[pic] | COMMISSION OF THE EUROPEAN COMMUNITIES |

Brussels, 5.12.2006

SEC(2006) 1570

COMMISSION STAFF WORKING DOCUMENT Annex to the

REPORT FROM THE COMMISSION

CONVERGENCE REPORT DECEMBER 2006(prepared in accordance with Article 122(2) of the Treaty){COM(2006) 762 final}

European Economy

Convergence Report – Technical annex

A Commission services working paper

SEC(2006) 1570

Contents

1. INTRODUCTION 1

1.1. Role of the report 1

1.2. Application of the criteria 2

1.2.1. Compatibility of legislation 3

1.2.2. Price stability 3

1.2.3. Government budgetary position 6

1.2.4. Exchange rate stability 11

1.2.5. Long-term interest rates 11

1.2.6. Additional factors 12

2. CZECH REPUBLIC 13

2.1. Legal compatibility 13

2.2. Price stability 14

2.2.1. Respect of the reference value 14

2.2.2. Recent inflation developments 14

2.2.3. Underlying factors and sustainability of inflation 15

2.3. Government budgetary position 17

2.3.1. The excessive deficit procedure for the Czech Republic 17

2.3.2. Developments until 2006 17

2.3.3. Medium-term prospects 18

2.4. Exchange rate stability 19

2.5. Long-term interest rates 20

2.6. Additional factors 21

2.6.1. Financial market integration 21

2.6.2. Product market integration 22

2.6.3. Development of the balance of payments 24

3. ESTONIA 25

3.1. Legal compatibility 25

3.2 Price stability 26

3.2.1. Respect of the reference value 26

3.2.2. Recent inflation developments 26

3.2.3. Underlying factors and sustainability of inflation 27

3.3 Government budgetary position 30

3.3.1. Developments until 2006 30

3.3.2. Medium-term prospects 30

3.4. Exchange rate stability 32

3.5. Long-term interest rates 33

3.6. Additional factors 34

3.6.1 Financial market integration 34

3.6.2 Product market integration 35

3.6.3 Development of the balance of payments 36

4. CYPRUS 38

4.1. Legal compatibility 38

4.2. Price stability 39

4.2.1. Respect of the reference value 39

4.2.2. Recent inflation developments 39

4.2.3. Underlying factors and sustainability of inflation 40

4.3. Government budgetary position 42

4.3.1. The excessive deficit procedure for Cyprus 42

4.3.2. Developments until 2006 43

4.3.3. Medium-term prospects 43

4.4. Exchange rate stability 45

4.5. Long term interest rates 46

4.6. Additional factors 47

4.6.1. Financial market integration 47

4.6.2. Product Market Integration 48

4.6.3. Development of the balance of payments 49

5. LATVIA 51

5.1. Legal compatibility 51

5.2. Price stability 52

5.2.1. Respect of the reference value 52

5.2.2. Recent inflation developments 52

5.2.3. Underlying factors and sustainability of inflation 53

5.3. Government budgetary position 55

5.3.1. Developments until 2006 55

5.3.2. Medium-term prospects 56

5.4. Exchange rate stability 57

5.5. Long-term interest rates 58

5.6. Additional factors 59

5.6.1. Financial market integration 59

5.6.2. Product Market Integration 60

5.6.3. Development of the balance of payments 62

6. HUNGARY 64

6.1. Legal compatibility 64

6.2. Price stability 65

6.2.1. Respect of the reference value 65

6.2.2. Recent inflation developments 65

6.2.3. Underlying factors and sustainability of inflation 66

6.3. Government budgetary position 68

6.3.1. The excessive deficit procedure for Hungary 68

6.3.2. Developments until 2006 69

6.4. Exchange rate stability 71

6.5. Long term interest rates 72

6.6. Additional factors 73

6.6.1. Financial market integration 73

6.6.2. Product market integration 75

6.6.3. Development of the balance of payments 76

7. MALTA 78

7.1. Legal compatibility 78

7.2 Price stability 79

7.2.1. Respect of the reference value 79

7.2.2. Recent inflation developments 79

7.2.3. Underlying factors and sustainability of inflation 80

7.3 Government budgetary position 82

7.3.1. The excessive deficit procedure for Malta 82

7.3.2. Developments until 2006 82

7.3.3. Medium-term prospects 83

7.4. Exchange rate stability 84

7.5. Long-term interest rates 85

7.6. Additional factors 86

7.6.1. Financial market integration 86

7.6.2. Product market integration 88

7.6.3. Development of the balance of payments 89

8. POLAND 91

8.1. Legal compatibility 91

8.2. Price stability 92

8.2.1. Respect of the reference value 92

8.2.2. Recent inflation developments 92

8.2.3. Underlying factors and sustainability of inflation 93

8.3. Government budgetary position 95

8.3.1. The excessive deficit procedure for Poland 95

8.3.2. Developments until 2006 96

8.3.3. Medium-term prospects 96

8.4. Exchange rate stability 98

8.5. Long-term interest rates 98

8.6. Additional factors 99

8.6.1. Financial market integration 99

8.6.2. Product market integration 101

8.6.3. Development of the balance of payments 102

9. SLOVAKIA 104

9.1. Legal compatibility 104

9.2. Price stability 105

9.2.1. Respect of the reference value 105

9.2.2. Recent inflation developments 105

9.2.3. Underlying factors and sustainability of inflation 106

9.3. Government budgetary position 109

9.3.1. The excessive deficit procedure for Slovakia 109

9.3.2. Developments until 2006 109

9.3.3. Medium-term prospects 110

9.4. Exchange rate stability 111

9.5. Long-term interest rates 112

9.6. Additional factors 113

9.6.1. Financial market integration 113

9.6.2. Product market integration 115

9.6.3. Development of the balance of payments 116

10. SWEDEN 118

10.1 Legal situation 118

10.2 Price stability 119

10.2.1. Respect of the reference value 119

10.2.2. Recent inflation developments 119

10.2.3. Underlying factors and sustainability of inflation 120

10.3 Government budgetary position 122

10.3.1. Developments until 2006 122

10.3.2. Medium-term prospects 123

10.4 Exchange rate stability 124

10.5 Long-term interest rates 125

10.6 Additional factors 126

10.6.1. Financial market integration 126

10.6.2. Product market integration 127

10.6.3. Development of the balance of payments 129

List of Tables

Table 1.1 Inflation reference value in previous and current convergence reports

Table 1.2 Estimated cost on the government deficit of systemic pension reforms

Table 2.1 Czech Republic: Components of inflation

Table 2.2 Czech Republic: Other inflation and cost indicators

Table 2.3 Czech Republic: Budgetary developments and projections

Table 2.4 Czech Republic: Product market integration

Table 2.5 Czech Republic: Balance of payments

Table 3.1 Estonia: Components of inflation

Table 3.2 Estonia: Other inflation and cost indicators

Table 3.3 Estonia: Budgetary developments and projections

Table 3.4 Estonia: Product market integration

Table 3.5 Estonia: Balance of payments

Table 4.1 Cyprus: Components of inflation

Table 4.2 Cyprus: Other inflation and cost indicators

Table 4.3 Cyprus: Budgetary developments and projections

Table 4.4 Cyprus: Product market integration

Table 4.5 Cyprus: Balance of payments

Table 5.1 Latvia: Components of inflation

Table 5.2 Latvia: Other inflation and cost indicators

Table 5.3 Latvia: Budgetary developments and projections

Table 5.4 Latvia: Product market integration

Table 5.5 Latvia: Balance of payments

Table 6.1 Hungary: Components of inflation

Table 6.2 Hungary: Other inflation and cost indicators

Table 6.3 Hungary: Budgetary developments and projections

Table 6.4 Hungary: Product market integration

Table 6.5 Hungary: Balance of payments

Table 7.1 Malta: Components of inflation

Table 7.2 Malta: Other inflation and cost indicators

Table 7.3 Malta: Budgetary developments and projections

Table 7.4 Malta: Product market integration

Table 7.5 Malta: Balance of payments

Table 8.1 Poland: Components of inflation

Table 8.2 Poland: Other inflation and cost indicators

Table 8.3 Poland: Budgetary developments and projections

Table 8.4 Poland: Product market integration

Table 8.5 Poland: Balance of payments

Table 9.1 Slovakia: Components of inflation

Table 9.2 Slovakia: Other inflation and cost indicators

Table 9.3 Slovakia: Budgetary developments and projections

Table 9.4 Slovakia: Product market integration

Table 9.5 Slovakia: Balance of payments

Table 10.1 Sweden: Components of inflation

Table 10.2 Sweden: Other inflation and cost indicators

Table 10.3 Sweden: Budgetary developments and projections

Table 10.4 Sweden: Product market integration

Table 10.5 Sweden: Balance of payments

List of Charts

Chart 2.1 Czech Republic: Inflation criterion since May 2004

Chart 2.2 Czech Republic: HICP inflation

Chart 2.3 Czech Republic: Inflation, productivity and wage trends

Chart 2.4 Nominal effective exchange rate: CZK

Chart 2.5 Exchange rates: CZK/EUR

Chart 2.6 Czech Republic: 3-M Pribor spread to 3-M Euribor

Chart 2.7 Czech Republic: Long-term interest rate criterion

Chart 2.8 Czech Republic: Long-term interest rates

Chart 2.9a Czech Republic: Structure of financial system relative to EU-10, EU-15 and EU-25 in 2005

Chart 2.9b Czech Republic: Foreign ownership and concentration in the banking sector in 2005

Chart 2.9c Czech Republic: Domestic credit expansion

Chart 2.9d Czech Republic: Share of foreign currency loans

Chart 3.1 Estonia: Inflation criterion since May 2004

Chart 3.2 Estonia: HICP inflation

Chart 3.3 Estonia: Inflation, productivity and wage trends

Chart 3.4 Nominal effective exchange rate: EEK

Chart 3.5 Exchange rates: EEK/EUR

Chart 3.6 Estonia: 3-M Talibor spread to 3-M Euribor

Chart 3.7 Estonia: Long-term interest rate indicator (12-month moving averages)

Chart 3.8 Estonia: Long-term interest rate indicator

Chart 3.9a Estonia: Structure of financial system relative to EU-10, EU-15 and EU-25 in 2005

Chart 3.9b Estonia: Foreign ownership and concentration in the banking sector in 2005

Chart 3.9c Estonia: Domestic credit expansion

Chart 3.9d Estonia: Share of foreign currency loans

Chart 4.1 Cyprus: Inflation criterion since May 2004

Chart 4.2 Cyprus: HICP inflation

Chart 4.3 Cyprus: Inflation, productivity and wage trends

Chart 4.4 Nominal effective exchange rate: CYP

Chart 4.5a CYP: Spread vs central rate

Chart 4.5b Exchange rates: CYP/EUR

Chart 4.6 Cyprus: 3-M Nibor spread to 3-M Euribor

Chart 4.7 Cyprus: Long-term interest rate criterion

Chart 4.8 Cyprus: Long-term interest rates

Chart 4.9a Cyprus: Structure of financial system relative to EU-10, EU-15 and EU-25 in 2005

Chart 4.9b Cyprus: Foreign ownership and concentration in the banking sector in 2005

Chart 4.9c Cyprus: Domestic credit expansion

Chart 4.9d Cyprus: Share of foreign currency loans

Chart 5.1 Latvia: Inflation criterion since May 2004

Chart 5.2 Latvia: HICP inflation

Chart 5.3 Latvia: Inflation, productivity and wage trends

Chart 5.4 Nominal effective exchange rate: LVL

Chart 5.5a LVL: Spread vs central rate

Chart 5.5b Exchange rates: LVL/EUR

Chart 5.6 Latvia: 3-M Rigibor spread to 3-M Euribor

Chart 5.7 Latvia: Long-term interest rate criterion

Chart 5.8 Latvia: Long-term interest rates

Chart 5.9a Latvia: Structure of financial system relative to EU-10, EU-15 and EU-25 in 2005

Chart 5.9b Latvia: Foreign ownership and concentration in the banking sector in 2005

Chart 5.9c Latvia: Domestic credit expansion

Chart 5.9d Latvia: Share of foreign currency loans

Chart 6.1 Hungary: Inflation criterion since May 2004

Chart 6.2 Hungary: HICP inflation

Chart 6.3 Hungary: Inflation, productivity and wage trends

Chart 6.4 Nominal effective exchange rate: HUF

Chart 6.5 Exchange rates: HUF/EUR

Chart 6.6 Hungary: 3-M Bubor spread to 3-M Euribor

Chart 6.7 Hungary: Long-term interest rate criterion

Chart 6.8 Hungary: Long-term interest rates

Chart 6.9a Hungary: Structure of financial system relative to EU-10, EU-15 and EU-25 in 2005

Chart 6.9b Hungary: Foreign ownership and concentration in the banking sector in 2005

Chart 6.9c Hungary: Domestic credit expansion

Chart 6.9d Hungary: Share of foreign currency loans

Chart 7.1 Malta: Inflation criterion since May 2004

Chart 7.2 Malta: HICP inflation

Chart 7.3 Malta: Inflation, productivity and wage trends

Chart 7.4 Nominal effective exchange rate: MTL

Chart 7.5a MTL: Spread vs central rate

Chart 7.5b Exchange rates: MTL/EUR

Chart 7.6 Malta: 3-M Mibor spread to 3-M Euribor

Chart 7.7 Malta: Long-term interest rate criterion

Chart 7.8 Malta: Long-term interest rates

Chart 7.9a Malta: Structure of financial system relative to EU-10, EU-15 and EU-25 in 2005

Chart 7.9b Malta: Foreign ownership and concentration in the banking sector in 2005

Chart 7.9c Malta: Domestic credit expansion

Chart 7.9d Malta: Net foreign assets of the MFI's

Chart 8.1 Poland: Inflation criterion since May 2004

Chart 8.2 Poland: HICP inflation

Chart 8.3 Poland: Inflation, productivity and wage trends

Chart 8.4 Nominal effective exchange rate: PLN

Chart 8.5 Exchange rates: PLN/EUR

Chart 8.6 Poland: 3-M Wibor spread to 3-M Euribor

Chart 8.7 Poland: Long-term interest rate criterion

Chart 8.8 Poland: Long-term interest rates

Chart 8.9a Poland: Structure of financial system relative to EU-10, EU-15 and EU-25 in 2005

Chart 8.9b Poland: Foreign ownership and concentration in the banking sector in 2005

Chart 8.9c Poland: Domestic credit expansion

Chart 8.9d Poland: Share of foreign currency loans

Chart 9.1 Slovakia: Inflation criterion since May 2004

Chart 9.2 Slovakia: HICP inflation

Chart 9.3 Slovakia: Inflation, productivity and wage trends

Chart 9.4 Nominal effective exchange rate: SKK

Chart 9.5a SKK: Spread vs central rate

Chart 9.5b Exchange rates: SKK/EUR

Chart 9.6 Slovakia: 3-M Bribor spread to 3-M Euribor

Chart 9.7 Slovakia: Long-term interest rate criterion

Chart 9.8 Slovakia: Long-term interest rates

Chart 9.9a Slovakia: Structure of financial system relative to EU-10, EU-15 and EU-25 in 2005

Chart 9.9b Slovakia: Foreign ownership and concentration in the banking sector in 2005

Chart 9.9c Slovakia: Domestic credit expansion

Chart 9.9d Slovakia: Share of foreign currency loans

Chart 10.1 Sweden: Inflation criterion since May 2004

Chart 10.2 Sweden: HICP inflation

Chart 10.3 Sweden: Inflation, productivity and wage trends

Chart 10.4 Nominal effective exchange rate: SEK

Chart 10.5 Exchange rates: SEK/EUR

Chart 10.6 Sweden: 3-M Stibor spread to 3-M Euribor

Chart 10.7 Sweden: Long-term interest rate criterion

Chart 10.8 Sweden: Long-term interest rates

Chart 10.9a Sweden: Structure of financial system relative to EU-10, EU-15 and EU-25 in 2005

Chart 10.9b Sweden: Foreign ownership and concentration in the banking sector in 2005

Chart 10.9c Sweden: Domestic credit expansion

Chart 10.9d Sweden: Share of foreign currency loans

List of Boxes

Box 1.1 Article 122(2) of the Treaty

Box 1.2 Article 121(1) of the Treaty

Box 1.3 Assessment of price stability and the reference value

Box 1.4 The excessive deficit procedure

Box 1.5 Pension reforms – impact on government accounts, accounting considerations and specific SGP provisions

Box 1.6 Data for the interest rate convergence criterion

Abbreviations and symbols used

Member States

BE Belgium

CZ Czech Republic

DK Denmark

DE Germany

EE Estonia

EL Greece

ES Spain

FR France

IE Ireland

IT Italy

CY Cyprus

LV Latvia

LT Lithuania

LU Luxembourg

HU Hungary

MT Malta

NL The Netherlands

AT Austria

PL Poland

PT Portugal

SI Slovenia

SK Slovakia

FI Finland

SE Sweden

UK United Kingdom

EU10 European Union Member States that joined the EU on 1 May 2004 (CZ, EE, CY, LT, LV, HU, MT, PL, SI, SK)

EUR12 European Union Member States having adopted the single currency (BE, DE, EL, ES, FR, IE, IT, LU, NL, AT, PT, FI)

EU15 European Union, 15 Member States before 1 May 2004 (EUR-12 plus DK, SE and UK)

EU25 European Union, 25 Member States

Currencies

EUR euro

ECU European currency unit

USD US dollar

CZK Czech koruna

EEK Estonian kroon

CYP Cypriot pound

LVL Latvian lats

HUR Hungarian forint

MTL Maltese lira

PLN Polish zloty

SKK Slovak koruna

SEK Swedish krona

Other abbreviations

CPI consumer price index

CR5 concentration ratio (defined as the aggregated market share of five banks with the largest market share)

ECB European Central Bank

EMI European Monetary Institute

EMU economic and monetary union

ERM II exchange rate mechanism II

ESCB European System of Central Banks

Eurostat Statistical Office of the European Communities

FDI foreign direct investment

GDP gross domestic product

GFCF gross fixed capital formation

HICP harmonised index of consumer prices

MTO medium-term objective

VAT value added tax

1. INTRODUCTION

1.1. ROLE OF THE REPORT

The euro was introduced on 1 January 1999 by eleven Member States, following several years of successful adjustment efforts to achieve a high degree of sustainable convergence. The decision[1] by the Council (meeting in the composition of the Heads of State or Government) on 3 May 1998 in Brussels on the eleven Member States deemed ready to participate in the single currency (from the beginning) had, in accordance with the Treaty (Article 121(4)), been prepared by the Ecofin Council on a recommendation from the Commission. The decision was based on the two convergence reports made by the Commission[2] and the European Monetary Institute (EMI), respectively.[3] These reports, prepared in accordance with Article 121(1) of the Treaty, examined in considerable detail whether the Member States satisfied the convergence criteria and met the legal requirements.

Those Member States which are assessed as not fulfilling the necessary conditions for the adoption of the single currency are referred to as "Member States with a derogation". Article 122(2) of the Treaty lays down provisions and procedures for examining the situation of Member States with a derogation (Box 1.1) . At least once every two years, or at the request of a Member State with a derogation, the Commission and the European Central Bank (ECB) are required to prepare convergence reports on such Member States.

Box 1.1: Article 122(2) of the Treaty

"At least once every two years, or at the request of a Member State with a derogation, the Commission and the ECB shall report to the Council in accordance with the procedure laid down in Article 121(1). After consulting the European Parliament and after discussion in the Council, meeting in the composition of the Heads of State or Government, the Council shall, acting by a qualified majority on a proposal from the Commission, decide which Member States with a derogation fulfil the necessary conditions on the basis of the criteria set out in Article 121(1), and abrogate the derogations of the Member States concerned."

Denmark and the United Kingdom negotiated opt-out arrangements before the adoption of the Maastricht Treaty[4] and do not participate in the third stage of EMU. Until these Member States indicate that they wish to participate in the third stage and join the single currency, they are not the subject of an assessment by the Council as to whether they fulfil the necessary conditions.

Greece submitted a request on 9 March 2000 for its convergence situation to be re-examined. The Ecofin Council adopted the decision[5] that Greece fulfilled the necessary conditions for adoption of the single currency on 19 June 2000. The decision was taken on the basis of a proposal from the Commission and having regard to the discussion of the Council, meeting in the composition of the Heads of State or Government. The decision was based on two convergence reports made by the Commission[6] and the ECB[7], which covered both Greece and Sweden. Greece adopted the single currency with effect from 1 January 2001. Sweden was assessed in 2000 as not fulfilling the necessary conditions for the adoption of the single currency.

In 2002, the convergence assessment covered only Sweden and concluded that Sweden was not fulfilling the necessary conditions for the adoption of the single currency and continued to be referred to as a "Member State with a derogation".[8]

In 2004, Sweden was examined together with the ten countries that joined the EU on 1 May 2004. In accordance with Article 4 of the Act of Accession, the ten countries became upon entry “Member States with a derogation”. Although the maximum period referred to in Article 122(2) of the Treaty had not elapsed for these countries in 2004, the re-assessment of Sweden was seized as an opportunity to analyse also the state of convergence in the new Member States. None of the eleven assessed countries was considered to have fulfilled the necessary conditions for the adoption of the single currency.[9]

In 2006, two years will have elapsed since the last comprehensive reports were made. The ten recently acceded Member States and Sweden have, therefore, to be re-assessed. Lithuania and Slovenia were assessed in convergence reports issued in May 2006 at the request of the respective national authorities.[10] Denmark and the United Kingdom have not expressed their wish to join the single currency. Therefore, this second convergence assessment of 2006 covers the following nine Member States with a derogation: the Czech Republic, Estonia, Cyprus, Latvia, Hungary, Malta, Poland, Slovakia and Sweden.

This Commission services Working Paper is a technical annex to the Convergence Report of December 2006 and includes a detailed assessment of the progress with convergence. The remainder of the first chapter presents the methodology used for application of the assessment criteria and an overview of the main findings. Chapters 2 to 10 examine, on a country-by-country basis, fulfilment of the convergence criteria and other requirements in the order as they appear in Article 121(1). The cut-off date for the statistical data included in this Convergence Report was 17 November 2006.

1.2. APPLICATION OF THE CRITERIA

In accordance with Article 121(1), the convergence reports shall examine the compatibility of national legislation with the Treaty and the Statute of the European System of Central Banks (ESCB) and of the European Central Bank. The reports shall also examine the achievement of a high degree of sustainable convergence by reference to the fulfilment of the four convergence criteria dealing with price stability, the government budgetary position, exchange rate stability and long-term interest rates as well as some additional factors (Box 1.2) . The four convergence criteria have been developed further in a Protocol annexed to the Treaty (Protocol No 21 on the convergence criteria).

Box 1.2: Article 121(1) of the Treaty

"1. The Commission and the EMI shall report to the Council on the progress made in the fulfilment by the Member States of their obligations regarding the achievement of economic and monetary union. These reports shall include an examination of the compatibility between each Member State's national legislation, including the statutes of its national central bank, and Articles 108 and 109 of this Treaty and the Statute of the ESCB. The reports shall also examine the achievement of a high degree of sustainable convergence by reference to the fulfilment by each Member State of the following criteria:

- the achievement of a high degree of price stability; this will be apparent from a rate of inflation which is close to that of, at most, the three best performing Member States in terms of price stability;

- the sustainability of the government financial position; this will be apparent from having achieved a government budgetary position without a deficit that is excessive as determined in accordance with Article 104(6);

- the observance of the normal fluctuation margins provided for by the exchange rate mechanism of the European Monetary System, for at least two years, without devaluing against the currency of any other Member State;

- the durability of convergence achieved by the Member State and of its participation in the exchange rate mechanism of the European Monetary System being reflected in the long term interest rate levels.

The four criteria mentioned in this paragraph and the relevant periods over which they are to be respected are developed further in a Protocol annexed to this Treaty. The reports of the Commission and the EMI shall also take account of the development of the ECU, the results of the integration of markets, the situation and development of the balances of payments on current account and an examination of the development of unit labour costs and other price indices."

1.2.1. Compatibility of legislation

In accordance with Article 121(1) of the Treaty, the legal examination includes an assessment of compatibility between a Member State’s legislation, including the statute of its national central bank, and Articles 108 and 109 of the Treaty and the Statute of the ESCB/ECB. This assessment mainly covers three areas. First, the objectives of the national central bank must be examined, in order to verify their compatibility with the objectives of the ESCB as formulated in Article 105(1) and Article 2 of the Statute of the ESCB/ECB. The ESCB’s primary objective is to maintain price stability. Without prejudice to this objective, it shall support the general economic policies in the Community. Second, the independence of the national central bank and of the members of its decision-making bodies (Article 108) must be assessed. This assessment covers all issues linked to a national central bank's institutional and financial independence and to the personal independence of the members of its decision-making bodies. Third, the integration of the national central bank into the ESCB has to be examined, in order to ensure that the national central bank acts in accordance with the ECB’s guidelines and instructions once the country concerned has adopted the single currency.

1.2.2. Price stability

The price stability criterion is defined in the first indent of Article 121(1) of the Treaty: “ the achievement of a high degree of price stability […] will be apparent from a rate of inflation which is close to that of, at most, the three best performing Member States in terms of price stability” .

Article 1 of the Protocol on the convergence criteria further stipulates that “the criterion on price stability […] shall mean that a Member State has a price performance that is sustainable and an average rate of inflation, observed over a period of one year before the examination, that does not exceed by more than 1.5 percentage points that of, at most, the three best-performing Member States in terms of price stability. Inflation shall be measured by means of the consumer price index on a comparable basis, taking into account differences in national definitions” .

Since national consumer price indices (CPIs) diverge substantially in terms of concepts, methods and practices, they do not constitute the appropriate means to meet the Treaty requirement that inflation must be measured on a comparable basis. To this end, the Council adopted on 23 October 1995 a framework regulation[11] setting the legal basis for the establishment of a harmonised methodology for compiling consumer price indices in the Member States. This process resulted in the production of the Harmonised Indices of Consumer Prices (HICPs) , which have been used for assessing the fulfilment of the price stability criterion. Until December 2005, HICP series had been based on 1996 as the reference period. A Commission Regulation (EC) No 1708/2005[12] provided the basis for a change of the HICP index base reference period from 1996=100 to 2005=100.

As has been the case in past convergence reports, a Member State’s average rate of inflation is measured by the percentage change in the arithmetic average of the last 12 monthly indices relative to the arithmetic average of the 12 monthly indices of the previous period. The reference value is calculated as the arithmetic average of the average rate of inflation of the three best-performing Member States in terms of price stability plus 1.5 percentage points (Box 1.3).

Over the 12 month period covering November 2005-October 2006, the three best-performing Member States in terms of price stability were Poland (1.2 percent), Finland (1.2 percent) and Sweden (1.5 percent) yielding a reference value of 2.8 percent.

The Protocol on the convergence criteria not only requires Member States to have achieved a high degree of price stability but also calls for a price performance that is sustainable. The requirement of sustainability aims at ensuring that the degree of price stability and inflation convergence achieved in previous years will be maintained after adoption of the euro. This implies that the satisfactory inflation performance must essentially be due to the adequate behaviour of input costs and other factors influencing price developments in a structural manner, rather than reflecting the influence of temporary factors. Therefore, this Working Paper examines also developments in unit labour costs as a result of trends in labour productivity and nominal compensation per head, and developments in import prices to assess whether and how external price developments have impacted on domestic inflation. From a forward-looking perspective, the report includes an assessment of medium-term prospects for inflation. The analysis of factors that have an impact on the inflation outlook, such as credit developments and cyclical conditions, is complemented by a reference to the most recent Commission forecast of inflation. That forecast can subsequently be used to assess whether the country is likely to meet the reference value also in the months ahead.

Box 1.3: Assessment of price stability and the reference value

The numerical part of the price stability criterion implies a comparison between a Member State's average price performance and a reference value.

A Member State’s average rate of inflation is measured by the percentage change in the unweighted average of the last 12 monthly indices relative to the unweighted average of the 12 monthly indices of the previous period, rounded to one decimal.

This measure captures inflation trends over a period of one year as requested by the provisions of the Treaty. Using the commonly used inflation rate – calculated as the percentage change in the consumer price index of the latest month over the index for the equivalent month of the previous year – would not meet the one year requirement. The latter measure may also vary importantly from month to month because of exceptional factors.

The reference value is calculated as the unweighted average of the average rates of inflation of, at most, the three best-performing Member States in terms of price stability plus 1.5 percentage points. The outcome is rounded to one decimal. While in principle the reference value could also be calculated on the basis of the price performance of only one or two best performing Member States in terms of price stability, it has been existing practice to select the three best performers.

The reference value has been defined in the Maastricht Treaty in a relative way. An absolute reference value could, depending on the overall economic circumstances at the time of the assessment, be considered to be unduly harsh or too loose. Alternatively, using the average of the inflation rates of all Member States as a basis for the reference value would imply that high inflation rates of a few countries could increase the average to undesired levels. These problems are avoided in the Treaty by requiring convergence towards the best performing Member States within a margin of 1.5 percentage points. As the reference value is a relative concept based on the Member States with the lowest rate of inflation, a margin of 1.5 percentage points is added.

Article 121(1) of the Treaty refers to 'Member States' and does not make a distinction between euro area and other Member States. The Convergence Reports therefore select the three best performers from all Member States – EU-15 for the Convergence Reports before 2004 and EU-25 for the reports as of 2004.

As a principle, and in line with what was intended by the authors of the Maastricht Treaty, the Commission and ECB reports select as best performers in terms of price stability those Member States which have the lowest average rate of inflation. In the 2004 report, the Commission decided to exclude countries in deflation from the calculation of the reference value because these countries could not be considered to be 'best performers' in terms of price stability – as suggested by the Treaty Protocol, which refers only to an average rate of inflation .

Table 1.1 lists the reference value as used in the Convergence Reports issued since 1998.

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1.2.3. Government budgetary position

The convergence criterion dealing with the government budgetary position is defined in the second indent of Article 121(1) of the Treaty as “ the sustainability of the government financial position: this will be apparent from having achieved a government budgetary position without a deficit that is excessive as determined in accordance with Article 104(6) ”. Furthermore, Article 2 of the Protocol on the convergence criteria states that this criterion means that “ at the time of the examination the Member State is not the subject of a Council decision under Article 104(6) of this Treaty that an excessive deficit exists ”.

The convergence assessment in the budgetary area is thus directly linked to the excessive deficit procedure which is specified in Article 104 of the Treaty and further clarified in the Stability and Growth Pact. The existence of an excessive deficit is determined in

relation to the two criteria for budgetary discipline set in Article 104(2), namely on the government deficit and the government debt. Failure by a Member State to fulfil the requirements under either of these criteria can lead to a decision by the Council on the existence of an excessive deficit, in which case the Member State concerned does not comply with the budgetary convergence criterion (for further information on this procedure, see Box 1.4).[13]

The budgetary positions of several Member States are affected by structural reforms consisting in the establishment of new pension schemes, and the classification of these schemes within government or outside. Box 1.5 provides further details on this issue and explains the relevant accounting rules and their practical implementation as well as the consideration of the cost of pension reforms in the excessive deficit procedure.

Box 1.4: The excessive deficit procedure [14]

The excessive deficit procedure (EDP) is specified in Article 104 of the Treaty, the associated Protocol on the EDP and Council Regulation (EC) No 1467/97 on speeding up and clarifying the implementation of the EDP[15], which is the “dissuasive arm” of the Stability and Growth Pact (SGP). Together, they determine the steps to be followed to reach a Council decision on the existence of an excessive deficit, which forms the basis for the assessment of compliance with the convergence criterion on the government budgetary position, and the steps to be followed to correct a situation of excessive deficit. According to Article 104(2), compliance with budgetary discipline is to be examined by the Commission on the basis of the following two criteria:

“ (a) whether the ratio of the planned or actual government deficit to gross domestic product exceeds a reference value [specified in the Protocol as 3 percent] , unless:

- either the ratio has declined substantially and continuously and reached a level that comes close to the reference value;

- or, alternatively, the excess over the reference value is only exceptional and temporary and the ratio remains close to the reference value;

(b) whether the ratio of government debt to gross domestic product exceeds a reference value [specified in the Protocol as 60 percent] , unless the ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace ”.

According to the Protocol, the Commission provides the statistical data for the implementation of the procedure. As part of the application of this Protocol, Member States have to notify data on government deficits, government debt and nominal GDP and other associated variables twice a year, namely before 1 April and before 1 October[16]. After each reporting date, Eurostat examines whether the data are in conformity with ESA95[17] rules and related Eurostat decisions and, if they are, validates them.

The Commission is required to prepare a report if a Member State does not fulfil the requirements under one or both of the criteria given above (Article 104(3)). The report also has to take into account whether the government deficit exceeds government investment expenditure and all other relevant factors (considerations related to the medium-term economic and budgetary position of the Member State). These factors should be considered in the steps of the EDP leading to the decision on the existence of an excessive deficit only under the double condition that the deficit is close to the reference value and its excess over it is temporary. Special provisions are foreseen for pension reforms introducing a multi-pillar system including a mandatory, fully-funded pillar (see Box 1.5).

The next step in the procedure is the formulation by the Economic and Financial Committee of an opinion on this report within two weeks of its adoption by the Commission (Article 104(4)). If it considers that an excessive deficit exists or may occur, the Commission then addresses an opinion to the Council (Article 104(5)). On the basis of a Commission recommendation, the Council decides, after an overall assessment, whether an excessive deficit exists (Article 104(6)). Any such decision has to be adopted as a rule within four months of the reporting dates (1 April, 1 October).

When it decides that an excessive deficit exists, the Council has to issue a recommendation to the Member State concerned with a view to bringing that situation to an end within a given period, also on the basis of a Commission recommendation (Article 104(7)). The Council recommendation has to specify when the correction of the excessive deficit should be completed, namely in the year following its identification unless there are special circumstances, and has to include a deadline of six months at most for effective action to be taken by the Member State concerned. The recommendation should also specify that the Member State concerned has to achieve a minimum annual improvement of at least 0.5percent of GDP as a benchmark in its cyclically-adjusted balance net of one-off and temporary measures.

If effective action has been taken in compliance with a recommendation under Article 104(7) and, compared with the economic forecasts in this recommendation, unexpected adverse economic events with major unfavourable consequences for government finances occur subsequent to its adoption, the Council may decide, on a recommendation from the Commission, to adopt a revised recommendation under the same article, which may notably extend the deadline for the correction of the excessive deficit by one year. Where it establishes that there has been no effective action in response to its recommendations, the Council adopts a decision under Article 104(8) on the basis of a Commission recommendation immediately after the expiry of the deadline for taking action (or at any time thereafter when monitoring of the action taken by the Member State indicates that action is not being implemented or is proving to be inadequate). The provisions of Article 104(9 and 11), on enhanced Council surveillance and ultimately sanctions in case of non-compliance, are not applicable to Member States with a derogation (that is, those that have not yet adopted the euro), which is the case of the Member States considered in this report.

When, in the view of the Council, the excessive deficit in the Member State concerned has been corrected, the Council abrogates its decision on the existence of an excessive deficit, on the basis of a Commission recommendation (Article 104(12)).

Box 1.5: Pension reforms – impact on government accounts, accounting considerations

and specific SGP provisions

Systemic pension reforms and the delimitation of general government

Many Member States have reformed or will reform their pension systems to ensure sustainable public finances.[18] The impact on the government balance of systemic pension reforms – replacing or complementing pay-as-you-go (PAYG) systems with funded systems, or changing defined-benefit schemes (DB) to defined-contribution schemes (DC) – depends on the delimitation of government before and after the reform. If a pension scheme is classified in the government sector, contributions collected and benefits paid by the scheme contribute to the government balance. If a pension scheme is classified elsewhere, the respective contributions and benefits are recorded in the private sector’s accounts. As far as the debt is concerned, the impact of classifying a pension scheme in government depends on the pension scheme’s debts, as well as on the pension scheme’s holdings of government bonds; government bonds in the possession of pension schemes classified in government (or of any other government unit) consolidate, that is, they are not taken in consideration in the government debt for fiscal surveillance purposes.

ESA accounting rules and Eurostat decision

The accounting rules that are relevant for the compilation of the government deficit/surplus are established by the European System of National and Regional Accounts (ESA).[19] Concerning the sectoral classification of pension schemes, ESA states that pension schemes classified in government are those which are “ imposed, controlled and financed by government ”. Such a rule needed to be interpreted and clarified to be applied to specific cases. On 2 March 2004 – after an intense consultation procedure with the Member States’ statistical authorities – Eurostat clarified that funded DC pension schemes did not fulfil the ESA criteria to be classified in general government.[20]

The Eurostat decision was based mainly on two considerations: who bears the risk of the pension scheme and who is the economic owner of the existing reserves. In the case of PAYG systems or of funded DB schemes, the government bears most economic risks, as the benefits to be paid are known beforehand or, at least, the pension award formulas are well defined in advance by the government. The government is responsible for financing pension payments, irrespective of economic conditions, for example changes in the value of reserves. In the case of funded DC schemes, pensions depend primarily on financial markets performance and are not controlled by the government. The risk of positive or negative financial developments, in particular changes in the value of the pension scheme’s reserves, is thus borne by the scheme members. Therefore, the reserves of funded DC schemes belong – from an economic viewpoint, even if not from a legal perspective – to the scheme members. The contributions paid to the funded DC schemes are saving of the scheme members; the latter are lending a share of their saving to the pension schemes and will be reimbursed through the payment of pensions in future. The Eurostat decision on the classification of pension schemes is valid even when the funded DC pension schemes are created at the government initiative, when affiliation is compulsory, when the schemes are managed by government (for example, managed by the same government agency in charge of the PAYG pillar) or when there is some guarantee of a minimum pension.

Cost of pension reforms

When a government decides to create a new funded DC pension scheme and shifts to this new scheme a share of the social contributions that were previously collected by an unfunded pension scheme, government revenue falls. On the other hand, the pensions that will be paid by the new pension scheme will not count as government expenditure. This means that such a reform will improve the government balance in the longer term at the cost of a deterioration in the short and medium terms. In other words, the reform consists, inter alia , in making explicit liabilities that were previously implicit. Table 1.2 shows the estimated cost of pension reforms in a number of Member States.

Transitory period until spring 2007

The Eurostat decision on the sectoral classification of pension schemes was a framework decision which required bilateral discussions with Member States before implementation. In the context of those discussions, Eurostat acknowledged that “ some Member States might need a transitional period to implement the decision and to avoid disruptions in the conduct of their budgetary policies. ”[21] This transitional period will expire with the first fiscal notification of 2007, which is due before 1 April 2007.

Three EU Member States (Denmark, Poland and Sweden) currently avail themselves of this transitory period. Therefore, for these Member States, social contributions and other revenue collected (and expenditure incurred) by funded DC schemes have been recorded as government revenue (and expenditure), which result in deficit and debts somewhat smaller, or larger surpluses, than otherwise. At the expiry of the transition period, the deficit and debts series of these Member States will have to be retropolated; in practice, deficits and debts will be revised upwards, and surpluses revised downwards.[22]

SGP provisions on pension reforms

The Stability and Growth Pact (SGP) as reformed in 2005 establishes that the assessment of budgetary developments and prospects should take into account the implementation of structural reforms. Notably, in the preventive arm of the SGP, structural reforms should be taken into account when defining and revising the Member States’ medium-term objective (MTO), as well as when describing the path towards the MTO providing that they have direct long-term cost-saving effects, including by raising potential growth, and therefore a verifiable impact on the long-term sustainability of public finances.

Among structural reforms, the Pact gives a specific relevance to systemic pension reforms, consisting in the introduction of mandatory fully-funded pension schemes. Such reforms should be taken into account in all steps of the EDP. Notably, if the government deficit has declined substantially and continuously and has reached a level that comes close to the reference value, the cost of such reforms can be considered for the decisions on the existence and abrogation of an excessive deficit. Specifically, consideration shall be given to the cost of the reform on a degressive scale for a period of five years: i.e. 100 percent of the reform cost in the first year, 80 percent in the second year and so on until 20 percent in fifth year after the reform has induced budgetary costs.[23]

1.2.4. Exchange rate stability

The Treaty refers to the exchange rate criterion in the third indent of Article 121 as “the observance of the normal fluctuation margins provided for by the exchange-rate mechanism of the European Monetary System, for at least two years, without devaluing against the currency of any other Member State”.

Article 3 of the Protocol on the convergence criteria stipulates: “The criterion on participation in the exchange rate mechanism of the European Monetary System (…) shall mean that a Member State has respected the normal fluctuation margins provided for by the exchange-rate mechanism of the European Monetary System without severe tensions for at least the last two years before the examination. In particular, the Member State shall not have devalued its currency’s bilateral central rate against any other Member State’s currency on its own initiative for the same period”. Based on the Council Resolution on the establishment of the ERM II[24], the European Monetary System has been replaced by the exchange-rate mechanism II upon the introduction of the euro, and the euro has become the centre of the mechanism.

As in previous reports, the assessment of this criterion verifies the participation in ERM II and examines exchange rate behaviour within the mechanism. The relevant period for assessing exchange rate stability in this Working Paper is November 2004 to October 2006.

1.2.5. Long-term interest rates

The fourth indent of Article 121(1) of the Treaty requires “the durability of convergence achieved by the Member State and of its participation in the exchange rate mechanism of the European Monetary System being reflected in the long-term interest rate levels”. Article 4 of the Protocol on the convergence criteria further stipulates that “the criterion on the convergence of interest rates (…) shall mean that, observed over a period of one year before the examination, a Member State has had an average nominal long-term interest rate that does not exceed by more than 2 percentage points that of, at most, the three best-performing Member States in terms of price stability. Interest rates shall be measured on the basis of long-term government bonds or comparable securities, taking into account differences in national definitions”.

For the assessment of the criterion on the convergence of interest rates, yields on benchmark 10-year bonds have been taken, using an average rate over the latest 12 months. For Estonia, which does not have a harmonised benchmark long-term government bond or a comparable security, an average interest rate for EEK-denominated new loans to households and non-financial corporations with maturities over five years is used as an indicator on which to base a qualitative assessment of the fulfilment of the long-term interest rate criterion (Box 1.6). The reference value is calculated as the simple average of the average long-term interest rates of the three best-performing Member States in terms of price stability plus 2 percentage points. In October 2006, the reference value, derived from the average interest rate in Poland (5.2 percent), Finland (3.7 percent) and Sweden (3.7 percent), was 6.2 percent.

1.2.6. Additional factors

The Treaty in Article 121 also requires an examination of other factors relevant to economic integration and convergence. These additional factors include financial and product market integration and the development of the balance of payments. The examination of the development of unit labour costs and other price indices, which is also prescribed by Article 121 of the Treaty, is covered in the chapter on price stability.

The additional factors are an important indicator that the integration of a Member State into the euro area would proceed without major difficulties. As regards the integration of financial markets , the focus is on compliance with the acquis communautaire in respect of the financial sector, on main characteristics, structures and trends of the financial sector and on progress in financial integration. Integration of product markets is assessed through trade, foreign direct investment and a smooth functioning of the internal market. Finally, the situation and development of the current account of the balance of payments is examined to ensure that the Member States joining the euro area are not subject to unsustainable external imbalances.

Box 1.6: Data for the interest rate convergence criterion

The fourth indent of Article 121(l) of the Treaty requires that the durability of nominal convergence and exchange rate stability in Member States should be assessed by reference to long-term interest rates. Article 4 of the Protocol on the convergence criteria adds that these “ Interest rates shall be measured on the basis of long-term government bonds or comparable securities, taking into account differences in national definitions”.

Article 5 of the Protocol requires that the Commission should provide the statistical data used for the application of the convergence criteria. However, in the context of the interest rate criterion, the ECB has developed the criteria for harmonising the series of yields on benchmark 10-year bonds on behalf of Eurostat and started collecting the data from the central banks. The selection of bonds for inclusion in this series is based on the following criteria:

- issued by central government;

- a residual maturity close to 10 years;

- adequate liquidity, which is the main selection criterion; the choice between a single benchmark or the simple average of a sample is based on this requirement;

- fixed coupon;

- yield gross of tax.

For all but eight Member States, the representative interest rates used in this report incorporate all of the above characteristics. The Czech Republic, Denmark, Latvia, Luxembourg and Poland use a benchmark bond or a basket of bonds with a residual maturity below 9.5 years, which is the lower boundary foreseen by the criteria developed by the ECB. [25] Two countries (Cyprus and Lithuania) use primary market yields due to insufficient development of the secondary market, while for the other countries, yields are calculated on the basis of secondary market rates. Twenty Member States use a single benchmark bond and four use a basket of bonds (Germany, Spain, Luxembourg and Malta).

For Luxembourg, where no government debt securities with a residual maturity of close to ten years exist, an indicator is used based on a basket of long-term bonds issued by a private credit institution with a solid credit rating.

For Estonia, no appropriate harmonised series or proxy could be identified. Instead, an indicator has been selected: the interest rate on the monthly EEK-denominated loans issued to non-financial corporations and households, with an original maturity over five years. This indicator will be replaced as soon as a more comparable instrument is available.

2. CZECH REPUBLIC

2.1. LEGAL COMPATIBILITY

Introduction

The Czech National Bank (CNB) was established on 1 January 1993, following the division of the State Bank of Czechoslovakia. Its creation was based on the Czech National Council Act No 6/1993 adopted on 17 December 1992. The Act on the CNB was amended several times in recent years, notably in 2002, 2004, 2005 and 2006. The supreme governing body of CNB is the Bank Board composed of seven Members (including the governor of the CNB), who are appointed and dismissed by the president of the Republic.

Objectives

The objectives of the CNB Act are fully compliant with those of the ESCB.

Independence

No incompatibilities with the Treaty exist in this area. The possibility for the Chamber of Deputies of approving or rejecting the annual financial report and to request modifications (Article 47(3)-(5)) could however impinge upon the central bank’s institutional (and possibly also financial) independence. In addition, the grounds for dismissal of the governor and of the other members of the decision-making bodies (Article 6(11)-(13)) should be brought more closely in line with Article 14(2) of the ESCB/ECB Statute and a right of judicial review should exist for the other members of the decision-making bodies.

Integration in the ESCB

The incompatibilities in this area are linked to the following ESCB/ECB tasks:

- the legislative power of the ECB (Articles 5(2)a and 37);

- the definition of monetary policy (Articles 2(2)a, 5(1) and 23);

- the conduct of foreign exchange operations and the definition of foreign exchange policy (Article 35a);

- the holding and managing of foreign reserves (Article 1(4); Article 35d contains an imperfection);

- the right to authorise the issue of banknotes and the volume of coins (Articles 12, 13 and 22; Article 2(2)b contains an imperfection);

- the monetary functions, operations and instruments of the ESCB (Articles 23, 25, 26, 28, 29, 32 and 33);

- the financial provisions related to the ESCB (Article 48(2)).

Prohibition of monetary financing

Under Article 1(2) of Act N° 229/2002 on the Financial Arbitrator, the CNB is required to support the latter's activities, including the payment of expenses of associated persons, as well as the salary and specified emoluments of the Arbitrator and its Deputy. This practice constitutes a form of financing of obligations pertaining to the public sector, which should be removed.

Assessment of compatibility

As regards central bank integration into the ESCB at the time of euro adoption, legislation in the Czech Republic, in particular the Czech National Bank Act, is not fully compatible with Article 109 of the Treaty and the ESCB/ECB Statute.

In addition, the correction of some residual imperfections is recommended. The Czech National Bank Act contains imperfections linked to the CNB’s integration into the ESCB, and in the field of institutional and personal independence. The Act on the Financial Arbitrator should be amended with respect to the prohibition of monetary financing.

2.2. PRICE STABILITY

2.2.1. Respect of the reference value

The 12-month average inflation rate, which is used for the convergence assessment, has been at or below the reference value since EU accession, except for the period September 2004-March 2005 when it slightly exceeded the reference value. After declining to 1.6 percent at the end of 2005, Czech 12-month average inflation started to rise and has been slowly approaching the reference value. In October 2006, the reference value was 2.8 percent, calculated as the average of the 12-month average inflation rates in the three best-performing Member States (Poland, Finland and Sweden) plus 1.5 percentage points. The corresponding inflation rate in the Czech Republic was 2.2 percent, 0.6 percentage point below the reference value.

2.2.2. Recent inflation developments

Following a period of exchange rate turbulences and volatile inflation in the second half of the 1990s, the Czech Republic has been successful in its disinflation effort. HICP inflation has been below 3½ percent since early 2002, and the average over 1999-2005 stood at 2.3 percent. Underlying inflationary pressures appear to have been contained over the last years. Wage inflation has been restrained by labour market slack, although the cyclical conditions of the economy have gradually improved during 2003-2005. Growth in import prices has been largely limited by a trend appreciation of koruna exchange rate in nominal effective terms. Czech inflation has been, nonetheless, somewhat more volatile than in the euro area due to the impact of administrative prices, the effect of EU accession and swings in food and import prices. Annual average inflation rose from -0.1 percent in 2003 to 2.6 percent in 2004 as a combined result of price effects related to EU accession and pick-up in import prices. After some easing of inflationary pressures on the back of koruna appreciation in the first half of 2005, HICP inflation slightly accelerated in the second half of 2005, notably on account of rising energy prices. Since October 2005, Czech inflation has been fluctuating close to the euro area level.

2.2.3. Underlying factors and sustainability of inflation

Macroeconomic policy mix and cyclical stance

Economic activity in the Czech Republic has picked up in recent years. Annual real GDP growth strengthened from around 3½ percent in 2003 to around 6 percent in 2005, and a growth of about 6 percent is expected also for this year. Economic growth is increasingly driven by domestic demand helped by a solid growth in disposable income. While the estimates of potential growth in the Czech Republic are subject to an unusual margin of uncertainty because of the structural changes in recent years, Commission services' calculations point to a closure of the negative output gap in 2006. Available data and indicators for 2006 suggest a modest tightening in some segments of the labour market.

Monetary policy, conducted within an inflation targeting framework,[26] has operated in an environment shaped by a number of anti-inflationary factors including moderate import prices; a favourable structure of economic growth which was driven mainly by exports and investment; and only a slow closure of the negative output gap. As a result, the Czech National Bank (CNB) has kept policy rates at a very low level, implying mostly a negative interest rate differential with euro area rates. During July-September 2006, in reaction to the re-assessment of the inflation forecast, the CNB raised its reference rate in two steps, by a total of 50 basis points to 2½ percent.

The Czech Republic showed some progress on fiscal consolidation in 2004-2005, bringing the general government deficit from around 6½ percent of GDP in 2003 to 3½ percent of GDP. Nonetheless, the budgetary stance – measured by the change in the cyclically adjusted primary balance – is expected to be mildly expansionary in 2006.

Wages and labour costs

The unemployment rate fell from some 8½ percent in 2004 to around 7½ percent expected for 2006, suggesting that the labour market conditions are gradually improving. The Czech labour market has been characterised in recent years by solid productivity gains, fostered by continued restructuring and strong FDI inflows. Nonetheless, employment increases have been rather modest. Recent evidence points to a pick-up in demand for skilled workforce in some sectors, notably in construction and industry, which is met partly by inflows of foreign workers with comparatively lower wage demands.

The wage negotiation process in the Czech Republic is rather decentralised with wage setting mostly at the enterprise level. Compensation per employee slowed down to an average of around 5 percent in 2004-2005, while ongoing productivity gains increasingly matched the rate of wage growth over recent years. This led to a deceleration in unit labour cost growth from around 6.3 percent in 2002 to around zero in 2005-2006.

Import prices

Given the high degree of openness of the Czech Republic, developments in import prices play an important role in domestic price formation. Import prices, as measured by the imports of goods deflator, decreased substantially between 2001 and 2003. This reflected notably the strong appreciation of the exchange rate in nominal effective terms between 2000 and 2002. Growth in import prices slightly rebounded from -0.3 percent in 2003 to 1.4 percent in 2004, following a period of slight koruna's depreciation. Since mid-2004, the nominal effective appreciation trend resumed and partly dampened the impact on import prices of the surge in global commodity prices (in particular oil) in 2005 and in the first half of 2006. Import prices are expected to be broadly flat in 2006 and 2007.

Administered prices and indirect taxes

Changes in administered prices and indirect taxes have been an important driver of inflation in the Czech Republic over the past years. Price regulations apply notably to public and social services, public transport, regulated energy prices and telecommunication charges. Administered prices, with

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a weight in the HICP of around 20 percent in 2006, have exerted almost permanent upward impact on inflation in recent years. By contrast, the contribution of indirect taxes to headline inflation has been somewhat uneven over time and was notably concentrated in 2004, mainly linked to tax harmonisation related to EU accession. Administered prices have started to push inflation relatively strongly in 2006, reflecting notably increases in regulated energy prices for households and telephone charges. This led to a sharp pick-up in annual growth in administered prices, exceeding 10 percent, and to a higher contribution to headline inflation of around 2 percentage points in the first half of 2006.

Medium-term prospects

HICP inflation is expected to accelerate moderately in the remainder of 2006 and during 2007, in line with buoyant consumer spending fuelled by rapid credit growth. The outlook for HICP inflation also depends in large part on planned increases in regulated prices and excise duties on tobacco in the course of 2007. A modest acceleration in wages in 2007 is expected in conjunction with a tightening of labour market conditions, though the impact on unit labour costs should be partly dampened by solid productivity growth. The impact of energy prices on annual inflation, due to a base effect, is expected to subside gradually. On this basis, the Commission services' autumn 2006 forecast projects a moderate acceleration of annual average HICP inflation from 2.5 percent in 2006 to 2.7 percent in 2007.

Risks to the inflation outlook appear broadly balanced. Moderate unit labour costs in conjunction with credible medium-term oriented monetary policy should help to contain price pressures over the medium term. Given the high degree of openness of the Czech Republic, exchange rate movements of the koruna in either direction would have a strong and rapid impact on future inflation developments. Possible further appreciation of the koruna, against the background of a solid outlook for the economy and improving trade balance, constitute the main downside risk to the inflation projection for the Czech Republic. Upside risks to inflation relate notably to uncertainties concerning the fiscal developments.

2.3. GOVERNMENT BUDGETARY POSITION

2.3.1. The excessive deficit procedure for the Czech Republic[27]

In July 2004, the Council decided that the Czech Republic was in excessive deficit, based on a deficit then estimated at 12.9 percent of GDP in 2003 (including the cost of a major one-off operation estimated at 6-7 percent of GDP)[28]. At the same time, the Council issued recommendations to correct the excessive deficit. In particular, the Czech Republic was recommended to take action in a medium-term framework in order to bring the deficit below 3 percent of GDP by 2008 in a credible and sustainable manner, in line with the Council opinion on the May 2004 convergence programme. The Council endorsed the following intermediate targets for the general government deficit: 5.3 percent of GDP in 2004, 4.7 percent in 2005, 3.8 percent in 2006 and 3.3 percent in 2007.

In its opinion on the November 2005 update of the convergence programme, the Council noted that the programme followed the deficit adjustment path set by the Council and that the budgetary stance in the programme seemed consistent with a correction of the excessive deficit by the 2008 deadline. The Council invited the Czech Republic to strengthen, in the context of a possible better budgetary outcome in 2005 as well as strong growth outcome and prospects, the structural adjustment effort in view of the small margin below the reference value targeted for 2008 and in order to speed up the attainment of the medium-term objective.

2.3.2. Developments until 2006

The widening of the government deficit after 2000 has to a large extent reflected increasing social expenditures and transition-related one-offs (connected mainly to restructuring in the enterprise and banking sectors, and government guarantees). The significant narrowing of the deficit in 2004, to 2.9 percent of GDP, was mainly attributable to stronger growth and the possibility given to government departments to carry over unspent funds; the main motivation behind this measure was to avoid wasteful spending towards the end of the year. In 2004, expenditures of about 1 percent of GDP were rolled over to the 2005 budget. In 2005, the deficit was 3.6 percent of GDP, significantly better than the target of 4.7 percent of GDP.

For 2006, the Commission services’ autumn 2006 forecast estimates a deficit of 3.5 percent of GDP, somewhat lower than the target of 3.8 percent due in part to stronger growth than anticipated by the authorities.

Developments in the cyclically-adjusted balance have been broadly similar to those in the headline balance. Although the output gap only turned positive in 2006, economic growth has been strong since 2003 and especially in 2005-2006. Economic conditions have therefore aided fiscal consolidation in recent years; however, towards the end of the period, strong growth has not been exploited to speed up the pace of adjustment.

While the government debt ratio has increased substantially compared to 2000, it remains relatively low at around 30 percent of GDP.

2.3.3. Medium-term prospects

The draft budget for 2007 was proposed in one of the final sessions of the outgoing government and is currently in the process of parliamentary approval. It includes additional social expenditure approved before the general election and some minor increases in education and R&D related expenditure introduced by the caretaker government.

The draft budget targets a government deficit of 3.8 percent of GDP. The Commission services forecast a deficit of 3.6 percent against a slightly higher growth forecast. The fiscal stance is anticipated to be expansionary in 2007 with the structural deficit widening from 3.6 percent to 4.1 percent of GDP.

The November 2005 update of the convergence programme covers the period from 2005-2008. The programme aims at reducing the deficit to below the 3 percent of GDP reference value in 2008. In particular, it projects the deficit to be cut by over 2 percentage points of GDP between 2005 (4.8 percent of GDP) and 2008 (2.7 percent).[29]

The programme sets the medium-term objective (MTO) for the budgetary position at a structural deficit (i.e. cyclically-adjusted deficit net of one-off and other temporary measures) of 'around' 1 percent of GDP, which it does not aim to achieve within the programme period.

The Commission services’ autumn 2006 forecast predicts the level of government debt to increase to about 31 percent of GDP in 2007. A comparison with the targets set in the 2005 update of the convergence programme is not appropriate as the debt series has been revised downwards since the submission of the programme.

2.4. EXCHANGE RATE STABILITY

The Czech koruna is currently not participating in ERM II. Since 1998, the Czech Republic has been operating explicit inflation targeting combined with a floating exchange rate regime. The koruna has experienced a long period of nominal appreciation starting at the end of the 1990s, interrupted only in the period between mid-2002 and spring 2004. From March 1999 to July 2002, the koruna appreciated vis-à-vis the euro by around 22 percent (29 percent in nominal effective terms), mainly reflecting substantial inflows of foreign direct investment associated with privatisation projects and capital inflows related to positive interest rate differentials. The appreciation trend came to a temporary halt in mid-2002, notably following uncertainty surrounding the public finance reform and a deteriorating current account deficit. The koruna depreciated against the euro by 10 percent between July 2002 and March 2004 and around 7 percent in nominal effective terms.

During the two years before this assessment, i.e. between November 2004 and October 2006, the koruna appreciated against the euro, as well as in nominal effective terms, by about 10 percent. A new appreciation impetus came in spring 2004, mirroring a change in financial market expectations related to higher expected policy rates as well as substantial improvements in the trade balance following a surge in merchandise exports. Despite a widening negative interest rate differential vis-à-vis the major world currencies, the trend appreciation (at a 5-6 percent annual rate in effective terms) continued between spring 2004 and summer 2006. Since mid-2006, the exchange rate vis-à-vis the euro broadly stabilised amidst generalised weakness in emerging market currencies and uncertainties about the domestic political situation after the parliamentary elections of early June.

The development of short-term interest rates differential reflects the record of low inflation and appreciation pressures on the Czech currency. The 3-month spread has been below 70 basis points since May 2002. Since April 2005, following the cuts in official interest rates, it became even negative. The negative interest differential has further widened in 2006 as the Czech National Bank has not fully followed the ECB tightening. In summer 2006, the 3-month PRIBOR moved to about 80 basis points below the EURIBOR. The main refinancing rate of the CNB was at 2.5 percent in October 2006, i.e. 75 basis points below the ECB reference rate.

2.5. LONG-TERM INTEREST RATES

Long-term interest rates in the Czech Republic used for the convergence examination reflect secondary market yields on a single benchmark government bond with a maturity below but close to 10 years.

The Czech 12-month moving average long-term interest rate relevant for the assessment of the Treaty criterion declined from late 2004 until early 2006, before increasing slightly in the subsequent months. In October 2006, the reference value, given by the average of long-term interest rates in Poland, Sweden and Finland plus 2 percentage points, stood at 6.2 percent. The 12-month moving average of the yield on ten-year Czech benchmark bond stood at 3.8 percent, 2.4 percentage points below the reference value.

Long-term interest rates in the Czech Republic had declined close to the euro area level by 2002, reflecting a successful disinflation which allowed a reduction in policy rates and a decreasing country-risk premium. The trend appreciation of the koruna, notably during 2001-2002 and 2004-2006, also played a role in driving yields down. Since 2002, long-term interest rates in the Czech Republic have been fluctuating around the euro area level, except for the period between mid-2003 and end-2004 when Czech rates temporarily increased to around 5 percent in response to a temporary halt in the koruna's appreciating trend, acceleration in inflation and subsequent increases of policy rates. The yield spread against the euro area widened temporarily to almost 100 basis points in mid-2004 but had practically disappeared by early 2005. Since then, yields on Czech government bonds have closely mirrored those of the euro area, with spreads not exceeding 35 basis points. After a period of a moderate positive differential in 2005, the spread turned slightly negative in the first half of 2006, notably as a reflection of the negative short-term interest rate differential.

2.6. ADDITIONAL FACTORS

2.6.1. Financial market integration [30]

The Czech Republic’s financial sector is substantially integrated into the broader EU sector. The main channel of integration has been a high degree of foreign ownership of financial intermediaries. Compliance with the acquis communautaire in the field of financial services was already broadly achieved on accession and good progress has been made in transposing the legislation adopted under the Financial Services Action Plan.[31]

The Czech Republic’s financial sector is smaller and less developed in comparison with EU-15. Potential for further financial deepening exists, notably in the area of bank lending where the value of outstanding credit was equivalent to only 42 percent of GDP at the end of 2005. This level of intermediation is significantly below that in other EU countries at a similar stage of economic development. Reflecting a low level of government debt, the value of outstanding debt securities was equivalent to less than 45 percent of GDP at the end of 2004, while equity market capitalisation was equivalent to 45 percent of GDP at the end of 2005.

Banks predominate among financial intermediaries, with a 75 percent share of total assets. The banking system is now almost fully privatised, with a strong presence of foreign-owned banks which accounted for 96 percent of total bank assets at the end of 2005. While this had positive effects in terms of higher profitability, better risk management and a wider range of products, services and distribution channels, the CR5 concentration ratio[32] had risen to 66 percent at the end of 2005 . Other financial intermediaries, i.e. insurance companies, investment funds, leasing companies and pension funds, are still at an early stage of development.

The expansion of domestic credit has been moderate compared to elsewhere in EU10. Bank lending to the corporate sector has gradually expanded since 2003, while lending to households has expanded – albeit from an initially low level – at an annual rate of 30 percent over broadly the same period amid a combination of low interest rates, strong economic growth, higher employment and rising disposable incomes. Household lending has been mainly secured against house purchases . The low interest-rate differential of the koruna against the euro has limited the incentive to borrow in foreign currency, with only corporations borrowing in euro to any significant extent. Accordingly, the Czech Republic is the only of the EU10 where the share of foreign currency loans was declining since 2000 before picking up slightly in 2006 .

The equity market remains small. Only 39 shares are listed on the Prague Stock Exchange (PSE), and some of the issues are listed also on other foreign exchanges. The market performed strongly in 2005, in line with the global trends. The fixed-income market is characterised by a relatively low share of central government debt (50 percent) and a significant share of financial issuance (40 percent), which are almost exclusively denominated in national currency. The remaining 10 percent of the market consist of corporate issues, which are mainly euro-denominated when maturities are above 10 years.

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The dominance of foreign-owned intermediaries poses a challenge for effective supervision of the financial sector. In order to face those challenges, the supervisory authorities have strengthened cross-border co-operation with other supervisors. On 1 April 2006, the Czech National Bank assumed responsibility for supervision of the entire Czech financial sector.

2.6.2. Product market integration

The Czech economy is highly integrated with the EU with extensive trade and FDI relations with other Member States. The Czech Republic's trade openness ratio has been growing steadily over the last years. In 2005, it was among the highest in the EU, well above the average for the small Member States in the period 2000-2005. Between 2000 and 2005, the ratio of intra-EU25 trade of goods to GDP has increased considerably while the ratio of extra-EU25 trade to GDP has remained stable.

The profound restructuring process of the past years has led to an industrial structure where medium and medium high technology sectors are predominant.[33] The share of low technology industries is the lowest among the new Member States (and is already lower than the EU15 average).

FDI has played an important role in the process of industrial restructuring. Between 2000 and 2005, the ratio of FDI inflows to GDP was clearly above the EU25 average. Inward FDI comes overwhelmingly from other EU Member States, promoting further market integration.

Price level upward convergence with the EU25 average has been progressing steadily. In 2005, the Czech level of consumer prices reached almost 60 percent of the EU25 average. However, while in 2005 manufacturing price levels stood at 76 percent of the EU25 average, in services they reached only 42 percent. Relative price levels remain particularly low (among the lowest in the EU) in sheltered services sectors such as transport and particularly recreational and cultural services and restaurants and hotels[34]. In sectors where efforts have been made regarding deregulation and enforcement of competition, convergence has been fastest as prices better reflect market conditions and costs. For example, energy prices are rapidly approaching EU25 levels (despite the price regulations in place) and communication services prices are 6 percent above the EU average.

Overall, structural reforms aimed at improving the business environment have been limited.[35] Progress has been particularly slow with respect to the procedures for licensing and closing down businesses as well as for compliance with fiscal obligations. However, steps have been taken to improve the regulatory framework and to reduce administrative costs, which should contribute to boost business dynamism.

Good efforts have recently been made to transpose the Internal Market directives into national legislation. The rate of transposition deficit dropped from 9.6 percent in 2004 to 2.5 percent in 2005. However, it continues to be among the highest in the EU.

2.6.3. Development of the balance of payments

The current account deficit in the Czech Republic has significantly narrowed in recent years, from 6.2 percent of GDP in 2003 to 2.1 percent of GDP in 2005. This improvement was chiefly on account of a surge in merchandise exports, in particular driven by foreign direct investment into manufacturing. From a sectoral perspective, the category 'machinery and transport equipment' accounted for a significant share of increased exports, notably thanks to some large new production capacities in the automotive industry. Imports remained weak, in line with a modest growth in disposable income, even though they reflected some fluctuations in the demand for fixed capital. As a result, the merchandise trade balance turned from a deficit of 2.7 percent of GDP in 2003 to a surplus of 1.4 percent of GDP in 2005, an improvement which continued in the first half of 2006. The favourable developments in the goods trade balance, supported by surpluses in the services balance (including a surplus on travel services), were partly offset by net factor income outflows due to rising repatriated profits (notably related to FDI) and salaries paid to non-residents.

The recent development of the financial account is characterised by a substantial increase in the inflow of net foreign direct investments, which picked up from 2.1 percent of GDP in 2003 to 8.2 percent of GDP in 2005. Manufacturing (particularly automotive industry) and real estate are the sectors that attracted substantial FDI. Portfolio investments flows have been somewhat volatile in recent years, influenced by the changes in the interest rate differential between the koruna and other major currencies and also by other factors, notably the issuance of Czech government bonds abroad.

Overall, the external position of the Czech Republic benefits from a number of factors: comparative advantages in some sectors (notably in manufacturing), geographical proximity to core EU markets, growing cross-border linkages of production processes and favourable developments in unit labour costs. This also suggests that financing constraints pose no major problems. While the most recent data suggest that robust export performance will continue in the years ahead, the sectoral concentration of investment (mainly in the automotive industry) may increase the vulnerability of the external position to sector-specific shocks.

3. ESTONIA

3.1. LEGAL COMPATIBILITY

Introduction

Eesti Pank was originally founded on 24 February 1919 and was restored as Estonia’s central bank in the 1990s. A monetary reform was implemented in 1992 based on the establishment of a currency board linked to the DEM, and to the euro as from 1999. The Eesti Pank Act was adopted on 18 May 1993 and last amended on 7 June 2006. The decision-making bodies of Eesti Pank are the governor of the Central Bank and the Supervisory Board. The president of the Republic appoints the governor on the proposal of the Supervisory Board. The governor is in charge of organising compliance with the operations of the ESCB.

Objectives

The incompatibilities and imperfections identified in the 2004 Convergence Report have been removed. The revised Article 2(1) of the Eesti Pank Act is now fully compatible with the EC Treaty.

Independence

No incompatibilities with the Treaty existed in this area. Moreover, a number of imperfections have been removed. An imperfection subsists with respect to the right of judicial review for the members of the decision-making bodies other than the governor, which should be specified.

Integration in the ESCB

Most incompatibilities and imperfections identified in the Convergence Report of 2004 have been removed, although a few imperfections subsist. With respect to the Eesti Pank Act, the revised version of Subsection 14(1)7, defining certain rights of the Eesti Pank, should refer to the ECB's and ESCB's role as regards the issuance of rules regulating the money market. The revised version of Subsection 14(1)8 should refer to the ECB's guidelines as regards the handling of euro banknotes and euro coins. Imperfections also subsist in Section 141, since the right to issue euro banknotes conferred by the ECB to NCBs is specific, and not permanent and general as indicated in the relevant Eesti Pank provision. In Section 31(1), the right for the Estonian Parliament to further examine the Eesti Pank's activities should be limited to non-ESCB related tasks. In Section 34, the statistical data to be collected by the Eesti Pank should not only include those stipulated in the Estonian Official Statistics Act, but also those covered by Article 5 of the ESCB/ECB Statute.

As regards the incompatibilities identified in Article 111 of the Estonian Constitution, Estonia's Parliament initiated a Constitutional review by the Supreme Court of the Eesti Pank Act on 25 January 2006. The Supreme Court indicated on 11 May 2006 that the Eesti Pank Act will be compliant with the Constitution after the introduction of the euro in Estonia, since Article 111 of the Constitution shall no longer be applicable as of the abrogation of the derogation of Estonia. While the formal ruling of the Supreme Court does not in itself remove the formal incompatibilities raised in the Commission's 2004 Convergence Report, it nevertheless provides legal clarity, in particular on the inapplicability of Article 111 after the introduction of the euro in Estonia. A formal amendment of this article of the Constitution is no longer required.

The Currency Law and the Law on the Security of the Estonian kroon still contain incompatibilities (notably related to the ECB's exclusive right to authorise the issue of banknotes and the ECB's role in the conduct of foreign exchange operations and in the definition of the foreign exchange policy). Both Acts are expected to be repealed by the Law on the Introduction of the Euro with effect from the date of the introduction of the euro in Estonia.

Assessment of compatibility

As regards central bank integration into the ESCB at the time of euro adoption, Article 111 of Estonia's Constitution is not formally compatible with the requirements of the Treaty and the ESCB Statute. However, the ruling of 11 May 2006 of the Constitutional Review Chamber of Estonia's Supreme Court removes the need for further amendment. The Currency Law and the Law on the Security of the Estonian kroon need to be repealed with effect from the date of the introduction of the euro.

The revised Eesti Pank Act still contains some imperfections related to the Eesti Pank's integration into the ESCB. An imperfection also subsists as regards the personal independence of the members of its decision-making bodies.

3.2 PRICE STABILITY

3.2.1. Respect of the reference value

The 12-month average inflation rate for Estonia, which is used for the convergence assessment, has been above the reference value since September 2004. Following a sustained fall since late-2001, Estonia's 12-month average inflation bottomed out at 1 percent in March-April 2004 and rebounded strongly until April 2005, subsequently stabilising in a narrow range around 4¼ percent. In October 2006 the reference value was 2.8 percent, calculated as the average of the 12-month average inflation rates in the three best-performing Member States (Poland, Finland and Sweden) plus 1.5 percentage points. The corresponding inflation rate in Estonia was 4.3 percent, i.e. 1.5 percentage points above the reference value.

3.2.2. Recent inflation developments

HICP inflation in Estonia[36] recorded a strong trend deceleration over the past decade, bottoming out at around 1½ percent in 2003. Inflation picked up to 3 percent in 2004, reflecting inter alia accession-related price increases (notably for fuel and food), and strengthened further to 4.1 percent in 2005 due to strong energy price increases. In the first 10 months of 2006, inflation averaged 4.3 percent year-on-year, amid a pick-up in price growth across broad segments of the HICP. The broadening of inflationary pressures has been reflecting in a significant increase of core inflation (HICP excluding energy and unprocessed food) from some 2½ percent to 4 percent between December 2005 and October 2006.

Estonia's persistently high headline inflation rates reflect an advanced cyclical position, a pick-up in wage costs and increased energy prices. The medium-term inflation profile is also affected by indirect tax increases as Estonia brings domestic rates of some excises in line with EU minima.

Among non-energy categories of the HICP, prices of industrial goods showed a mildly deflationary trend until mid-2005, reflecting an environment of increasing retail competition as well as cheaper imports in a globalising economy, but they picked up

gradually since the second half of 2005 in the context of buoyant demand conditions. Services inflation has also picked up in 2006, with prices for housing-related services increasing particularly strongly on the back of a booming real estate sector. At the other end of the spectrum, prices for telecommunications services have continued to fall amid a strongly competitive environment.

Following upward pressure due to accession-related effects in 2004 (including price arbitrage that allowed food price convergence as well as a one-off impact due to a change in the sugar regime), food prices resumed a more moderate path in 2005. However, year-on-year food price inflation picked up in early 2006 and increased further during the summer. This pattern, which was observed in a number of other Member States as well, reflects a relatively weak harvest but also the impact of higher energy prices on food production costs.

3.2.3. Underlying factors and sustainability of inflation

Macroeconomic policy-mix and cyclical stance

Economic activity in Estonia remains buoyant. Real GDP growth strengthened from 7 percent in 2003 to some 10½ percent in 2005, and a further pick-up to around 11 percent is expected for this year. While the estimation of potential growth and output gaps is surrounded by large uncertainties for fast-changing economies such as Estonia, Commission services' estimates suggest that the economy is currently operating above potential. Signs of overheating have strengthened, particularly against the background of a rapidly tightening labour market.

Domestic demand has been underpinned by vigorous credit growth, against the background of low interest rates and increased competition in the banking sector. In order to contain risks related to credit growth, the central bank has tightened capital adequacy rules and reserve requirements. Higher short-term interest rates could also contribute to an easing of credit dynamics. Financial stability indicators suggest that the financial system is robust and resilient, but continued vigilance by banks and supervisors will be required.

Estonia's fiscal position remains strong, with budgetary positions firmly in surplus and public debt close to zero. Estonia's cyclically-adjusted primary balance improved strongly in 2003 and strengthened further in 2004, while it recorded a moderate weakening in 2005. The Commission autumn forecast projects the cyclically-adjusted primary surplus to decline slightly further this year and more significantly in 2007, which would imply a pro-cyclical fiscal stance at a time of very strong growth.

Wages and labour costs

Estonia's unemployment rate fell significantly during 2005 and is expected to reach a record low of 5½ percent in 2006, suggesting that slack on the labour market is rapidly diminishing. Skills mismatches compound the problem, as labour shortages are apparent in some skilled sectors (e.g. craftsmen). Sectoral bottlenecks also appear to have emerged in particular in construction, as buoyant housing demand – fuelled by a continuing strong rise in mortgage credit – has met with supply constraints.

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Nominal wages in the Estonian economy, measured as compensation per employee in the national accounts, have increased at double-digit rates since 2003. Wage growth is expected to accelerate from 11¼ percent in 2005 to some 12¾ percent in 2006. Productivity growth has also been buoyant over the last years, accelerating from around 5½ percent to 8¼ percent between 2003 and 2005. This has led to a deceleration of unit labour cost growth, which reached some 2½ percent in 2005, close to the rate of the early 2000s. Productivity growth is expected to show a slight dip in 2006 in view of a strong increase in employment, leading to a relatively sharp pick-up in nominal unit labour cost growth to around 5 percent.[37]

Import prices

Import prices, as measured by the imports of goods deflator in the national accounts, recorded minor decreases in 2002-2003, but picked up subsequently, rising by some 4 percent in 2005. Import price inflation is expected to remain at elevated levels this year and next, on the back of high commodity prices. The nominal effective exchange rate of the kroon has recorded only minimal fluctuations since 2004, thus exerting no appreciable effect on import price dynamics.

Energy prices have been a major component of imported inflation in the recent past. Year-on-year fuel price inflation amounted to almost 20 percent in 2005 and around 17 percent on average in the first 8 months of 2006, though followed by an average 12 percent year-on-year drop in September-October. Given a comparatively low weight of ad quantum (i.e. price-neutral) excises in total fuel prices, volatility of "pump prices" in response to global oil market developments tends to be high. The impact of high fuel price inflation on total HICP inflation has been compounded by the relatively large weight of fuels in the HICP basket (6 percent in 2006, compared to around 4 percent in the euro area).

Administered prices and taxes

Adjustments in indirect taxes have had a noticeable upward impact on HICP inflation in Estonia in the period since EU accession, and further increases are in the pipeline. Increases in excise rates for fuel, alcohol and tobacco are estimated to have driven up HICP inflation by more than ½ percentage point in both 2004 and 2005. Further increases in excises on alcohol and tobacco were postponed to January 2008, when the next step in fuel excise increases is also planned, with a possible cumulative impact of around ¾ percentage point. An increase of VAT rate on district heating is scheduled for July 2007, with a possible impact of around ½ percentage point on HICP inflation until June 2008.

Regulated prices for energy products have pushed up inflation relatively strongly in 2005-2006. Electricity prices were increased by 13 percent in March 2005, but have remained broadly unchanged since then. Following an average year-on-year price increase of some 5¾ percent in 2005, natural gas prices for direct household consumption increased by some 15 percent year-on-year on average in the first 9 months of 2006, with a further massive jump to 50 percent year-on-year in October. While the price for gas is expected to rise further over the coming years under new supply contracts with Gazprom, the trajectory of price increases is subject to uncertainties. Regulated prices for heat energy have also picked up strongly in view of significant increases in input costs (shale oil and natural gas). Average year-on-year inflation of heating prices increased steadily from around 2 percent on average in 2005 to some 13 percent in October 2006. While there are uncertainties on the medium-term profile for heating prices, which depend on global energy price fluctuations as well as longer-term supply-side factors, heating is expected to exert upward pressure on headline inflation for some time to come.

Medium-term prospects

Inflation performance in the remainder of 2006 will reflect upward pressures stemming from labour cost developments and higher energy prices, which will partly be reflected in consumer prices only with a lag. The Commission 2006 autumn forecast projects a slight decline of inflation in 2007 towards an average level of 4.2 percent amid strong, though gradually decelerating, growth. Wage inflation is expected to ease slightly, leading to moderately lower growth of unit labour costs. Estonia's flexible labour market and the absence of wage indexation should support a return to wage growth rates closer to productivity growth, provided that medium-term inflation expectations do not pick up. Estonia's inflation profile is also strongly affected by changes in indirect taxes, notably an increase in VAT on heating scheduled for mid-2007 and planned excise increases for alcohol, tobacco and fuel in 2008.

Risks to the inflation outlook appear broadly balanced. Given Estonia’s high sensitivity to oil prices, global price movements in either direction would have a strong and rapid impact on future inflation developments. More favourable oil price developments constitute the main downside risk to the inflation projection for Estonia. While the outlook thus strongly depends on energy price developments, further inflationary pressures in the context of high growth and a tight labour market cannot be excluded, particularly if high inflation expectations become entrenched; conversely, a stronger-than-expected cooling of domestic demand could contribute to an easing of underlying inflationary pressures. Disinflation is also contingent on fiscal policy remaining vigilant with a view to controlling demand pressures; in particular, a pro-cyclical fiscal stance should be avoided.

3.3 GOVERNMENT BUDGETARY POSITION

3.3.1. Developments until 2006

Over the 2000-2005 period Estonia recorded an average public finance surplus of 1.1 percent of GDP, following several alignments of government accounts to the ESA95 methodology. After slight deficits of less than half a percent of GDP in 2000 and 2001, in the aftermath of the 1998 Russia crisis, public finances remained in sound surplus and regularly outperformed the balanced budget targets. The surplus reached 2.3 percent of GDP in both 2004 and 2005.

Looking at the track record of the public finance projections over recent years, actual budget balances turned out considerably better than initially projected, in particular because revenue growth has been regularly underestimated due to a combination of very high growth rates, increasing efficiency of tax collection and nominal expenditure restraint, despite customary supplementary budgets towards the end of the year. A similar outcome can be expected for 2006. According to the Commission services' autumn 2006 forecast the general government surplus in 2006 would be 2.5 percent of GDP (taking into account the September 2006 supplementary budget). The original official target for 2006 (set in the December 2005 update of the convergence programme) was a surplus of 0.1 percent of GDP. In August 2006, the official government forecast underlying the draft 2007 budget revised the 2006 target to a surplus of 3.4 percent of GDP. The September 2006 supplementary budget, which primarily set aside part of the excess revenues into pension reserves, foresees a reduction of this latter target to a surplus of just 1.7 percent of GDP. None