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Eseje zagranicznych i polskich ekonomistów
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5 ESEJE ZAGRANICZNYCH I POLSKICH EKONOMISTÓW SPIS TREŚCI PRZEDMOWA 2 I. PETER BACKÉ: Credit Growth and Financial Deepening: Implications for Euro Adoption? 4 II. WILLEM H. BUITER, ANNE C. SIBERT: New Theories of Optimal Currency Areas and their Application to Poland s Adoption of the Euro: the Asymmetric- Shocks-on-its-Head and the Lender-of-Last-Resort Theories of Optimal Currency Area 48 III. BARRY EICHENGREEN, KATHARINA STEINER: Is Poland at Risk of a Boomand-Bust Cycle in the Run-Up to Euro Adoption? 62 IV. JEFFREY FRANKEL: Should Central European Countries join the Euro? A Review and Update of Trade Estimates and Consideration of Endogenous OCA Criteria 106 V. KAROL LUTKOWSKI: O Charakterze Korzyści i Kosztów Wejścia Polski do Strefy Euro 134 VI. RONALD MACDONALD: Some Exchange Rate Issues for the New Accession Countries: An Update, with a Special Emphasis on Poland 156 VII. RONALD MCKINNON: The Intricacies of the Theory of Optimum Currency Areas: What is Relevant for Poland? 171 VIII. LEOKADIA ORĘZIAK: Międzynarodowa Pozycja Euro 201 IX. WITOLD ORŁOWSKI: Rozkład Kosztów i Korzyści Wprowadzenia w Polsce Euro pomiędzy Grupy Społeczne 239 X. JERZY OSIATYŃSKI: Integracja z Euro Wyzwania dla Polityki Gospodarczej 271 XI. ANDREW K. ROSE: EMU, Trade and Business Cycle Synchronization: What do We know and What does it mean for Poland? 279 XII. CHRISTOPH ROSENBERG: Slovakia's Path to Euro Adoption A Blueprint for Poland? 298 XIII. SUSAN SCHADLER: Euro Adoption in Central Europe: A Case for Action and Priorities for Preparation 302 XIV. JÜRGEN STARK: The European Monetary Integration Process Challenges for the Central and Eastern European EU Member States 318 XV. ANDRZEJ WERNIK: Równowaga Finansów Publicznych a Euro 339 XVI. LESZEK ZIENKOWSKI: Euro Szanse i Zagrożenia 372
6 ESEJE ZAGRANICZNYCH I POLSKICH EKONOMISTÓW PRZEDMOWA Prace nad Raportem na temat pełnego uczestnictwa Rzeczypospolitej Polskiej w trzecim etapie Unii Gospodarczej i Walutowej prowadzone były na zasadach otwartej i przejrzystej komunikacji i konsultacji z partnerami społecznymi, organizacjami pracodawców i pracobiorców, polskimi i zagranicznymi ośrodkami akademickimi, instytucjami finansowymi, organizacjami międzynarodowymi i instytucjami administracji publicznej. Przyjęcie powyższych zasad wynikało z przekonania, że wykorzystanie wiedzy i doświadczenia różnych środowisk zapewni osiągnięcie wysokiego poziomu merytorycznego Raportu i pozwoli zbliżyć się do konsensusu w kwestii przyjęcia optymalnej ścieżki integracji Polski ze strefą euro. Intencją przyjęcia tych zasad była także chęć osiągnięcia wysokiego stopnia obiektywności Raportu. Narodowy Bank Polski zaprosił do udziału w pracach nad Raportem wybitnych polskich i zagranicznych ekonomistów zaangażowanych w międzynarodową debatę na temat integracji walutowej. Efektem współpracy NBP z ekonomistami jest niniejszy zbiór esejów, poświęconych tematyce integracji Polski ze strefą euro. Przedstawione w dokumencie analizy i płynące z nich wnioski mogą stanowić drogowskaz dla polskich organów władzy, odpowiedzialnych za właściwe przygotowanie Polski do wejścia do strefy euro. Jest to również bardzo ważny wkład do akademickiej debaty na temat korzyści i kosztów członkostwa państwa w Unii Gospodarczej i Walutowej. Narodowy Bank Polski pragnie złożyć wyrazy podziękowania wszystkim ekonomistom, którzy przyczynili się do opracowania tego niezwykle wartościowego dokumentu. 2
7 ESEJE ZAGRANICZNYCH I POLSKICH EKONOMISTÓW INFORMACJE DODATKOWE Publikacja Eseje zagranicznych i polskich ekonomistów składa się z 16 opracowań ułożonych w porządku alfabetycznym, według nazwiska autora. Dobór tematyki opracowań został przeprowadzony w drodze bezpośrednich konsultacji Dyrekcji Biura ds. Integracji ze Strefą Euro z ekonomistami. Ekonomiści zostali poproszeni o zabranie głosu w debacie na temat korzyści i kosztów członkostwa Polski w strefie euro. Niektórzy ekonomiści dokonali aktualizacji wcześniejszych badań, rozszerzając ich zakres o dodatkowe wartości odnoszące się do Polski. Eseje zostały przygotowane w okresie czerwiec - grudzień 2008 r. W dniu 15 października 2008 r. Narodowy Bank Polski zorganizował międzynarodową konferencję pt. Common Currency and its Future: Lessons for the New Member States z udziałem autorów esejów. Podczas konferencji ekonomiści przedstawili swoje opinie na temat integracji Polski i innych, nowych państw członkowskich ze strefą euro. Konferencja Common Currency and its Future: Lessons for the New Member States była jednym z najbardziej prestiżowych i najznakomiciej reprezentowanych wydarzeń tego typu, jakie miały miejsce w Polsce w ostatnich kilkunastu latach. Autorzy esejów, prezentowanych w niniejszym dokumencie, wnieśli ogromny wkład w rozwój nauk ekonomicznych, co nierzadko miało bezpośrednie odzwierciedlenie w przebiegu procesów gospodarczych na świecie. Niniejszy dokument można zatem uznać za wkład wybitnych ekonomistów w rozwój nauki i gospodarki polskiej. 3
8 I PETER BACKÉ: CREDIT GROWTH AND FINANCIAL DEEPENING: IMPLICATIONS FOR EURO ADOPTION? DR PETER BACKÉ 1 Z wykształcenia jest ekonomistą i prawnikiem. W 1982 r. ukończył Wydział Prawa na Uniwersytecie Wiedeńskim. W 1989 r. uzyskał Master of Arts in International Affairs na The Johns Hopkins University w Bolonii, we Włoszech. Od 1990 r. jest związany z austriackim bankiem centralnym. W latach pracował w Europejskim Banku Centralnym, gdzie nadzorował badania dotyczące przygotowań nowoprzyjętych krajów UE do członkostwa w strefie euro. Wynikiem tych badań jest publikacja EBC zatytułowana The Acceding Countries' Strategies Towards ERM II and the Adoption of the Euro: An Analytical Review. Od 2007 r. jest zastępcą dyrektora Departamentu Zagranicznego Narodowego Banku Austrii. Uznawany jest za jednego z najwybitniejszych znawców tematyki procesów integracji walutowej w Europie Środkowej i Wschodniej. Jest recenzentem w czasopismach Economic Systems oraz Banca Nazionale del Lavoro Quarterly Review. CREDIT GROWTH AND FINANCIAL DEEPENING: IMPLICATIONS FOR EURO ADOPTION? 1 October 2008 INTRODUCTION 1 Oesterreichische Nationalbank. Foreign Research Division. The standard disclaimer applies. The author thanks Zoltan Walko for valuable comments and excellent support on data issues. The author is also grateful to Julia Wörz for the calculation of intra-industry trade indices and to Josef Schreiner and Andreas Nader for complementary research assistance.
9 I PETER BACKÉ Rapid private-sector credit growth has been a pertinent feature of economic developments in Central and Eastern European EU Member States (CEE MS) during much of the current decade. Apart from a lively debate on how to assess these lending expansions and to explore policy implications, the issue arises how credit developments relate to the question of euro adoption by CEE MS. Developments within the present euro area have also shed light on the interaction between monetary integration and lending dynamics, as the adoption of the single currency was in some cases accompanied by credit booms, followed in Portugal by an extended period of economic underperformance (which reversed earlier income convergence gains). In this article, we revisit these issues for those CEE countries which acceded to the European Union in 2004 but have not yet joined the euro area, namely Poland, the Czech Republic, Hungary and the Baltic countries. (Developments in Slovenia and Slovakia, which were included in the euro area with effect from 2007 and 2009 respectively, are also captured for comparison and complementary reference.) The article therefore focuses on selected economic aspects of monetary integration that are part of a bigger picture consisting of a very rich set of economic and political considerations. This article is structured as follows. First, to set the stage, we revisit the structural and policy factors that are of major importance for joining a monetary union and review briefly how the CEE MS stack up with respect to these factors. We then consider how credit growth and financial deepening affect the balance of arguments about monetary integration. Subsequently, stylized facts of credit growth and financial deepening in CEE MS are presented. Looking forward, we explore how lending in CEE MS could develop in the future, in the context and as a consequence of euro adoption, and discuss policy implications. The main findings are summarized in the concluding remarks. THE GENERAL SETTING By acceding to the European Union, the CEE MS undertook to strive towards the eventual adoption of the euro upon fulfilling the convergence criteria laid down in the Treaty. Joining the euro area is therefore not a question of whether, but of 5
10 I PETER BACKÉ how and when. For more than a decade, this latter question has stirred intense and thorough discussion that has featured a wide variety of perspectives and arguments, thereby demonstrating the multitude of factors and aspects that come into play in the context of monetary integration. 2 During the past few years, as the euro area has been enlarged, this issue has been settled and resolved for Slovenia and Slovakia (as well as for Malta and Cyprus), while it remains on the agenda for the other CEE MS. Participation in a monetary union has far-reaching economic implications. A cost-benefit analysis provides guidance on whether a country would reap net gains from participation in a monetary union, i.e. whether it can be expected to perform better within a monetary union than outside. Such an analysis also captures how the cost-benefit calculus may change over time, for example through ongoing structural change or integration, but also as a result of policy action. The implications associated with the fulfillment of the criteria that need to be met to enter a monetary union in the case of EMU the achievement of a high degree of sustainable nominal convergence, as embodied in the Maastricht convergence criteria also have to be incorporated in the analysis. 3 On this basis, alternative timing options for joining a monetary union can be weighed and the design of policies on the way to monetary union can be considered. Cost-benefit analyses are largely, but not exclusively, based on considerations that derive from the theory of optimum currency areas (OCA theory). Economic costs and the risks of participation in a monetary union relate to the abandoning of an autonomous monetary and exchange rate policy, while the benefits pertain to higher trade and investment and thus higher growth and welfare gains. More specifically, the rise in investment is due to the reduction in risk premiums and thus funding costs that are expected to come with a monetary union. It may be useful to recall that the effects relating to participation in a monetary union are of diverse nature (macro and micro, one-off and permanent), their time profiles differ, and endogeneity also matters (entry into the monetary union itself will shift the cost-benefit balance going forward). Uncertainty prevails, in particular, about the dynamics effects and the conditions under which they will unfold and along what time-lines. In addition, risks (i.e. potential costs which 2 Just to recall, in Poland this topic came to the fore in the mid-1990s and already back in 1996, the Polish Finance Ministry released a first strategy paper on these matters that suggested 2006 as a possible target date for euro adoption. 3 For a discussion of this issue, see for example Backé and Mooslechner (2004). 6
11 I PETER BACKÉ may or may not materialize) have to be taken into account as well. Thus, what cost-benefit analysis can provide is a ballpark picture of the approximate strength of the main costs and benefits. Despite these limitations, a careful weighing of the costs and benefits of euro adoption is of the essence to inform the political decision-making process, the main stakeholders in society and the public about the effects and implications of monetary integration. Joining the euro area is a political decision and, as the weighing of costs and benefits is difficult, judgment and consensus building will eventually play an important role. 4 Experience also shows that joining the euro area is best grounded on broadly based social support, for the simple reason that this facilitates the regime change. Agents adapt their expectations and their behavior more easily and quickly to the new state if they understand and share the underlying reasoning for the regime shift and therefore also back policies that ensure the fulfillment of the Maastricht convergence criteria in a sustainable manner and are committed to the enactment and implementation of appropriate flanking measures to ensure a successful participation in a monetary union (on the commitment aspect, see also Trichet 2008). In other words, in the process, economic agents internalize the trade-offs and constraints that life in monetary union will entail, which is key to a successful membership of the single currency area. Domestic consensus-building would ideally be completed before a country sets out to fulfill the Maastricht criteria. In this context, the lead time implied by the need to fulfill the convergence criteria in a sustainable manner is also to be taken into consideration, while in procedural terms the lead time also results from the staged process towards euro area participation (ERM II entry preparations in case a country is not yet member of this mechanism; a minimum of two years of ERM II participation without severe tensions; followed by the convergence examination and decision; and finally a few months to complete practical and logistic preparations). Exploring the cost-benefit issue in more detail, the following aspects are worth mentioning. OCA theory suggests that the costs of giving up an autonomous monetary and exchange rate policy are a function of a country s exposure to 4 Compare also Niedermayer (2007): I am convinced that euro adoption would be advantageous for the country [the Czech Republic], in particular for entrepreneurs. Of course, there are also risks. The weighing is difficult. Much depends on personal convictions. After all, it is a political decision. 7
12 I PETER BACKÉ idiosyncratic shocks. A key indicator capturing this exposure is the degree of business cycle convergence which, in turn, relates to the similarity of economic structures as well as trade and financial integration. As for trade integration, intra-industry trade and a higher technology content of exports reduce the exposure to shocks. In addition, the costs depend on the (remaining) adjustment mechanisms to idiosyncratic shocks, in particular price and wage flexibility 5 (as well as labor mobility 6 ) and the availability and effectiveness of fiscal policy to dampen short-term economic fluctuations. (The latter is particularly true for the euro area, where fiscal policy has remained in the national domain and an areawide fiscal transfer system that would dampen cyclical fluctuations in the participating countries is not in place. 7 ) Moreover (and beyond the confines of OCA theory), the cost calculus depends on a further question, namely: If a given country chose to stay outside monetary union for an extended period of time would it indeed be in a position to use monetary policy effectively for macroeconomic stabilization and, in a related way, would its exchange rate be a shock absorber or rather a source of shocks? (OCA theory does not address this question as it assumes that a given country can use monetary policy in an adequate manner for stabilization purposes.) However, for emerging economies, it is questionable whether monetary and exchange rate policy can effectively be used as an instrument for macroeconomic stabilization and shock absorption (see Frankel 1999, Hausmann et al. 1999). Monetary policy in catching-up economies is constrained in influencing real interest rates and these constraints are tighter the lower the risk premiums are and the higher the capital mobility is. 8 This holds, in principle, across the whole spectrum of exchange rate regimes. Uncovered interest rate parity (UIP) links nominal interest rates across countries. As income convergence goes hand in hand with price level convergence, a catching-up economy will experience either 5 More specifically, real wages need to adjust flexibly to ensure external competitiveness. In a low inflation environment, this also requires downward nominal wage flexibility in order to achieve sizeable real wage reductions swiftly, if such adjustments are needed. Wage flexibility which is the key adjustment mechanism, as regards labor markets, in the monetary union, is partly determined by labor market institutions (minimum wages, replacement ratios, duration of unemployment benefits, public sector wage setting etc.). Structural labor market flexibility in the broader sense can also facilitate the functioning of the adjustment to idiosyncratic shocks within monetary union (MNB 2008). 6 Removal of barriers to labor mobility may temporarily impede the functioning of the real wage adjustment channel, as it could spur wage convergence through migration if initial wage differentials were large. Moreover, as Ahearne et al. (2008a) show, the effectiveness of the labor mobility channel depends on the kind of the shock. More specifically, this channel may not contribute to adjustment in overheating situations that are associated with housing price booms. 7 Transfer schemes exist at the EU level, in particular structural and cohesion funds. However, these funds are geared towards supporting the economic development of poorer, structurally weak and agricultural regions rather than to smoothing cyclical fluctuations. 8 This point, which is particularly pertinent to catching-up countries that are characterized by a scarcity of physical capital, coupled with a reasonably strong endowment of human capital and infrastructure, also features under the notion Tošovský Dilemma (see Lipschitz et al. 2002). 8
13 I PETER BACKÉ higher inflation than advanced countries or nominal trend appreciation or a combination of the two. If UIP holds, expected nominal trend appreciation will have a dampening effect on domestic interest rates. Thus, in theory, the exchange rate regime matters for real interest rates only in as much as it is associated with differences in exchange rate risk premiums across regimes, the latter providing countries with flexible exchange rates some additional leeway for monetary policy compared to hard pegs. If UIP is violated by too high domestic policy interest rates, this may induce currency substitution (domestic borrowing in foreign currency) and carry trades which will reduce monetary policy effectiveness. 9 It is also noteworthy that, under high capital mobility, UIP cannot be overcome by sterilization policies, as such policies are not effective for more than short periods (they can however be very costly). 10 In practice, market frictions and home bias may well restrain UIP-induced arbitrage, which opens up some room for keeping up real interest rate differentials across countries in excess of risk premiums. Two points deserve to be highlighted in this context. First, risk premiums can be volatile and disconnected from domestic fundamentals. This implies that the room for maneuver for monetary policy is in part a function of exogenous conditions which themselves are potentially highly unstable. Second, to the extent that risk premiums are a function of domestic policy credibility, more credible policies will typically reduce the room for maneuver for monetary policy to set real interest rates. Thus, the leeway for monetary policy will narrow in the run-up to monetary integration, if and when a country embarks on a credible track towards fulfilling the entry criteria for a monetary union. 11 Clearly, to what extent these caveats and constraints pertain to a particular country context is primarily an empirical question. In the discussion about the costs and benefits of monetary unions, it has been questioned whether the lowering of real interest rates due to participation in a monetary union, while being a clear benefit in the long term, may rather be a mixed blessing over the short to medium term, and specifically so for catching- 9 Moreover, in case of large unhedged foreign exchange exposure of households and SMEs, a major depreciation of the exchange rate could lead to substantial adverse balance sheet and wealth effects. In fact, these effects work both ways. In case of monetary tightening and adjacent exchange rate appreciation, positive balance sheet and wealth effects would further fuel domestic demand in the short term, thus possibly augmenting rather than dampening cyclical fluctuations. 10 See Schadler (2008) for a more detailed discussion. 11 See Backé and Wójcik (2008) for a simple formalization of this point. 9
14 I PETER BACKÉ up economies. The argument concerns the issue of macroeconomic stabilization in a monetary union and holds that, over the cycle, the area-wide monetary stance would be too loose for countries with potential growth rates that are tangibly higher than the area-wide average. Income convergence is associated with relative price level convergence (i.e. a trend appreciation of the equilibrium real exchange rate). Thus, inflation over the cycle will be higher in these countries than for the average of monetary union. Consequently, real interest rates will be lower, while the higher marginal return to capital in these countries would suggest that, in fact, they ought to be higher to achieve macroeconomic equilibrium. This, together with the pro-cyclical behavior of real interest rates at certain stages of the cycle decreasing if expected inflation rises during upturns and vice-versa (the well-known Walters critique) would expose catching-up economies in a monetary union to boom-bust cycles, render macroeconomic stabilization particularly challenging and potentially involve substantial costs in terms of long-term growth and welfare, which would not arise if a country had stayed outside monetary union (see Kröger and Redonnet 2001, Ahearne and Pisany-Ferry 2006; also Backé, Thimann et al take note of this risk). There are also several qualifications to this line of reasoning. First, in a monetary union, fiscal policy is the principal stabilization tool. Kirsanova et al. (2006) show that cyclical instability which results from idiosyncratic shocks can be mitigated by fiscal policy that reacts to inflation differences. Experience demonstrates that well-designed and binding fiscal rules are well suited to promote appropriate fiscal policy reactions to cyclical fluctuations. Thus, a priori, there is no reason why assigning stabilization to fiscal policy would be inferior to alternative policy assignments. Moreover, as discussed above, alternative policy assignments that would give monetary policy a more active stabilization role also have potential drawbacks in terms of feasibility and efficiency. Thus, monetary policy autonomy would not necessarily offer an easy solution to the stabilization problem. Second, Miller and Sutherland (1991) show that the Walters critique depends on inconsistent expectations which may generate temporary volatility but cannot lead to dynamic instability, as two potent stabilizing mechanisms remain in place. Countries with positive output gaps will record (demand-driven) rises in relative price levels. This will lower their price competitiveness, which in turn will dampen aggregate demand and thus rein in inflation. In other words, over 10
15 I PETER BACKÉ time the competitiveness channel will prevail over the real interest rate channel and bring about adjustment. Moreover, agents expectations will adjust in a learning process. In a similar vein, Kirsanova et al. (2006) show that the Walters critique only applies if inflation expectations have a backwardlooking component. With an entirely forward-looking model of inflation, a positive demand shock produces a jump in inflation. Moreover, they show that, in the absence of credit constraints and with full inter-temporal optimization, consumption becomes a forward-looking variable that jumps to the new equilibrium right away. After the initial adjustment consumption will no longer be affected by the real interest rate, i.e. in such a setting low real interest rates (due to monetary union or other factors) cannot generate consumption booms. 12 Third, monetary policy mandated with ensuring area-wide price stability also anchors exchange rate and medium-term inflation expectations in the countries participating in monetary union. Thus, joining a monetary union characterized by long-standing price stability will secure the firm anchoring of medium-term inflation expectations at low levels and reduce inflation persistence. Fourth, as already discussed above, flexible prices and wages are key to ensuring that adjustment takes place sufficiently fast and smoothly, i.e. to strengthening the operation of the competitiveness channel of adjustment in a monetary union and thus to prevailing over potentially destabilizing effects in the real interest rate channel. High productivity growth in catching-up economies will facilitate the adjustment of relative unit-labor cost levels without recourse to nominal wage cuts, which is of particular relevance in the presence of nominal downward wage rigidities. Thus, while catching-up economies may tend to overheat (and undercool) more easily in a monetary union than countries with moderate potential growth rates, high productivity growth helps correct such deviations more quickly (ceteris paribus). Finally, in the case of EMU, the sustainable fulfillment of the convergence criteria, as stipulated in the Treaty, should entail a substantial degree of structural and policy convergence already before entering the euro area and thus help meet the macroeconomic stabilization challenges upon euro area entry (see 12 Of course, in practice inflation expectations may not be fully forward looking, credit constraints may exist (at least for some agents) and agents may not be complete inter-temporal optimizers. Nevertheless, the models put forward by Kirsanova et al. (2006) are highly instructive in displaying the underlying factors that determine the operation of the real interest channel and the occurrence of consumption booms in a low real interest rate environment. 11
16 I PETER BACKÉ Papademos 2004). For example, the sustainable fulfillment of the inflation criterion implies an appropriate anchoring of expectations already in the run-up to entry into the currency union. At the same time, the experience of EMU during its first decade underlines the importance of sustainability, in particular in the form of effective adjustment and stabilization tools (see Ahearne and Pisany- Ferry 2006). Box: Structural convergence, adjustment to shocks and macroeconomic stabilization in CEE MS How do CEE MS fare with respect to the structural and policy aspects that play a role in the monetary integration context? Clearly, exploring this issue in depth would fill a separate paper. 13 Rather than attempting a detailed discussion, this box intends to provide a broad but concise cross-country overview of the key features, focusing mainly on developments during the last five years, so as to set the stage for the more specific discussion in the remainder of the paper. 14 The alignment of economic structures has moved substantially ahead, with some differences remaining at higher levels of disaggregation (see Charts 1a and 1b). Trade openness of CEE MS is comparable with the euro area countries of similar size and has been rising in recent years; Central European MS do the bulk of their trade with the euro area; for the Baltic states, trade is at a somewhat lower level but still considerable, considering their trade links with non-euro area Nordic countries and with Russia (see Charts 2a and 2b). 15 Intra-industry trade takes a substantial share in overall trade with the euro area for most CEE MS (except for Latvia and Lithuania) and has tended to rise further in recent years (see Chart 3a). This also holds for manufacturing branches (see Chart 3b). The structure of exports of CEE MS has shifted notably to goods with medium- and higher technology content (see Chart 4). Financial integration has been advancing dynamically and has reached comparatively high levels across the region, with Estonia and Latvia standing out most (see Chart 5). 13 See Backé, Thimann et al. (2004) for an analytical exercise capturing the state of affairs as of We are not aware of a more recent study that undertakes a comprehensive and cross-country examination of these issues. 14 Unless indicated otherwise, this box is based on Eurostat data. For brevity reasons, the underlying data are displayed only selectively. 15 Trade shares with the euro area have fallen somewhat for almost all countries under review (due to rising oil and commodity imports in value terms from third countries, rising trade among CEE MS since EU accession, increasing import penetration by China and other non-european emerging economies, rising import demand by CIS countries, especially Russia). 12
17 I PETER BACKÉ Business-cycle synchronization is diverse, being more advanced in Hungary, Poland and Slovenia than in the other countries under review (see Artis et al for an empirical analysis). Business cycle alignment, measured in GDP terms, has in general been more pronounced than co-movements of private consumption. Moreover, on both measures synchronization improved until 2005, but since then cyclical divergence has risen (see Charts 6a and 6b). Finally, household consumption in CEE MS is much more volatile than in the euro area (see Chart 6d). As regards adjustment capabilities, labor market flexibility in CEE MS is diverse, ranging from intermediate to relatively high (see Boeri and Garibaldi 2006, Angeloni et al. 2007, World Bank 2008b). Labor market institutions are broadly comparable, in terms of their flexibility, with those in current euro area members. In the private sector, wage bargaining predominantly takes place at the company level. 16 Labor market institutions tend to be conducive to wage flexibility. Replacement rates are low to medium, while unemployment benefits are paid for relatively limited periods. Minimum wages exist in most countries, but they are relatively low compared with average wages and the percentage of employees working for these rates is fairly small. A less positive element is public sector wage formation. Wage growth in the public sector has often run ahead of the private sector, thus allowing for negative demonstration effects. Research based on micro data is rather scarce; where analysis is available, it suggests that wage flexibility is indeed existent to a tangible degree, with evidence for at least some downward nominal flexibility (see MNB 2008). Moreover, as Büttner (2007) shows, regional wage formation in CEE MS is responsive to regional differences in unemployment. Apart from Slovenia until 2004, wage levels in CEE MS have developed in a way that has been compatible with either stable or trend-appreciating nominal exchange rates, i.e. there has been no need to use exchange rate adjustments to correct for an overshooting of relative wage levels. Up to now, CEE MS have sustained or increased their market shares in world imports, despite real effective exchange rate appreciation (see Charts 7a and 7b). Labor mobility between CEE MS and other EU countries has risen since 2004, despite remaining restrictions (which will 16 The two notable exceptions, where sectoral and central wage bargaining play a major role, are those two CEE countries that have joined the euro area, namely Slovenia and Slovakia. 13
18 I PETER BACKÉ however expire soon). The (partial) opening of labor markets within the enlarged EU has contributed to spurring wage convergence at the macro level, in particular in the Baltic countries. More recently net migration flows have stabilized again (except for Lithuania which still recorded some net migration outflow in 2007, see Chart 7c). Empirical evidence of price flexibility in product markets in CEE MS is relatively scant. Franta et al. (2007) find that inflation persistence in Central European MS is broadly comparable with that in present euro area countries, but underlying roots may differ. Inflation expectations in Central European MS seem to be more backward-looking than in euro area countries. (Franta et al conclude from this that an improved anchoring of expectations during the euro adoption process may still be very important for CEE MS.) Looking at the issue from a regulatory angle, EBRD transition indicators suggest that price liberalization is complete in CEE MS, while there is room for improvement with respect to establishing fully competitive market structures in all CEE MS (better enforcement to reduce abuse of market power and to promote a competitive environment; further reduction of market entry restrictions). Frazer Institute data on business regulations show Central European countries scoring at intermediate levels (comparable with South-European euro area members), while Baltic countries score higher (comparable with Ireland); this indicator includes aspects like market entry and competitive market structures, which have a bearing on price flexibility. (World Bank Doing Business data also capture market entry, with Estonia, Latvia, Hungary, Slovenia and Slovakia being ranked comparatively high, the Czech Republic and Lithuania in the middle ranges and Poland more poorly.) Headline fiscal positions in most CEE MS have improved in recent years. However, budget deficits in most Central European countries are still relatively large (smaller than, but not much below, 3% of GDP, except for Hungary, which is still undergoing an excessive deficit procedure, despite major consolidation efforts in , after a previous huge worsening of the fiscal stance). Moreover, the improvement of fiscal position has been helped by good economic growth, so that progress with respect to cyclically adjusted balances has been less pronounced. In fact, in some instances, cyclically adjusted balances relapsed during economic upturns, pointing at a degree of pro-cyclicality of fiscal policies 14
19 I PETER BACKÉ in some CEE MS during good times (for a more detailed account of fiscal developments, see Convergence Reports 2004, 2006 and 2008 by the European Central Bank and the European Commission). There appears to be fairly little supportive empirical evidence in favor of the feasibility and effectiveness of monetary and exchange rate policy for macroeconomic stabilization and shock absorption (see Gros and Hozba 2003, Borghijs and Kuijs 2004, Crespo-Cuaresma and Wójcik 2006, Darvas and Szapáry 2008). At the same time, risks that the exchange rate could be a major shock generator (as suggested by Eichengreen 2003, Buiter and Sibert 2006) have at least so far not materialized in CEE MS. Until mid-2007, global financial conditions were extremely benign, thus mitigating this risk. In times of financial market crises, as today, the exchange rate could more likely become a source of shocks, and this has been shown by the considerable weakening of some CEE currencies since September 2008, which can hardly be explained by fundamental factors. Moreover, looking forward, it is acknowledged that path dependency is a relevant issue, especially in the case of long-standing hard pegs (Mody and Rosenberg 2006, European Commission 2008). CREDIT GROWTH AND FINANCIAL DEEPENING Credit growth and financial deepening enter the monetary integration debate in multiple ways. As credit growth and financial deepening in catching-up economies are closely associated with financial integration (see e.g. World Bank 2008b, Mendoza and Terrones 2008 for empirical evidence), it is expedient or even indispensable to also incorporate financial integration into the following discussion. Credit developments and financial integration may have a bearing on monetary transmission. Equilibrium credit levels and monetization increase as countries catch up in per-capita income level (a process known as financial deepening ). While this would strengthen the interest rate channel of monetary transmission (and consequently, upon accession to a monetary union, business cycle synchrony), financial integration, in particular the presence of foreign 15
20 I PETER BACKÉ banks, can weaken interest rate transmission, as foreign banks are able to access international capital markets and are therefore less sensitive to domestic monetary conditions than domestically-owned banks (see World Bank 2008b). 17 Thus, before entry into the common currency area, the net effect on monetary transmission is uncertain. Upon accession to a monetary union, the presence of banks that also operate in other participating countries will presumably promote the degree of synchrony of monetary transmission throughout the currency area. Financial integration can also have an impact on business cycle synchronization by allowing for consumption smoothing. 18 It is useful, in our context, to differentiate between consumption smoothing over the economic cycle (risk sharing in case of economic disturbances), which will reduce consumption volatility, and lifetime consumption smoothing (borrowing against expected higher income in the future so as to bring consumption forward and achieve a flatter consumption schedule over the life-cycle). The main factors that drive the latter are changes in (expected) future income streams and interest rates (discount factors). Risk sharing will help the business cycle alignment, while borrowing against future income can imply a temporary lowering of business cycle comovements, in particular in cases of discrete changes in expectations or of removal of credit constraints, which have previously barred inter-temporal optimization. Consumption smoothing works through capital markets and through credit markets, the latter being particularly relevant to the main topic addressed in this paper. Entry into a monetary union will increase financial integration through the reduction of risk and thus facilitate consumption smoothing. It should be noted that the positive effects that risk sharing and a strengthened interest rate channel have on business cycle co-movements will tend to reduce macroeconomic stabilization needs over time and thus help fiscal policy cope with the challenge of keeping cyclical volatility in check. 17 Foreign banks tend to have access to cheaper refinancing than domestic banks, they may react more slowly to changes in domestic policy interest rates, and they tend to extend more foreign-currency loans to domestic non-banks (especially if their domestic deposit base does not grow fast enough to finance domestic credit growth to keep open foreignexchange positions in check). 18 Consumption smoothing would however be hampered in case of major market failures abroad that are transmitted to the domestic financial system. The international financial turmoil that started in the summer of 2007 and intensified in September 2008 is a vivid example of such market failures. Likewise, the current crisis also points to the perils associated with an insufficient assessment of the risk profile of foreign financial assets that are acquired, for example, for consumption smoothing purposes. 16
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