Charting a Course Toward Successful Euro Adoption

• Author: Susan Schadler
• Position: Deputy Director in the IMF's European Department
• Pages: 29-33

Newest EU entrants should reap net gains from joining the euro area

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The First Wave of transition countries to join the European Union (EU) are turning their attention to the next step in their integration with Europe-replacing their national currencies with the euro. Upon joining the EU, these countries also became members of the Economic and Monetary Union (EMU) with a derogation on adopting the euro. This means that each will be committed to taking the step but can choose when to do so.

Joining the euro area will involve major economic changes for these countries. On the benefit side, they will gain in growth and efficiency from closer integration with the euro area; they will also leave behind emerging market risk. The potential cost of monetary union stems from the susceptibility of member countries to asymmetric shocks-economic shocks that affect one or more members differently from the rest of the currency area. Economies linked by a monetary union have a common monetary policy, which may not be the optimal one for a country facing an asymmetric shock. Relinquishing the ability to conduct a national monetary policy could, therefore, result in greater economic volatility unless other macroeconomic policies or behavior- primarily fiscal policy and wage and price flexibility-is effective in smoothing the effects of asymmetric shocks.

Current conditions in the new member states present challenges for the approach to euro adoption.

Real convergence- narrowing the gap in real per capita income-is markedly behind that of even the poorest euro area members. While nominal convergence-the narrowing of gaps in inflation-is rather advanced, policy convergence-particularly aligning fiscal deficits-is at least as much of a hurdle in most of the new member states as it was for the most difficult pre-EMU cases. These initial conditions raise questions about the balance of benefits and costs, the policies that must be put in place for a successful experience in the monetary union, and the challenges of meeting the entry tests-the EU Maastricht convergence criteria. This article examines these questions with a focus on the Central European countries and the kinds of considerations that should guide IMF surveillance in these countries.

Since each new member state is committed to adopting the euro, the critical issues are when and how to do so. The considerations are complex but broadly reflect three distinct questions:

[ SEE THE GRAPHIC AT THE ATTACHED PDF ]

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* Do the long-term benefits of being in the euro area outweigh the costs? If the gains from increased trade, growth, and policy discipline are expected to be larger than the costs of relinquishing monetary policy as an instrument for economic stabilization, countries should move ahead quickly to put in place policies necessary for euro adoption. If benefits and costs are balanced and net gains are likely to rise over time, a slower approach to euro adoption might be preferable.

* What policy or institutional changes are required to ensure a successful experience in the euro area? Broadly, these involve enhancing both synchronization with the euro area economies and economic mechanisms-such as wage and price flexibility and fiscal policy-for absorbing asymmetric shocks.

* How long will it take to credibly and efficiently put needed policies in place and to meet the Maastricht criteria? Any policy regime change carries risks of macroeconomic volatility, and a strategy for managing such risks is essential.

"The Maastricht criteria coincide with goals-low inflation and a conservative fiscal position-that any country should have before joining a low-inflation currency union."

Identifying costs involved in meeting the Maastricht criteria, ways of minimizing these costs, and the optimal time for bearing them is important.

Pros and cons of currency union

Recent research on the benefits of currency unions for trade and income suggests that gains over 20-30 years can be large. For example, a 2003 study by Andrew Rose (University of California at Berkeley), concludes that a currency union can increase trade between members by amounts ranging from 10 to 100 percent-almost entirely through trade creation rather than trade diversion. Together with estimates of the impact of greater trade on income, euro adoption could raise GDP by up to 10 percent over 20 years in Poland and by up to 20-25 percent in most of the other Central European countries. Recent work on the actual experience of EMU in its first four years finds that, even during its short life, it has had positive effects on trade and growth for the existing members that-if continued-could be consistent with large long-term effects.

One unresolved puzzle, however, is what causes increased trade in a currency union. The elimination of foreign exchange risk seems to be an obvious channel. However, studies looking at how exchange rate volatility affects trade in a wide cross section of countries within and outside Europe do not unambiguously point to significant gains from its elimination. And most models of the benefits of currency union membership control for free trade arrangements, so the removal of trade barriers is not the explanation either. This suggests that other effects of a currency union-notably, lower transaction costs and greater competition and transparency of prices-must play a role. Euro adoption...