European Affairs

Summer 2005

 

Economy and Finance

100 Smaller New EU Members May Join the Euro First

By J. Onno de Beaufort Wijnholds

 

All ten countries that joined the European Union in May 2004 will eventually have to adopt the euro, although there is no fixed timetable for them to do so. While three of the 15 older member states - the UK, Denmark and Sweden - have declined to join the single currency, the new member states were not given that choice in their negotiations for EU membership.

As a consequence, the current 12-nation euro zone should
expand to at least 22 members in the years ahead. The UK and Denmark, which long ago sought and won the right to opt out of the single currency, are for now showing no sign of changing their minds. That is also true of Sweden, which rejected the euro in a referendum.

The lack of choice does not, however, seem to be a problem for the new member countries, who tend to be enthusiastic about euro membership. Politically, joining the euro would solidify their status as committed EU members; economically, it would aid their economic growth by significantly lowering interest rates.

All this will mean a great deal of work for the European Central Bank (ECB), which, together with the European Commission, has to assess the readiness of the new member states for euro membership. Entrants into the euro area must fulfill the so-called convergence criteria - also known as the Maastricht criteria - that set targets for fiscal deficits, government debt, inflation, and interest rates.

Specifically, the criteria stipulate that annual government budget deficits must not exceed three percent of GDP; that total outstanding government debt must not exceed 60 percent of GDP; that inflation must not be more than 1.5 percentage points above the three best performing euro area countries; and that average nominal long term interest rates must not be more than two percentage points higher than the average rate in the three countries with the lowest inflation rates.

Even if they meet these criteria, however, the new member countries could not join the single currency immediately. Aspirants to euro membership have to establish their stability credentials by spending at least two years in an exchange rate mechanism (known as ERM2) that limits how far their currencies can fluctuate against the euro. Some people call this a "waiting room"; we say it is more of a "workout room", where a little muscle can be developed before moving on to the more demanding obligations of the euro area.

Although they all entered the European Union at the same time, in what was known as the "Big Bang", the ten new member states are unlikely to repeat the experience in joining the euro. Their accession to the euro area is more likely to come in several waves. Some countries, particularly the smaller ones, are more prepared to take the step and have shown a lot of discipline in their fiscal policies. Cyprus, Estonia, Latvia, Lithuania, Malta and Slovenia have already pegged their currencies to the euro by joining ERM2, and their performance under the arrangement has so far been very good.

Other new member states are still discussing their target dates for adopting the euro, and their timetable for joining ERM2, which requires participants to keep their exchange rates within a band of plus or minus 15 percent against the euro. These discussions have tended to drift a little. At first, there was a great desire to adopt the euro as soon as possible. But this subsequently changed with the realization that some of the adjustments needed might take more time. Some of the larger new member states have now set target dates for euro entry toward the end of the decade, after the requisite minimum two-year preparatory period in ERM2.

There are no formal criteria for joining the exchange rate mechanism - a country can simply declare its intentions to the relevant authorities in Brussels and Frankfurt. But successful participation requires that major policy adjustments be undertaken before joining. The ECB and the Commission, as well as the IMF, have been encouraging aspirant countries to make these changes before moving to the ERM2 phase. If they fail to do so, they will have a tougher time in the exchange rate mechanism.

"Some of the larger new member states have set target dates
for euro entry toward the end of the decade"

The recommendation is first to adjust fiscal policy, to bring it much closer to the Maastricht criteria, and to lower inflation if it is too high. Countries still, of course, have a minimum of two years to continue working on these policy objectives while they are members of ERM2. But it is better to be in good shape before joining the exchange rate mechanism. Unfit people who go to the gym and immediately get on a high-speed treadmill are not going to do very well.

It is important to stress that each country will be assessed on its own merits and be given equal treatment. There is no single trajectory toward euro adoption, and not every country will feel ready at the same time. Each country's progress will be continually monitored by the Commission and the ECB, but without any preset timetable for euro membership.

There are a number of reasons why the entry of the new member states will not change the ECB's monetary policy. First of all, the principles of "non-inflationary growth" and "price stability" are defined as key objectives in the European Union Treaty. The central banks of the new member states will also have to adopt central banking laws which ensure that price stability is the primary objective of monetary policy, and that
decision-making is independent from political authorities.

"The entry of the new member states will not change the ECB's monetary policy"

In any case, the entry of the new member states will not add much to the economic weight of the euro area. All ten countries together represent about six percent of euro area GDP, although we certainly hope and expect that this will soon rise, as they are growing much faster than the old member states.

Furthermore, the need to fulfill the convergence criteria implies that the main macroeconomic parameters of the new member states are likely to be similar to those of the euro area. In other words, at the time of entry we expect that their fiscal deficits will be in line with the criteria, and their inflation rates not far above the euro area average, as provided for in the rules.

When the new member states adopt the euro, they will be represented on the governing council of the ECB, and we expect the new governors to be committed to guaranteeing price stability in the euro area as a whole. Eventually, there will be a change in the way the European Central Bank council functions in
order to prevent the number of voting members from growing too large and unwieldy as more and more countries join the euro.

A rotation system will be introduced, under which not every council member will always be allowed to vote - not that there is actual voting today, but in principle there could be on monetary policy issues. Under the future system, voting rights will vary according to a country's economic weight. Thus
Germany, for instance, will have a voting seat more often than Malta, which is not surprising. Even Germany, however, will not always be entitled to vote.

Critics, of course, may argue that the expansion of the euro area will make "one size fits all" monetary policies even less appropriate than they are today. And it is true that ECB monetary policy will continue to be geared toward price stability in the euro area as a whole. But governments can still respond to specific shocks to their economies through national policy measures. Flexibility in labor and product markets will be particularly important in helping economies adjust, and governments should heed the constant calls that are being made for structural economic reform in Europe. Some of the new member states, in fact, have considerably more flexible markets than some of the older members and should be able to set useful examples of needed changes.

Finally, it must be stressed that the single monetary policy cannot and should not try to address national or regional differences in inflation and output growth. And here we can look to another major currency area - the United States - to provide the example. Suppose, say, the Texas oil industry runs into difficulties, as has happened in the past. The monetary policy of the Federal Reserve cannot react to that problem alone. It has to take into account of what is happening throughout the United States. That will also be the approach of the ECB.

J. Onno de Beaufort Wijnholds is the Permanent Representative of the European Central Bank in Washington. He previously served as Executive Director at the International Monetary Fund, representing the Netherlands and eleven other countries, mainly in Eastern Europe. Before that, he was Deputy Executive Director at De Nederlandsche Bank, responsible for monetary policy and financial markets, and Alternate Executive Director at the IMF. He has been Professor of Money and Banking at the University of Groningen, the Netherlands.