Christian Noyer: Challenges ahead - the accession process
Speech by Mr Christian Noyer, Vice-President of the European Central Bank, at the Foreign and
Commonwealth Office, London, 12 November 2001.
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Ladies and gentlemen,
It is a great pleasure for me to be able to be here today at the Foreign and Commonwealth Office to
share with you some thoughts on the process of EU accession and the challenges that this process
poses for the accession countries. While recognising that this process raises challenges for the EU
itself, I will not elaborate on those in my speech today.
Undoubtedly, the enlargement of the European Union to embrace a number of countries from central,
eastern and southern Europe and the Mediterranean constitutes, after the changeover to the euro
banknotes and coins, one of the main challenges currently faced by European policy-makers.
However, I would be giving a somewhat misleading impression if I devoted my speech today solely to
the "challenges ahead" without first mentioning the very foundations of the European structure. The
latter form the basis for our capacity to actually meet those challenges.
EU enlargement rests on the proven success of European integration. The European Union
constitutes an unprecedented framework for the successful development of regional co-operation. Not
only have the original objectives of European integration been achieved, namely to ensure peace and
prosperity in a historically conflict-ridden part of the world, the European Union has also shown its
ability to overcome the various economic and political challenges with which it has been confronted
throughout its almost 45-year history. Such is the attractiveness of the European integration project
that, since the Treaty of Rome was signed in 1957, nine countries have joined the original six, and a
host of others are keen to do so. A key accomplishment of this progress towards "ever closer union"
will become truly tangible in a few weeks' time, on 1 January 2002, when most of the citizens of the
European Union will finally have the euro, our money, in their pockets.
In many ways, the prospect of EU accession has also been instrumental in triggering reform in the
12 countries currently negotiating entry into the EU, namely five Central and Eastern European
countries, the Czech Republic, Hungary, Poland, Slovakia and Slovenia; three Baltic States, Estonia,
Latvia and Lithuania; two southern European countries, Bulgaria and Romania; and Cyprus and Malta
in the Mediterranean. Following some troublesome years at the beginning of the transition process,
the accession countries have made substantial progress in building institutions and designing
appropriate policy. The accession countries have now generally achieved macroeconomic stability.
The significance of these achievements can be demonstrated by the resilience shown by the
accession countries to the Asian and Russian crises in 1997-1998 and, more recently, to the adverse
developments in Argentina and other emerging market economies.
However, a number of important challenges remain. The years to come will be crucial to ensure that
the current significant momentum of the accession process is maintained, and that the remaining
difficulties are dealt with effectively in order to permit the smooth integration of accession countries
into the EU and, later on, into the euro area.
The forthcoming enlargement of the EU will, no doubt, increase the diversity and complexity within the
Union in an unprecedented way. In economic terms, the discrepancies in real per capita income and
price levels between the accession countries and the euro area are of a magnitude that has never
been observed in previous enlargement rounds. In this regard, however, it should be borne in mind
that the combined GDP of all the accession countries accounts for only around 5% of that of the EU.
The enlargement also confronts European policy-makers with enormous challenges in political and
institutional terms. The sheer increase in the number of Member States that the current enlargement
represents renders the functioning of decision-making bodies more difficult. As we all know,
substantial institutional reforms are needed to ensure that the EU can continue to function effectively
after enlargement.
From the Eurosystem's perspective, there are five economic issues that appear to be of greater
relevance at the current juncture: real convergence, inflation developments in the accession countries,
monetary policy and exchange rate strategies, capital account liberalisation, and the structure and
functioning of the financial sector. Let me elaborate briefly on each of these.
1. Real convergence
Sustainable rates of GDP growth will be a key challenge for accession countries in the years, and
even decades, to come. 2000 was the first year since the beginning of the transition process in which
all accession countries experienced positive growth. The degree of real convergence with the euro
area, that is, the catching-up of the per capita income and price levels of accession countries with
those of the euro area, has remained limited. Looking ahead, it appears unlikely that the overall
growth differential between the accession countries and the euro area will be significantly higher than
a few percentage points. Overall, the gap between the average GDP per capita of the accession
countries and that of the euro area remains large. On average, GDP per capita in the accession
countries is, in terms of purchasing power parity, around 44% of that of the euro area, and this figure is
even lower when current exchange rates are taken into account. The size of the gap, combined with
the limited growth differentials, suggests that the process of real convergence will be a very slow one,
likely to continue far beyond the tentative dates for EU accession and for the adoption of the euro.
Hence, although differences in income levels are compatible with membership of EMU, it is important
for accession countries to progress in the process of real convergence with the euro area. In
particular, real convergence can help to create economic cohesion within EMU and promote
integration between Members States. Further real convergence will also help to minimise the risks and
the effects of asymmetric shocks. Against this background, it seems crucial that accession countries
pursue structural policies that enhance the potential output growth of their economies.
2. Inflation developments
With regard to inflation developments, I should like to stress that, on the whole, the accession
countries have made remarkable progress in bringing inflation down to single-digit rates. Inflation in
the accession countries is expected to average around 6%-7% by the end of this year. However,
reducing inflation from relatively low levels to even lower ones is clearly a difficult task. Evidence
points to a number of micro and macroeconomic factors which affect current inflation rates in the
accession countries. These include ongoing price liberalisation, privatisation processes, relatively
expansionary fiscal policies and stubborn inflation expectations. Inflationary pressures stemming from
high productivity growth in the tradable sector of fast-growing economies - known as the
Balassa-Samuelson effect - have also been cited as one of the main reasons for higher inflation in
catching-up economies, such as those of the accession countries.
A closer examination of inflation developments in the accession countries shows, however, that the
Balassa-Samuelson effect alone cannot explain the persistence of inflation differentials vis-à-vis the
euro area. Moreover, notwithstanding its importance, the Balassa-Samuelson effect should not be
overstated when explaining current inflation rates in the accession countries. Indeed, most empirical
studies estimate the Balassa-Samuelson effect within a range of 1 to 2 percentage points. This does
not mean, however, that the pursuit of real convergence conflicts with further progress on disinflation.
On the contrary, the process of disinflation should be advanced in the accession countries, at a pace
determined by the overall economic situation and in particular by the need for these countries to
increase real convergence. The Maastricht inflation criterion, which will not be revised to take into
account any possible Balassa-Samuelson effect, should not be seen as an immediate requirement for
these countries, but rather as a medium-term objective for central banks. As the experience of some
euro area participants shows, progress in nominal and real convergence can be, and should be,
pursued in parallel. Indeed, the experience of countries such as Greece, Spain and Portugal confirms
that a key element of their successful entry into the euro area was their success in controlling sources
of inflation other than the Balassa-Samuelson effect. In particular, a balanced monetary and fiscal
policy mix and the control of real wage increases have supported the disinflation process in these
countries, and allowed them to advance in the process of nominal convergence without compromising
the gradual catching-up in real incomes.
3. Monetary policy and exchange rate strategies
With regard to monetary policy and exchange rate strategies, most accession countries have already
indicated their intention to join ERM II as early as possible after entry into the EU. The accession
countries have also signalled their intention to adopt the euro as soon as possible, that is, after two
years of ERM II membership.
The whole issue of the timing of ERM II membership, both as to when to join and how long to remain
in the system, is dependent on a somewhat more complex question, namely whether the discipline
which ERM II imposes on its members is advantageous for the accession countries. The answer, in
our view, is "yes".
Ladies and gentlemen, allow me to reflect on this question for a moment and explain why we hold this
view.
Being small open economies, most accession countries cannot disregard exchange rate
developments when making their monetary policy decisions. The exchange rate is generally a more
potent transmission channel of monetary policy decisions than domestic interest rates, and it also
plays a crucial role in explaining the pass-through to price developments in most accession countries.
Thus, in order to achieve further disinflation and sustainable growth, excessive exchange rate
fluctuations need to be avoided. In our view, and this view is supported by our previous experiences
with the EMS/ERM framework, ERM II provides a useful mechanism to anchor exchange rate
expectations. At the same time, ERM II, with its adjustable central rate and its current fluctuation band
of ±15%, provides accession countries with the same degree of flexibility as the EMS/ERM following
the decision to widen the fluctuation band in 1993. This may be suitable for accession countries. Given
that accession countries still need to complete the process of restructuring their economies and
catching up in terms of real income, the flexibility inherent in ERM II and its wider fluctuation bands
provides accession countries with sufficient scope to accommodate these reforms. Bearing in mind
that ERM II constitutes a multilateral arrangement, and that it is consistent with the regional integration
process in which all accession countries are deeply involved, ERM II is likely to have fewer potential
weaknesses than other alternative exchange rate arrangements have shown over recent years. Of
course, as for any exchange rate arrangement, coherence between macroeconomic policies must be
ensured for successful participation in ERM II.
With regard to the length of the period of ERM II membership, in view of the varying degrees of
convergence of the accession countries, limiting the duration of ERM II membership to the minimum
permissible time to qualify for the adoption of the euro - that is, two years - may not be an optimal
choice for all accession countries. Longer membership of ERM II may, in some cases, be helpful since
it would allow accession countries to retain the exchange rate as an instrumental policy variable during
the catching-up process. Indeed, this option has proven useful for most of the current euro area
participants. Again, it is worthwhile to recall the examples of Greece, Portugal and Spain. In the case
of Greece, the final revaluation of the drachma on 17 January 2000 took place at the request of
Greece, with the agreement of the EU authorities, to support the country's efforts to preserve
sustainable price stability and progress in real convergence without jeopardising the competitiveness
of the economy. Portugal and Spain, which participated in the EMS/ERM for a longer period of time,
also used the option of realigning the respective exchange rates of the escudo and the peseta at
several points along the road towards entry into the euro area.
Participation in ERM II should, therefore, not be seen as a mere "waiting room" prior to the adoption of
the euro. Instead, it should be regarded as a meaningful and flexible framework for increasing nominal
and real convergence with the euro area, and for tackling the challenges faced by the accession
countries as they progress towards the adoption of the euro. Indeed, the experience of current euro
area member countries in the fields of inflation and exchange rate developments strongly suggests
that the existing institutional framework for accession to the euro area, including the convergence
criteria as defined in the Maastricht Treaty, is sound. Furthermore, this framework should be
sufficiently flexible to accommodate most of the challenges that accession countries will face on their
path to the eventual adoption of the euro.
4. Capital account liberalisation
Ladies and gentlemen, the fourth economic issue I would like to refer to is capital account
liberalisation. In several accession countries, capital movements are still subject to a number of
restrictions. The most relevant restrictions, from a monetary policy perspective, apply to short-term
portfolio investments. Although transitional periods may be allowed under the Treaty in the early years
of EU membership, as well as prior to accession under the Europe Agreements, thus far, only a few
countries have requested them. In those few cases, transitional periods mainly relate to areas that are
not particularly relevant from a monetary policy point of view (e.g. real estate purchases).
Despite the generally positive impact of capital liberalisation on the growth prospects of the accession
countries, one should bear in mind that the speed of capital account liberalisation may carry risks for
countries with underdeveloped financial sectors, especially in a context of fixed or tightly managed
exchange rate regimes. If not carefully sequenced and supported by consistent macroeconomic and
structural policies, capital account liberalisation could pose some risks to macroeconomic or financial
stability in the accession countries. It is therefore crucial that the right policies are put into place before
EU accession.
5. Financial sector structure and functioning
The last issue I would like to elaborate on concerns the structure and functioning of the financial sector
in the accession countries. Partly for historical reasons, the financial sector in the accession countries
is largely dominated by the banking sector, whereas other financial sector intermediaries still need to
be further developed. Over the past few years, significant progress has been made in restructuring
and consolidating the banking sector. This progress has been accomplished through the large-scale
privatisation of state-owned banks and through the extensive opening-up of the banking sector to
foreign ownership. Undoubtedly, this process has contributed to greater integration with the EU and
significant efficiency gains. It has also supported the strengthening of financial stability and provided
the banking sector with know-how and capital.
However, the degree of financial intermediation remains rather low and the challenges ahead are
considerable. Given the major implications that the structure and functioning of the financial sector
may have for macroeconomic developments, a strengthening of the accession countries' financial
markets, including the enhancement of legal frameworks and prudential supervision, is needed. The
principal reasons for this are twofold. First, the weakness of the financial sector has been partly
responsible for the relatively modest growth rates observed in some accession countries during the
last decade. In spite of substantial structural reforms in the real sector of the economy, the as yet
insufficient development of the financial sectors may have made the transition to a fully functioning
market economy more costly in many accession countries. Financial sector development is, therefore,
crucial if potential economic growth is to be increased and real incomes are to catch up with those of
the euro area. Second, financial stability in the accession countries is of great relevance to the ECB,
since it is a central aspect of ensuring the smooth conduct of monetary policy in an enlarged euro
area. Financial sector vulnerabilities have to be avoided as they may complicate the efficient working
of the monetary policy transmission mechanism. They may also pose great challenges for the conduct
of monetary policy, for central banks' credibility and for the maintenance of price stability.
Finally, accession countries have embarked on the process of developing a modern financial market
infrastructure. This is essential in order to facilitate the transition from a planned to a market economy
and, at the same time, to support the conduct of a single monetary policy in an enlarged euro area.
Setting up such a financial infrastructure is, however, a difficult task. First, preparatory work in this field
is subject to very long lead times and, therefore, needs to be implemented years before the adoption
of the euro. Second, the target of this preparatory work is a moving one: certain components of the
euro area financial infrastructure may need to be adapted before new Member States can be
integrated into the euro area. Furthermore, there is an ongoing debate in international fora about the
optimal structure of modern financial markets in an increasingly integrated global financial system.
More and more, market pressures, economies of scale and efficiency gains point to the need for
further consolidation of the financial infrastructure. In the context of EU entry, and taking into account
the relatively small size of the financial sectors in the accession countries, plans to develop the
financial market infrastructure may need to bear in mind the specific conditions applying to accession
countries. Indeed, there is a risk that accession countries may now be investing considerable efforts
and resources to develop infrastructures similar to those that some euro area countries are trying to
rationalise.
Concluding remarks
Ladies and gentlemen, I shall conclude with a few brief remarks of a more general nature. The
ultimate goal of entry into the euro area is an ambitious one and, for this reason, it is necessary to start
preparing for this prospect well in advance. Broadly speaking, the prospect of EU membership should
encourage accession countries to make all the macro and microeconomic adjustments necessary to
join the euro area. In this way, EU accession may set in motion a virtuous cycle of long-term
sustainable economic growth. As the experience of current euro area participants shows, accession
countries may encounter difficulties, and even sometimes feel frustration, during the different stages of
this process. However, these difficulties should not discourage accession countries from going ahead
with the project of entry into EU and, later on, the euro area.
Undoubtedly, EU enlargement poses great challenges to both the accession countries and to the
European Union itself. Creating the right economic and political conditions and adjusting the European
institutions for the eventual integration into the EU of all accession countries is certainly an enormous
task. However - and here I come back to what I mentioned at the beginning of my speech - the
project of European integration should not be regarded just as a stimulating exercise of facing up to
never-ending "challenges ahead", but rather as a historic opportunity to deepen and extend the idea of
Europe. I am confident that we, as Europeans, and more specifically in our central banking function at
the ECB, will be able to master the "challenges ahead" and, in this way, to contribute to the completion
of the European project through the successful integration of the future Member States into the euro
area.
Thank you for your attention.