in and keep the Italians out. That's not quite fair. It may be true, but it's not quite fair. It would be more accurate to say that these criteria were devised to require that the national governments do the hard work of achieving domestic price stability and fiscal sustainability before EMU began, thereby assuring that the ECB, the new Central Bank, could start its work in a benign environment and escape the onus of imposing the hardships required to create that environment. That is really what was going on, at least in my understanding.

The individual criteria have been widely criticized. Several people have noted, for example, that it doesn't make too much sense to require that a country maintain exchange rate stability in order to enter a monetary union which will have no exchange rate of its own. It's also been noted that a country's long-term interest rate, the fourth of the criteria referring to interest rates, tends to reflect market participants' expectations about that country's prospects for entering the Monetary Union and is therefore really not an independent test of the country's readiness to enter the Union.

The more important issue facing us right now, however, is how these criteria should be applied to the accession countries, to the new members of the European Union. Much of what is written on the subject, the European Commission has adhered strongly to the principle of equal treatment. Its own impartiality requires it to uphold that principle. In this particular instance, however, equal treatment should mean that all of the new countries seeking to enter EMU should be treated equally. It cannot mean that they should be treated in precisely the same way as when the initial round of admissions took place. That is not because the countries are different. It's because circumstances are different.

First and foremost, EMU is now in being. There is, therefore, a well-defined euro area inflation rate and a well-defined euro area average of long-term interest rates, and it would be perfectly natural to use those rather than this odd construct of three EU countries with the lowest inflation rates.

Second, the 1993 decision to suspend the narrow margins of EMS reflected recognition of a basic truth. Free capital mobility, fixed exchange rates and independent monetary policies constitute what Robert Mundell described as an unholy trinity. You can't combine all three of them. EMS members themselves learned that when they dismantled their capital controls pursuant to the single European act, but then tried to keep their currencies within the old narrow margins, and yet pursued different monetary policies because they faced different economic conditions. And they gave further recognition to the same basic truth when in designing ERM-II, they chose as the new standard margins the wide 15 percent margins that they had adopted temporarily in 1993.

Last year, however, the EU Commissioner for Monetary Affairs announced that the Commission would apply a much stricter test when judging the exchange rate stability achieved by the accession countries seeking to enter EMU. In effect he was saying, or he says essentially that the Commission would apply in its evaluation the narrow 2-1/4 percent margins of ERM-I rather than the 15 percent margins of ERM-II. Why? Because equality of treatment required it. It was used in 1998 and therefore should be used again today and forever in the future.

This, as I said, despite the fact that many EU and ECB officials have urged accession countries to enter ERM-II precisely because it affords more adequate exchange rate flexibility, and this despite the fact that the narrow normal margins of ERM-I could not survive the exchange rate turbulence of 1992-93.

Now, Onno has given us a slightly different reading on this application of the criterion, and I assume that this represents consensus between the ECB and the Commission, but note that it is still an asymmetric and stiff test when it comes to any downward movement of a currency, that is to say a depreciation of the currency. You cannot use the full margins, the 15 percent margins freely. You are under much tighter constraints than we were led to believe when the ERM-II was proposed as the new exchange rate mechanism.

Let me make one other point that has not been made today. Under the old EMS, the obligation to stabilize exchange rates was borne jointly by the surplus country and the deficit country or more accurately, the strong currency country and the weak currency country. Today the obligation, or in the future, under ERM-II, the obligation will reside primarily with the government of the country concerned. There will be no legal obligation on the ECB to intervene, and so you are therefore exposed to the possibility of a downward movement in your currency, and you cannot count on international or ECB assistance to provide financial support.

This, I submit, is going to cause delay on the part of some accession countries for this reason. Suppose that a country wanted to enter the Monetary Union at the beginning of 2008? It would have then to enter the ERM-II by the beginning of 2006 at an exchange rate agreed with the ECB, and would have then to keep its currency from moving downward at least far from that agreed rate during the next two years. During that two-year period, however, market participants will be placing bets on the country's chances of entering EMU, and will therefore be tracking its progress in meeting the rest of the convergence criteria.

If they find, in their judgment, that the country is not making satisfactory progress in reducing its budget deficit below the 3 percent ceiling required in bringing its inflation rate down to whatever is the ceiling imposed for judging price stability and so forth, they will then bet against that country by selling its currency, and if they do that, the currency will tend to depreciate, making it harder for the country to meet the exchange rate criteria.

For all these reasons I'm inclined to endorse the advice which the Fund staff has offered in its superb analysis of the accession countries' prospects for EMU entry, and the benefits of it, and that is to say, don't join ERM-II until you are absolutely confident, as confident as we can be in an uncertain world, that you will satisfy the other convergence criteria during the course of the next two years; there will be no accidents, and that means essentially no political accidents as well as economic accidents, so that you will not indeed encounter a speculative crisis which will cause you to violate the exchange rate criteria, because if you fail once, they'll bet against you the second time and it will be harder.

I'm afraid what this means is that even I, as enthusiastic about entry into EMU by these countries, would have to say, if advised today, put it off until you're sure, and then stay in ERM-II only as long as required, namely the two years in the anteroom.

MS. SCHADLER: Thank you, Peter.

Now, what I'm going to do is attempt to summarize what I've heard today at least in the form of three questions that I will throw out, and then I will open the floor to other people who have questions, but I'm hoping that the panelists in the meantime don't forget my questions.

Actually, I have to start with one piece of information that our External Relations Department has informed me that I had forgotten, which is self promotion.

[Laughter.]

MS. SCHADLER: The study that several people have referred to--and I promise you that we didn't pay them to say nice things about it--the press version of it I believe is somewhere in the back of the room. It's going to come out as an occasional paper shortly, but our press version was released a couple of weeks ago, and there are copies back there for you to take.

On to my questions. In the last few days, the news about this issue of euro adoption, when and how countries are going to do it, has been flowing pretty freely. The Financial Times this morning, some of you may have seen, had an article saying that Estonia, Lithuania, Slovenia and Cyprus are all likely to make the leap into ERM-II soon. Another story this morning also pointed out that Hungary, the Government of Hungary is going to announce next week a timetable for adopting the euro. In Poland we're hearing a lot of news about the political ructions that they're going through that will also undoubtedly have a major effect on the potential timing for adopting the euro for fulfilling the conditions in adopting the euro. And finally, Reuters this morning quoted Krzysztof Rybinski, Deputy President, National Bank of Poland, saying that the countries that lag behind in adopting the euro are going to feel the effects strongly in less good performance in direct foreign investment and employment creation than the countries that move ahead more rapidly.

Now, today, all of these bits that we've been seeing in the news have sort of come together in various people's presentations. Lajos, for example, has emphasized another dimension in this process in the timing issues, which is that countries that cannot get their policies in order, ERM-II and euro adoption both being a strong disciplining mechanism, are going to fall behind in terms of their growth rates. Likewise, Hari emphasized that the potential gains from euro adoption could be wasted if supportive policies are not in place.

So my question at the end of all of this is, just how good do policies really have to be for these countries to step up their timetable for adopting the euro? Obviously, they need to meet the rules, but there is, within meeting the rules, a fairly wide range of possible policies or policy packages that could be consistent with adopting the euro sooner or later. Do they have to be held to a gold standard or should they really be able to improve their policies, get them to a certain sort of minimum level and then move them as quickly as possible?

The second question is: if several or even most of the countries do move ahead rather quickly with euro adoption or at least getting into ERM-II with the goal of adopting the euro fairly quickly, how costly will it be for the countries that are lagging behind in the process?

A second point that I have found very interesting today is, assuming that the countries are going to be serious about moving ahead as quickly as possible in adopting the euro, how important is it to have a target date? Hari has emphasized that for Greece it was really a major mobilizing factor. I think for some of the other countries that were original members of EMU also, the target date, the sort of galvanizing of support around a time when things had to get done would have been critical.

But the question is, how can countries create the political consensus that they need to underline a concrete target date and what kinds of hooks can the countries use to establish this date? We no longer have getting into the euro in the first wave of getting into the euro area before the notes and coins are issued. There has to be some other kind of marker that's set out there, and these countries are going to need to use such a marker I think for some of them to galvanize the political support that they need.

And then a third set of questions concerns rules. EMU is a rules-based system, and so I think the questions here are really more about how to apply the rules rather than whether or not the rules should exist. The rules do exist, and I think just about everybody agrees that opening up the box of rules would be a mistake. Onno presented the rules. Peter questioned the rules, but Onno also pointed out that the rules in many respects are more flexible than what many people had expected them to be, even as recently as six months or a year ago. The question that occurs to me is this: is it good to have very strict rules that provide a clear marker for countries to understand the conditions that they have to meet in order to join the euro, or is a little bit more flexibility in interpreting those rules a good thing? The uncertainly invariably, however, leads to a certain ambiguity, a certain amount of judgment that could easily be construed as being unfair or politically motivated.

So I think that on the question of rules there is this sort of rules versus discretion element even within the broad rules that they have.

Now I'm going to open the floor to questions to supplement the ones that I've asked, or build upon them, or offer hypotheses from the floor on them, and then we'll turn back to the panelists.

Press the red button on the adjoining armrest to activate the microphone.

QUESTION: Something I don't think I understand, all the new countries are supposed to go through two years of ERM before they can adopt the euro. During that period if they had a Currency Board before, can they stay on the Currency Board?

And then a more political question. Why are countries that have shown to be able to run a Currency Board forced into this two-year delay and a somewhat risky situation of getting into the ERM-II? And to what extent is it simply a reflection of a negative attitude on the part of the ECB to have too many countries join the euro?

MS. SCHADLER: I'll take a couple of questions if there are any more. I think I saw one other hand go up. Go ahead. Could you identify who you are before you ask your question?

QUESTION: I just had a really layman question. I was looking toward the private sector development in terms of real convergence. We talked about how the government should keep their house in order, but I'm kind of interested in what is the EMU trying to achieve in terms of the private sector being strong enough? I guess, is the point to bring the productivity, the potential growth, the competitiveness of these new regions to western European standards? Could you comment on that? And then on the other side of the coin?

MS. SCHADLER: Okay.

QUESTION: All these countries, euro has been working for many years now in the commercial market, while taking them into the European Union. Their performance must have been judged and examined before they are considered to be acceptable to the European Union. Now, why is this two-year period again imposed on them for consideration?

MS. SCHADLER: Can I call first perhaps on Onno, to answer some of those questions?

MR. WIJNHOLDS: On the matter of countries operating a currency board and what the process would be for them to enter ERM-II. In fact, it has been made clear that in these cases there would not be what is called a double regime change. It would not make a lot of sense for them to give up their currency board to go into ERM-II. In other words, their currency board regime can be maintained, but they will in fact be considered to enter ERM-II when they so request, and this is likely to happen pretty soon. So I think there's no real trouble there.

As regards the matter of the two-year period in ERM-II, this is again the question of what I called the view of a waiting room versus the workout room. Some people are skeptical about the workout room. I'm aware of that. I think the view is that it can be useful for countries to take some more time to get all of these measures taken and the structural reforms needed before they really get into a euro zone.

I don't really think there's an issue of negative attitude by the ECB or for that matter I suppose the European Commission. Right behind you [questioner] is a representative of the European Commission.

[Laughter.]

MR. WIJNHOLDS: I think that all members are welcome and there's not a concern of that many countries joining up. I am certainly not aware of that.

Then I think the second question was on what was--was there also behind the entry into EMU a approach to bringing to a higher level of productivity in the new member states, and that is certainly a very important consideration, which is actually subsumed under the title convergence, nominal and real convergence. These are the very important approaches that are being followed to get the new member states eventually to a level of standard of living that's comparable to the present member states, and what we do see in fact is that growth rates in the new member states are considerably higher than in the old members, I should say. I can't say present members about the old members. And so this catching up process is already pretty much under way.

Thanks.

MR. VITTAS: Well, I wanted to make a couple of points on two of the questions that Susan raised, first on the target date. I think it is useful to have a target date, but it is not absolutely essential. It's much more important to have in place policies that are consistent with the eventual adoption of the euro.

The other question I would like to comment a little bit on is on this rules versus flexibility. I think obviously the EMU is a rules-based system, but as far as I can tell only one of the rules of the system is absolutely rigid. All the others are open to some interpretation on flexibility. The one that's absolutely rigid is the prohibition on the monetary financing of budget deficits. That's both in the process towards EMU and after you get in.

All the other rules and the criteria in particular for adopting the euro are meant to facilitate the judgments that the Ministers and the ECB and the European Commission will have to make at some stage. I think there is definitely room for judgment to be made, and as far as I know, again, there are already cases in the past where flexibility was on interpretation. Thank you.

MS. SCHADLER: Peter [Kenen]?

MR. KENEN: I think that the new members may find the going a bit harder than it was in 1998 for a couple of reasons. First of all, some of the countries seeking to qualify in 1998 employed some accounting gimmicks and some fancy footwork, that they would have--I think the Eurostat and the Commission would be tougher on that today. The rules have gotten a little tougher. It's harder to do those things than it was in 1998.

Secondly, and I think this is even more important, for reasons that always seemed mysterious to me, there was a sudden change of heart in 1997 and 1998, especially on the part of Germany, when it suddenly came down in favor of admitting as many countries as could be admitted. I'm exaggerating a bit, but that was practically true. Countries which, for example, were running deficits in excess of 3 percent after removing the tricks, countries with debt levels over 100 percent of GDP were admitted. And I think perhaps the issue had to do with the political circumstances of Europe at the time, facing the collapse of the Soviet empire, concerned about the situation to the East and the plight of what we now call the accession countries. And the problem of getting a harmonized European response to those issues I think may have led the German Government, Chancellor Kohl in particular, to decide that he did not want a further division within the politics of Europe over the question of EMU, and he wanted as broad as possible a vote or entry in the first wave. I think that's what actually happened.

This time it's going to be country by country I think, and just in the nature of the issue, and I don't think the politics will work in favor. This is not to say that there will be a deliberate toughening of the line, but I think the criteria may be applied more strictly than they were last time.

MS. SCHADLER: I had one point in response to the second question. I think Onno's quite right, that a big part of the goal of the European Monetary Union or the new member states adopting the euro and joining EMU, is certainly to raise standards of living and productivity and so forth, but I think, going back to Peter's point, that there's--you know, the vision of the single European currency is part of a vision of a united Europe, an intertwining of countries that's close and difficult to break up. You know, a currency is certainly a very unifying thing in a political union, and I think that that's--there is definitely a political aspect to the goals of having a single currency in Europe, which is to create a more peaceful, more harmonious economy, and so it's not strictly about income levels. It's also about the way you achieve the kind of integration that Europeans would like to have.

MR. BOKROS: Just to complement the picture, Alexander Lamfalussy, a year ago, in a conference in Hungary, said that there will be no such a thing as a piecemeal accession to the European Monetary Union because that's not the way how the European Commission can handle things. So it's better to have a big bang approach because that was always the case. I don't know whether it's true or not, I just wanted to mention that.

But perhaps I can answer the question, which was about private sector development. In this respect, I'm quite confident most of the countries can very easily meet the criteria of EMU entry also if there is any criterion on that. Productivity and competitiveness, especially in the so-called tradeable part of their economy can easily meet European levels, to that's not a problem. In fact, many of these countries have much more flexible labor markets, much more productive export sectors than some of the continental European countries. Moreover, I also think that there's no such thing any more as Slovak-Czech or Hungarian Banking systems because all of the banks, not only the systemic ones but even the smaller ones, are in the hands of foreign strategic investors, so these are already well integrated parts of the unified European area.

Where we have problems is, as I said, agriculture, but that's a problem in my view in the European Union too as a consequence of this common agricultural policy, so I'm confident about private sector development.

Let me say a few words on some of your questions. As someone coming from Central and Eastern Europe, I do believe that it's important to have rules, and also it's important to have a target date for EMU entry. One may argue how to interpret the rules or how to apply them, but rules are very important also, because otherwise it would be extremely difficult for the European Commission and for the Council of Ministers to really judge these countries. There should be some kind of uniformity in making those judgments. But even more so, I think the political dynamics of the whole issue is that the political elite in Central and Eastern Europe has a very fast-changing and very variable approach towards meeting the requirements of EMU entry, and as a consequence it's important for them to see those rules which are to be met, that's a kind of a national target, and therefore, they can subscribe to that.

I also think that if some of the countries move ahead, maybe those four, which have been already announcing that they want to join ERM-II. The others will have a hard time not to speed up structural reforms, which I feel is very good. I really think that this kind of creative tension which we have come as an exogenous challenge, will be important for these less flexible, less radical minded countries to join.

Thank you.

QUESTION: Could I ask a follow-up question simply for clarification? What does it mean joining ERM-II? Peter [Kenen] explained that ERM-II doesn't exist any more among the--certainly not among the members that are now part of the euro. I assume that joining ERM-II doesn't mean that the new ERM-II is created among the 10 applicant countries, that Estonia has to support the currency of Malta and Malta the currency of Lithuania. Is it more than a commitment to maintain an exchange rate, and is there a mechanism to change that exchange rate? Who gives the permission?

And furthermore, for a country that has a currency board and sticks to a currency board, which means no fluctuation, no margins, does it mean anything that it joins the ERM-II?

MR. KENEN: These are very detailed questions, and I appreciate all the interest, but I would say that there is an agreement that is called ERM-II, and you know, there's Denmark in it now. It exists. There is an agreement with Denmark, by the way, on the narrower band. But it's a requirement of the Treaty, so there's all this language that exists, so joining the ERM-II definitely means something. Otherwise people wouldn't be talking about it so much I suppose.

As regard to currency board cases, they are special cases, and as I indicated already, in a way they will be treated as such, and there will not be a requirement for them to adopt to wider margins. So I think for them indeed much less of a change will take place, that's right. But for those countries, as I showed on my chart, that are now floaters or managed floaters, the change is substantial, yes.

MS. SCHADLER: Hari has something to add here too.

MR. VITTAS: I just wanted to say that for countries which have not adopted a currency board arrangement, they can get into ERM-II which already exists, with Denmark as the only participant as far as I know. The central rate or decisions relating to the width of the margins of fluctuation of the central rate, and any possible changes in the future are taken jointly by the authorities of the country concerned, and the (?) and the ECB.

MS. SCHADLER: I think the question then also is, is ERM-II just a commitment to a certain kind of exchange rate regime, or is it, as it was in the old days, a commitment to mutually support one another's currencies through intervention, if I'm not wrong?

And you know, my reading of the rules is it still has an element of the latter in it, although obviously it's going to be different from what it was in the 1990s because there isn't Germany intervening to defend the franc alongside the Bank de France. This would be, you know, very small countries, and then a giant, the ECB, and there is a question about what role the ECB would play in defending the parity should a challenge arise.

I think my interpretation is those questions are--there is a setup for this, but the actual experience will be defined by events, but I see that [inaudible].

QUESTION: If it may help [inaudible] on this point, representing the European Commission here. The ERM, the first ERM wasn't [inaudible]. It was a [inaudible] system. ERM-II is basically a commitment between central banks, between the ECB on the one hand and the Central Bank which issues the currency [inaudible], so it's very different.

The second real difference, which is not I think enough emphasized maybe in your paper, is the fact that ERM-II is to be seen against a very different background, a background of freedom of capital movement, financial flows, where indeed, in ERM-I, until late '91, '92, even for certain countries, free capital movement not only decided when central banks got their independence quite late, and I think it's a very different background from the future. Thank you.

Wijnholds: Maybe I can add just one point, and this is quote from a ECB statement that--and this is about ERM-II. "Interventions at the margin will in principle be automatic and unlimited unless they conflict with the primary objective of price stability in member states of the euro area."

I'm not going to go into an interpretation of this.

MS. SCHADLER: More questions?

QUESTION: I would like to come to a question of taxation. During a recent presentation of a Slovakia Government representative on PSD issues in the World Bank, he mentioned a flat taxation rate of 19 percent on private taxable income as well as corporate taxable income. So during a break a lot of us started asking questions about, you know, [inaudible] part of the European community, what would be the forms of flow or integrations of--incorporation, sorry--of companies into Slovakia just to be able to have a benefit from the differential in taxation rate. And his answer was not very specific because he had no clue apparently, or at least he didn't want to share with us clues about how will the harmonization of taxation go for the European community.

So my question is what will be done on that front and when it will be done, to harmonize the taxation, different taxation policies between different European members?

MS. SCHADLER: Another question? Okay, one in the back.

QUESTION: Two questions. I would welcome some comments on how closely that a new member can just look at the experience of UK and Sweden, I mean, since these are the countries which are now growing slower than the others, not having adopted the euro, so what does this experience tell the new members, even more so that the UK is claiming that they are not flexible to adopt the euro, so how come the new members would be more flexible than the UK at this stage?

The second comment is on the current criteria, I have a lot of sympathy to what Professor Kenen has said on the inflation criteria. There is one more twist to this, that the definitions that this is the best performance, and the question is whether the best performance which the one which is hitting the inflation target, or whether the one which is zero, the one who has had inflation, so that of course would be also the question, how to define the target? And there's of course a big consequence of that because the new members have a lot of catching up to do, and if there is a difference in growth of only .8 percent of 1 percent, it would take up to 100 years to get to 75 percent of the levels. Of course they need to grow faster and they can grow faster at the cost of probably somewhat high inflation to accommodate for the [inaudible] effect, so I wonder if it would make sense for them to suppress inflation even temporarily to get into the euro area and then to have the inflation go up again as many new member countries--many current member countries which are growing faster, they also are having slightly higher inflation than the average.

PANELIST: Let me try to address these interesting points. It's interesting that the point involves the matters of the UK and Sweden. I take it that he also advises his own government on these things, so he must have his own view on this I guess. But his country is determined to move forward in Europe and adopt the euro.

As regards the UK and Sweden, they are for now doing better. Whether they will always do better is another question. One has to take a longer view I think. Let me just say that indeed the UK has done very well in terms of bringing more flexibility in its economy, which is I think a good example for others. However--and I refer here to IMF analysis--productivity in the UK is still considerably lower than in many continental European countries, so there's still some questions for the longer term there.

And whether there is a matter of suppressing inflation at the cost of growth, that sounds a little bit old-fashioned Keynesian to me, if I may say. I'm not so sure that there is a question of that really. After all, we are not talking about pushing inflation to extremely low levels, and I think much of the recent literature on inflation shows that there is not a real conflict between lowering inflation unless one goes to extreme lengths, and economic growth, certainly viewed in the medium to longer term.

Thank you.

PANELIST: I can perhaps comment on the tax harmonization question, although I am not speaking for any government in the region, in the new EU member states.

My impression is that none of these governments would like to see too much of tax harmonization before they reach a much higher stage of development. That is the publicly announced official view of all of these governments. I understand that it is a headache for some of the richer Western European countries, as we heard Chancellor Schroeder complaining about Slovakia the other day, and even threatening Slovakia or some other countries by cutting back on subsidies coming from Brussels. Of course, it's a very complex issue, but if we put it into the context of the overall flexibility and competitiveness of the European Union, vis-à-vis the United States or the North American free trade area or Asia for that matter, and I think the rule of the game should not be punishing those countries which are making quite radical reforms on taxation, but perhaps the other countries should also think about tax reform, and as a consequence, put their house more in order.

MS. SCHADLER: Thanks. Any other comments, Peter, on that, that you'd like to make? Nothing?

I think that we're getting past the time that we had originally decided to wind up, so I'd like to thank you all for coming, and thank the panelists for their contributions.




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