Report from the Commission convergence Report december 2006 (prepared in accordance with Article 122(2) of the Treaty) {SEC(2006) 1570}
Date: 2006-12-05
Institutions: European Commission
Subjects: EU Member State, Economic and Monetary Union, European integration, accession to the European Union, convergence criteria, economic convergence, non-participating country (euro area)

COMMISSION OF THE EUROPEAN COMMUNITIES 

Brussels, 5.12.2006 
COM(2006) 762 final 

REPORT FROM THE COMMISSION 

CONVERGENCE REPORT DECEMBER 2006  

(prepared in accordance with Article 122(2) of the Treaty) 

{SEC(2006) 1570} 

EN 

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1. 

PURPOSE OF THE REPORT 

Article 122(2) of the Treaty requires the Commission  and the ECB to report to the 
Council,  at  least  once  every  two  years,  or  at  the  request  of  a  Member  State  with  a 
derogation,  on  the  progress  made  in  the  fulfilment  by  the  Member  States  of  their 
obligations regarding the achievement of economic and monetary union.  

The  latest  Commission  and  ECB  regular  convergence  reports,  adopted  in  October 
2004, covered the ten Member States that joined the EU in May 2004 and Sweden1. 
At  the  request  of  the  respective  national  authorities,  Lithuania  and  Slovenia  were 
assessed in convergence reports issued in May 20062. The present report covers the 
other  nine  Member  States  with  a  derogation:  the  Czech  Republic,  Estonia,  Cyprus, 
Latvia, Hungary, Malta, Poland, Slovakia and Sweden3. A more detailed assessment 
of the state of convergence in these countries is provided in a technical annex to this 
report (SEC(2006) 1570).  

The content of the reports prepared by the Commission and the ECB is governed by 
Article  121(1)  of  the  Treaty.  This  Article  requires  that  the  reports  include  an 
examination of the compatibility of national legislation with Articles 108 and 109 of 
the  Treaty  and  the  Statute  of  the  ESCB  and  of  the  ECB.  The  reports  also  have  to 
examine the achievement of a high degree of sustainable convergence in the Member 
State  concerned  by  reference  to  the  fulfilment  of  the  convergence  criteria  (price 
stability,  government  budgetary  position,  exchange  rate  stability,  long-term  interest 
rates), and take account of several other factors mentioned in the final sub-paragraph 
of Article 121(1). The four convergence criteria are further developed in a Protocol 
annexed to the Treaty (Protocol No 21 on the convergence criteria). 

The  examination  of  the  compatibility  of  national  legislation,  including  the  statutes 
of the national central banks, with Articles 108 and 109 of the Treaty and the Statute 
of  the  ESCB/ECB  requires  an  assessment  of  compliance  with  the  prohibition  of 
monetary  financing  (Article  101  EC);  the  prohibition  of  privileged  access  (Article 
102  EC);  consistency  with  the  ESCB's  objectives  (Article  105.1  EC);  central  bank 
independence  (Article  108  EC);  and  integration  of  national  central  banks  into  the 
ESCB (several EC Treaty and ESCB Statute articles). 

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”. 

1 

2 

3 

European  Commission,  Convergence  Report  2004  -  COM(2004)  690,  20.10.2004  -  and  European 
Central Bank, Convergence Report 2004, October 2004. 
European  Commission,  Convergence  Report  2006  on  Lithuania  -  COM(2006)  223,  16.5.2006; 
European  Commission,  Convergence  Report  2006  on  Slovenia  -  COM(2006)  224,  16.5.2006;  and 
European Central Bank, Convergence Report May 2006, May 2006. 
Denmark  and  the  United  Kingdom  negotiated  opt-out  arrangements  before  the  adoption  of  the 
Maastricht Treaty 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 for euro adoption.  

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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”. The 
requirement  of  sustainability  implies  that  a  satisfactory  inflation  performance  must 
essentially  be  achieved  by  the  adequate  behaviour  of  input  costs  and  other  factors 
influencing  price  developments  in  a  structural  manner,  rather  than  reflect  the 
influence of temporary factors. Therefore, the convergence examination includes an 
assessment of the underlying factors of inflation and of medium-term prospects. It is 
also assessed whether the country is likely to meet the reference value in the months 
ahead.  

The inflation reference value was calculated to be 2.8 percent in October 20064, with 
Poland, Finland and Sweden the three best-performing Member States. 

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”. 

The  relevant  two-year  period  for  assessing  exchange  rate  stability  in  this  report  is 
November 2004 to October 2006. 

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  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 

4 

The cut-off date for the data used in this report is 17 November 2006.  

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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”. 

The interest rate reference value was calculated to be 6.2 percent in October 2006. 

Article 121  of  the  Treaty  also  requires  an  examination  of  other  factors  relevant  to 
economic integration and convergence. These additional factors include financial and 
product  market integration, the development of the balance of payments on current 
account and the development of unit labour costs and other price indices. The latter 
are covered within the assessment of price stability. 

2. 

ASSESSMENT BY MEMBER STATE 

2.1. 

The Czech Republic 

In  the  2004  Convergence  Report,  the  Commission  assessment  was  that  the  Czech 
Republic  fulfilled  two  of  the  convergence  criteria  (on  price  stability  and  long-term 
interest rates). The assessment on legal convergence concluded that legislation in the 
Czech  Republic  was  not  fully  compatible  with  Article  109  of  the  Treaty  and  the 
ESCB/ECB Statute. 

The  Act  on  the  Czech  National  Bank  (CNB)  has  been  amended  several  times  in 
recent years, notably in 2005 and 2006. However, the incompatibilities highlighted in 
the 2004 Convergence Report have not been addressed.  

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. 

5

6

3

4

2.3 

Chart 1a.  Czech Republic: Inflation criterion since May 2004
 (percent, 12-month moving average)

Annual  HICP  inflation  in  the 
Czech  Republic  has  been  below 
3½  percent  since  early  2002,  and 
the average over 1999-2005 stood 
at 
percent.  Underlying 
inflationary  pressures  appear  to 
have  been  contained  over  the  last 
years.  Wage  inflation  has  been 
restrained by labour market slack, 
although 
conditions 
cyclical 
gradually  improved  during  2003-
2005. Growth in import prices has 
been  largely  limited  by  a  trend 
appreciation of the koruna exchange rate in nominal effective terms. Czech inflation 
has nonetheless been somewhat volatile due to the impact of administred prices, the 
effect  of  EU  accession  and  swings  in  food  and  import  prices.  A  modest  pick-up  in 

2006
Sources:  Eurostat, Commission services' autumn 2006 forecast

Reference value

Czech Republic

2005

2004

2007

0

2

1

EN 

4 

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inflation is expected for 2007-2008, on the back of improved cyclical conditions and 
planned increases in excise duties and regulated prices. Inflation performance in the 
medium term will also depend on exchange rate developments, given the high degree 
of openness of the Czech Republic, and on the fiscal policy stance. 12-month average 
inflation in the Czech Republic has been at or below the reference value since April 
2005.  The  average  inflation  rate  in  the  Czech  Republic  during  the  12  months  to 
October 2006 was 2.2 percent, below the reference value of 2.8 percent, and is likely 
to remain below the reference value in the months ahead. The Czech Republic fulfils 
the criterion on price stability.  

The Czech Republic is at present subject to a Council decision on the existence of an 
excessive deficit (Council decision of 5 July 2004)5. The Council recommended the 
Czech  Republic  to  bring  the  deficit  below  3  percent  of  GDP  by  2008  in  a  credible 
and  sustainable  manner.  The  widening  of  the  government  deficit  after  2000  was 
largely  due  to  transition-related  one-offs,  notably  connected  to  restructuring  in  the 
enterprise  and  banking  sectors,  and  increasing  social  expenditures.  The  significant 
narrowing of the deficit in 2004, to 2.9% of GDP, was mainly attributable to a pick-
up in economic growth and the possibility given to government departments to carry 
over 
funds. 
unspent 
Economic  conditions  have 
aided  fiscal  consolidation 
in  recent  years;  however, 
strong growth has not been 
fully exploited to speed up 
fiscal 
the 
pace 
adjustment.  While 
the 
government  debt  ratio  has 
substantially 
increased 
compared 
it 
remains  relatively  low  at 
around  30%  of  GDP.  The 
general  government  deficit  was  3.6 percent  of  GDP  in  2005,  and  government  debt 
was  30.4  percent  of  GDP6.  The  Czech  Republic  does  not  fulfil  the  criterion  on  the 
government budgetary position. 

Chart 1b . Czech Republic: Government budget balance and debt
(in percent of GDP)

Government balance (lhs)
Cyclically adjusted balance (lhs)
Gross debt (rhs)

(*) Commission services' autumn 2006 forecast

to  2000, 

Source : Commission services

inv e rte d s c ale

of 

2006(*)

2000

2001

2002

2003

2005

2004

10

20

30

40

50

60

-8

-7

-6

-5

-4

-3

-2

-1

0

0

The  Czech  koruna  is  not  participating  in  ERM  II.  Since  1998,  the  Czech  Republic 
has been operating explicit inflation targeting combined with a floating exchange rate 
regime.  The  Czech  koruna  has  experienced  a  long  period  of  nominal  appreciation 
since the end of the 1990s, with an interruption between mid-2002 and spring 2004. 
During  the  two  years  before  this  assessment,  i.e.  between  November  2004  and 
October  2006,  the  koruna  appreciated  against  the  euro  by  about  10  percent.  The 
Czech Republic does not fulfil the exchange rate criterion. 

The  average  long-term  interest  rate  in  the  Czech  Republic  in  the  year  to  October 
2006 was 3.8 percent, below  the reference  value  of 6.2 percent. Average long-term 
interest  rates  in  the  Czech  Republic  have  been  below  the  reference  value  since 

5 
6 

Decision 2005/185/EC - OJ L 62, 9.3.2005, p. 20. 
For  2006,  the  Commission  services'  autumn  forecast  projects  a  general  government  deficit  of 
3.5 percent of GDP.  

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accession  to  the  EU.  Since  early  2005,  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.  The  Czech  Republic  fulfils  the  criterion  on  the 
convergence of long-term interest rates.  

Additional factors have also been examined, including product and financial market 
integration  and  balance  of  payments  developments.  The  Czech  economy  is  highly 
integrated  with  the  EU.  In  particular,  trade  and  FDI  relations  with  other  Member 
States are extensive and integration of the domestic financial sector into the broader 
EU  sector  has  progressed  substantially,  mainly  through  a  high  degree  of  foreign 
ownership  of  financial  intermediaries.  The  external  position  of  the  Czech  Republic 
has improved in recent years. The current account deficit has significantly narrowed, 
from around 6 percent of GDP in 2003 to close to 2 percent of GDP in 2005, chiefly 
on  account  of  a  surge  in  merchandise  exports.  On  the  financing  side,  the  financial 
account  is  in  surplus  reflecting  notably  a  substantial  increase  in  the  inflow  of  net 
foreign direct investment, which reached about 8 percent of GDP in 2005. 

In  the  light  of  this  assessment,  the  Commission  concludes  that  there  should  be  no 
change in the status of the Czech Republic as a “Member State with a derogation”. 

2.2. 

Estonia 

In  the  2004  Convergence  Report,  the  Commission  assessment  was  that  Estonia 
fulfilled  two  of  the  convergence  criteria  (on  price  stability  and  the  government 
budgetary position) and that there was no reason to conclude that Estonia would not 
fulfil the interest rate criterion. The assessment on legal convergence concluded that 
legislation in Estonia was not fully compatible with Article 109 of the Treaty and the 
ESCB/ECB Statute. 

As  regards  central  bank  integration  into  the  ESCB  at  the  time  of  euro  adoption, 
legislation  in  Estonia  (in  particular,  the  Eesti  Pank  Act,  the  Constitution  of  the 
Republic  of  Estonia  as  well  as  the  Currency  Law  and  the  Law  on  the  Security  for 
Estonian kroon) was assessed as not fully compatible with Article 109 of the Treaty 
and the ESCB/ECB Statute. 

A  draft  Act  amending  the  Eesti  Pank  Act  was  submitted  to  the  Riigikogu 
(Parliament)  in  September  2005  and  adopted  on  7  June  2006.  With  respect  to  the 
Eesti  Pank  Act,  the  incompatibilities  raised  in  the  2004  Convergence  Report  have 
been removed. 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  provides 
legal clarity, in particular on the inapplicability of Article 111 after the introduction 
of the euro in Estonia, and therefore removes the need for further amendment.  

National  legislation  in  Estonia  can  be  considered  fully  compatible  with  the 
requirements  of  the  Treaty  and  the  ESCB  Statute,  subject  to  the  repeal  of  the 
Currency Law and the Law on the Security of the Estonian Kroon with effect from 
the date of the introduction of the euro. 

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6

5

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3

2

1

strong 

inflation 
a 

Chart 2a.  Estonia: Inflation criterion since May 2004
 (percent, 12-month moving average)

HICP 
in  Estonia 
trend 
recorded 
deceleration over the past decade, 
bottoming  out  at  1.4  percent  in 
2003.  However,  inflation  picked 
up to 3 percent in 2004 and to 4.1 
percent in 2005, and has remained 
at  high  levels  since  then.  While 
this  was  initially  mainly  due  to 
external  price  shocks  (notably 
higher  global  oil  prices)  and 
adjustments 
taxes, 
underlying  inflationary  pressures 
also  appear  to  have  picked  up  more  recently,  as  buoyant  demand  growth  and  a 
rapidly tightening labour market are imposing increasing capacity constraints on the 
economy.  Inflation  is  expected  to  remain  elevated  for  some  time,  reflecting  strong 
demand  and  wage  growth,  higher  prices  for  household  energy,  and  increases  in 
indirect taxes to comply with EU requirements. Estonia's 12-month average inflation 
has been above the reference value since September 2004. The average inflation rate 
in  Estonia  during  the  12  months  to  October  2006  was  4.3 percent,  above  the 
reference value of 2.8 percent, and it is likely to remain above the reference value in 
the months ahead. Estonia does not fulfil the criterion on price stability.  

2006
Sources:  Eurostat, Commission services' autumn 2006 forecast

indirect 

Reference value

in 

Estonia

2004

2007

2005

0

1

0

-3

-2

-1

60

40

inv e rte d s c ale

Government balance (lhs)
Cyclically adjusted balance (lhs)
Gross debt (rhs)

Chart 2b . Estonia: Government budget balance and debt
(in percent of GDP)

Estonia  is  not  subject  to  a 
Council  decision  on  the 
existence  of  an  excessive 
deficit.  Between  2000  and 
2005,  Estonia  recorded  an 
average 
general 
government  surplus  of  1.1 
GDP. 
of 
percent 
targets  have 
Budgetary 
been 
regularly 
outperformed,  notably  on 
account 
buoyant 
of 
revenue  developments.  In  2005,  Estonia  recorded  a  general  government  surplus  of 
2.3 percent, the same level as one year earlier7. The cyclically-adjusted surplus has 
been declining somewhat in 2005, implying an expansive fiscal stance in a period of 
very strong growth. This general government gross debt ratio stood at 4.5 percent of 
GDP in 2005, the lowest of all the EU Member States. The authorities have used the 
period of strong growth to build up considerable government reserves. Estonia fulfils 
the criterion on the government budgetary position. 

(*) Commission services' autumn 2006 forecast

Source : Commission services

2006(*)

2002

2003

2000

2005

2001

2004

-60

-40

-20

20

3

2

0

The Estonian kroon has participated in ERM II since 28 June 2004, i.e. for more than 
two  years  at  the  time  of  adoption  of  this  report.  Before  ERM  II  entry,  Estonia  had 
successfully pursued a currency board regime anchored to the D-Mark, and later the 
euro, since 1992. Upon ERM II entry, Estonia unilaterally committed to maintain its 

7 

For  2006,  the  Commission  services'  autumn  forecast  projects  a  general  government  surplus  of 
2.5 percent of GDP. 

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currency  board  in  the  mechanism.  Additional  indicators,  such  as  developments  in 
short-term interest rates and foreign exchange reserves, do not point to pressures on 
the exchange rate. The currency board enjoys high credibility with financial markets 
and the public. During the two-year period under review, the Estonian kroon has not 
deviated  from  its  central  parity  and  has  not  experienced  severe  tensions.  Estonia 
fulfils the exchange rate criterion. 

As a result of Estonia's low level of government indebtedness, no benchmark long-
term government bond or comparable security is available to assess the durability of 
convergence as reflected in long-term interest rates. An interest rate indicator based 
on  long-term  kroon-denominated  bank  loans  to  households  and  non-financial 
businesses stood, on average, at 4.1 percent in the year to September 20068. On the 
basis of developments in the interest rate indicator and taking into account, inter alia, 
the low level of government debt, there is no reason to conclude that Estonia would 
not fulfil the criterion on the convergence of long-term interest rates.  

Additional factors have also been examined, including product and financial market 
integration and balance of payments developments. The Estonian economy is highly 
integrated  with  the  EU.  In  particular,  trade  and  FDI  relations  with  other  Member 
States are extensive and integration of the domestic financial sector into the broader 
EU  sector  has  progressed  substantially,  mainly  through  a  high  degree  of  foreign 
ownership  of  financial  intermediaries  and  the  extensive  use  of  the  euro  as  a 
borrowing  and  investment  currency.  Estonia's  current  account  deficit  has  exceeded 
10 percent of GDP since 2002. The high current account deficit largely reflects the 
rapid  catching-up  process,  where  foreign  savings  are  mobilised  via  external 
borrowing  to  increase  domestic  investment  and  productivity  growth.  However,  the 
external position implies substantial financing needs in the medium term and inflows 
need  to  be  used  productively.  The  external  shortfall  has  been  mainly  financed  by 
sizeable FDI inflows and intra-group bank lending.  

In  the  light  of  this  assessment,  the  Commission  concludes  that  there  should  be  no 
change in the status of Estonia as a “Member State with a derogation”. 

2.3. 

Cyprus 

In  the  2004  Convergence  Report,  the  Commission  assessment  was  that  Cyprus 
fulfilled  two  of  the  convergence  criteria  (on  price  stability  and  long-term  interest 
rates). The assessment on legal convergence concluded that legislation in Cyprus was 
not fully compatible with Article 109 of the Treaty and the ESCB/ECB Statute. 

No national legislation has been enacted so far resolving the legal convergence issues 
identified  in  the  2004  Convergence  Report.  However,  a  draft  Law  amending  the 
Central Bank of Cyprus Law of 2002 and 2003 was submitted to Parliament on 12 
October  2006  in  order  to  address  these  issues  and  to  ensure  full  compatibility  with 
the Treaty and the ESCB/ECB Statute. In its present form, this draft Law removes all 
incompatibilities raised in the Convergence Report of 2004.  

8 

The latest data available. 

EN 

8 

   EN 

 
                                                 
Pending  the  adoption  of  the  new  draft  Law,  legislation  in  Cyprus,  in  particular  the 
Central Bank of Cyprus Law, is not fully compatible with Article 109 of the Treaty 
and the ESCB/ECB Statute as regards central bank integration into the ESCB at the 
time of euro adoption. 

6

Chart 3a.  Cyprus: Inflation criterion since May 2004
 (percent, 12-month moving average)

Cyprus has traditionally enjoyed relatively low, although at times volatile, inflation, 
reflecting  the  sensitivity  of  its  small  and  open  economy  to  external  price  shocks. 
HICP  inflation  was  2.7  percent  on  average  in  1999-2005  but  it  reached  highs  of 
around 6 percent in the spring of 2000 and again in the winter of 2003, in the latter 
case  partly  due  to  accession-related  increases  in  VAT  rates  and  excises.  Inflation 
picked  up  in  early  2006,  but  has  moderated  in  recent  months,  to  1.7  percent  in 
October 2006. These swings largely reflect the impact of energy and food prices. As 
the  energy  price  shock  fades  away,  inflation  is  expected  to  decline  gradually. 
However, increases in VAT and excises that are related to fulfilling EU requirements 
are  expected  to  have  a  notable 
upward  effect  on  inflation  at  the 
latest when the current derogations 
expire  at  the  end  of  2007.  The 
the 
inflation  performance  over 
large 
term  will, 
medium 
extent,  depend  on  the  containment 
of  possible  wage  pressures.  12-
month  average  inflation  in  Cyprus 
has been below the reference value 
since  August  2005.  The  average 
inflation  rate  in  Cyprus  during  the 
12  months  to  October  2006  was 
2.3 percent, below the reference value of 2.8 percent, and it is likely to remain below 
the  reference  value  in  the 
months 
ahead.  Cyprus 
fulfils the criterion on price 
stability.  

Chart 3b . Cyprus: Government budget balance and debt
(in percent of GDP)

2006
Sources:  Eurostat, Commission services' autumn 2006 forecast

to  a 

Reference value

inv e rte d s c ale

Cyprus

2007

2005

2004

80

-7

5

2

0

1

4

3

-6

-5

70

60

-2

-4

-1

-3

50

of 

Cyprus is at present not the 
a  Council 
subject 
decision on the existence of 
an  excessive  deficit,  the 
decision on the existence of 
such  deficit 
in  Cyprus 
adopted  by  the  Council  on 
5  July  20049  having  been 
abrogated  by  the  Council 
decision of 11 July 200610. The general government deficit peaked at 6.3 percent of 
GDP  in  2003,  but  was  reduced  markedly  in  the  following  years,  to  2.3  percent  of 
GDP in 200511. During the six years to 2005, both total revenue and total expenditure 

2004
Government balance (lhs)
Cyclically adjusted balance (lhs)
Gross debt (rhs)

(*) Commission services' autumn 2006 forecast

Source : Commission services

2006(*)

2005

2000

2002

2003

2001

40

30

10

20

0

0

9 
10 
11 

Decision 2005/184/EC - OJ L 62, 9.3.2005, p. 19. 
Decision 2006/627/EC - OJ L 256, 20.9.2006, pp. 13-14. 
For  2006,  the  Commission  services'  autumn  forecast  projects  a  general  government  deficit  of 
1.9 percent of GDP. 

EN 

9 

   EN 

 
                                                 
ratios followed, on average, an upward trend. Total revenue increased due to a mix of 
structural and one-off measures. The former included the alignment of VAT tax rates 
with the acquis and measures to discourage tax evasion, while the one-off measures 
took  the  form  of  an  exceptional  dividend  on  past  profits  of  semi-governmental 
organisations  and  a  tax  amnesty.  Expenditure  growth  was  restricted  by  the 
imposition  of  a  ceiling  on  the  nominal  growth  rates  of  current  primary  and  capital 
expenditure, a policy which has been continued in subsequent budgets. Government 
debt  decreased  to  69.2 percent  of  GDP  in  2005.  Cyprus  fulfils  the  criterion  on  the 
government budgetary position. 

The Cyprus pound has participated in ERM II since 2 May 2005, i.e. for 19 months 
at  the  time  of  adoption  of  this  report.  Before  ERM  II  entry,  the  Central  Bank  of 
Cyprus had been operating a system to contain fluctuations against the euro within a 
relatively narrow band of ± 2¼ percent from the central rate. A wider ± 15 percent 
official  fluctuation  band  had  been  effective  since  2001,  but  the  wider  fluctuation 
margins  were  not  used  in  practice.  In  the  period  of  the  assessment  not  covered  by 
ERM II participation, the pound stayed close to the future central rate. Since ERM II 
entry,  the  pound  has  remained  close  to  the  central  rate  and  has  not  experienced 
severe tensions. Cyprus does not fulfil the exchange rate criterion. 

The  average  long-term  interest  rate  in  Cyprus  in  the  year  to  October  2006  was 
4.1 percent,  below  the  reference  value  of  6.2  percent.  Average  long-term  interest 
rates  in  Cyprus  have  been  below  the  reference  value  since  November  2005.  Long-
term interest rates in Cyprus have decreased substantially in the past few years. Low 
yield spreads vis-à-vis the euro area testify to the low residual country risk priced in 
by  markets.  Cyprus  fulfils  the  criterion  on  the  convergence  of  long-term  interest 
rates.  

Additional  factors  have  been  examined,  including  product  and  financial  market 
integration and balance of payments developments. The Cypriot economy is highly 
integrated with the EU. In particular, trade and FDI are increasing, and the Cypriot 
financial system is substantially inter-linked with the financial systems of the EU and 
other  countries  in  terms  of  branches  and  subsidiaries  of  foreign  banks  operating  in 
Cyprus. The Cypriot current account deficit has widened in recent years, reaching 5.7 
percent of GDP in 2005. The current account deficit reflects large disparities in net 
trade  in  goods  and  services.  Traditionally,  substantial  surpluses  on  services  trade 
have not fully offset very large deficits in goods trade and negative income balances. 
On the financing side, net FDI inflows have been substantial, albeit volatile.  

In  the  light  of  this  assessment,  the  Commission  concludes  that  there  should  be  no 
change in the status of Cyprus as a “Member State with a derogation”. 

2.4. 

Latvia 

In  the  2004  Convergence  Report,  the  Commission  assessment  was  that  Latvia 
fulfilled two of the convergence criteria (on the government budgetary position and 
long-term  interest  rates).  The  assessment  on  legal  convergence  concluded  that 
legislation in Latvia was not fully compatible with Article 109 of the Treaty and the 
ESCB/ECB Statute. 

EN 

10 

   EN 

 
The  Law  on  the  Bank  of  Latvia  has  been  amended  twice  since  the  adoption  of  the 
2004 Convergence Report (December 2005 and June 2006). However, only a limited 
number of the incompatibilities highlighted have been resolved.  

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

Annual  average  inflation  in  Latvia  has  been  mostly  above  6  percent  since  2004, 
reflecting the impact of external price shocks and adjustments in administered prices 
and indirect taxes as well as increasing capacity constraints in a context of prolonged 
very  rapid  real  GDP  growth.  Most  recently,  headline  inflation  has  moderated 
slightly,  to  5.6  percent  in  October  2006.  While  external  factors  (notably  energy 
prices)  have  had  a  substantial  upward  impact  on  recent inflation  outturns,  demand-
side factors appear to have become increasingly important in sustaining inflation at 
elevated levels, as shown by relatively high core inflation rates. Inflation is expected 
to  remain  at  elevated  levels  for  some  time,  reflecting  upward  pressures  stemming 
from  labour  cost  developments  against  the  background  of  a  tight  labour  market, 
buoyant 
activity, 
economic 
increases in excise taxes, and pro-
cyclical  fiscal  policies.  12-month 
average  inflation  in  Latvia  has 
been  above  the  reference  value 
since  EU  accession.  The  average 
inflation rate in Latvia during the 
12  months  to  October  2006  was 
6.7 percent,  above  the  reference 
value  of  2.8 percent,  and  it  is 
likely 
the 
reference  value  in  the  months 
ahead.  Latvia  does  not  fulfil  the 
criterion on price stability.  

Chart 4a.  Latvia: Inflation criterion since May 2004
 (percent, 12-month moving average)

Sources:  Eurostat, Commission services' autumn 2006 forecast

remain  above 

Reference value

to 

Latvia

2004

2005

2006

2007

8

2

3

7

5

1

4

0

6

Latvia  is  not  the  subject  of  a  Council  decision  on  the  existence  of  an  excessive 
deficit. Following the 1998 Russian currency crisis, a period of fiscal consolidation 
ended abruptly in 1999 when the deficit surged to 5.3 percent of GDP. Subsequently, 
the general government balance registered smaller deficits averaging 1.8 percent of 
GDP  over  the  period  2000-2004,  while  2005  recorded  a  marginal  surplus  of  0.1 
percent  of  GDP.  At  the  same  time,  the  tax  burden  on  the  economy  continued  to 
decline, from 32 percent of 
GDP in 1999 to 29 percent 
in  2005.  Both  revenue  and 
primary  expenditure  ratios 
to  GDP  have  declined 
steadily. 
general 
The 
government  position  was 
balanced 
and 
debt  was 
government 

Chart 4b . Latvia: Government budget balance and debt
(in percent of GDP)

Government balance (lhs)
Cyclically adjusted balance (lhs)
Gross debt (rhs)

in  2005 

inv e rte d s c ale

-2.5

-2.0

-1.5

-1.0

-3.0

-0.5

20

60

30

40

50

10

0.0

0

0.5

-10

2000

2001

2002

2003

2004

2005

2006(*)

(*) Commission services' autumn 2006 forecast

Source : Commission services

EN 

11 

   EN 

 
12.1 percent  of  GDP12.  Latvia  fulfils  the  criterion  on  the  government  budgetary 
position. 

The Latvian lats has participated in ERM II since 2 May 2005, i.e. for 19 months at 
the time of adoption of this report. Before ERM II entry, the lats was pegged to the 
SDR until end-2004 and to the euro from 1 January 2005 onwards. In the period of 
the assessment not covered by ERM II participation, the lats depreciated moderately 
against the euro and then stabilised following the re-peg. Upon ERM II entry, Latvia 
unilaterally  committed  to  maintain  the  lats  in  a  range  of  ± 1  percent  around  the 
central rate. Since ERM II entry, the lats has remained close to the central rate and 
has not experienced severe tensions. Additional indicators, such as developments in 
short-term interest rates and foreign exchange reserves, do not point to pressures on 
the exchange rate. Latvia does not fulfil the exchange rate criterion. 

The  average  long-term  interest  rate  in  Latvia  in  the  year  to  October  2006  was 
3.9 percent,  below  the  reference  value  of  6.2  percent.  Average  long-term  interest 
rates in Latvia have been below the reference value since EU accession. Since ERM 
II entry long-term interest rate spreads to the euro area have fluctuated at relatively 
moderate levels, illustrating the stability of the currency peg and the confidence that 
investors  have  in  it.  Latvia  fulfils  the  criterion  on  the  convergence  of  long-term 
interest rates.  

Additional  factors  have  been  examined,  including  product  and  financial  market 
integration  and  balance  of  payments  developments.  The  Latvian  economy  is 
becoming increasingly integrated with the EU. In particular, trade and FDI relations 
with  other  Member  States  are  extensive  and  integration  of  the  domestic  financial 
sector into the broader EU sector has progressed substantially, mainly through a high 
degree  of  foreign  ownership  of  financial  intermediaries  and  the  merger  of  the 
domestic stock exchange into the OMX Group of Nordic exchanges. Latvia's current 
account deficit has exceeded 10 percent of GDP since 2004, reaching 12.7 percent of 
GDP in 2005. The pattern of high current account deficits, principally accounted for 
by  substantial  deficits  in  goods  trade  partly  offset  by  positive  balances  in  services 
and  current  transfers,  largely  reflects  the  rapid  catch-up  path  of  the  economy, 
whereby  foreign  savings  have  been  mobilised  via  external  borrowing  to  increase 
domestic investment and productivity growth. However, the external position implies 
substantial  financing  needs  in  the  medium  term  and  inflows  need  to  be  used 
productively. The current account deficits have been mainly financed by positive net 
FDI inflows and large intra-group bank lending, as well as sizeable foreign residents' 
deposits.  

In  the  light  of  this  assessment,  the  Commission  concludes  that  there  should  be  no 
change in the status of Latvia as a “Member State with a derogation”. 

2.5. 

Hungary 

In  the  2004  Convergence  Report,  the  Commission  assessment  was  that  Hungary 
fulfilled  none  of  the  convergence  criteria.  The  assessment  on  legal  convergence 

12 

For  2006,  the  Commission  services'  autumn  forecast  projects  a  general  government  deficit  of 
1.0 percent of GDP. 

EN 

12 

   EN 

 
                                                 
concluded that legislation in Hungary was not fully compatible with Article 109 of 
the Treaty and the ESCB/ECB Statute. 

The Hungarian Parliament amended the Act of the Magyar Nemzeti Bank at the end 
of 2004. The amendments did not however remove the incompatibilities raised in the 
2004 Convergence Report. Furthermore, an incompatibility exists with respect to the 
prohibition of monetary financing.  

As  regards  central  bank  integration  into  the  ESCB  at  the  time  of  euro  adoption  as 
well as the prohibition of monetary financing, legislation in Hungary (in particular, 
the Magyar Nemzeti Bank Act, the Constitution Act and the Credit Institutions Act) 
is not fully compatible with Article 109 of the Treaty and the ESCB/ECB Statute. 

1

3

2

4

0

8

7

6

5

in 

Hungary

the  early-2000s 

Chart 5a.  Hungary: Inflation criterion since May 2004
(percent, 12-month moving average)

After  declining  from  around  10 
percent 
to 
around  4  percent  in  2003,  HICP 
inflation picked up again in 2004, 
mainly  due  to  increases  in  the 
prices  of  energy  and 
food. 
Inflation  has  however  moderated 
since the end of 2004 and stood at 
just  above  2  percent  at 
the 
beginning  of  2006,  largely  as  a 
result  of  an  abrupt  decline  in 
processed  food  prices  coupled 
with  a  decrease  in  energy  prices.  Inflation  in  Hungary  has  picked  up  again  more 
recently,  driven  by  rises  in  food  prices,  changes  in  indirect  taxes  and  administered 
prices  enacted  during  the  summer  and  the  lagged  impact  of  the  depreciation  of  the 
exchange rate in the first half of 2006. Inflation is expected to accelerate further due 
to the carry-over effects of several measures implemented  in the  course of  2006 as 
well  as  significant  increases  in  administered  prices  and  indirect  taxes  foreseen  for 
2007.  In  addition,  several  reforms  in  the  health  and  education  systems  expected 
before the end of 2007 will likely put upward pressure on prices. 12-month average 
inflation  in  Hungary  has  been  above  the  reference  value  since  EU  accession.  The 
average  inflation  rate  in  Hungary  during  the  12  months  to  October  2006  was 
3.5 percent, above the reference value of 2.8 percent, and it is likely to remain above 
the  reference  value  in  the  months  ahead.  Hungary  does  not  fulfil  the  criterion  on 
price stability.  

2006
Sources:  Eurostat, Commission services' autumn 2006 forecast

Reference value

2007

2004

2005

Chart 5b . Hungary: Government budget balance and debt
(in percent of GDP)

of 

excessive 

Hungary  is  at  present  the 
subject 
a  Council 
decision on the existence of 
an 
deficit 
(Council decision of 5 July 
2004)13. 
Council 
The 
recommended  Hungary  to 
take  action  in  a  medium-
term framework in order to 

inv e rte d s c ale

-12

-10

-8

-6

-4

-2

0

70

60

50

40

30

20

10

0

2000

2001

2002

2003
2004
Government balance (lhs)
Cyclically adjusted balance (lhs)
Gross debt (rhs)

2005

2006(*)

(*) Commission services' autumn 2006 forecast

Source : Commission services

13 

Decision 2004/918/EC - OJ L 389, 30.12.2004, p. 27. 

EN 

13 

   EN 

 
                                                 
bring  the  deficit  below  3  percent  of  GDP  by  2008  in  a  credible  and  sustainable 
manner.  In  November  2005,  the  Council  decided  that  Hungary  had  not  taken 
adequate action in response to its recommendations. On 1 September 2006, Hungary 
presented an adjusted convergence programme on the basis of which, on 9 October 
2006,  the  Council  granted  Hungary  an  additional  year  to  correct  its  deficit  (until 
2009).  Every  year  since  2001,  the  orientation  of  fiscal  policy  in  Hungary  has  been 
expansive,  fuelled  by  large  increases  in  public  expenditure  (particularly  in  public 
wages and social transfers) and tax cuts which have not been offset by corresponding 
reductions  in  expenditure.  Since  2002,  each  year  the  budget  deficit  has  been  well 
over 6 percent of GDP, reaching 7.8 percent of GDP in 2005, including the costs of 
pension  reform.  In  2006,  the  Government  announced  major  budgetary  slippages. 
After corrective measures, the authorities are now targeting a deficit of 10.1 percent 
of GDP this year14. Government debt has increased to 61.7 percent of GDP, in spite 
of  massive  privatisation  receipts.  Hungary  does  not  fulfil  the  criterion  on  the 
government budgetary position. 

The  Hungarian  forint,  which  is  unilaterally  pegged  to  the  euro  with  a  ±  15 percent 
fluctuation margin since 2001, is not participating in ERM II. For most of the period 
since  the  introduction  of  the  unilateral  peg  to  the  euro,  the  forint  has  fluctuated 
within  the  upper part of the band.  However,  from  August  2005  onwards,  the  forint 
depreciated substantially vis-à-vis the euro, to a low point in June 2006, after which 
it gradually started to strengthen again. During the two years before this assessment, 
i.e.  between  November  2004  and  October  2006,  the  forint  depreciated  against  the 
euro by about 9 percent. Hungary does not fulfil the exchange rate criterion. 

The  average  long-term  interest  rate  in  Hungary  in  the  year  to  October  2006  was 
7.1 percent,  above  the  reference  value  of  6.2  percent.  Average  long-term  interest 
rates  in  Hungary  have  been  above  the  reference  value  since  EU  accession.  Bond 
yield spreads with the euro area widened from a level of around 280 basis points in 
June 2006 to approximately 350 basis points in August 2006, and to around 375 basis 
points in October 2006. Hungary does not fulfil the criterion on the convergence of 
long-term interest rates.  

Additional factors have also been examined, including product and financial market 
integration  and  balance  of  payments  developments.  The  Hungarian  economy  is 
highly  integrated  with  the  EU.  In  particular,  trade  and  FDI  relations  with  other 
Member States are extensive and integration of the domestic financial sector into the 
broader  EU  sector  has  progressed  substantially,  mainly  through  a  high  degree  of 
foreign  ownership  of  financial  intermediaries.  The  current  account  deficit  declined 
from a peak of 8.5 percent of GDP in 2004 to 6.8 percent of GDP in 2005, as a result 
of  a  smaller  deficit  in  goods  and  services  trade.  The  substantial  current  account 
deficits  in  recent  years,  which  reflect  inter  alia  a  shortfall  in  public  savings,  have 
been  mainly  financed  by  sustained  high  net  FDI  (with  the  exception  of  2003  when 
they  dropped  considerably)  and  portfolio  inflows.  In  the  first  half  of  2006,  a 
worsening in foreign investors' assessment of Hungarian economic fundamentals led 
to a sharp fall in portfolio inflows. 

14 

The Commission services' autumn forecast projects a general government deficit at the same level. 

EN 

14 

   EN 

 
                                                 
In  the  light  of  this  assessment,  the  Commission  concludes  that  there  should  be  no 
change in the status of Hungary as a “Member State with a derogation”. 

2.6.  Malta 

In  the  2004  Convergence  Report,  the  Commission  assessment  was  that  Malta 
fulfilled one of the convergence criteria (on long-term interest rates). The assessment 
on  legal  convergence  concluded  that  legislation  in  Malta  was  not  fully  compatible 
with Article 109 of the Treaty and the ESCB/ECB Statute. 

Although the Central Bank of Malta Act was amended twice in 2005, the amending 
acts  did  not  remove  all  the  incompatibilities  highlighted  in  the  2004  Convergence 
Report. A new draft Act amending the Central Bank of Malta Act was submitted to 
Parliament  on  13  November  2006  in  order  to  address  the  remaining  issues  and  to 
ensure full  compatibility with the  Treaty and the ESCB/ECB Statute. In its present 
form,  this  draft  Act  removes  all  incompatibilities  raised  in  the  2004  Convergence 
Report. 

Pending  the  adoption  of  the  new  draft  Act,  legislation  in  Malta,  in  particular  the 
Central Bank of Malta Act, is not fully compatible with Article 109 of the Treaty and 
the ESCB/ECB Statute as regards central bank integration into the ESCB at the time 
of euro adoption. 

6

1

4

3

2

0

5

Malta

inflation 

Chart 6a.  Malta: Inflation criterion since May 2004
 (percent, 12-month moving average)

in  Malta  has 
HICP 
fluctuated around a level of some 
2.5 percent over recent years, with 
some  volatility,  primarily  due  to 
the  fact  that  Malta  is  an  open 
economy  vulnerable  to  external 
shocks  (particularly  in  food  and 
energy  prices),  and  to  changes  in 
indirect taxes. Inflation picked up 
considerably 
in  autumn  2005, 
mainly  reflecting  a  sharp  rise  in 
regulated  prices  for  energy  and 
related  products.  It  has  shown  considerable  volatility  during  2006,  with  a  strong 
decline in October, mainly on the back of favourable oil price developments. HICP 
inflation excluding energy has remained contained at an average of below 2 percent 
in  2006.  Moderate  core  inflation  dynamics  suggest  that  underlying  inflationary 
pressures  have  remained  limited,  against  the  background  of  a  negative  output  gap 
and  low  wage  pressures.  Inflation  is  expected  to  remain  on  a  moderate  path  in  the 
medium  term  as  the  energy  price  shock  ebbs  away.  The  emergence  of  indirect  or 
second-round  effects  from  energy  price  increases  remains  a  risk,  though  there  has 
been  no  indication  of  significant  spillovers  so  far.  12-month  average  inflation  in 
Malta has been above the reference value since May 2006. The average inflation rate 
in Malta during the 12 months to October 2006 was 3.1 percent, above the reference 
value of 2.8 percent, and it is likely to return to a position close to the reference value 
in the months ahead. Malta does not fulfil the criterion on price stability.  

Sources:  Eurostat, Commission services' autumn 2006 forecast

Reference value

2004

2006

2005

2007

EN 

15 

   EN 

 
-12

in 

inv e rte d s c ale

Chart 6b . Malta: Government budget balance and debt
(in percent of GDP)

Malta is at present the subject of a Council decision on the existence of an excessive 
deficit (Council decision of 5 July 2004)15. The Council recommended Malta to take 
action in a medium-term framework in order to bring the deficit below 3 percent of 
GDP  by  2006  in  a  credible  and  sustainable  manner.  Malta's  general  government 
deficit  has  fluctuated  at  relatively  high  levels  over  the  past  years  (including  due  to 
one-off  operations),  reaching  a  high  of  around  10  percent  of  GDP  in  2003  and 
the 
decreasing 
in 
the 
following  years 
the 
of 
context 
government's 
fiscal 
consolidation  programme. 
The 
ratio  has 
followed an upward trend, 
whilst 
expenditure 
increased  until  2003  but 
thereafter. 
decreased 
General  government  debt 
increased  significantly  in 
the 
the 
first  half  of 
decade, peaking at around  75  percent in 2004. The general government deficit was 
3.2 percent of GDP in 2005 and government debt decreased slightly to 74.2 percent 
of GDP16. Malta does not fulfil the criterion on the government budgetary position. 

2004
Government balance (lhs)
Cyclically adjusted balance (lhs)
Gross debt (rhs)

(*) Commission services' autumn 2006 forecast

Source : Commission services

revenue 

2006(*)

2003

2005

2000

2002

2001

-10

60

10

80

30

70

20

40

50

-2

-8

-4

-6

0

0

The Maltese lira has participated in ERM II since 2 May 2005, i.e. for 19 months at 
the time of adoption of this report. Before entering ERM II, the lira was pegged to a 
euro-dollar-sterling  basket.  In  the  period  of  the  assessment  not  covered  by  ERM  II 
participation, the lira stayed close to the future central rate. Upon ERM II entry, the 
Maltese  authorities  unilaterally  committed  to  maintain  the  lira  at  the  central  rate. 
During  ERM  II  participation,  the  lira  has  remained  stable  vis-à-vis  the  central  rate 
and has not experienced severe tensions. Additional indicators, such as developments 
in short-term interest rates and foreign exchange reserves, do not point to pressures 
on the exchange rate. Malta does not fulfil the exchange rate criterion. 

The  average  long-term  interest  rate  in  Malta  in  the  year  to  October  2006  was 
4.3 percent,  below  the  reference  value  of  6.2  percent.  Average  long-term  interest 
rates in  Malta have been below the reference  value  since  EU  accession.  Long-term 
yield  spreads  vis-à-vis  the  euro  area  have  fluctuated  at  relatively  moderate  levels 
over the past years, hovering around 50 basis points in autumn 2006. Contained yield 
spreads testify to limited residual country risk priced in by markets. Malta fulfils the 
criterion on the convergence of long-term interest rates.  

Additional factors have also been examined, including product and financial market 
integration and balance of payments developments. The Maltese economy is highly 
integrated  with  the  EU.  In  particular,  trade  and  FDI  relations  with  other  Member 
States  are  extensive  and  Malta’s  financial  system  is  substantially  inter-linked  with 
the  financial  systems  of  other  countries,  both  in  and  outside  the  EU,  via  the 

15 
16 

Decision 2005/186/EC - OJ L 62, 9.3.2005, p. 21. 
For  2006,  the  Commission  services'  autumn  forecast  projects  a  general  government  deficit  of 
2.9 percent of GDP. 

EN 

16 

   EN 

 
                                                 
establishment of financial intermediaries and the provision of cross-border services. 
Malta's current account balance has been rather volatile over the past years, reflecting 
the small size and narrow sectoral base of the economy. The external position shows 
large disparities in net trade in goods and services, with a high deficit in goods trade 
being partly compensated for by a substantial services surplus. The current account 
deficit has increased significantly in recent years, reaching a level of 10.6 percent of 
GDP  in  2005.  This  increase  reflected  difficult  market  conditions  in  the  dominant 
electronics and tourism sectors and, in 2005, a strong increase in the oil bill. On the 
financing  side,  net  FDI  inflows  have  been  substantial,  albeit  volatile.  The  external 
position implies substantial financing needs in the medium term. 

In  the  light  of  this  assessment,  the  Commission  concludes  that  there  should  be  no 
change in the status of Malta as a “Member State with a derogation”. 

2.7. 

Poland 

In  the  2004  Convergence  Report,  the  Commission  assessment  was  that  Poland 
fulfilled  none  of  the  convergence  criteria.  The  assessment  on  legal  convergence 
concluded that legislation in Poland was not fully compatible with Article 109 of the 
Treaty and the ESCB/ECB Statute. 

Amendments  were  made  to  the  Act  on  the  National  Bank  of  Poland  in  2004  and 
2006,  although  none  of  them  address  the  incompatibilities  highlighted  in  the  2004 
Convergence  Report.  Furthermore,  incompatibilities  exist  with  respect  to  the 
prohibition of monetary financing.  

As regards central bank integration into the ESCB at the time of euro adoption and 
the prohibition of monetary financing, legislation in Poland (in particular, the Act on 
the  National  Bank  of  Poland,  the  Constitution  of  Poland  and  the  Law  on  the  Bank 
Guarantee  Fund)  is  not  fully  compatible  with  Article  109  of  the  Treaty  and  the 
ESCB/ECB Statute. 

5

3

6

4

2

Poland

in 

low 

Reference value

inflation 

to  a  very 

Chart 7a.  Poland: Inflation criterion since May 2004
 (percent, 12-month moving average)

and  volatile 
Following  high 
inflation 
the  1990s,  HICP 
inflation  in  Poland  has  decreased 
sharply 
level, 
averaging  2.1  percent  over  the 
period  2002-2005.  Underlying 
inflationary  pressures  have  been 
contained over the last few years. 
Wage 
been 
restrained by labour market slack, 
although  cyclical  conditions  have 
gradually improved in 2005-2006. 
Growth 
import  prices  has 
decelerated substantially since 2004, notably reflecting the appreciation of the zloty's 
nominal  exchange  rate  in  effective  terms.  Nonetheless,  Polish  inflation  has  been 
somewhat volatile, notably due to the effect of EU accession and fluctuations in food 
and import prices. A slight pick-up in inflation from the current low level is expected 
on the back of improved cyclical conditions and planned increases in indirect taxes in 
the  course  of  2007-2008.  Maintaining  a  satisfactory  inflation  performance  in  the 

Sources:  Eurostat, Commission services' autumn 2006 forecast

has 

in 

2005

2006

2004

2007

1

0

EN 

17 

   EN 

 
medium  term  will  hinge  on  keeping  wage  growth  in  line  with  productivity 
developments,  as  the  expected  fall  in  unemployment  could  somewhat  add  to  wage 
pressures. 12-month average inflation in Poland has been at or below the reference 
value  since  November  2005.  The  average  inflation  rate  in  Poland  during  the  12 
months  to  October  2006  was  1.2 percent,  below  the  reference  value  of  2.8 percent, 
and  it  is  likely  to  remain  below  the  reference  value  in  the  months  ahead.  Poland 
fulfils the criterion on price stability.  

0

-3

-6

-5

-1

-4

-2

50

20

40

30

10

60

2000

2001

2002

2003

a 

credible 

inv e rte d s c ale
-7

 including pension reform cost

Chart 7b . Poland: Government budget balance and debt
(in percent of GDP)

Poland  is  at  present  the 
subject  of 
a  Council 
decision  on  the  existence 
of  an  excessive  deficit 
(Council  decision  of  5 
July  2004)17.  The  Council 
recommended  Poland  to 
bring  the  deficit  below  3 
percent  of  GDP  by  2007 
in 
and 
sustainable  manner.  On 
the 
28 November  2006, 
Council  decided  that  the 
action taken by Poland in response to its recommendations of July 2004 was proving 
to  be  inadequate.  The  general  government  balance  was  negative  during  the  period 
2000-2005,  recording  a  deficit  of  3.2 percent  of  GDP  on  average.  The  deficit 
deteriorated in 2001 and again in 2003, when the expenditure-to-GDP ratio peaked. 
The deficit narrowed during 2004-2005, notably on account of income tax reforms, a 
freezing of the indexation of social transfers, lower-than-expected public investment 
and some changes in the accrual methodology. The general government deficit was 
2.5 percent of GDP in 2005. If the mandatory funded pension scheme were excluded 
from the government sector, the general government deficit would total 4.4 percent 
of  GDP18,19.  The  general  government  debt  ratio  increased  by  around  6  percentage 
points  between  2000  and  2005.  Government  debt  was  42.0  percent  of  GDP;  the 
figure  excluding  the  mandatory  funded  pension  scheme  would  be  47.3  percent  of 
GDP. Poland does not fulfil the criterion on the government budgetary position. 

2004
Government balance (lhs)
Cyclically adjusted balance (lhs)
Gross debt (rhs)

(*) Commission services' autumn 2006 forecast

Source : Commission services

2006(*)

2005

0

The  Polish  zloty  is  not  participating  in  ERM  II.  Since  the  abandonment  of  the 
crawling peg regime in 2000, Poland has been operating an inflation targeting regime 
combined  with  a  floating  exchange  rate.  The  zloty  exchange  rate  has  fluctuated 
widely over the past few years. The currency strongly appreciated during 2000-2001, 
but then experienced a significant correction until early 2004. During the two years 
before  this  assessment,  i.e.  between  November  2004  and  October  2006,  the  zloty 

17 
18 

19 

Decision 2005/183/EC - OJ L 62, 9.3.2005, p. 18. 
Poland has availed itself of a transitional period to implement the Eurostat decision of 2 March 2004 on 
classification  of  funded  pension  schemes.  During  this  period,  which  will  expire  with  the  first  fiscal 
notification of 2007, Poland can record revenues and expenditures incurred by funded pension schemes 
within the government sector, resulting in a lower general government deficit.  
For  2006,  the  Commission  services'  autumn  forecast  projects  a  general  government  deficit  of 
2.2 percent of GDP (the figure excluding the mandatory funded pension scheme would be 4.2 percent 
of GDP). 

EN 

18 

   EN 

 
                                                 
appreciated against the euro by about 8½ percent. Poland does not fulfil the exchange 
rate criterion. 

The  average  long-term  interest  rate  in  Poland  in  the  year  to  October  2006  was 
5.2 percent,  below  the  reference  value  of  6.2  percent.  Average  long-term  interest 
rates in Poland have been at or below the reference value since August 2005. Polish 
long-term interest rates have fluctuated over the past years reflecting notably shifts in 
the  inflation  outlook  and  monetary  policy  stance  as  well  as  changes  in  market 
sentiment  that  impacted  on  country risk  premia.  The  long-term  spread  vis-à-vis  the 
euro area declined significantly as compared to the early 2000s. Spreads narrowed to 
around 100 basis points in spring 2006, but widened again to above 150 basis points 
in the summer. Poland fulfils the criterion on the convergence of long-term interest 
rates.  

Additional factors have also been examined, including product and financial market 
integration  and  balance  of  payments  developments.  The  Polish  economy  is  highly 
integrated  with  the  EU.  In  particular,  trade  and  FDI  relations  with  other  Member 
States are growing, and integration of the domestic financial sector into the broader 
EU  sector  has  progressed  substantially,  mainly  through  a  high  degree  of  foreign 
ownership  of  financial  intermediaries.  Poland's  current  account  deficit  temporarily 
widened to just above 4 percent of GDP in 2004, largely due to a surge in the income 
deficit which primarily reflected robust profits from FDI, but declined to 1.7 percent 
of GDP in 2005. FDI inflows, though at a low level compared to other new Member 
States, were largely sufficient to finance current account deficits in the past years.  

In  the  light  of  this  assessment,  the  Commission  concludes  that  there  should  be  no 
change in the status of Poland as a “Member State with a derogation”. 

2.8. 

Slovakia 

In  the  2004  Convergence  Report,  the  Commission  assessment  was  that  Slovakia 
fulfilled one of the convergence criteria (on long-term interest rates). The assessment 
on legal convergence concluded that legislation in Slovakia was not fully compatible 
with Article 109 of the Treaty and the ESCB/ECB Statute. 

The  Act  on  the  National  Bank  of  Slovakia  was  amended  in  2004  and  in  2005, 
without  however  addressing 
the  2004 
Convergence  Report.  Furthermore,  an  incompatibility  exists  with  respect  to  the 
prohibition of monetary financing.  

incompatibilities  highlighted 

the 

in 

As  regards  central  bank  integration  into  the  ESCB  at  the  time  of  euro  adoption  as 
well as the prohibition of monetary financing, legislation in Slovakia (in particular, 
the  Act  on  the  National  Bank  of  Slovakia  and  the  Law  on  the  Protection  of  Bank 
Deposits) is not fully compatible with Article 109 of the Treaty and the ESCB/ECB 
Statute. 

Chart 8a.  Slovakia: Inflation criterion since May 2004
 (percent, 12-month moving average)

In 
recent  years,  Slovakia  has 
experienced  volatile,  and  at  times 
high, HICP inflation, reflecting the 
impact  of  external  factors  and 
adjustments  in  administered  prices 

10

9

8

7

6

5

4

3

2

EN 

1
19 
0

2004

Slovakia

Reference value

   EN 

2005

2006
Sources:  Eurostat, Commission services' autumn 2006 forecast

2007

 
and  indirect  taxes.  The  koruna's  trend  exchange  rate  appreciation  in  2002-2005 
exerted  a  moderating  effect  on  inflation.  Adjusted  for  the  impact  of  administered 
price  increases,  developments  in  underlying  inflation  have  on  the  whole  been 
relatively  favourable.  More  recently,  domestic  demand  pressures  and  energy  prices 
have  contributed  to  a  pick-up  in  inflation  from  2.8  percent  on  average  in  2005  to 
about 5 percent in the summer of 2006. Inflation is expected to moderate in 2007 and 
2008, mainly in view of lower increases in administered prices, while strong demand 
and wage growth are expected to put some upward pressure on inflation. 12-month 
average inflation in Slovakia has been above the reference value since EU accession. 
The  average  inflation  rate  in  Slovakia  during  the  12  months  to  October  2006  was 
4.3 percent, above the reference value of 2.8 percent, and it is likely to remain above 
the  reference  value  in  the  months  ahead.  Slovakia  does  not  fulfil  the  criterion  on 
price stability.  

-14

inv e rte d s c ale

ratio 

Chart 8b . S lovakia: Government budget balance and debt
(in percent of GDP)

Slovakia  is  at  present  the  subject  of  a  Council  decision  on  the  existence  of  an 
excessive  deficit  (Council  decision  of  5  July  2004)20.  The  Council  recommended 
Slovakia  to  take  action  in  a  medium-term  framework  in  order  to  bring  the  deficit 
below  3  percent  of  GDP  by  2007  in  a  credible  and  sustainable  manner.  Slovakia's 
general government deficit reached levels around 7 percent of GDP at the beginning 
of  the  decade  but  has  been 
reduced  substantially  since 
2002. Both the revenue and 
expenditure 
have 
decreased,  the  latter  at  a 
General 
higher 
rate. 
government 
has 
declined  significantly  since 
2000,  when 
it  stood  at 
some  50  percent  of  GDP. 
The  general  government 
deficit  was  3.1 percent  of 
GDP 
2005,  while 
government  debt  was  34.5 
percent of GDP21. Slovakia does not fulfil the criterion on the government budgetary 
position. 

Government balance (lhs)
Cyclically adjusted balance (lhs)
Gross debt (rhs)

(*) Commission services' autumn 2006 forecast

Source : Commission services

debt 

2006(*)

in 

2003

2002

2004

2005

2000

2001

-10

-12

50

30

60

20

40

10

-4

-6

-2

-8

0

0

The Slovak koruna has participated in ERM II since 28 November 2005, i.e. for 12 
months at the time of adoption of this report. Before ERM II entry, Slovakia operated 
a  managed  floating  exchange  rate  regime.  In  the  period  of  the  assessment  not 
covered by ERM II participation, the koruna initially appreciated moderately against 
the euro and then remained close to the future central rate. Since ERM II entry, the 
koruna has remained above the central rate except for a limited period in the summer 
of  2006  when  post-election  uncertainty  about  the  euro  adoption  date  and  fiscal 
uncertainties combined with broader pressures on the central European currencies led 
to  significant  downward  pressures,  which  were  countered  by  central  bank  action. 
Since July 2006, the koruna has been on a marked appreciating path, which brought 

20 
21 

Decision 2005/182/EC - OJ L 62, 9.3.2005, pp. 16-17. 
For  2006,  the  Commission  services'  autumn  forecast  projects  a  general  government  deficit  of 
3.4 percent of GDP. 

EN 

20 

   EN 

 
                                                 
it 5.5 percent above the central parity at the end of the assessment period. Slovakia 
does not fulfil the exchange rate criterion. 

The  average  long-term  interest  rate  in  Slovakia  in  the  year  to  October  2006  was 
4.3 percent,  below  the  reference  value  of  6.2  percent.  Average  long-term  interest 
rates  in  Slovakia  have  been  below  the  reference  value  since  EU  accession.  The 
spread vis-à-vis euro area long-term benchmark bonds had been declining markedly 
since the adoption of the government's reform programme in 2002 and had become 
negative  for  several  months  in  2005,  before  turning  positive  again  in  2006  in 
response  to  a  pick-up  in  inflation  and  subsequent  hikes  in  the  key  policy  rates. 
Slovakia fulfils the criterion on the convergence of long-term interest rates.  

Additional factors have also been examined, including product and financial market 
integration  and  balance  of  payments  developments.  The  Slovak  economy  is  highly 
integrated  with  the  EU.  In  particular,  trade  and  FDI  relations  with  other  Member 
States are extensive and integration of the domestic financial sector into the broader 
EU  sector  has  progressed  substantially,  mainly  through  a  significant  degree  of 
foreign ownership of financial intermediaries. Slovakia's current account balance has 
been  highly  volatile  in  recent  years  reflecting  swings  in  export  performance  driven 
by  new  FDI-related  production  capacities,  in  particular  in  the  automotive  sector. 
Following a substantial improvement in 2003, the current account deficit widened to 
8.6 percent of GDP in 2005. The worsening of Slovakia's external position in the last 
years  has  been  driven  by  dynamic  private  consumption  and  an  increase  in  FDI-
related  imports.  Substantial  new  export-oriented  production  capacity  is  expected  to 
boost  exports  in  the  coming  years.  The  current  account  deficit  has  been  mainly 
financed by large net FDI inflows. 

In  the  light  of  this  assessment,  the  Commission  concludes  that  there  should  be  no 
change in the status of Slovakia as a “Member State with a derogation”. 

2.9. 

Sweden 

In  the  2004  Convergence  Report,  the  Commission  assessment  was  that  Sweden 
fulfilled  three  of  the  convergence  criteria  (on  price  stability,  the  government 
legal 
budgetary  position  and 
convergence  concluded  that  legislation  in  Sweden  was  not  fully  compatible  with 
Article 109 of the Treaty and the ESCB/ECB Statute. 

interest  rates).  The  assessment  on 

long-term 

The Riksbank Act was amended in 2004 and 2006, without however addressing the 
incompatibilities  highlighted 
the  2004  Convergence  Report.  Moreover, 
incompatibilities have been identified in the Law on the Exchange Rate Policy.  

in 

As  regards  central  bank  financial  independence  as  well  as  central  bank  integration 
into the ESCB at the time of euro adoption, legislation in Sweden, in particular the 
Sveriges  Riksbank  Act,  the  Instrument  of  Government  (the  country’s  Constitution) 
and the Law on the Exchange Rate Policy, is not fully compatible with Articles 108 
and 109 of the Treaty and the ESCB/ECB Statute. 

HICP  inflation  in  Sweden  has  generally  been  below  2  percent  over  the  past  few 
years, with the exception of periods in 2001 and 2003 when rises in electricity prices 
contributed  to  higher  headline  inflation.  Relatively  robust  economic  growth  has 

EN 

21 

   EN 

 
6

prospects 

conditions 

Chart 9a.  Sweden: Inflation criterion since May 2004
 (percent, 12-month moving average)

mainly been driven by high productivity gains, which have largely offset the impact 
of wage growth on unit labour costs. A gradual pass-through of the strengthening of 
the  krona  exchange  rate  between  2002  and  2004  and  the  disinflationary  impact  of 
international  competition  and  globalisation  on  the  prices  of  imported  manufactured 
goods have also contributed to low inflation. Strong demand growth and improving 
labour  market 
are 
expected  to  put  some  moderate 
inflation. 
upward  pressure  on 
medium-term 
However, 
inflationary 
remain 
favourable  in  view  of  positive 
supply  factors  and  well-anchored 
inflation  expectations.  12-month 
average  inflation  in  Sweden  has 
consistently 
the 
been 
reference  value  in  recent  years. 
The  average 
in 
Sweden  during  the  12  months  to 
October  2006  was  1.5 percent,  below  the  reference  value  of  2.8 percent,  and  it  is 
likely to remain below  the  reference value in the months ahead. Sweden  fulfils the 
criterion on price stability.  

Sources:  Eurostat, Commission services' autumn 2006 forecast

inflation 

below 

Reference value

rate 

Sweden

2004

2005

2006

2007

0

1

2

3

4

5

Sweden  is  not  the  subject  of  a  Council  decision  on  the  existence  of  an  excessive 
deficit.  Sweden  ran  a  general  government  surplus  over  the  period  2000-2005 
averaging 2.0 percent of GDP. This high average surplus reflects the Swedish rules-
based budgetary framework. In 2005, the surplus stood at 3.0 percent of GDP. If the 
mandatory  funded  pension  scheme  were  excluded  from  the  government  sector,  the 
general 
government 
surplus  would  total  2.0 
of  GDP22,23. 
percent 
Government  debt  was 
50.4  percent  of  GDP  in 
2005; the figure excluding 
funded 
the  mandatory 
pension  scheme  would  be 
to  50.9  percent  of  GDP. 
the 
Sweden 
the 
criterion 
government 
budgetary 
position.  

Chart 9b . S weden: Government budget balance and debt
(in percent of GDP)

Government balance (lhs)
Cyclically adjusted balance (lhs)
Gross debt (rhs)

(*) Commission services' autumn 2006 forecast

fulfils 
on 

Source : Commission services

including pension reform cost

inv e rte d s c ale

2006(*)

2000

2001

2002

2003

2004

2005

-120

-100

-80

-60

-40

-20

20

40

60

-3

-2

-1

0

1

2

3

4

5

6

0

The  Swedish  krona  is  not  participating  in  ERM  II.  Sweden  operates  an  inflation 
targeting  regime  combined  with  a  floating  exchange  rate.  Apart  from  a  rapid 

22 

23 

Sweden has availed itself of a transitional period to implement the Eurostat decision of 2 March 2004 
on classification of funded pension schemes. During this period, which will expire with the first fiscal 
notification  of  2007,  Sweden  can  record  revenues  and  expenditures  incurred  by  funded  pension 
schemes within the government sector, resulting in a higher general government surplus.  
For  2006,  the  Commission  services'  autumn  forecast  projects  a  general  government  surplus  of 
2.8 percent of GDP (the figure excluding the mandatory funded pension scheme would be 1.7 percent 
of GDP). 

EN 

22 

   EN 

 
                                                 
depreciation  of  the  exchange  rate  immediately  after  abandoning  a  fixed  exchange 
rate system in 1992, the krona/euro exchange rate has mostly moved in a relatively 
narrow  range  vis-à-vis  the  Deutsche  mark  and  subsequently  the  euro.  Between 
November  2004  and  October  2006,  the  krona  depreciated  against  the  euro  by  just 
below 3 percent. Sweden does not fulfil the exchange rate criterion. 

The  average  long-term  interest  rate  in  Sweden  in  the  year  to  October  2006  was 
3.7 percent,  below  the  reference  value  of  6.2  percent.  Average  long-term  interest 
rates  in  Sweden  have  consistently  been  below  the  reference  value  in  recent  years. 
The spread vis-à-vis euro area long-term interest rates declined markedly since 2003, 
from  around  50  basis  points  to  currently  minus  10  basis  points,  reflecting  among 
other things a negative policy rate differential vis-à-vis the euro area. Sweden fulfils 
the criterion on the convergence of long-term interest rates.  

Additional factors have also been examined, including product and financial market 
integration and balance  of  payments development.  The  Swedish  economy  is highly 
integrated  with  the  EU.  In  particular,  trade  relations  with  other  Member  States  are 
growing and the domestic financial sector is highly integrated with the broader EU 
sector,  mainly  through  Swedish  ownership  of  financial  intermediaries  in  the 
Nordic/Baltic  region  and  the  merger  of  the  Swedish  stock  exchange  into  the  OMX 
Group  of  Nordic  stock  exchanges.  Sweden  has  had  a  current  account  surplus  of 
around 6-7 percent of GDP for several years as a result of strong export performance. 
Net FDI outflows largely account for the financial account deficits.  

In  the  light  of  this  assessment,  the  Commission  concludes  that  there  should  be  no 
change in the status of Sweden as a “Member State with a derogation”.  

EN 

23 

   EN