Why would anyone want to join the euro? That was the response of many international observers to announcements earlier this year by the governments of Latvia, Lithuania and Poland of plans to push ahead with adoption of the single currency. For Nobel Prize-winning economist Paul Krugman, the news that Poland in particular was proposing to tie its healthy economy to the euro was enough to “make you want to bang your head against a wall”.
And indeed, after three years of relentless bad news from the eurozone, it can be hard to see why policymakers in emerging Europe would be eager to join what many see as a doomed institution – particularly with the examples of Spain and Ireland as awful warnings of what can happen when fast-growing, less-developed economies throw in their lot with the likes of Germany.
So is this an example of collective delusion? Or is there still a rationale – economic or otherwise – for signing up for the single currency?
The answer, unsurprisingly, is complex. First, analysts point out that it is essential to distinguish between countries, such as Latvia and Lithuania, that have been pegged to the euro via the Exchange Rate Mechanism (ERM II) for nearly a decade and those, such as Poland, that still have a free-floating currency.
For countries with pegged currencies, the consensus seems to be that it makes more sense to move to full eurozone membership than to remain in ERM II limbo. “The worst possible option is staying pegged to the euro but not being a member,” says Zsolt Darvas, a research fellow at European think-tank Bruegel. “Those countries have already surrendered control over monetary policy, but they don’t get the benefits of euro area membership in terms of bank access to European Central Bank facilities and the elimination of transaction costs.”
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| Rimantas Sadzius, minister of finance, Lithuania |
The third option – exiting the ERM II and unpegging from the euro – is not seen as viable by policymakers in either Latvia or Lithuania. Indeed, the latter’s finance minister, Rimantas Sadzius, insists that such a step would have “disastrous consequences” for the Lithuanian economy. “For a small country with no real banking history and traditions, moving to unpeg the currency would be absolutely irrational,” he says. Analysts are less convinced of the impossibility of unpegging but acknowledge that the Baltic economies are now so heavily euroized – the single currency comprised 80% of total loan portfolios in Latvia at the end of 2012 – that moving to a floating-rate system would risk huge revaluation effects.
As Timothy Ash, head of emerging market research at Standard Bank, points out, one of the main benefits of euro entry for Estonia – which adopted the single currency in 2011 after more than six years in the ERM II – was the overnight elimination of its high external debt burden.
Where the debate heats up is over the question of whether or not those EU members in central and eastern Europe without long-standing currency pegs – Poland, the Czech Republic, Hungary and Romania – should move towards euro adoption.
Much of the argument revolves around the extent of economic convergence – or lack of it – between these countries and their neighbours in western Europe. Birgit Niessner, chief analyst for CEE macro at Erste Group, notes that price levels in even the region’s most advanced economy, the Czech Republic, are barely 75% of the EU-27 average, while for countries such as Poland and Romania the figure is closer to 60%.
Similarly, as befits a developing region, present and forecast growth rates for the majority of CEE countries are well above those of core Europe, let alone the eurozone periphery. Poland and Romania are expected to post GDP growth of 1.3% and 1.6% this year and more than 2% in 2014, according to the IMF, compared with -0.3% and 1.1% for the eurozone as a whole.
Both indicators point to higher inflation in CEE than in western Europe in the short to medium term, says Neil Shearing, chief emerging markets economist at Capital Economics. Premature euro adoption would therefore likely result in artificially low interest rates for emerging Europe, creating the conditions for a credit-fuelled spending and housing bubble of the type seen in Spain and Ireland before the crisis.
What is more, adds Shearing, a lack of labour-market flexibility across the region means that, in any future downturn, CEE economies would struggle to restore competitiveness without the option of currency devaluation. Poland’s success in avoiding recession in 2009, thanks in large part to a nearly 50% depreciation of the zloty against the euro in just six months, is cited by eurosceptics such as Krugman as one of the main arguments against the single currency.
Euro supporters, by contrast, point to Latvia as an example of what can be achieved in a pegged economy via austerity and internal devaluation. The Baltic state suffered a GDP contraction of 17.7% in 2009 but recovered to post average growth of 5.5% over the past two years despite operating with an ultra-tight peg to the euro. (The lats has a fluctuation band of 1% either side of the peg rate, compared with the 15% required under the terms of the Maastricht Treaty.)
“As our experience shows, even with a pegged currency, some downward wage adjustment is possible, and the recovery of competitiveness also entails productivity gains,” says Latvia’s finance minister, Andris Vilks.
Others are less convinced by the Latvian story, pointing to the dramatic increase in unemployment over the past five years. By end-2012, after four years of GDP growth, 13.8% of the total workforce was still out of a job, nearly twice the pre-crisis level of around 7%.
For Shearing, this suggests that, rather than having achieved genuine internal devaluation, Latvia’s increased productivity and reduced labour costs stem primarily from the fact that the least productive sector of the workforce has been laid off. “The presumption must be that once unemployment comes down there will be a concomitant slump in productivity and rising unit labour costs,” he says.
A similar debate is under way over the appropriateness of the Maastricht criteria for euro entry as targets for emerging European countries. Sceptics, such as Bruegel’s Darvas, argue that the focus on bringing budget deficits down to below 3% can constitute an unnecessary brake on growth in economies where public debt levels are still – with the exception of Hungary – comfortably inside the 60% requirement.
“These countries clearly have better growth potential than nearly all the countries in the euro area, so delaying fiscal adjustment and reducing their deficits more slowly would likely not endanger fiscal sustainability, whereas if they have to cut spending to meet the Maastricht criteria that could definitely have a recessionary impact,” he says.
Critics also note that, although the requirement to keep inflation within 1.5% of the level of the three best-performing members of the eurozone might be less problematic in the current environment, it will become increasingly onerous as growth picks up. As Darvas notes: “Operating in a low-inflation environment is always more difficult than operating in a higher-inflation environment.”
By contrast, Maastricht’s proponents – who include a number of policymakers in CEE – insist that the criteria can still provide valuable economic discipline. For Jacek Dominik, Poland’s government plenipotentiary for euro adoption, they constitute “the indicators of a healthy economy” and – equally important – an extra incentive to push ahead with labour-market reform. As he points out, although currency devaluation might have helped Poland in the past, “keeping labour costs very low is not a rational long-term basis for competitiveness”.
Indeed, far from resenting the Maastricht criteria as an economic straitjacket, several CEE governments have in recent years enacted fiscal discipline laws that impose even stricter targets than those set by the European Commission. Poland, for example, has had a debt ceiling of 55% of GDP in place since 2010 and Latvia passed legislation in January that requires the government to balance the budget within three years.
A less contentious argument in favour of euro adoption in CEE concerns the region’s strong trade ties with western Europe. Even euro naysayers such as Capital Economics’ Shearing acknowledge that for these relatively small, very open economies, eliminating exchange rate volatility could benefit producers and reassure foreign investors. He also notes that, despite the continuing convergence gap between west and east, the high level of trade integration “does at least mean the economic cycles move together”.
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| Peter Attard Montalto, emerging markets economist at Nomura |
Meanwhile, Peter Attard Montalto, emerging markets economist at Nomura, warns that any discussion of the rationale for euro adoption should cover geopolitical as well as economic issues. As he points out, for CEE countries, euro membership is about “placing themselves within the broader European framework. That’s why this somewhat bizarre push towards euro adoption, which can seem baffling to global investors, is occurring despite the chaos in the eurozone periphery.” Not only does eurozone membership mean a seat in the ECB’s governing and general councils, it also offers “access to the inner circle of the EU and a say in its future development”, says Niessner at Erste.
For Sadzius, this is particularly important for recent EU entrants with international ambitions, such as Lithuania. “Euro adoption will mean that Lithuania has stepped up to another level and joined the club of important countries, not only in Europe but also worldwide,” he says.
What is more, adds Darvas, while countries with “very credible policy regimes”, such as Poland and the Czech Republic, may have little need of the imprimatur of the EC or ECB, for countries such as Hungary and Romania that have been less successful in recent years “the added credibility that membership in the euro area would bring would be a major asset” and a positive signal to investors.
Whatever the merits of euro membership, policymakers and analysts agree that the key takeaway from the recent travails of the single-currency area is that countries need to put their houses in order before signing up.
As Kornél Kisgergely, deputy state secretary for financial policy at Hungary’s ministry for national economy, puts it: “The experience of the past three years shows that it is essential for economies to reach maturity before introducing the euro. We have seen all too clearly that premature adoption can be devastating.”
Poland’s Dominik agrees that euro adoption “does not of itself grant any economic benefits”. To be successful within the eurozone, he says, “you have to prepare your economy for the single currency and for the opportunities that it gives”, adding that those who fail to do “their homework will be in trouble sooner or later”.
Widely cited in this context are the recent divergent fortunes of CEE’s longest-standing eurozone members, Slovakia and Slovenia. Following a brief slowdown in 2009, the year in which it adopted the single currency, Slovakia recovered rapidly to post growth of 4.4% in 2010 and has since remained among the best performers in the EU. Slovenia, by contrast, which joined in 2007, saw its GDP contract by 2.3% last year and is expected to remain mired in recession until 2014 following repeated failures by policymakers to resolve a protracted crisis in the predominantly state-owned banking sector.
Analysts broadly agree that in both cases the outcomes would likely have been the same with or without the single currency. As Attard Montalto at Nomura notes, Slovakia’s success “has nothing to do with the euro and everything to do with the fact that it – unlike Slovenia – has a single-party government, political stability, a relatively clean banking sector and a competitive workforce, and has been consistent about undertaking structural reforms.”
For CEE policymakers, this provides a useful regional example to rebut popular fears that adopting the euro means following in the footsteps of Spain or Portugal. Dominik also points to the similar fates of Cyprus and non-euro member Iceland as evidence that “the problems of debt and other structural issues in various countries are the result of long-standing policies that have nothing to do with membership of the single currency”.
What successive country crises have produced, he adds, is “a general consensus that governance in the EU, and especially in the eurozone, needs to be strengthened”, with a narrow focus on debt and deficit levels being replaced by broader surveillance of macroeconomic imbalances.
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| Zsolt Darvas, a research fellow at European think-tank Bruegel |
Given past policy failures, analysts remain unsurprisingly sceptical of the new institutional framework’s ability to prevent future upheavals – although, as Darvas acknowledges, “the risks of euro membership are now well understood, and national and European policymakers will be more alert to the danger signals”. While admitting that “one might have wished for better and faster results in certain situations”, however, Lithuania’s Sadzius rejects suggestions that the response of European authorities to problems within the single-currency area over the past three years points to an inherent weakness in eurozone politics. “So far all of the crises – many of which developed very rapidly – have been tackled or resolved in one way or another,” he says. “This proves that the structure for managing banking and finance in Europe does actually work well.”
As to the ultimate viability of the single currency itself, Sadzius – like his Polish and Latvian counterparts – refuses to entertain the possibility of failure. “The euro is beneficial for all the member countries but also for the entire EU, has proved its worth as a major global currency and can survive any imaginable crisis,” he insists.
Even Hungary’s governing Fidesz party, not noted for its conciliatory tone towards European institutions in recent years, is at least publicly supportive of the project. “We are waiting to see the full implementation of agreed reforms but overall we still think that the euro is a success story,” says Kisgergely at the national economy ministry.
Of course, whether or not countries should join the eurozone is a separate question from that of whether they will. For the two Baltic states, euro adoption looks set to go ahead, barring disaster in the single currency itself. Latvia already fulfils the convergence criteria and is widely expected to receive a positive response when the EC reports on its application in early June, paving the way for adoption at the start of next year.
Lithuania has work to do on getting inflation down to Maastricht levels, but Sadzius says he is “optimistic” that the country can meet the criteria in time to hit the current target for adoption of January 2015.
Policymakers in both countries are also confident that they can convince their countrymen of the benefits of euro adoption. Although polls suggest that barely a third of the population in either state is now in favour of the single currency, a roughly equivalent number are still undecided – and both governments have the advantage of strong mandates, a good case to make for moving on from the ERM II, as well as an example of successful adoption in neighbouring Estonia.
The situation is very different in the two other countries that are closest to meeting the Maastricht criteria, Poland and the Czech Republic. A March survey found that 62% of Poles were opposed to euro adoption, while in the Czech Republic – traditionally the most eurosceptic country in the region – support for the single currency is consistently below 20%.
Given that the Czech Republic is a rare example of a country where populace and policymakers are in accord on the issue, most analysts agree that there is little chance of the country adopting the euro in the foreseeable future. “There would need to be a fundamental shift in the mindset of politicians and civil servants for the Czechs to join,” says Attard Montalto. “What I’d expect to see from them is a five-year target for adoption that is just rolled forward every year.”
In Poland, by contrast, Donald Tusk’s ruling Civic Platform party is at odds with the population in its enthusiasm for the single currency. This presents unique problems for Polish policymakers as an amendment to the country’s constitution will be necessary before the euro can legally be adopted.
Civic Platform does not currently have the requisite two-thirds majority in parliament to make the change, and the main opposition Law and Justice party is opposed to euro entry.
According to Dominik, a desire to “unlock the political situation” was one of the drivers for Tusk’s surprise announcement in March of support for a referendum on euro adoption. No date has been set for the poll, and indications are that it is unlikely to take place before 2015 – but Dominik is adamant that its primary role is not to postpone the issue but to “show that there is increasing public support for the single currency”.
With big issues such as banking union still under discussion at EU level, however, analysts have speculated that Tusk’s decision to reopen the euro debate was, as Ash at Standard Bank puts it, “more about Poland’s international image and ensuring the country gets a seat at the top table in Europe than about a serious attempt to push forward the agenda”.
Even those who take Civic Platform’s enthusiasm for the euro at face value – and Attard Montalto vouches for the existence of a “strongly integrationist strain in Polish politics that surpasses anything that comes out of western Europe” – point to signs that Poland is preparing to leverage its size and economic strength to pursue “reverse conditionality” around single-currency adoption.
Already on the table is the requirement for ERM II entry, after central bank governor Marek Belka commented publicly in April that Poland should have the “chutzpah” to demand euro membership without it. Also up for discussion could be an increase in structural funds, says Attard Montalto, and reports suggest that the Polish government is looking for concessions on eight other issues ahead of euro adoption.
Whatever the motivation for the recent outbreak of europhilia in Poland, however, analysts agree that for the moment expressing support for the euro effectively amounts to a free option for CEE policymakers. Even Poland, the likeliest candidate after the Baltic republics, has ruled out any action before 2015, while Hungary, Romania or Bulgaria are unlikely to be ready to adopt the single currency before the end of the decade.
“The temptation for the bigger economies in particular is clearly to wait and see how the euro fares over the next couple of years,” says Ash. “There’s no particular reason to push ahead quickly, given that independence of monetary policy is certainly useful at this stage still.”
With so many crucial issues still up for discussion in the EU, policymakers in emerging Europe are perhaps after all not as illogical as they have been painted by Krugman and the eurosceptics in refusing to come out in opposition to the single currency.
