THE EURO ZONE EASTERN ENLARGEMENT: CHALLENGES TO CURRENT MEMBERS AND THE ECB

The eastward enlargement of the euro area entails significant implications both for acceding countries and for the current euro area member States or for the European Central Bank. The present analysis intends to assess the challenges up against the latter. The issue is analyzed from two points of view: firstly, relating to the risks caused by the group’s drawing away from the status of optimum currency area, complemented by increasing development disputes and the difficulty of implementing a unique currency policy, and secondly – the issue of the voting mechanism within the ECB. When analyzing those two issues, we can easily notice that the difficulties for ECB and even for the actual euro zone member will increase. Since the extended euro zone will draw away from the status of optimum currency area, the costs of the monetary unification will increase for the new group as a whole (not only for the new members). Moreover, for the new euro zone, which is becoming more divergent, it will be very hard to find suitable monetary policy instruments for all. With reference to the second subject, the ECB will implement a new voting mechanism, but this will not solve the problem of having large economies with weak representation, and small economies that have strong representation in the Governing Council. convergence of new members to euro zone state is concerned. In this respect, we will proceed to see what ECB and euro zone member states might “fear” in the case of a much too early Eastern state accession. The Optimum Currency Area and the Eastern extension of the euro zone The Optimum Currency Area Theory is based on the seminal work of Robert Mundell (1961), but it was developed by some economists as Mc. Kinnon (1963), Kenen (1969), Frankel & Rose (1998) etc.2 The theory analyzes the costs and benefits of monetary unions (focusing on the cost component) and shows that the costs will be minimized if some conditions are accomplished. For benefits side, a common currency reduces transaction costs and eliminates exchange rate volatility between union partners. Further, lower transaction costs and lower uncertainty encourage trade flows between members. For SEE countries, but not only for them, monetary union means credibility import and inflation expectation anchoring. This will bring stability and lower interest rates, as well as higher investment. As about costs, the loss of monetary policy and exchange rate are the most important. Once in monetary union, a country has to comply with monetary policy decisions of the monetary union authority. As SEE countries are small countries it is clear that their interests will not weigh heavily in ECB’s decision making. Without an autonomous monetary policy, the member countries’ ability to respond to idiosyncratic shocks is reduced. Moreover, the fiscal constraints imposed by the Growth and Stability Pact restrict the ability to respond to asymmetric shocks. Following this cost-benefits analysis, OCA theory shows the criteria that makes the monetary union successful. The theory is based on two types of criteria. The first one consists of convergence and symmetry: countries with the symmetric economic response will not experience high costs of monetary union. The second explains us that even with asymmetric response, countries still can benefit from monetary union if they have other mechanisms to adjust the economy (the issue of flexibility). The criteria that define Optimum Currency Area are listed below, by proposing a specific way of classification: 1. Criteria related to the possibility of asymmetric shocks (they can prove the existence of s t r u c t u r a l convergence): a. The degree of economic openness b. The similarity of production structure c. Production and consumption diversification d. Similarities of inflation rate 2. Criteria that prove the possibility of market adjust (market flexibility): a. Labor mobility b. Capital mobility c. Price and wage flexibility d. Financial integration 3. Criteria that show authorities the capability to intervene in the absence of the exchange rate mechanism: a. Fiscal integration b. Political union 4. “Meta” criteria; (the two criteria presented are more complex): a. Similarity of demand shocks b. Similarity of supply shocks MIHAI SEBEA 42 2 For an interesting OCA theory analysis see Mongelli (2002) THE EURO ZONE EASTERN ENLARGEMENT: CHALLENGES TO CURRENT MEMBERS AND THE ECB 43 Anyway, it is not easy to determine either if a group of countries represents an OCA or not. Most of the analysis3 couldn’t conclude that EU as a whole represents an OCA at the moment of the stage three of EMU. We can see instead, that there is a small group of member states that could form an OCA. Moreover we can follow Frankel and Rose analysis to find out that a group of countries can form a monetary union, even if is not an OCA4. From our point of view, that EU is a “ f u n c t i o n a l monetary area”, an area that could have benefits from monetary integration even if it does not represent an OCA. As regarding East European Countries, few of them seem to be ready for EMU from OCA theory point of view. If the euro area enlargement will imply only the countries that are ready from the structural convergence point of view, the specific pressures for the euro zone will not be high. But if we consider an euro zone that comprises 25 (or even 27) members, we can say that this group is going far away from the OCA status, and there will be specific risks for the group as a whole, and not only for those members that are not prepared. Graph 1 best represents the situation. Two concepts can be outlined in this case: the functional currency area and the optimum currency area. The AA line represents the outline of the functional currency area, in the sense that when a group of countries is above the line, then it lies outside the functional currency area, meaning that the risks entailed by making up a monetary union are high. The BB line separates the optimum from the functional areas, meaning in the case 3 Mc Morrow (1996), Bini-Smaghi & Vori (1993), Bayoumi & Eichengreen (1992) etc. 4 See Frankel and Rose 1998, for endogeneity of OCA criteria. Those economists said that the criteria could be better fulfilled after unification, and countries should look after long term benefits. when a group of states are within this perimeter, they can make up a monetary union together, even if is not an optimum one. In practice, the AABB rectangle hypothetically outlines the “grey” area of the monetary union costs and benefits, where it is not clear whether benefits are higher yet there are still premises for the monetary union to operate properly. If for the 12 countries there are sufficient reasons to say that they could be in the grey area, a 27 member monetary union will be situated outside the gray area, and draw away from the status of an optimum currency area. Even so, for the twelve countries there will remain premises for net benefits. Graph 1 The monetary area optimum parameters related to the EMU eastern enlargement What are we interested in, in fact? Euro is an EMU currency, comprising all members. Should this structure be jeopardized, then all members are likely to suffer, not only those whose economies do not evince OCA criteria. Therefore, drawing away from the optimum currency area is an element accounting for the qualms current members (and the ECB) have when it comes to an early accession of new members to the euro zone. They might want new member states to switch to euro after they come close to the structural convergence and flexibility requirements set up, so that the risks involved in enlarging the EMU should be mitigated. An important element we should take into account is Great Britain’s accession to the EMU, since its impact can be more significant than the one of the 12 new members or of the future EU members. And this is because of the EU member states, Great Britain’s economy is the least correlated with the euro zone. Moreover, the British GDP is approximately 17% of the EU GDP, as opposed to the 5% of the 12 member states’ GDP. The necessity of real convergence: why does it matter for EMU? Real convergence means the reduction or even elimination of per capita GDP gap between the EU countries and candidate countries. This challenge of real convergence needs economic growth for SEE countries greater than EU’s, which implies the convergence of prices and wages. Eastern countries have a weak performance concerning per capita GDP. Should real convergence be reached within the EMU, it is to be expected that poorer countries should have growth rates that are superior to the overall euro zone, until the levels of prices and productivity no longer substantially differ. This process will go on due to competitive markets, until the GDP per capita is the same all throughout the euro zone. Before 1999, there used to be a trend stating that an enlarged monetary union including Portugal, Spain, Italy and Greece will pose difficulties to the ECB in implementing a restrictive monetary policy. Experience has shown that “poorer” countries register higher growth rates than the strongest, France and Germany. Moreover, the real convergence process involving “poorer” countries also entails higher prices hence higher inflation rates. Such countries would rather have a harsher monetary policy than the ECB’s current one, addressing the overall interests of the euro zone. Currently, even a fast convergence in the case of Portugal, Spain or Greece is not likely to pose problems for the Eurosystem to reach its inflation target. These countries are nonetheless close to the EU average, and their ratio in the harmonized commodity price index for the euro zone is and shall remain low.5. After EMU enlargement, things became more complicated because ECB will follow a monetary policy for the euro area interest, and it will not look at a specific country’s inflation. Anyway the Eastern