THE RUN-UP TO THE EURO II: EMU/EU ENLARGEMENT

1. THE RUN-UP TO THE EURO II: EMU/EU ENLARGEMENT Week 6 Ch.7

2. Additional Material: • Gros, D. “The Maastricht Criteria after Enlargement: Old Rules for New Members?” • Material for individual / group presentations • Convergence reports material (more later)

3. WHICH FLOOR ARE WE ENLARGING?! • EU is a three-floors building: • First floor: Customs Union (1957) • Second floor: Economic Union / Single Market (1993) • Third floor: Monetary Union (1999) • Countries joining the EU actually join the first and the second floor. • To be more precise, they join the first floor way before joining the second (Association agreements, and so on). • EU enlargement = enlargement of the single market

4. The waves of enlargements • 1957: Italy, Germany, France and BENELUX countries. • 1973: Uk,Ireland and Denmark • 1986: Spain, Portugal and Greece (1981) • 1995: Austria, Finland and Sweden • 2004-2007: former communist countries + Malta and Cyprus • If Maastrich criteria regulate the entry into the third floor (EMU), what supervises the accession to the second one (EU) ?

5. The Copenaghen criteria • 1) The political criterion: stable institutions able to guarantee democracy, rule of law, human rights and tolerance towards minorities. • 2) The economic critierion: an established market economy able to cope with market forces and competitive pressure inside the Economic Union • 3) The “acquis communitarie” criterion: the country must be able and ready to accept and implement all the obligations deriving from membership (harmonization of law and regulations, and so on). • The European Council opens the negotiations if and only if criterion 1 is met, and the country becomes Candidate State.

6. The EU accession situation today • There are 2 and a half Candidate States….. • Croatia: Candidate State since 2004 • Macedonia: Candidate State since 2005 • Turkey: negotiations opened in December 2004 but interrupted two years later mainly because of situation in Cyprus • There are 4 and a half Potential Candidate States… • Albania, Bosnia-Herzegovina, Montenegro, Serbia and Kosovo.

7. …what about other European states?! • Switzerland: referendum rejected EU membership in 1992 • Norway: negative vote in 1972 and 1994 • Iceland: member of European Free Trade Area (asked for EMU membership last month after going bankrupt) • Among the many former Soviet Republics, only Ukraine might maybe have a reasonable chance to become one day EU member.

8. A LOOK AT EU-27: GDP

9. POPULATION

10. Germany, France, Uk and Italy represent: • - 65,4% of EU-27 economy • - 53,5% of EU-27 population • If we also include Spain, then: • - 73,7% “ “ “ • - 62,3% “ “ “

11. ONE WORD ON EU ACCESSION • Beginning of the 90s: former communist European nations begin their journey to market economy • How long did the journey had to be?! • Shock therapy: instantaneous. (Poland, Czech Republic and Slovakia, Estonia, Latvia) • Gradualism: (Romania, Hungary, Lithuania) • Shock therapy countries had a rapid output growth and quicker transition, but more inequality and unemployment. • Gradualist countries recovery was much slower, but with a lower degree of inequality and unemployment.

12. Anyway, they all are into EU now with different economic situation (Poland, Czech Republic, Estonia a step ahead of others, Bulgaria and Romania still lagging behind). • Four of them (Slovenia, Cyprus,Malta and Slovakia) already joined the Euro in 2007,2008 and 2009. What about the remaining eight? When will they take the steps to the third floor ? • Let alone the fact that they are obliged to (they signed up the obligations when entering EU), let’s verify that it is in their best interest anyway.

13. ONE LESSON WE KNOW • If there is free capital movement • If countries are very integrated • if they want to maintain exchange rate stability • …the most appropriate thing is to share a common currency. • IF’s check: • 1) It is part of their membership in the single market. • 2) Look at table 1, pag.3, Gros paper. • 3) Sure they do. Too much volatility and uncertainty in the value of their currency might jeopardize their catch-up process. • ….anyway, what exchange rate systems (“monetary regime”) do they have at the moment?

14. Estonia, Lithuania, Latvia: EMS II • Czech Rep, Romania, Poland: floating exchange rates • Bulgaria and Hungary: fixed or semi-fixed exchange rates • How different were their macroeconomic performances so far (BEFORE THE CRISIS)? • Floaters = low inflation, balanced current account, high public debt. • Fixers = high inflation, high current account deficit, low public debt. • Who tells me why?

15. Here’s why…. • Fixers must somehow keep the interest rate at the same level of the economy they fixed their currency to (euro). • EU interest rates have been low, and thus does not fit the macroconditions of those economy which, being in the middle of their catching-up process, are experiencing high growth. • Hence: higher growth, higher inflation, higher current account deficit (because of inflation and growth), lower debt (because of inflation). • Although appealing for some features (debt and growth), sooner or later it contrasts the first and most important Maastricht crtieria. • In fact, for instance, Lettonia failed EMU accession in 2007 because of inflation.

16. HOW IS THE CRISIS CHANGING ALL THAT? • In the last 3 months we have been observing huge depreciations of Easter European members of EU (and non-EU-members) • Poland = - 23.2% • Russia = -24.2% • Hungary= -13% • Czech Rep= -13.9% • Romania= -11.8% • Ukraine =-27.2% • What’ s happening?!

17. Something similar to 1997 Far East crisis • Private and public sector has heavily indebted in foreign currency: - private sector: mortgages were more convenient abroad (especially in Sweden) - public sector: current account deficit (on average around 10% of GDP; in Bulgaria 25%). In other word: internal savings were not enough to cover the needed (private and public) investment.

18. - The crisis has triggered capital outflows (headquarters are withdrawing funds). - Depreciation of the currency - Nominal value of the debt increases (because it is denominated in foreign currency, whose value has increased, following depreciation of national currency) • Rating agencies (Moody’s and Standard and Poor) are downgrading sovereing rating • This, in turn, increases interest rate on debt issuing (countries’risk profile has worsened). • This is exactly what happened in one recent (regional) financial crisis: July 2th 1997, originated in Thailand.

19. Differences and consequences • Most of debt is towards EMU banks. Some economists are beginning to call this situation “the European subprime”. • Austria: credits towards those countries are equivalent to 70% of national GDP (Belgium 25%, Sweden 20%, Italy 10%). • This danger is maybe over-emphasized. • Possible solution: speed-up EMU membership (so to curb self-fulfilling depreciation expectations). • But in order to do that we need to soften the third Maastricht criterion (two years “waiting room” into EMS II).

20. Are Maastricht criteria still adequate after 17 years (1992-2009)? Criterion on interest rate: Yes. Preventing arbitrage opportunities after exchange rates are locked is a ever-lasting need. • Criterion on debt/deficit: Past (and future) discussion on the 3% and 60% figures. See also Gros paper (pages 10-17). What about exchange rates and inflation? Let’s work out a framework which helps us rationalize the situation.

21. Balassa-Samuelson effect • Are in for some more math….?

22. If ANE > AE : • - if E = 0 -- NE > E • - if NE =E - E --- new comers’ currency • must appreciate • You can’t have both. • Hungary last year. In order to allow inflation to go down, they abandoned any form of limitations to the exchange rate.

23. However…(there is always an “however” in economics….) • 1) Maastricht does not actually bind NE =E • There is a spread of 1.5% of tolerance. • It means that the productivity growth differential can be as big as 2.1%. • ANE > AE = 1.5 / (1-α)

24. 2) E is not actually = 0 • There are bands of fluctuations. • How large do this bands have to be?! • a) Large enough to accomodate for productivity growth differentials (considered that inflation rate cannot diverge that much) • b) Large enough to be credible (don’t repeat the mistake of EMS I….they set too narrow bands for Italy and Uk and they dropped out, with a loss of credibility of the whole system)

25. So…. • The application of Maastricht criteria to new member states actually presents some new problem: • 1) On the inflation-exchange rate side. • 2) On the public finance side. • 1), we have seen, is not as bad as might seem at first glance • 2) …probably is more of a problem for those who are already in the EMU…..and we’ll talk about that next week (SGP and reform).

26. Presentations • European Commission Convergence Report – December 2006 – PLEASE LOOK FOR MORE UPDATED VERSIONS. ON THE ADMISSION TO EMU – 7 countries (Czech Rep, Estonia, Latvia, Hungary,Poland, Sweden).

27. You will be assessed on: • How clearly you present the countries’situation to a non-economist. • How you infer the future pespectives for EMU accession • How you elaborate on the data you had been analysing, and the way you make your own remarks and draw your own conclusions. • Each presentation cannot exceed 30 minutes, including five minutes for discussion. • Timing….?