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Atlantic Economic Journal
Vol. 31, Number 4, December 2003, 295 – 310.
Symposium
“The Impact of European Monetary Union Enlargement
On Central Banks”
Contents:
1. Eduard Hochreiter: Introduction to a Symposium on “The Impact of European
Monetary Union Enlargement on Central Banks”
2. Zdenek Tuma: “Monetary Policy Towards E(M)U Accession – A Central Banker’s
View”
3. Darko Bohnec: “The Impact of EU Enlargement – Challenges for Slovenia´s
Monetary and Exchange Rate Policies”
4. Manfred Neumann: “The Impact of European Union Enlargement on Voting
Procedures of the ECB Governing Council”
5. Andres Sutt: “Challenges Facing the Estonian Economy on its Way to the European
Union”
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Introduction to a Symposium on “The Impact of European Monetary Union
Enlargement on Central Banks”
Eduard Hochreiter
Oesterreichische Nationalbank
On May 1, 2004 ten further countries will join the EU, eight of which from Central and
Eastern Europe1. This brings the total number or EU countries to 25. On the same date, these
countries will also become members of EMU. The new members however, will enter EMU
with a derogation, as the uno actu adoption of the euro is not possible according to the
Maastricht Treaty2. Finally, it is often forgotten that EU entry also implies participation in the
ESCB. Of course, just as is the case with Denmark, Sweden and the U.K., the new members
will not be allowed to participate in monetary policy decision making until they have adopted
the euro. Adoption of the euro is dependent upon the fulfillment of the Maastricht
convergence criteria, i.e., the inflation criterion, the fiscal criteria on public deficit and debt,
the interest rate criterion and the exchange rate criterion. The latter criterion expects the
country to participate for at least two years in the ERM II, which is a pegged exchange rate
system with a horizontal band of +/ - 15 % or , by common agreement, with a narrower
fluctuation band.
Many of the new EU entrants have already signaled that they aspire to adopt the euro
rather sooner than later and quite a few hope to adopt the euro as soon as possible. More over,
the majority of new members seem to prefer a shorter rather than longer time in the ERM II.
In contrast, both the European Commission and the ECB have taken a more cautious line on
road map to the adoption of the euro pointing inter alia to the possibility of continuing
asymmetric structural shocks. There is also a potential conflict between the exchange rate and
the inflation criterion as faster real growth leads to higher inflation due to the Balassa-
Samuelson effect. In any event, monetary policy of the new EU member states is confronted
with a number of quite serious challenges encompassing the institutional, technical and
monetary policy areas of central banking. At the same time, the ESCB is preparing for
enlargement not only from an economic and technical perspective but also from an
institutional perspective.
This symposium brought together three high-ranking experts from Central Banks from the
Czech Republic, Estonia and Slovenia for an exchange of views on the issues emanating from
EU/EMU accession for their central banks. To complement, an academic economist discusses
the challenges facing and the solution offered by the ESCB to maintain an efficient monetary
policy decision-making process after enlargement.
All three countries presented in this symposium aspire to adopt the euro rather sooner than
later. On current economic trends, however, they will not be likely to adopt the euro at the
same time in particular due to different fiscal performances and adjustment paths. Estonia has
maintained a currency board arrangement since 1992. Slovenia, at the other end of the
spectrum of exchange rate regimes, has followed a (heavily) managed float since the
country’s independence and has supplemented this float with an intermediate monetary target.
Both strive at introducing the euro with the shortest possible delay. The Czech Republic was
forced to switch from a pegged exchange rate system to a floating exchange rate in 1997,
1
The Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia and Slovenia as well as Cyprus and
Malta.
2
Denmark and the UK were granted opt-out clauses. Sweden was excluded because it did not and still fails to
fulfill all convergence criteria (i.e. the exchange rate criterion).
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which it anchors with an inflation-targeting regime. This switch of policies was necessary due
to inconsistent economic policies. Looking ahead, monetary policy must square real exchange
rate adjustment with smooth participation in the ERM II and the fulfillment of the Maastricht
inflation (and interest rate) criterion. Hence, the timing of entry, the (multilateral) decision on
the central rate and the duration in the ERM II are central policy issues.
Darko Bohnec from the Bank of Slovenia, Andres Sutt from the Bank of Estonia and
Zdenek Tuma from the Czech National Bank discuss the strategies their banks take until the
adoption of the euro. Bohnec and Sutt describe the technical preparations and analyze the
policy problems from their point of view while Tuma takes a broader perspective. Central to
their discussion are issues related to the participation in the ERM II as stipulated by the
Maastricht Treaty.
Looking from the “other side”, Manfred Neumann´s focus is on the institutional
preparation of the ESCB to cope with up to 27 members. He evaluates the ECB Council’s
proposal on voting procedures. This “rotation scheme” should ensure efficient, transparent
and swift decision making by the ECB Council. The scheme divides the NCB governors into
three voting groups, based on GDP and a financial indicator weight of the respective member
state. Two criticisms relate to the still to high number of voting council members (i.e. 18) and
the alleged partial “re-nationalization” of monetary policy. The latter is due to the grouping
according to economic and financial weight, with different propensities to vote assigned to the
three groups.
The papers in this symposium tell much about the very different monetary strategies the
three countries have been following in the preparation to be fit for EU and EMU entry and
how the ESCB intends to maintain an efficient decision making structure. They also teach us
about the problems that still lie ahead and how senior monetary policy makers expect to deal
with them. The papers are informative and worthwhile for readers interested in monetary
European accession issues.
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“Monetary Policy Towards E(M)U Accession
– A Central Banker´s View”
by
Zdenek Tuma3
Czech National Bank
In this paper, I will give a brief overview on main economic issues related to the
forthcoming integration of the new EU member countries into the euro area. Subsequently I
will discuss in more detail three broad issues concerning the monetary side of EU
enlargement. First, I address the timing of euro area enlargement and monetary policy regimes
in the run up to the EMU. Then I focus on the ERM II as an interim step towards the euro
area. Third, I express my views on the future of the ECB and euro area, which we will have
an opportunity to co-determine after our entry.
1. Overview
With the signing of the accession treaties, the EU looks forward to the largest-ever
one-off enlargement of the European Union. As a result, the earlier theoretical debates on
what challenges might be associated with accession to the EU – and later on also to the EMU
– have now shifted towards the practical level of finding how best to cope with these
challenges. In many respects, the academic – and usually open-ended – discussions of the
pros and cons of the integration process now need to be replaced by action to design the actual
steps to be taken.
These steps must necessarily take into account the particular circumstances of each
accession country, such as its current economic situation, monetary policy regime and fiscal
stance. For example, the roadmap towards the EMU in a country with a currency board will
be completely different from that of an inflation-targeting country with a floating exchange
rate. Thus, my remarks are sufficiently general for the accession countries as a group, but at
the same time specific and focused enough to reflect the current stage of development.
Let me point out the most important issues in the debate on the challenges of EU/EMU
accession. The potential trade-off between the real and nominal convergence processes has
received particular attention in these discussions. It has been questioned whether the accession
countries can simultaneously achieve low inflation, nominal exchange rate stability,
consolidated public budgets and sufficiently fast economic growth. It has often been argued
that economic growth should be given priority at the current stage, and only later on should
nominal convergence goals be pursued more vigorously.
In my opinion, this potential conflict has quite often been exaggerated. There are
certainly links between the two convergence processes. For example, fast disinflation through
tough monetary policy would be connected with a temporary growth slowdown. It is also true
that faster GDP growth is likely to lead to a real exchange rate appreciation, making it
impossible to have both very low inflation and a completely stable nominal exchange rate.
Nevertheless, my position is that the two processes are not incompatible, and that they have
different time horizons. Nominal convergence is achievable in the medium run, whilst real
convergence remains a long-term matter.
3
Governor, Czech National Bank. The paper is based on the author’s luncheon address as well as the
symposium’s panel discussion on the topic at the International Atlantic Economic Society, Vienna conference,
14 March 2003
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Most of the accession countries have achieved impressive results in the nominal
convergence process. They are now among the countries with moderate or even very low
inflation rates, and their nominal interest rates have converged to the EU levels. In the
majority of cases, no practical problems with achieving the Maastricht criteria on inflation
and long-term interest rates are envisaged. Moreover, this progress has often been achieved
simultaneously with satisfactory growth performance. Admittedly, some countries have gone
through economic recessions that have helped them with disinflation, but these were usually
reactions to previous imbalances in the economy rather than consequences of ambitious anti-
inflationary policies.
As far as real appreciation is concerned, at the current stage we need to shift from
purely qualitative judgments to a more practical level. It is true that most of the accession
countries have exhibited a clear trend towards real exchange rate strengthening over recent
years. Moreover, in many cases – including the Czech Republic – its pace has been fairly
high, more than can be readily explained by economic theory. We thus need quantitative
analyses of its causes before we can make any policy judgments for the future. For example,
the majority of empirical studies of the Balassa–Samuelson effect have concluded that this
hypothesis explains only 1–2 percentage points (or even less) a year of the real appreciation in
the Central European countries. The rest must be explained by other factors, such as price
deregulations, quality and terms-of-trade improvements and structural changes in the
economy. It is quite likely that these effects will become less important in the medium term,
slowing down the equilibrium real appreciation. Therefore, the real appreciation does not
necessarily have to be a significant problem either in the ERM II – as its wide fluctuation
band gives room for a modest strengthening – or in the euro area. In other words, the real
appreciation might be modest enough not to pose a serious conflict with low inflation and
satisfactory economic performance.
This is not to say, of course, that fast-track adoption of the euro is a universal best
option for all accession countries. As I said at the beginning, there is no single prescription for
all the accession countries. In many cases, the practical constraint seems to be the public
budgets. Notable exceptions are the Baltic States and some other economies for which there
seem to be few obstacles to early euro area entry. But many other countries run large public
deficits, even after subtracting one-off transition costs. The necessary reforms would have to
include changing the public finance structure to address the ageing problem, overly generous
social security systems, etc. These are problems shared by all European countries, and are
politically quite hard to resolve. The consolidation of public budgets to a sustainable position
is thus one of the key immediate challenges, both for some accession countries and for the
present EU members.
The case for fiscal consolidation is further strengthened by the fact that upon EU
accession, the Stability and Growth Pact will become relevant to the new member states. This
is something that has not been fully realized and appreciated yet. There are two possible
reasons for this. First, it may be because the application of sanctions will be postponed until a
country becomes a member of the euro area. But even if a country is not subject to sanctions,
as a member of the EU club it should have in place at least a credible program towards
achieving its objectives. Second, there is uncertainty on how the S&G Pact will look in the
future. Concerning this point, I believe that some rules of this kind will always have to be in
place in the euro area. They are justified both as part of the trend towards rules and greater
transparency in economic policies, and – in the EMU context – also by the need to deal with
the free-rider problem in the absence of fiscal federalism. Certainly, it is possible – and
probably also reasonable – to think about modifying the existing rules to make them less
rigid, for example by defining them in terms of the structural budget balance and by taking
sustainability issues (such as lower debt) more directly into account. Nonetheless, it is clear
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that the current levels of public deficits in some of the accession countries will not be
tolerable under any thinkable rules, as the deficits are largely structural in their nature and
related to the long-run unsustainability of some public spending programs.
Finally, I would like to mention an issue that has to be decided by the accession
countries’ central banks rather quickly – their strategy as regards ERM II membership. The
proponents of the ERM II regime argue as follows: The ERM II is a useful monetary policy
framework that can have a disciplining impact on domestic policies, limit exchange rate
volatility, and help determine the conversion rate for EMU entry, but at the same time
provides enough flexibility. Even though there is no doubt a valid point in all these
arguments, some of the accession countries’ central banks – including the CNB – have
expressed much less enthusiasm about the ERM II. It may be argued that the disciplining
impact is already embodied in the other Maastricht criteria. Moreover, a managed float
combined with inflation targeting may achieve the same goals concerning reduced exchange
rate volatility and finding the conversion rate, and at the same time avoid the danger of self-
fulfilling speculative attacks on the exchange rate’s fluctuation bands. In reality, however, the
ERM II exchange rate criterion is – for political reasons – quite unlikely to be modified or
cancelled in the near future. On the practical level, the question is thus not whether or not to
enter the ERM II, but rather how to minimize its risks by choosing the appropriate timing,
suitable central parity, supportive policy mix, etc.
All these are questions that are occupying our minds at present. Let me now turn to
three important issues in more detail:
2. Three main challenges on the road to the euro:
2.1. Timing of EMU accession and choice of monetary policy regime
Many of the current monetary policy discussions in Central and Eastern Europe focus on
the timing of EMU accession. It has been extensively debated whether the candidate countries
should adopt a “fast-track” approach or a more cautious one. Different countries have
expressed different preferences so far. This is a natural implication of their specific
circumstances as well as their history.
In particular, the current monetary policy and exchange rate regime has got important
implications for the roadmap towards the euro area. At the beginning of economic transition,
most post-communist countries chose exchange-rate-based stabilization programs, using
pegged exchange rates as a nominal anchor for their economies. At present, though, the
accession countries are divided into two broad groups in this respect. On one hand, there are
countries with currency boards or very rigid exchange rate pegs, such as Estonia, Bulgaria,
Lithuania, and Latvia. On the other hand, the Czech Republic, Slovakia, Poland and Hungary
are examples of inflation targeting countries with floating exchange rates (except for Hungary
with its ±15% fluctuation band).
This situation of the accession countries fits well into the general, global trend towards
the corner exchange rate regimes. Whilst many countries have moved to a greater exchange
rate flexibility since early 1990s, some other economies have adopted hard exchange rate
pegs. On the contrary, the number of countries with intermediate exchange rate regimes has
declined significantly. This reflects the belief that soft pegs are inherently unstable, as they
may be exposed to self-fulfilling speculative attacks.
The choice between the two corners depends on many factors, the most important ones
being the credibility of the domestic monetary policy, the degree of economic and political
integration with other countries, historical experience etc. Typically, hard pegs are introduced
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either in countries hit by macroeconomic instability, which starve to establish a credible
macroeconomic framework quickly by importing low inflation from abroad, or by countries ,
which have progressed in their economic integration to such a degree that they decided to
establish a monetary union.
Both of the two corner solutions seem to be viable options for the accession countries.
All of them have established sufficient credibility of their authorities to enable them to pursue
autonomous monetary policies with domestic nominal anchors (typically an inflation target)
and floating exchange rates. On the other hand, they have also dramatically increased their
economic integration with the EU over the previous decade. At present, many accession
countries sell 60-75 % of their exports to the EU, the share of intra-industry trade with the EU
has been increasing, etc. In addition, there has been massive inflow of FDI to many candidate
countries, a majority of it coming from EU-based companies. As part of this trend, the
banking sectors of the accession countries have been usually sold to foreign strategic partners,
mainly EU banks. Even though in some areas the convergence is still far from perfect, for
example in the business cycle synchronization, a hard peg to the euro – most preferably an
official euro adoption – has been becoming a very attractive choice.
It is clear that eventually the accession countries share the same exit strategy from
their current monetary policy regimes, i.e. future euro area membership. The entry into the
euro area is tied to their EU-accession, as they are not granted an opt-out clause. The euro
adoption will represent a completion of the candidate countries’ integration into the EU
structures, giving them the possibility to participate fully in formulating and implementing the
single European monetary and exchange rate policy. Given the high degree of economic
integration discussed earlier, the EMU entry is also a rational policy objective for them, as the
benefits are likely to outweigh risks in the long run.
The question therefore is not whether to adopt the euro or not, but when and what
monetary policy regime to use before the adoption. As I have mentioned before, both of the
two corner regimes are viable for the accession countries. This means that I can imagine both,
the fast and slower tract to the euro area. It should not make a first-order welfare difference
whether a country adopts euro a bit earlier or later on, as long as this difference concerns a
few years only (which is the case speaking about the accession dates that have been proposed
so far). At the same time, it means that I find little arguments for delaying the entry date
artificially. It is in the own interest of the accession countries to quickly carry out reforms to
assure fiscal sustainability and to further reduce structural rigidities of their economies. Once
these preconditions for smooth EMU accession are fulfilled, the euro should be adopted.
Finally, it also implies that any of the two corner options for the monetary policy
regime are plausible for most accession countries before the EMU accession. In such a
situation, it is each country’s history what becomes decisive for the chosen strategy. The
choice of monetary policy regime is path-dependent. This reflects the fact that frequent
changes of the regimes are not desirable, as it takes several years to change the central bank
mentality, as well as to win understanding and credibility from the public. As a result, it
seems optimal for currency board countries to go immediately from the current regime into
the euro area, whilst I would not recommend the current inflation targeting countries to think
about a hard peg seriously as an interim step before euro adoption.
The exact road to the euro area must, of course, reflect the particular situation and
tradition of each country. I would like to stress once again that there is no universal
prescription that would suit to all.
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2.2.ERM II as a precondition for the euro area entry
A precondition which constraints the possible timing and monetary policy regime choice
before the EMU accession is the ERM II participation for at least two years. The ERM II has
been subject of many heated debates, and the opinions on its usefulness remain quite
polarized.
The proponents of ERM II believe that announcing a central parity would provide
guidance to participants in the foreign exchange markets, helping to reduce exchange rate
fluctuations. The ERM II can also serve as a disciplining device on the domestic policies in
the run-up to the EMU accession. The opponents, on the other hand, argue that this guidance
will be only limited since the central parity may be changed. The ERM II is a soft peg
exchange rate regime, which may be vulnerable in the world of liberalized capital flows. The
EMS turbulence at the beginning of the 1990s, or the recent experience of Hungary, supports
this argument.
In my opinion, the ERM II inherited many of its characteristics from its predecessor
EMS/ERM. In the past, this system played its important role in the European monetary
integration process, including its disciplining impact on the national governments. But
EMS/ERM is by its nature a regime of the past, not of the present nor the future. It lost its role
as an intermediate step towards monetary union with the euro’s birth. At the same time, it
does not reflect the increased globalization of the financial flows and the current skeptical
view on the soft peg exchange rate regimes.
For the currency board countries, the ERM II seems to have no value added compared to
their current regime, which is just one small step from adopting the euro officially. In this
case, it would be probably reasonable to adopt the euro as soon as possible, without being
artificially forced to linger in the ERM II for two years. It is a step back for the inflation
targeting countries, too, as it introduces a potential inconsistency into their modern monetary
policy regimes, which may under unfavorable circumstances increase the risk of their
macroeconomic destabilization.
Most probably, though, the accession countries will have to cope with the requirement of
the ERM II membership. In practice, and if they are lucky enough, it might be consistent with
maintaining their current regimes, both in the case of currency board and inflation targeting
countries. The CNB has subscribed to this point of view in its Draft Accession Strategy,
stating that: “Until the monetary integration process has been completed, independent Czech
monetary policy will continue to be implemented by means of the inflation targeting strategy.
Continuing participation of the koruna in the ERM II is consistent with this strategy. ERM II
is regarded merely as the gateway to euro area participation and not as an alternative to the
existing monetary policy regime.”
The accession countries might reduce the risks associated with the ERM II participation
by choosing the appropriate timing, which I believe should be minimized to two years in most
cases, setting a sustainable central parity, and supporting the monetary policy with an
appropriate policy mix. From the EU’s side, it is first necessary to give a clear interpretation
of the Maastricht exchange rate criterion, which has so far not been fully unified among the
EU institutions. In my opinion, this interpretation should be guided primarily by the concern
to minimize the risks associated with the ERM II participation. The EU might also consider
some of the proposals to adjust the particular details of the ERM II, such as the mechanism of
joint foreign exchange interventions, to reflect better the nowadays reality.
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2.3.Future of the euro area and the ECB
The euro area is a young currency area, and the ECB is still a maturing institution.
Therefore, it has been evolving, and many changes are to be expected for the future as well.
For the accession countries, it is thus not important to focus on their integration with the
current euro area only, but also to watch the debates where the euro area is heading itself.
I would like to point to two important policy debates that are currently underway in the
EU. The first one concerns the Stability and Growth Pact, the other relates to the plans on
adjusting the voting mechanism at the ECB’s Governing Council after the accession of new
member states.
The Stability and Growth Pact will become relevant to the accession countries upon their
EU entry; even though the application of sanctions will be postponed until they become
members of the euro area. At present, it seems possible that the Pact’s design and
interpretation will be modified. There is still considerable uncertainties, though, what will it
actually look like in the future, which makes the situation of policy-makers more difficult. In
my opinion, however, the key premise the policy-makers should base their actions on is that
some rules similar in nature to the current Stability and Growth Pact will always have to be in
place in the euro area. They are justified as part of the trend towards rules and greater
transparency in economic policies. In the EMU’s context they also represent a necessary
response to the free-rider problem stemming from the absence of fiscal federalism. Even if the
existing rules are adjusted to make them less rigid, it is clear that sustainability of public
finance will remain to be enforced by similar rules. Reforms aiming at public finance
sustainability thus must not be delayed in the accession countries on the ground of uncertainty
about the Pact’s future.
Concerning the proposed rotating principle on the ECB’s Council, with countries divided
into three groups, I personally think that it is an acceptable compromise reflecting the current
stage of development in the euro area. However, I consider it a temporary solution only. First
of all, it does not solve the problem of the Governing Council being too large for having full-
fledged monetary policy discussions and taking decisions flexibly. Secondly, it runs against
the principle of the governors being not viewed as representatives of their respective national
interests, but as professional individuals making monetary policy for the whole euro area.
Personally, I would prefer a two-tier decision-making structure at the ECB, in which the
interest rate decisions and other daily business of the ECB would be run by a relatively small
body – called for example Executive Committee – built on a professional, not nationalist
ground. The governors of the national central banks would remain members of the ECB’s
Council, supervising the Executive Committee and taking the ECB’s strategic decisions, e.g.
defining the monetary policy regime. Such a change would allow positive developments in
the ECB’s policy framework towards a more transparent and understandable one. I realize,
though, that it will need more time to reach a point at which such a full-scale reform would be
feasible.
To summarize, there are many important issues occupying the minds of monetary policy
makers on both sides of the EU enlargement process. These include finding a suitable timing
for the adoption of euro by the accession countries, clarifying the interpretation of the
Maastricht exchange rate criterion by the EU and defining the accession countries’ policy
positions towards the ERM II membership, discussing the future of the S&G Pact, ECB’s
voting principles etc. The approaching EU enlargement forces us to take decisions quite soon
on all these issues.
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The impact of EU Enlargement – Challenges for Slovenia´s Monetary and Exchange
Rate Policies
by
Darko Bohnec*
Bank of Slovenia
1. Introduction
Following the successful conclusion of the accession negotiations in December 2002, and
the March 2002 strong referendum vote for the EU membership, the signing of the Treaty and
Act of Accession – scheduled for April 16, 2003 Slovenia will most probably become the EU
member in May 2004.
A smooth and balanced process towards the early entry into ERM II and the adoption of
Euro, at minimal costs and disruptions, is at heart of monetary policy as well as of other
macroeconomic policies not only in Slovenia, but as well in many other accession countries.
Why the introduction of the Euro seems to be a natural goal for Slovenia is discussed in terms
of optimal currency area criteria in the first part of this paper. In the second part the current
status of indicators for nominal and real convergence for Slovenia are presented. In the
following part monetary and exchange rate policy framework, as it is set by the Bank of
Slovenia, is described. In the concluding part some currently opened or still discussed issues
about the entry and participation in the ERM II are pinpointed.
2. Economic and Monetary Union as an optimal currency area for Slovenia
The most important question which has to be answered positively, when considering
joining broader currency area, is weather macroeconomic policies can equally be efficient in
the case of nonexistent own monetary policy. The answer mainly depends on the similarity of
the stage of the development of the economies in the currency area, on the probability of
asymmetric shocks and on own capability to absorb such shocks. The fact that Slovenia is
very small economy (its GDP, measured by purchasing power standards, represents only 0,4%
of the GDP of EMU) at least assures that ECB's monetary policy effectiveness for the Euro
currency area would most probably not be endangered.
The stage of the development of the Slovenian economy, measured by GDP per capita in
PPS, in comparison with the least developed EMU countries and especially compared with
the stage of their development at the time of their accession to EMU, is sufficient. In terms of
the level of GDP per capita Slovenia reached approximately 70% of EU average in the year
2001 while this indicator for Greece was a bit lower and for Portugal a bit higher. It is worth
to mention that this EU countries had been receiving about 4% of GDP as financial transfers
in terms of structural and development funds, while Slovenia had caught up about 5
percentage points in previous 5 to 6 years without such kind of financial help. This indicates
that the current speed of catching up is so fast that it would need less time to reach the average
level of GDP per capita of EMU countries than the least developed EMU member countries.
Slovenia, being a small country, is even more comparable with EU regions than with
individual countries. By number of regions, about two thirds of regions within EMU have
lower GDP per capita than the average for EMU countries. About one third of these regions
have lower GDP per capita than Slovenia.
*
Vice Governor in the Bank of Slovenia; the opinions expressed are those of the author and do not necessarily
reflect the views of the Bank of Slovenia.
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The probability of asymmetric effects of shocks on the economies is a very important
criterion for the decision about accession to a common monetary area. If such effects are
relatively more probable, the fact that an economy cannot use its own monetary policy makes
adjustment to a shock more costly. The probability of asymmetric shocks is lower if:
the structure of the economy is relatively more heterogeneous,
the structure of the economy is similar to the structure of other economies, participating in
a common monetary area,
the trade with countries, participating in a common monetary area, is predominant
business cycles are well synchronized
transition process and structural reforms are in the advanced stage.
Slovenia produces and trades heterogeneous products by different sectors of the economy.
This heterogeneity reduces the need to use monetary policy and exchange rate adjustments to
absorb shocks. If we compare the structure of the Slovenian economy with the structure of the
average EMU economy, the main difference is in the share of the financial sector (10
percentage points lower share) and of industrial sector (10 percentage points higher share),
showing in fact high level of similarity with evident positive trend of convergence in recent
years. This similarity in the structure of the economies augments the probability that shocks
appear to be symmetric.
Equal direction and similar magnitude of business cycle in the economies, participating in
the common monetary area, are important for the monetary policy effectiveness. They are
even more important for a small individual economy because opportunity costs of adjustment
through fiscal and income policies could be very high in the case of divergent effects of
monetary policy actions, geared in line with prevailing overall situation in the common
monetary area.
In terms of direction of aggregate activity, Slovenian economy is well synchronized with
the EMU economies due to high integration of Slovenian companies with the common EU
market. With its trade of goods and services ratio of 120% of GDP it is ahead of EMU
countries average (79% of GDP), at the similar level as Netherlands, but bellow the levels of
some small EMU countries i.e. Luxembourg, Ireland, Belgium. Two other indicators support
the conclusion that Slovenia is predominantly trading with countries of “Euroland”: 59,6% of
traded goods with nonresidents are being exchanged with residents of “Euroland” countries
and 59,8% of GDP is being exchanged with Euro currency area.
The capability to absorb asymmetric shocks is in most cases assessed in relation with
mobility of work and capital and in relation with adaptability of fiscal and income policies.
This is a tough “battle area” even for the counties, members of EMU. Also in the case of
Slovenia, someone could easily notice rigidities in providing real downward adjustments of
government and broader public spending as well as in de-indexing wage agreements, but at
least authorities up till now have successfully avoided major macroeconomic imbalances to
occur.
It is obvious that money and capital markets will never reach the level of development of
those of bigger and more advanced economies. Still liberalization of capital flows has been
implemented in Slovenia even before the date agreed with EU countries in Pre Accession
Agreement. Financial and capital inflows in several years, even in times of capital controls,
have accounted for more than 5% of GDP annually. At the same time an important share of
savings has been accumulated in foreign exchange.
Despite deficiencies in labor market infrastructure, some indicators of labor mobility seem
to be favorable for Slovenia. Relative differences in unemployment rates on regional level are
smaller than on average for EMU countries (coefficient of variability of unemployment rates
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for Slovenia is 33,4, for EMU countries 48,2). If social transfers related to labor market are
relatively high (more open economies seem to be more exposed to shocks than less opened),
they might discourage mobility of labor. Slovenia spends 1,3% of GDP for such social
transfers while EMU countries on average 2,2%.
3. Inflation and long term interest rates - major challenges in fulfilling nominal
convergence criteria for EMU
In 2002, Slovenia enjoyed a solid growth of close to 3 percent for the second consecutive
year. After the last downward adjustment that takes into account the recent developments in
the global economy, economic growth in 2003 is still expected to be around 3 percent, with
respect to 3.7 percent projected last autumn. Solid external and internal position in 2002
supported this steady trend; the first with a comfortable external current account surplus of 1.8
percent of GDP, and the second with a relatively moderate fiscal deficit of 1.4 percent of
GDP, and the general government debt ratio of 28 percent of GDP. Despite the weakening of
economic environment in EU trading partners, in 2002 Slovenia retained its growth of activity
at solid level among other reasons also due to regional shift in trade towards former Yugoslav
market.
The public finance position in Slovenia is continually sound, it was in a slight surplus
until mid 90’s, and in a deficit of below 1.5 percent of GDP since then. The 2003 – 2004
budget - targeting a deficit of 1.2 percent of GDP in 2003 and of 0.9 percent of GDP in 2004 -
has announced gradual fiscal consolidation in the period ahead to the adoption of the Euro.
Main adjustments have to occur on the expenditure side.
The developments in inflation in the beginning of 2003 are positive, resuming the
disinflation process interrupted in 1999 following the introduction of the VAT. The end-2002
original inflation projection of 5.8 percent, indeed, could not be met, mostly due to cost-push
factors, and the year 2002 ended with the inflation resisting at slightly above 7 percent. In
January 2003, however, the Government took a decisive action by adjusting excise duties on
oil, and, by taking a coordinated approach towards the administered prices. As a result, the
annual inflation was brought down by the end of February 2003 to 6.2 percent. In early March
2003 the Bank of Slovenia followed these effects by reducing its policy rate and consequently
also the pace of depreciation. In the absence of external surprises, the inflation targets of 5.3
percent for end-2003 and of 3.5 percent for end-2004 are within reach, thus securing a smooth
ERM II entry planned for January 2005.
The fulfillment of the criterion of long-term interest rates is very much related to
inflationary developments. On the one hand, it is obvious that the level of interest rates in
conditions of inflationary pressures has to be relatively high and on the other, as in the case of
Slovenia, indexation of financial contracts is still wide spread. The Treasury of the state is
courageously testing the market for fixed income bonds with maturity of 3 and 5 years and
even 10 years that would, together with further development of money market and reduction
of inflation, set the stage for achieving the needed (low) level of long term interest rates.
To assess the stability of the exchange rate, a country aiming to adopt Euro, first has to be
participant in ERM II. It has not yet been set precisely how strict the assessment at the end of
at least two years long participation in ERM II would be. Despite the band around central
parity being wide enough (+/- 15%), the acceptable stability of the exchange rate would most
probably be the one where at the end the currency would not become weaker in nominal
terms, compared to Euro, for more than 2,25% from the initial central parity. To succeed in
fulfilling this criterion in a sustainable way (i.e. not to be trapped in excessive nominal and
real appreciation because of interest rate sensitive capital inflows pressures, deriving from
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wide opened interest rate differentials) the most important to do is to reduce inflation and
interest rates close to the level of Euro currency area before entering ERM II.
4. Monetary and exchange rate policy framework
The monetary policy framework of the Bank of Slovenia is tailored to the country specific
circumstances. The Bank of Slovenia conducts its monetary policy in the context of a
managed floating exchange rate regime. The given choice of exchange rate regime allows it
some flexibility in the conduct of monetary policy even within a context of the free flow of
capital. The Bank’s ability to sterilize the effects of net foreign exchange inflows through the
instruments at its disposal is an important precondition to choose the control of money supply
as the core stone of the monetary policy strategy.
In conducting its monetary policy, the Bank of Slovenia uses two levers to control the
money supply, namely interest rates and the exchange rate. Interest rates, particularly those of
sterilization instruments, have to be adjusted in line with the needed monetary stance related
to inflation dynamics and inflationary expectations. Exchange rate adjustments, expressed as
annual growth rates, have to be managed, in view of the Bank of Slovenia, to eliminate any
differentials between domestic and foreign interest rates (except those due to country risk) in
order to prevent speculative, mainly short-term financial inflows and outflows. The Bank thus
uses its instruments for intervening on the foreign exchange and money market in order to
achieve an appropriate supply of base money.
In conditions of the free flow of capital and strong capital inflows, foreign exchange
interventions are an important mechanism for managing the exchange rate. There are three
main pillars of this mechanism:
an agreement between the Bank of Slovenia and individual banks, thus constituting the
"Bank Club",
temporary purchases of foreign currency (i.e. currency swaps) by the Bank of Slovenia,
sterilization operations by means of central bank bills.
The cooperation agreement on the foreign exchange market, concluded between the Bank of
Slovenia and the individual commercial banks, enables the Bank of Slovenia to signal the
exchange rate. It sets the range of rates at which the banks can deal with other parties (at least
90% of all deals of a bank have to be within set range of rates). For their part, the banks that
are party to the agreement (all the banks, except a branch of a foreign bank, joined the club in
October 2001) enjoy exclusive access to central bank money through a standing facility –
foreign currency repurchase instrument.
Through this instrument, being the second pillar of foreign exchange operations of the
Bank of Slovenia, it purchases foreign currency only temporary (instead of outright) by means
of 7-days swaps. The difference between such an arrangement and outright foreign currency
purchases can be summarized as follows:
Short-term currency swaps allow banks to manage their liquidity comfortable, but restrain
them to extend long-term loans on the basis of very short term funds.
The use of currency swaps enables the Bank of Slovenia to compensate a great deal of
sterilization costs. The interest rate on the swap instrument is set in relation to the desired
pace of depreciation, which in view of the Bank of Slovenia has to reflect the principle of
uncovered interest parity (UIP). The main policy rate of the Bank of Slovenia is
consequently the sum of the swap "interest" rate and the main refinancing rate of ECB (as
a proxy for Euribor).
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The short term nature of instrument and flexible pricing deter potential arbitrage and
restrain the emergence of interest rate sensitive capital inflows on one hand and on the
other, still provide some flexibility for own monetary policy needs.
The third pillar of the Bank of Slovenia's exchange rate policy is the sterilization of excess
Tolar liquidity stemming from the extensive monetization of foreign exchange inflows. The
Bank of Slovenia uses Tolar-denominated 60 days (as a standing facility), 270 days (as an
open market operation) and from time to time 360 days (as an open market operation) central
bank bills for the purpose of sterilization.
In 2002, two major factors, high inflation and record capital inflows, complicated the
monetary policy. The record FDI inflows, equal to 8.8 percent of GDP, were mainly fueled by
sales of equity shares in a big pharmaceutical company and in the biggest Slovenian bank.
The Bank of Slovenia policy setting was successful in sterilizing liquidity, thus preventing
excessive growth of money supply and unsustainable nominal appreciation shock.
Due to higher inflation rates in the beginning of 2002, the Bank of Slovenia increased the
main policy rate and interest rates of other monetary instruments several times. These
adjustments together with the opposite trend in foreign interest rates development prevented
further slow down of depreciation of Tolar. The policy rate cut in December 2002, of 0.5
percentage points, followed the ECB cut of main refinancing rate. This was only possible due
to the positive results in coordination of policies between government and central bank in
terms of reducing inflation. The second cut in March this year, of 0.75 percentage points, was
response to both, the decline in inflation and the ECB cut. For the first reason also nominal
depreciation of Tolar was slowed down. Despite the different directions of domestic and
foreign interest rate movements which halted depreciation at higher pace throughout the year
2002, real appreciation of the Slovenian Tolar amounted to 5.3 percent for the period of
twelve months up to February 2003.
In 2003, major changes in the conduct of the monetary policy are not envisaged. The
reduction of interest rates will go hand in hand with the expected decline in inflationary
expectations also taking into account the movements of the interest rates abroad. This will
most probably provide some space for slowing the rate of depreciation thus supporting the
disinflation efforts. Further down the road, the Bank of Slovenia has started to suspending its
continuous presence in the foreign exchange market. However, the monetary and exchange
rate policy actions will be considered with due regard to the capital flows, international
developments, as well as the domestic investors’ and consumers’ behavior.
5. Appropriateness of the monetary and exchange rate policy framework for ERM
II participation
Countries aiming at becoming EMU members have to fulfill the exchange rate stability
criterion. It is assessed on the basis of two years long participation in the formalized exchange
rate mechanism ERM II. Before entering ERM II an acceding country has to reach an
agreement with other EU countries, with EU Commission and with ECB on central parity for
its currency against Euro and possibly on the narrower band of fluctuation which can formally
be +/- 15% wide.
The “fixity” of the central parity provides valuable orientation for the foreign exchange
market participants and a needed anchor for monetary and other economic policies. On the
other side, setting provides enough flexibility to adjust in case of internal or external shocks.
These arguments are most often stated by those who advocate the appropriateness of ERM II
for the countries on the way to EMU. However, at the same time these characteristics of ERM
II have been source of naming this mechanism in several cases as a semi-fixed exchange
regime.
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Taking into account “the impossible trinity”, according to which a country has to give up
one of three goals: exchange rate stability, autonomous monetary policy or financial market
integration, such an in-between regime is not firm enough to set credibility oriented monetary
policy framework. These deficiencies could be overcome by well-balanced agreement about
central parity, narrower band for fluctuation of exchange rate and about intramarginal
interventions with the aim to keep the exchange rate close to central parity. Such a framework
would be very much as a fixed exchange rate regime.
The alternative framework where only central parity is agreed and where only coordinated
marginal interventions at the margin of +/- 15% can be expected is from the short-term
prospective free-floating regime. It is well known that autonomous monetary policy is
consistent with free-floating regime. Nevertheless, autonomy, when dealing with inflationary
pressures, becomes rather illusion when the monetary policy is confronted with large financial
inflows due to interest rate differential.
In both cases it becomes evident that stability of macroeconomic fundamentals has to be
achieved before entering ERM II. Otherwise a country might need to re-align the central
parity and thus not fulfill the exchange rate stability criterion or might be trapped in marginal
nominal appreciation of 15% because of interest rate sensitive capital inflows pressures,
deriving from wide opened interest rate differentials, needed for restrictive monetary policy.
All in all, the following three cornerstones emerge: First, Slovenia is aiming at fast
integration with EMU after entering EU. Second, authorities are cautious about entering into
ERM II being well prepared in terms of nominal convergence criteria. Third, being well
advanced in convergence process at the beginning of ERM II participation authorities aim at
the shortest needed time to spend in ERM II.
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“The Impact of European Union Enlargement on Voting Procedures
of the ECB Governing Council
by
Manfred J.M. Neumann
University of Bonn
Enlargement of the European Union will be an ongoing process over the next two
decades. Apart from the most advanced group of accession countries, like the Czech
Republic, Hungary, Poland, Slovenia and the Baltic states, more countries are asking for
membership. From today’s point of view, it is to be expected that membership will rise from
currently 15 up to 27 over the medium run. In fact, the European Union has become an
attractive enterprise.
Though the accession countries are eager to enter the union as early as possible,
preparing for entrance is not easy for them as it requires to change at home a host of micro
and macroeconomic characteristics such that the domestic economy gets on a path of
convergence to the member economies of the European Union. After all, the potential entrants
are asked to comply to the same convergence criteria – as regards inflation, the budget, the
debt level and exchange rate stability – that the current members of the European Union had
to fulfill upon entrance.
At the same time, the prospect of enlargement creates problems of adjustment for the
existing members of the union. A very important aspect is the impact of enlargement on the
workability of the European Union’s institutions, such as the European parliament, the
European commission, and the European system of central banks. When these institutions
were founded, they were built under the assumption that the union would comprise up to 12
members instead of the current 15 or the future 27. As regards the European parliament, a
plan has been adopted in late 2001 at the European summit of Niece that clarifies how the
parliament and its voting procedures will be adjusted to a growing number of member
countries.
Similar provisions for adjusting the European commission and the European Central
Bank’s policymaking body, the Governing Council of the ECB, are necessary. The
membership of both policy bodies will rise with the number of member countries. This creates
the danger that it will become more and more difficult to take policy decisions. After all, we
know from organization theory that the costs of preparing and taking decisions rise not just in
proportion but also progressively with the number of committee members. For this reason,
most large companies prefer to have less than eight people in the executive board. On that
account today’s Governing Council of the ECB, consisting of the six members of the ECB’s
executive board and the 12 national governors of the central banks belonging to the European
system of central banks, is already too large.
In order to secure efficient procedures with an even larger number of council
members, the Governing Council has recommended redefining and reorganizing its voting
procedures by introducing a rotation schema. The EU Council, meeting in the composition of
Heads of State or Government, has recently adopted the recommendation; see ECB (2003).
The new voting system takes different sizes of the European Monetary Union into account. It
curtails the voting rights of the national governors while the voting rights of the six board
members remain untouched. The rotation among the governors shall start when more than 15
but less than 22 countries belong to the European Monetary Union. Then two groups of
governors will be formed using the size of countries as the criterion. Size is measured by a
weighted average of a country’s shares in total gross domestic product and in total assets of
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the monetary financial institutions. A first group of the governors originating from the five
largest countries receives four votes and the second group of up to 17 governors receives up
to eleven votes. When the number of governors rises above 22, a third group of up to five
governors from the smallest countries of the union will be formed and receive up to three
voting rights. In this case, the number of voting rights for the second group will be reduced
from 11 to 8, in order to assure that the total number of voting rights for governors never
exceeds 15.
To see what the new rotation rule will achieve, consider a national governor who
serves two terms of altogether 16 years, say. Depending on the relative size of his home
country, he will have to abstain from voting in the ECB council during three, seven or even
ten years. The feature that the frequency of a governor’s taking part in the decisions by voting
is linked to the size of the home country is undesirable. It will give to the governors from
large countries dominant weight in decision making, even during the relatively rare times
when they have to abstain. This runs counter to the principle of treating the governors as
equals and as independent decision makers who care about the bonum commune Europae
instead of the interests of their home countries. The danger of a rotation determined by
country weights is that it favors the interpretation that the governors serve on the Governing
Council as the deputies of their home countries instead of in a personal capacity of
independence.
Another important aspect to note is that the new rotation will not be efficiency
enhancing, as it does not cut back the enlargement-induced rise in council membership. Thus,
it will not contribute to redress the rising costs of decision-making. There is a simple reason
for that. Those governors who have to abstain from voting for some time are nevertheless
expected to fully engage in the council’s deliberations. Indeed, this is the American
experience with rotation in the Federal Open Market Committee (FOMC), the policy-making
body of the Federal Reserve System. In fact, in the US it was not the attempt at raising
efficiency that led to the introduction of rotation in the FOMC but the interest in redressing
the power of the periphery in favor of the center. The voting rights of the 12 regional Federal
Reserve Banks were cut to five in 1935 to secure the seven members of the Board of the
Federal Reserve System the majority.
In the medium to long run, the Governing Council of the ECB will have to face a
dramatic loss of efficiency, given that its size will rise from today’s 18 to 33 members. Then,
at the latest, one will have to consider another reform where the bulk of decision-making will
be entrusted to a smaller committee. It seems what is called for is a two-step approach where
the Governing Council meets no more than twice a year and restricts itself to decisions on
policy guidelines. The guidelines may then serve for the more frequent, short-run oriented
decision-making by a smaller committee. To be sure, a straightforward solution would be to
hand all short-run decision making to the ECB’s executive board. Nevertheless, this might not
be acceptable to the smaller countries. Thus, an alternative is that the Governing Council
appoints a subcommittee of 12 or at most 15 members. In addition to the six members of the
executive board who should have permanent seats, up to nine governors might be included.
The governors would have to rotate but this would not require ranking them by some
composite indicator. They could be treated as equals. For example, once the union comprises
27 member countries, each of the national governors could be asked to serve on the
subcommittee every third year. In any case, the recently adopted reform of the voting system
does not cope with the inefficiency challenge that is created by the expansion of the euro area.
Reference
European Central Bank (2003): “The Adjustment of Voting Modalities in the Governing
Council”, Monthly Bulletin, May 2003, 73-83.
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Challenges Fasing the Estonian Economy on its Way to the European Union
by
Andres Sutt4
Bank of Estonia
The strategic choices of economic and monetary policy must take into account the
realities of the broader environment to work effectively. For Estonia, the early stages of
transition have been characterized by the nonexistence of well-developed financial markets
and predictable monetary transmission mechanism. Estonia's choice of monetary framework
reflects our search for high credibility and transparency of monetary policy as well as a firm
ground for economic reforms.
After regaining its independence Estonia started the transition from a planned to a
market economy in a quite unfavorable position. The enormous structural rigidities of the
Soviet economy compared to the somewhat more liberal regimes of eg Poland and Hungary
were notable. This meant deeper initial restructuring and also bigger social adjustment than in
many other transition economies. This is very clearly reflected in the official growth data of
the early 90ies. In addition, being a newly independent country, Estonia had to rebuild its
most basic elements of credibility from nothing – and that is where the monetary strategy has
been probably one of the key factors (albeit not the only one), anchoring the functioning of
the market economy and supporting a stable framework for the reallocation of resources.
Since 1992 Estonia has operated a currency, board based monetary system. That
means:
• full reserve backing of the monetary base,
• automatic intervention on the spot foreign exchange market as the sole active policy
instrument
• no central bank interest rates, the key monetary policy interest rate for Estonia is the
ECB main refinancing rate,
• banking policy is a responsibility of the central bank while supervision is carried out
by independent financial supervision authority reserve requirement is used to ensure
proper levels of liquidity in the banking system as Eesti Pank does not act as LLR;
Estonian financial sector refinances its operations in European money and repo markets
and consequently, banks obtain kroon liquidity by trading euros to kroon via central bank’s
automatic foreign exchange window. This is, in fact, tantamount to continuous intervention on
local spot foreign exchange market by central bank.
Due to the automatic stabilizers built into a currency board arrangement the adjustment
processes in Estonia have been, perhaps, more rapid than under a more conventional monetary
environment. But that may be all to the good from the point of view of the country’s
preparations for the EU accession as the structure of the economy has proved to be flexible
enough to respond to changing external demand and domestic productivity shocks.
Recent Estonian economic developments might look quite dynamic against the
background of global slowdown. Investor and consumer sentiments have remained high,
partially supported by positive outlook and partially encouraged by lower than expected
interest rates.
4
Vice Governor, Bank of Estonia.
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In 2002 Estonia’s real GDP growth was 5,6%, CPI growth – 3,6%, average long term
kroon lending rate (end 2002) – 6,4%, according to the present estimations the current
account deficit exceeded 10% and the government budget was in surplus by 1,2%.
The Estonian economy is already strongly integrated into the European economic area.
The share of current and future EU member states in Estonia's exports is about 81%. Estonia
is no longer a catching-up candidate country as it was three-four years ago. However, we still
cannot say that the restructuring of our economy has been completed.
What are the main challenges ahead?
First, for Estonia like for all new member states the only possible way to join the euro
system is to do it in full compliance with the letter and spirit of the EU Treaty. As we well
know, the key issue here is the fulfillment of the Maastricht criteria. At this point, we expect
no great difficulties in meeting the sovereign debt and budget deficit criteria – Estonia’s
general budget has been roughly balanced or even in surplus over the last couple of years.
The remaining two criteria - low inflation and exchange rate stability - are connected with
some specific problems.
The fulfillment of the inflation criteria might not be as difficult as sometimes expected.
However, in the context of rapid accession it becomes a serious issue, not least, because
inflation is a crucial economic policy issue under a fixed rate of exchange.
A gradual increase of price level is an inevitable result of real convergence under a
fixed rate of exchange. According to our PEP the annual consumer price indices are expected
to fluctuate in the range of 3,5 - 4,2 per cent during next 3 - 4 years.
We believe that a difference of some 2 to 3 percentage points between Estonia’s and
Euro Area inflation would correspond to “equilibrium” real appreciation path. That is based
on the assumption that every 1-percentage point GDP growth differential between EU and
Estonia would lead to an average 0.7 pp differential in CP inflation and that nominal
convergence will coincide with real convergence over medium term.
Does the inflation development, so far, support the assumption that a 2 to 3 per cent
differential vis-à-vis the Euro Area can be explained by real convergence? It is perhaps
difficult to provide exact figures in that respect, but there are several indications that lead to
the conclusion that a substantial part of inflation is caused by the Balassa-Samuelson effect.
The Estonian economy is integrated into European product and capital markets,
providing the necessary preconditions for Balassa-Samuelson effect to materialize.
- The price level in open sector is fairly stable and initial price distortions have been largely
eliminated.
-The ratio of open sector and sheltered sector wages has remained constant over time, thus
supporting the assumption that wages in sectors with lower productivity have kept pace with
those of higher productivity industries.
- The measured productivity growth in open sector of the economy has constantly outpaced
productivity increases in sheltered sector. It should be noted that over the last 6 years the
cumulative productivity growth in Estonia, relative to its main trading partners, has amounted
to 25 per cent. Corresponding CPI-based real exchange rate appreciation equals to 22 per
cent.
Based on all that we believe that at least presently the inflation performance is in line
with medium term convergence scenario and – given the continuation of present policies – is
likely to remain so.
The second type of challenge I would like to mention is the possible increase in the
more volatile capital flows to the accession countries. In the forthcoming years we must keep
an especially watchful eye on the external equilibrium of our economy.
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As a point of departure, we expect the current account to remain in deficit over the
medium term. I believe that this is a reflection of real catching up, insofar as a substantial
share of capital inflows is directly related to differences in marginal productivity. The crucial
policy issue, thus, is the financing side or, to put it simply, the question whether possible
short-term inflows may create unwelcome bubbles of asset prices.
A stable business environment and credible economic policies seem to have abolished
the extreme sensitiveness of investments to the cycle. During the downturn in 1999, for
example, the gross fixed capital formation fell by nearly 15 per cent in real terms in Estonia.
In 2001, in contrast, the sentiment of foreign investors was not hit by the global slowdown
and their long-term investments projects in Estonia– including some one-off large ones - were
not put aside
By the end of the PEP period, the saving–investment gap in Estonia is projected to
stabilize at a 6 to 7 per cent level of GDP.
Traditionally, FDI inflows have been roughly equal to the current account deficit and
there have been no excessive short-term inflows, save for a brief period immediately before
the Asian crisis. There are several reasons that might explain the lack of volatile short-term
movements, e.g., prudent fiscal policy and virtually non-existent government borrowing
requirement as well as an early opening of the financial system to foreign capital flows and
foreign ownership.
This general pattern is expected to continue during the next few years. At the same
time, the share of other inflows, both debt and non-debt creating is expected to increase - and
that was exactly what happened last year. The fast development of internationalization in the
banking sector and the nominal convergence of interest rates have made it attractive to replace
FDI-type financing by borrowing from Estonian commercial banks.
Euro-based currency board is not a substitute for participation in the ERM II. Estonia’s
adoption of the euro will take place in three stages in accordance with the acquis - joining the
European Union, joining the ERM II exchange rate mechanism and, once the Maastricht
criteria are met, joining the euro area. The European Commission and the European Central
Bank have indicated, however, that the euro-based fixed exchange rate and currency board
regime, in principle, are in harmony with the acquis and conform to the requirements set for
the monetary policy of the non-euro zone economies. Given present economic fundamentals
Estonia considers it optimal to maintain the current exchange rate arrangement until joining
the euro area. For a currency board, the ERM II entry would mean a relatively small change –
given that for a euro-based currency board arrangement ERM II means one-sided
commitment with the clause that the decision of the central parity against the euro is matter of
common concern. Due to the euro-based currency board Estonia has been operating, in
general, under the same constraints as the current EMU members.
However, the strategy of direct changeover from euro-based CBA to EMU framework
at the end of ERM II period presumes a smooth and timely operational convergence process.
Here, the necessary changes are clearly bigger than in other areas.
Operational convergence towards the ESCB framework started from the
reorganization of the banks’ minimum reserves system in 1999 and is expected to continue
until Estonia becomes a full member of the EMU.
In conclusion: After regaining its independence, Estonia started the transition from a
planned to a market economy in a quite unfavorable position. Due to the currency board
arrangement the adjustment processes have been, perhaps, more rapid than under a more
conventional monetary environment. The structure of the economy has proved to be flexible
enough to respond to changing external demand and domestic productivity shocks. It could be
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said, that recent Estonian economic developments would even look quite dynamic against the
background of global slowdown.
Estonia’s economy is already integrated into European and in particular Scandinavian
markets and the likelihood of macroeconomic ‘surprises’ has decreased considerably.
Speaking about the challenges of the EU accession, no great difficulties are expected
in meeting the sovereign debt and budget deficit criteria – Estonia’s general budget has been
roughly balanced or even in surplus over the last couple of years. The remaining two criteria -
low inflation and exchange rate stability - are connected with some specific problems. Still,
the inflation and competitiveness performances over the last decade have been encouraging.
Estonia’s adoption of the euro will take place in three stages in accordance with the
acquis Due to the euro-based currency board Estonia has been operating, in general, under
the same constraints as the current EMU members. However, the direct changeover from
euro-based CBA to EMU framework at the end of ERM II period presumes a smooth and
timely operational convergence process. Here, the necessary changes are clearly bigger and ,
thus, operational convergence is expected to continue until Estonia becomes a full member of
the EMU.
However, the challenges will not end there. We should not forget about the policy
efforts necessary after becoming part of the EU and the EMU - fiscal policy will remain an
important stabilization tool also, issues concerning the flexibility and efficiency of labor,
product and capital markets will remain important challenges, just as they have been up to
then.
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