Toward an Enlarged Euro Area: The Next 10 Years and Beyond

4.1 The story so far

As we look ahead toward the next 10 years of EMU, a key open issue is the future pace of euro-area enlargement, as well as the implications of this process for the functioning and governance of EMU. All Member States except Denmark and the United Kingdom have committed to the goal of adopting the euro, once a high degree of sustainable convergence has been achieved. As we have seen, this process is neither predetermined nor linear. Countries themselves are ultimately in the driver's seat of their euro ambitions (by calibrating their path toward the fulfillment of the criteria set by the Treaty), but must also take into account uncertainties in economic performance (which led to the postponement or abandonment of euro adoption targets by a number of new Member States [NMS]).

The last few years have shown that euro-area enlargement is an open process, with four of the 10 NMS that joined the EU in 2004 having already fulfilled the necessary conditions and joined the euro area. This needs to be seen in the proper perspective. While the starting conditions for the first three entrants may have been somewhat more favorable than those of other NMS (comparatively high income levels in Slovenia and the two islands; absence of shocks related to the transformation from former socialist to market economies and long-standing pegs in Cyprus and Malta; strong fiscal starting point in Slovenia), all of the new entrants had to pursue significant policy adjustments to qualify for the euro. These included the move from a crawling peg to a fixed exchange rate for Slovenia; fiscal consolidation in Cyprus, Malta, and Slovakia; and the completion of post-transition administered price adjustments in Slovakia. Structural reforms to strengthen domestic adjustment capacity and competitiveness were also pursued in preparation for life with the euro.

Euro adoption has clearly paid off for the new entrants by providing a shield in the crisis. Their longer-term performance will hinge on keeping the commitment to necessary policies and reforms.

4.2 Financially driven convergence: From boom to crisis and beyond

What are the prospects for the further enlargement of the euro area toward the NMS?¹⁹ Until recently, the NMS' euro adoption strategies were fairly clearly divided into two approaches, which mapped closely with the choice of exchange rate regimes.

• One group of NMS operates hard pegs to the euro, either through currency board arrangements (Estonia, Lithuania, Bulgaria) or through a conventional peg (Latvia). These countries see euro adoption as an obvious exit strategy from their pegs and a logical endpoint of their monetary integration with the euro area, which they want to accomplish as soon as feasible.
• The other group of NMS have chosen to maintain more flexibility in their exchange rate arrangements, following domestic monetary anchors through inflation targeting regimes, with managed or free floats. The Czech Republic and Poland have pursued inflation targeting regimes since the late 1990s, Romania made this move in 2005, and Hungary gave up its hybrid inflation–exchange rate targeting regime in early 2008. These countries did not pursue near-term euro adoption plans after EU accession, partly because they still saw the need to be able to use the exchange rate instrument as a shock absorber, and partly because they still had to make major progress with nominal convergence (e.g., in fiscal positions). Most recently, the vulnerability of the floating NMS to the crisis has led to a reconsideration of euro adoption plans in some cases, reflecting the euro's increased attractiveness. For instance, Poland adopted for the first time a euro adoption target (2012); however, this has proved unrealistic and is now being revised.

The main elements of the convergence process help in judging the challenges and prospects of the NMS on the way to the euro. Some stylized facts illustrate the general trends:

• Real convergence has been substantial. While average incomes in the NMS are still considerably below those in the original euro area (at an average of some 52% in 2008), the gap in GDP per capita has narrowed by more than 10 percentage points since the start of this decade (see Figure 10 [ PDF 23.4KB | 1 page ]).
• The NMS' economies have become increasingly well integrated with the broader EU economy. This fact reflects two interconnected underlying trends: more open trade and financial flows in general, as the NMS established full-fledged market economies,²⁰ and—particularly since the late 1990s—a clear orientation of integration toward the EU, culminating in full membership in 2004/2007.
• Financial integration has proceeded even more forcefully than the integration of the real sector. This has clearly been visible in a strong expansion of external balance sheets of NMS, with the average stock of external assets and liabilities rising from some 120% to more than 200% of GDP between 1999 and 2006. In the same vein, financial sector development in the NMS has proceeded at a brisk pace, with domestic financial deepening increasing rapidly from previously depressed levels (Figure 11 [ PDF 17.1KB | 1 page ]). Foreign-currency borrowing has become widespread in the majority of NMS, creating balance-sheet vulnerabilities.²¹ Banking sectors are largely foreign owned (mainly by banks from other EU countries), lowering risks of “sudden stops” in capital flows but implying common creditor risks (Figure 12 [ PDF 33.5KB | 1 page ]).
• In the context of “financially driven” convergence, the NMS have been able to mobilize foreign savings on a large scale in the context of catching-up and high returns on investment (see Figure 13 [ PDF 17.2KB | 1 page ]). A sustained underlying improvement in risk perceptions vis-à-vis the NMS compared with other regions (reflecting, among other things, the EU accession process) is likely to have played a role in explaining the pattern of capital flows to the NMS in recent years and, indeed, an underpricing of risk may have contributed to the buildup of imbalances.²²

In many new Member States, capital inflows have financed sizable external deficits, in the context of their catching-up process. Temporarily high external deficits may be economically benign insofar as they reflect an efficient inter-temporal allocation of resources by economic agents. This is particularly the case if foreign savings are used to improve longer-term productive capacity. High investment rates in most NMS over the last few years, amounting to an average of 29% of GDP over 2004–2008, compared with some 21% of GDP in the euro area, provide evidence for such an underlying trend. However, a large share of investment in sectors such as real estate that do not directly improve productive potential has raised vulnerabilities in a number of NMS, including the Baltics.

Against the background of large capital inflows and sustained credit-driven demand growth that eventually led to overheating, external imbalances in some NMS clearly surpassed levels that are sustainable in the medium term. With external deficits of well above 10% of GDP (and, in the case of Latvia and Bulgaria, reaching levels at or above 20% of GDP in 2008), the NMS have gone well beyond the traditional metrics of macro-financial sustainability analyses. As a result of cumulated external deficits, average gross external debt in the NMS rose steeply from 50% to 80% of GDP between 2002 and 2008, with debt levels exceeding 100% of GDP in Bulgaria, Estonia, Latvia, and Hungary, and net international investment positions widened sharply.

While the NMS' high external deficits have generally not resulted from a loss of external competitiveness, the picture on this front has clouded more recently. Rapid real appreciation in some countries on the back of high demand and wage growth surpassed levels that could be considered as “equilibrium” in a catching-up context.²³ Indeed, lending booms amid rapid financial integration have arguably exerted temporary (nonequilibrium) upward pressure on the real exchange rate, which must eventually be reversed (Székely and Watson 2007).

Since the second half of 2008, the crisis has started to hit the NMS severely, and many of them have fallen into sharp recessions. In most cases, a rapid retrenchment of current accounts has set in amid falling domestic demand, though a weak external environment has slowed down the correction. Credit growth has also dropped significantly, reflecting tighter liquidity as well as higher risk awareness among lenders and borrowers (both supply and demand factors). External financing conditions have deteriorated, in a number of cases to the point of creating a need for external financial assistance, notably in Hungary, Latvia, and Romania. The NMS have not all been equally vulnerable in the crisis. Financial market conditions have deteriorated most for NMS with particularly large imbalances and vulnerabilities.

The past boom years as well as the ongoing adjustment have had a significant impact on the NMS' progress toward meeting the conditions for euro-area entry. At the time of the last convergence assessment by the European Commission in May 2008, all NMS but one (Slovakia, which later joined the euro) failed to meet the inflation criterion, some by large margins. At the same time buoyant growth had led to a significant improvement in fiscal balances, leading all but two NMS to meet the fiscal criteria. Long-term interest rate convergence was well advanced for most NMS, with Hungary and Romania as outliers in view of weak fundamentals and low policy credibility. Exchange rate pegs were operating smoothly, while most of the floating currencies were on a sustained appreciation path amid high investor interest.

Since the crisis hit Eastern Europe in the second half of 2008, the picture has reversed sharply, pointing to an exceptionally challenging environment ahead. Inflation is on a generalized downward trend, hampered in some cases by currency depreciation, while meeting the fiscal criteria will be a challenge.²⁴ Long-term interest rate spreads have widened significantly, while the floating currencies have recorded sizable depreciation, and the pegs face testing times in a context of adverse external financing conditions and sharp domestic adjustment. Beyond the immediate challenges of the crisis, the NMS may face a relatively difficult and volatile macroeconomic and financial environment for some time to come.

4.3 The crisis and euro adoption strategies

Given the wide divergence of exchange rate regimes and euro adoption strategies among the NMS, a key question is to what extent the crisis will affect feasible and desirable convergence paths for individual countries. In this respect, some differentiation is due. The boom-bust dynamics described above have been more pronounced among NMS with an exchange rate peg, reflecting the virtual absence of perceived exchange rate risk and low real interest rates, but also a generally low starting position in real convergence and financial deepening. While the fixed exchange rates have served the peggers well for a long time, the crisis is putting them to an unprecedented test. Comparatively strong starting positions in public finances and flexibility of markets may be mitigating factors,²⁵ but the uncertainties ahead are high. The crisis has reinforced the prevailing euro adoption strategies followed by the peggers, with euro-area membership perceived as a credible exit strategy propping up confidence (among residents and nonresidents alike) in the pegs. Euro adoption is not seen as posing additional constraints on economic policy making, because the main benefit of staying out of the euro—the “option value” of an exit from the peg—may actually have turned negative at the current juncture. At the same time, the adoption of the euro would relieve liquidity constraints and eliminate exchange rate mismatches.

The situation for the “floaters” among the NMS is somewhat more differentiated. They generally enjoyed slower growth than the peggers, with commensurately lower imbalances. The flip side has been weaker policy discipline—less favorable fiscal outturns, higher rigidities, and weaknesses in the business environment. It might have been expected that, in the absence of an exchange rate straitjacket, short-term risks and policy challenges for the floaters would be lower than for the fixers at this stage, but this situation has only partly materialized.

In particular, three interlinked risk factors have come to the fore. First, the scope for actual exchange rate flexibility is limited by the degree of foreign-currency borrowing.²⁶ This consideration has turned out to be highly relevant for Hungary and Romania, and to some extent Poland, but not for the Czech Republic, significantly increasing the country's resilience.²⁷ Second, the evidence suggests that in practice exchange rates are not only shock absorbers but also shock amplifiers.²⁸ This is confirmed by the sharp downtrend and increase in volatility of the floating NMS currencies since the second half of 2008, in excess of levels that could reasonably be justified by fundamentals. Third, an unbalanced policy mix has increased fiscal vulnerabilities in some cases, and thus created tension points in the current environment. For instance, the ultimate trigger for Hungary's need for financial assistance was a seizing-up of the government bond market. These vulnerabilities were not as apparent in a context of strong growth and very favorable global financing conditions, and hence did not signal a high degree of urgency for euro adoption. The deterioration of economic and financial conditions, however, appears to have shifted the trade-offs seen by policy makers in favor of earlier or more determined efforts to meet the conditions for euro-area entry.

4.4 A digression: Is the euro adoption framework still relevant?

With euro adoption gaining new strategic importance for the NMS as a group and amid the difficult global economic and financial conditions, the idea of going beyond the Treaty and advancing euro adoption for the new Member States has been floated in the debate. In this context, some remarks are in order. Yes, the euro provided a shield in the current crisis, and its attractiveness to neighboring countries has increased. Nevertheless, an accelerated euro-area enlargement that would require a waiver or a loosening of the entry criteria specified in the Treaty is not a desirable avenue to pursue. A number of factors, both economic and institutional, should be stressed in this context.

Regarding the underlying economics, euro adoption without convergence appears to be a suboptimal and potentially risky strategy. The requirement of convergence in public finances, inflation, exchange rate policy, and long-term interest rates provides an orientation for policies and acts as a disciplinary device, with membership in the European Exchange Rate Mechanism (ERM II) as a “training ground” in preparation for the irrevocable fixing of exchange rates.²⁹ The “policy convergence” that took place in the run-up to euro adoption was a key ingredient for the smooth entry of the first wave of euro entrants into the new policy framework, and the same holds for future entrants.

Regarding the possible effect of ad hoc euro adoption on macrofinancial stabilization, several caveats are also in order. First, while exchange rate risk is indeed removed with euro adoption, credit risk is not. If the real exchange rate is perceived as overvalued by investors, raising doubts about medium-term external sustainability, this will still be reflected in external financing costs and the availability of foreign funding. Second, the core argument for euro adoption is about liquidity and exchange rate risks. It does not address issues related to bank solvency or external debt sustainability. Third, the underlying imbalances that built up when economies overheated have to be worked out under any monetary regime. While it is true that, at least for the peggers, euro adoption does not remove significant degrees of freedom in this respect, the issue of euro adoption should not detract from the underlying adjustment challenge. Fourth, while access to ECB operations would address the need for euro liquidity, it has become more apparent over the past months that complementary action can, at least to a degree, fulfill this function. The menu of instruments includes private sector solutions, indirectly transferring the benefits from enhanced ECB liquidity provision to countries outside the euro area, financial assistance by the EU and the International Monetary Fund, and flanking operations by central banks, including ECB repurchase agreements with Hungary and Poland, and a Riksbank swap with Estonia.

Regarding the institutional dimension, which is key in a large union of 27 Member States, both the European Commission and the Member States have consistently reaffirmed that the Treaty framework for euro area enlargement, based on the achievement of sustainable convergence, remains fully relevant and is an integral part of EMU governance. The rules-based framework of the Treaty provides for a transparent and accountable process of euro-area enlargement, based on a sound economic rationale. Compliance with the convergence criteria in a sustainable manner is in the interest of both the prospective and existing members of the euro area. It signals the commitment and the ability to ensure a stable macroeconomic environment after irrevocably giving up the national exchange rate and monetary policy, and thus contributes to the smooth functioning and stability of the euro area.

As an alternative option, some have suggested aiming for a “negotiated solution” by which countries would adopt the euro as legal tender while formally staying outside the euro area. In this respect, the institutional and economic arguments are equally clear. The EU Council has repeatedly stressed³⁰ that unilateral “euroization” runs counter to the underlying spirit of the Treaty, which is based on joint responsibility for the management of the euro area, and therefore is not an option for existing or prospective Member States. While some individual NMS may indeed be “too small to matter,” unilateral euroization could well trigger similar demands around the region, both inside and outside the EU, eventually transforming EMU into a “two-tier” structure. Such a two-tier structure would increase uncertainty, for instance in terms of emergency liquidity assistance, with adverse implications for the credibility of the monetary integration framework as a whole. In summary, it is difficult to see how the potential short-term benefits of euroization could outweigh these significant broader concerns. Circumventing the Treaty to engineer a broad-based ad hoc euro adoption is neither desirable nor feasible.

4.5 Looking ahead: Toward an enlarged euro area

Euro adoption remains a key anchor for medium-term policies and expectations for NMS. An orderly convergence path is important to underpin market sentiment and strengthen investor confidence. The European Commission strongly encourages and supports Member States in pursuing policies that will bring them closer to the euro and ensure successful participation in the euro area. Necessary policy measures include efforts to strengthen fiscal discipline, correct macro-financial imbalances, preserve financial stability, and foster productivity and competitiveness. These policies will allow countries to move toward euro-area membership, and are also necessary for longer-term catching-up under any monetary regime. Conversely, premature euro entry without convergence would not be a promising starting point for life with the single currency. By heightening economic divergences and adjustment problems, it would make the management of EMU as a whole more difficult. As discussed in the previous section, this lesson is underlined by the experience of the euro area after its first decade.

While uncertainty on the short-term convergence path of the NMS has increased, the main scenario is still one in which more Member States are expected to adopt the euro over the coming years. Ultimately the composition of the euro area will align closely with that of the EU, in line with the Treaty objective. Such a significant enlargement could have implications for the management and the policy challenges facing the single currency area in the medium term. From a strategic perspective, it will be important to identify policies that facilitate the smooth integration of new entrants and bolster the stability and resilience of the enlarged euro area.

What will be the impact of euro enlargement on the present euro area? A look at the economic characteristics of the new Member States yields a number of contrasting conclusions with regard to the potential impact of enlargement on the euro area:

• On the one hand, the data clearly suggest that the entry of the new Member States will not have a significant impact on the euro-area economy on aggregate. The aggregate GDP of the 12 new Member States (in euro terms) is around 11% of the original euro area total.³¹ Given their limited economic weight, developments in the new Member States will not materially affect aggregate growth and inflation rates in the euro area. Higher trend growth rates should lead to a gradual increase in the relative weight of the NMS (the share of NMS GDP relative to the euro area rose by around 3 percentage points between 2004 and 2008), but the overall effect will remain modest. In this respect, the impact of enlargement on the overall euro-area policy setting should be limited.
• On the other hand, country-specific diversity within the group is large. Also, the catching-up context sets the prospective new entrants somewhat apart from the existing euro area “core.” That said, the new Member States are not the first catching-up economies to join the euro area, and the potential challenges implied by their euro-area entry are in themselves not fundamentally different from those facing existing catching-up members.
• Compared with the integration of previous catching-up euro-area entrants, the ongoing euro-area enlargement could comprise a potentially new dimension mainly because of (i) the relatively large number of expected new entrants, which would increase the share of the euro-area “periphery” in the overall membership; and (ii) the fact that some of the NMS are considerably less advanced than the spectrum of existing euro-area members in terms of real convergence, indicating that the catching-up challenges facing them may be both more pronounced and more prolonged than for previous cases.
• Euro-area enlargement will also be reflected in the governance structures of EMU. The Eurogroup will become a larger and potentially more unwieldy body, and ways will have to be devised to maintain an efficient functioning while maintaining the informal character of the group. Decision making on monetary policy will accommodate euro-area enlargement by introducing a rotation system, aimed at balancing accountability and efficiency concerns.

Overall, despite a limited aggregate effect, the conclusion is that heterogeneity is set to increase within an enlarged euro area. In analyzing the underlying factors (and developing appropriate policy responses), a number of stylized facts can be outlined.

Country-specific variability of macroeconomic aggregates among euro-area members is likely to become larger, at least in the initial period of enlargement. Macroeconomic aggregates in new Member States tend to be more volatile than the euro-area average. Though cyclical correlation with the euro area has increased, growth rates have fluctuated significantly; in particular, higher trend investment rates might remain a cyclical amplifier for some time to come. Inflation has also been more volatile, reflecting both cyclical and structural factors, such as changes in market structures, administered price adjustments, and a relatively large weight of energy in the economy.

Sectoral structures have not yet fully aligned, raising the probability of asymmetric shocks. While the evidence suggests that existing sectoral divergences should not be a fundamental obstacle to successful euro-area participation by the NMS, in view of ongoing integration and other factors, they will have to be appropriately taken into account in surveillance and policy making within the enlarged euro area.³²

On a related note, differences in production and consumption structures may also generate a divergent impact of common shocks. For example, volatility in global food and energy prices affects inflation patterns in the NMS more strongly, given the larger weight of these items in consumption baskets—about 40% on average, compared with some 30% in the euro area.

As real convergence progresses, this type of divergence is set to diminish. Also, the divergences do not, in themselves, signal imbalances that need to be corrected. Rather, they are an inherent feature of a broad-based monetary union. The policy response should largely be focused on containing related risks to the medium-term real convergence path, for instance by putting particular emphasis on adjustment mechanisms and on reforms to promote potential growth, to accelerate the completion of the real convergence process.

Potentially suboptimal responses to the regime shift implied by euro adoption could magnify divergences. A key role in this respect is played by financial integration and the removal of remaining balance-of-payments constraints.³³ Financial integration is therefore an important element facilitating smooth adjustment to shocks in monetary union through enhanced risk-sharing capacity. However, the vulnerabilities associated with high credit growth fueling unsustainable domestic demand and asset price booms have become all too apparent during the current crisis. Compared with previous catching-up economies entering the euro area, the already high and increasing degree of financial integration implies that euro adoption itself is likely to have a smaller impact on many NMS, while euro-area membership should increase macro-financial resilience, for instance by reducing liquidity risks and eliminating currency mismatches. Macro-financial risks must be managed and external financing channeled to productive uses to ensure the smooth integration of the NMS into the euro area.

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