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The Euro and the New Member States

The Euro and the New Member States. Natalia Tamirisa International Monetary Fund Warsaw, October 29, 2007. Focus. Macroeconomic challenges NMS face as they prepare to join EMU Policies that can help overcome these challenges

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The Euro and the New Member States

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  1. The Euro and the New Member States Natalia Tamirisa International Monetary Fund Warsaw, October 29, 2007

  2. Focus • Macroeconomic challenges NMS face as they prepare to join EMU • Policies that can help overcome these challenges • For details, see Euro Area Policies: Selected Issues, Country Report No. 07/259, July 31, 2007 www.imf.org/external/pubs/cat/region.asp

  3. Maastricht Treaty • Requires NMS to adopt the euro • But only after they satisfy entry conditions • Timing is left open • EC and ECB review progress annually (Convergence Reports) • Unilateral euroisation is inconsistent with the Treaty

  4. Entry Conditions • Inflation should not exceed, on a sustainable basis, by more than 1.5% that of the three best performing EU countries in terms of price stability • Exchange rates should be within the “normal” fluctuation margins provided for by ERM-II; no devaluations • Long-term interest rates should not exceed by more than 2% that of at most the three best performing EU countries in terms of price stability • The fiscal deficit should not exceed 3% of GDP • Gross government debt should not exceed 60% of GDP

  5. NMS plan to adopt the euro, but for now have different exchange rate regimes

  6. Questions relevant for euro adoption • What are benefits and costs of euro adoption for NMS and the euro area? • Is fulfilling the entry criteria feasible for NMS? • Will NMS economies perform well in the monetary union? • How much policy adjustment would NMS need to undertake to fulfill the entry condition?

  7. What are benefits and costs of NMS euro adoption for NMS and the euro area?

  8. Benefits and Costs of Euro Adoption • Elimination of exchange rate risk • More trade and investment • Faster convergence (1% per year) • But loss of a shock absorber • Efficiency gains for the euro area through outsourcing and competition

  9. Is fulfilling the entry criteria feasible for NMS?

  10. NMS are converging to the euro area in real and nominal terms Price convergence results in real appreciation

  11. One of the factors driving real appreciation is the Balassa-Samuelson effect

  12. Other factors • Persistent equilibrium effects • Quality upgrading of tradables and nontradables • Shifts in domestic preferences toward services • EU transfers • Transient equilibrium effects (level adjustment) • Shifts in foreign preferences towards NMS products • EU accession and adoption of acquis communitaire • Disequilibrium effects • Irrational exuberance, speculative flows, overheating

  13. Uncertainty about equilibrium appreciation rates contributes to controversy over criteria • Can the built-in margins—1.5% under inflation criterion and 15% under exchange rate stability criterion—accommodate equilibrium real appreciation in NMS? • Yes • Real appreciation is largely transient, and Balassa-Samuelson and other equilibrium effects are small • No • Catching-up euro-area economies posted 3-3.5% inflation in 1999-2006, above the Maastricht reference value • The Maastricht reference value may be driven down by idiosyncratic factors (administrative and tax changes) (Choueiri, Ohnsorge, and van Elkan, forthcoming)

  14. Real appreciation is taking place in the context of convergence-driven booms...

  15. ...supported by capital inflows

  16. Rising concerns about overheating and balance sheet mismatches

  17. Cooling off convergence-driven booms is difficult • Fiscal tightening • Significant? Medium-term considerations? • Monetary tightening • Further capital inflows? Sterilization costs? • Capital controls • Prohibited under EU rules? Effective? • Prudential regulation • As a macro instrument?

  18. Will NMS economies perform well in the monetary union?

  19. Strong productivity growth, may not be sustainable...

  20. ...but significant catch-up potential remains

  21. Measures of labor market flexibility provide comfort but have not been tested

  22. Product market flexibility is lower than in the euro area

  23. Significant presence of major foreign banks should facilitate intertemporal risk-sharing...

  24. ...but NMS financial systems are still less developed and integrated than its peers

  25. Automatic stabilizing properties of NMS budgets are weaker than in the euro area...

  26. ...but variation in expenditures is higher, especially in discretionary categories

  27. How much policy adjustment would NMS need to undertake to fulfill the entry conditions?

  28. Dynamic Stochastic General Equilibrium Model (GIMF by Kumhof and Laxton, 2007) • Fiscal and monetary policy reaction functions • Overlapping generations, open economy monetary business cycle model Blanchard (1985) and Weil (1989) • Non-Ricardian features: finite planning horizons and liquidity constrained consumers • Calibration to a representative NMS

  29. Fiscal policy cannot permanently reduce inflation in NMS with pegs

  30. Greater wage and price flexibility and lower nominal rigidities reduce output costs... ...but do not make inflation reduction sustainable

  31. In NMS with flexible exchange rates, monetary tightening can lower inflation... ...but cannot resolve the tension between joint price and exchange rate stability objectives

  32. What margin to use for unanticipated inflation and fiscal shocks? Prudent fiscal deficits are estimated at 1-2 percent of GDPSchadler et al, 2005

  33. What sacrifice ratios to use to quantify output losses from disinflation? • Euro area: 1.25% of GDP Coffinet, Matheron, Poilly (2007) • EU-15: 0.5% to 3.5% of GDP Bulir and Hurnik (2006) • NMS: 1.5% to 4% of GDP Bulir and Hurnik (2006) • Pegs: short-run multipliers from GIMF

  34. What levels of inflation to use? • Upper limit: Contemporaneous inflation • But could be influenced by transient factors • Lower limit: Long-run equilibrium trend • Average euro area inflation (just under 2 percent) • Add 1.5% for Balassa-Samuelson effects • Compare to 2.5% “adjusted” reference value

  35. Upper limit on output losses associated with disinflation Lower limit is 0.5-1.5 percent of GDP

  36. For fiscal tightening, there is a trade-off between short- and long-run effects

  37. Conclusion • NMS face considerable macroeconomic challenges are they prepare for joining EMU • Distinguishing benign appreciation in NMS from overheating is difficult • Degree of appropriate macroeconomic adjustment is uncertain, but could be significant • In any event, NMS need to be well prepared before joining to perform strongly in EMU • Benefits of euro adoption are considerable for both for NMS and the euro area

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