Andras Simor: The euro and the enlargement - challenges ahead
Speech by Mr Andras Simor, Governor of Magyar Nemzeti Bank (the central bank of
Hungary), for the panel on "The euro and the enlargement: challenges ahead", at the Fifth
ECB Central Banking Conference "The Euro at Ten: Lessons and Challenges", Frankfurt am
Main, 14 November 2008.
* * *
I am glad to be invited to this panel. It seems to me that "euro enlargement" in the past
couple of years featured prominently on the agenda of various European conferences and
policy fora and, as such, ended up a bit over-discussed. However, the recent bout of the
financial crisis has definitely put this topic in a new perspective. My impression is that a
number of New Member States, as well as some of the old opt-outs, that were seriously
affected by the crisis now wish that they were already in the eurozone when this latest, most
severe episode erupted. I would not be surprised if, as a consequence of the crisis,
ambitions for speeding up the eurozone entry process intensified in these countries. This
panel discussion is a good opportunity for me to present the motivation, arguments and
concerns that an "out" country may have in this respect. Naturally, I can only speak on behalf
of Hungary, or more precisely the Hungarian Central Bank. It may not be a typical view as
this country was perhaps the most spectacularly affected by the crisis among the New
Member States. Nevertheless, I think at least some elements of this view are shared by our
Central Eastern European peers.
I would like to touch upon three major topics.
First, how we, at the Hungarian Central Bank saw the "pros and cons" of a quick euro
strategy before the crisis.
Second, how the crisis has changed this assessment.
Finally I would like to say a few words about the Maastricht criteria and the way we envisage
to meet them.
The Hungarian Central Bank has long been a proponent of an "as soon as possible"
eurozone entry strategy. We made our first comprehensive cost-benefit analysis back in
2001. The analysis suggested that Hungary constituted an optimal currency area with the
eurozone, at least to the extent that some peripheral eurozone member countries did. The
benefits appeared to be large, stemming from trade creation and the disappearance of a
sizeable currency risk premium. At that time fiscal policy seemed broadly on track. We had
just introduced inflation targeting which showed some early success in breaking inflation
inertia. In the eurozone itself, there were no signs of divergence, either. All this suggested
that a quick eurozone entry was doable and worth pursuing. The future looked rosy.
However, things turned out to be quite different. An unprecedented fiscal expansion in
20022006 shed a cruel light on the structural and institutional weaknesses of the Hungarian public
finances and slowed down the disinflation process. The country was drifting away from
meeting the Maastricht criteria and the expected date of entering the eurozone was moving
further and further out in the future. At the same time, news from the euro area caused some
discomfort too, as growth in some less developed member countries slowed down so much
that their real convergence stopped or even reversed.
Having had this experience, it is not surprising that when we did our review of the costs and
benefits of the euro this year we were a bit more cautious than seven years ago. Although
our basic conclusion remained the same, that is, we still think that Hungary should join the
eurozone as soon as possible, clearly we had become more aware of some risks involved in
the quick euro adoption strategy.
Let me elaborate on two of these risks.
The first is entering the eurozone without sufficient progress in structural reforms; the second
is the problems caused by potentially large capital inflows after the common currency is
introduced.
It is a commonly shared view that efficient labour and product markets, which help a
country's dynamic adjustment to asymmetric shocks, are essential for success within a
monetary union. In terms of labour and product market reforms Hungary still has a lot to do.
Although nominal and real wages are more flexible than in the core eurozone, the
employment rate is one of the lowest in the EU. Our analysis suggests that this may be
related to wrong incentives hindering labour supply, such as generous early retirement and
maternity leave schemes and a very high tax wedge. These are in turn manifestations of a
bigger problem, "the premature welfare state", which is weighing heavily on potential growth
on the one hand, and is a source of a chronic fiscal imbalance on the other. Our fiscal and
labour market weaknesses are deeply interconnected and we have to address them together
in a wide-ranging structural reform.
Scaling back the overly generous welfare state is painful and the political willingness to do so
is not so strong, so when this structural reform will take place is rather uncertain.
The question is, can we afford to enter the eurozone if this reform is not yet completed? This
brings us to the territory of political economy, more precisely to the issue of whether the euro
fosters or hinders structural reform. Although this issue has received a lot of attention
recently in both theoretical and empirical work, my impression is that so far no consensus
has emerged. What this means for the euro strategy of Hungary is that probably we should
not risk entering the eurozone until this crucial structural reform - that is, the scaling back of
overly generous the welfare state in order to increase the labour supply, foster potential
growth and stabilize public finances - is completed or is at least safely on track.
The second risk, which frequently took the centre stage in debates on euro accession, is that
of large and potentially disruptive capital inflows. The starting point of the argument here is
that the catching-up process of New Member States is about to continue for a long period
even after they introduce the common currency. The catching-up entails a real appreciation,
which, once the exchange rate is irrevocably fixed, translates into higher inflation and lower
real interest rates. Low real interest rates may in turn trigger excessive demand fuelled by an
unsustainable credit boom financed from foreign borrowing. When the inevitable correction
comes, there is no independent monetary policy to smooth the adjustment and a serious bust
follows the boom. Such boom-bust patterns were clearly observable in some first-wave
eurozone members like Portugal, Ireland and Spain. Better wait with euro adoption, the
argument goes, until catching-up is more progressed and the equilibrium real appreciation is
smaller.
I have one observation to this argument. We cannot ignore the fact that the financial
integration of the New Member States to a large extent had already taken place. The banking
sectors in these countries are owned predominantly by euro area banks. In the past couple
of years of abundant global liquidity, cross-border lending by parent banks in foreign
currency was available in virtually unlimited quantities. This practically meant that foreign
(euro or Swiss franc) interest rates had become the point of reference for domestic
consumption and investment decisions well before the euro was introduced, pushing down
the effective real interest rate. It is obvious by now that the credit boom that was envisaged
to take place after eurozone entry actually arrived much earlier. The only difference was that,
not having the common currency yet, it left us with a sizeable currency mismatch. Staying out
of the eurozone did not prevent us from running into the boom. Now that we have to face the
bust, it is not clear either whether having an independent monetary policy places us in a
better position to smooth the adjustment. That is because the effectiveness of monetary
easing and the subsequent depreciation is seriously limited by the negative wealth effect on
the sizeable unhedged foreign currency liabilities the private sector had accumulated. In
short, with integrated financial systems, large capital flows have been taking place in New
Member States regardless of the fact that they have not yet introduced the euro. Euro
adoption does not carry an extra risk in this respect, on the contrary, it may help eliminate
potentially dangerous currency mismatches. It is important to see that in this respect, it would
eliminate a source of instability from the point of view of the eurozone parent banks as well.
Let me now turn to the implications the current crisis may have on euro adoption strategies.
First, the crisis clearly illustrates that having your own currency may be more of a source of
shocks than a shock-absorbing device. You may say that Hungary deserved what it gets
now, but there are other countries with more sound fundamentals that are undergoing
serious stress.
Second, the crisis is an obvious indication that the years of abundant global liquidity are over.
We are probably in the middle of a credit contraction globally and the chances of another
credit-boom evolving in the foreseeable future are minimal. The risk of a credit-fuelled
boombust, should a country enter the eurozone in the next couple of years, is greatly reduced.
Third, the crisis may have increased the disciplining power of financial markets. The
deleveraging process that we are going through implies a thorough repricing of risk. Just like
in other asset classes, there is increased differentiation among government bonds based on
the issuers' risk profile. This is well illustrated by the unprecedented differences we currently
see between CDS spreads on bonds of euro area sovereign issuers. Countries with weaker
public finances, and Hungary is obviously one of them, will receive stronger incentives from
the financial markets in the coming years to put their fiscal house in order. This means that
the crisis may actually speed up the most important structural reform in Hungary, the
muchneeded scaling back of overly generous the welfare state. From the euro strategy
perspective this would be good news, since, as I said before, we think that adopting the euro
without going through this painful reform carries the risk of a prospective underperformance
in the eurozone.
All in all, this crisis has evidently demonstrated that the banking sectors of the euro area and
the New Member States are deeply integrated, has greatly reduced the chances of credit
booms in the forthcoming years and may exert an extra disciplining power in countries prone
to fiscal misbehaviour in the future. For these reasons, I think it may act as a catalyst for the
euro accession process. Importantly, it should be let to act as a catalyst, that is, it should not
be used as an excuse to make the entry criteria, or their interpretation, more stringent.
Finally, let me turn to the prospects of meeting the criteria in Hungary and, more specifically,
what I think this implies for our euro strategy.
Currently, there is no official target date for euro adoption in Hungary. Popular support for the
euro is relatively strong, and it probably intensified further after the recent currency turmoil.
All the major political parties agree on the desirability of introducing the common currency.
However, at the current juncture, Hungary does not meet any of the Maastricht criteria.
Government and Central Bank officials, including myself, repeatedly expressed that the
earliest date to start talking about a roadmap to eurozone may be somewhere in 2009. Given
Hungary's not too convincing track record regarding the fiscal balance and inflation, an ERM
II entry is only reasonable when the prospective meeting of the Maastricht criteria is safely on
track.
Hungary's Convergence Programme envisages meeting the fiscal deficit criterion by 2009,
but chances are that this could take place as early as this year (albeit only by a narrow
margin). As a reaction to the recent bout of the global financial crisis and the deteriorating
prospects for external financing, the government decided to withdraw the draft 2009 budget
and rewrite it so that the deficit reduction next year is more pronounced. In addition, the IMF
rescue package came with conditions which implied further expenditure-cutting measures.
The Central Bank's latest inflation forecasts imply that the Maastricht inflation criterion may
be met by 2010. These developments mean that the chances of meeting the entry criteria
relatively quickly has improved somewhat, which implies that, in principle, we should not wait
with ERM II entry too long.
On the other hand, the financial turmoil has undoubtedly reached Eastern Europe. As a
result, currently there is extreme uncertainty in the New Member States regarding the future
course of such fundamental things as financial intermediation, credit growth, the exchange
rate and real convergence in general. These are all very important factors that have to be
taken into account when making a decision on the euro strategy or indeed on ERM II entry
itself. It is therefore worth waiting with setting out very specific euro adoption plans for
Hungary until the dust settles at least a little bit.
In the meantime, the Slovakian experience with the euro, starting next year but showing its
implications already in the recent unfolding of the crisis, will provide a good natural
experiment for the other New Member States, and will no doubt be closely watched.