EU accession countries: Finding the right time for euro adoption

• Pages: 194-195

Page 194

The accession, in May 2004, of 10 countries (Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, the Slovak Republic, and Slovenia) to the European Union (EU) marked the end of the first phase of the economies' integration into the EU. These countries are also committed to entering the European Monetary Union (EMU) and adopting the euro, but when should they do so? There is no predefined timetable, and in a new IMF Working Paper, Ale?s Bulír and Kater?ina Smídková warn that an early "race to the euro"may entail substantial economic costs in terms of growing external imbalances and real exchange rate misalignment.

Under the Maastricht rules, to qualify for euro area membership, a country must achieve a high degree of price stability, have a sustainable fiscal position (in terms of the public deficit and public debt), maintain a stable exchange rate-the country must be a member of the Exchange Rate Mechanism (ERM2) for a minimum of two years-and have long-term interest rates close to those in the euro area (see box below).

Bulír and Smídková point to potential difficulties in sustaining the ERM2 regime prior to adoption of the euro, if the accession countries enter with domestic currencies appreciating in real terms or with weak policies, or both.

Volatile real exchange rates

How challenging will it be for the new EU member countries to meet the EMU criteria and adopt the euro? Bulír and Smídková foresee a possible conflict between appreciation of real exchange rates in the Central European transition countries in recent years and the EMU criteria of low inflation and a stable nominal exchange rate. Looking at a sample of four new accession countries-the Czech Republic, Hungary, Poland, and Slovenia-for which consistent data are available, Bulír and Smídková find that, on average, between 1992 and 2003, exchange rates appreciated by 3.3 percent a year.

Is real exchange rate appreciation now over, making EMU entry relatively simple? Or is it likely to continue for a few more years, resulting in potentially costly adjustment in those countries? If the latter is true, would a switch to the euro do harm? If so, how serious would the resulting exchange rate misalignment be? And what drives this appreciation anyway?

To answer these questions, Bulír and Smídková derive estimates of sustainable real exchange rates...