Friday, November 17, 2006

lead note from this week's Europe section

The euro

An uncommon current

From The Economist print edition

East European countries are struggling to join the euro. What if they give up?

ON THE surface, the ex-communist countries' economic outlook looks bright. Growth is rapid, foreign investment strong, and their economies are becoming more sophisticated, swapping labour-intensive exports for services and higher value-added products. The European Bank for Reconstruction and Development, in its annual update published this week, said that growth this year in the 29 countries it covers would be 6.2%, compared with 5.7% in 2005.

But sunny weather is a bad test of rainwear. The real question is why the new democracies are not dealing with their fundamental problems now, while outsiders are so willing to lend and invest. Inflation is too high, public finances bloated and reform slow. And the next big goal of the new and future members of the European Union—adopting the euro—is receding into the distant future.

In a forthcoming study, Susan Schadler of the International Monetary Fund and a co-author estimate (see chart) that borrowing costs in central and eastern Europe are up to a percentage point less than you would expect, given the political, economic and financial risks these countries pose. The likely explanation, she argues, is a “halo effect” from the EU. Markets see membership as a big plus, especially with euro adoption in view. In theory, all EU countries (barring Britain and Denmark, which have an opt-out) are supposed to join the common currency. Yet in practice, those that want to join have found it unreasonably difficult. And others are not sure that they want it at all.

So far only Slovenia (see article) has managed to meet the criteria for membership, which set the ratios of government deficits and debts to GDP, exchange-rate fluctuations and inflation rates. Slovenia will adopt the euro on January 1st. Lithuania (which missed thanks to inflation just 0.1% above the limit) and Estonia (arguably the soundest and most dynamic economy in the whole region) are unlikely now to be able to join before 2010.

Yet both have a foot in the euro zone already, because their currencies are pegged to the euro and backed by currency boards. The price of having only one foot in is some residual exchange-rate risk (dismantling a currency board is much easier than leaving the euro) which may add ten basis points to bond yields; the cost (around 0.2% of GDP annually) of currency conversion; and the lack of a voice in the euro area's management.

Some of the ex-communist states' economic problems stem, excusably, from success. High rates of investment in poorish countries are unlikely to be met by domestic savings alone; the resulting inflows swell the current-account deficit. Estonia's economy is growing at 12% annually. Inflation was 4.3% in mid-2006. With a budget already in surplus, it was hard to see how the authorities could have cut inflation to the required 2.6%.

But other difficulties are more troubling. Joaquin Almunia, the EU's economic and monetary affairs commissioner, lambasted the Hungarian authorities this week for a budget deficit that will reach a whopping 10.1% of GDP this year. Progress towards meeting the membership conditions appeared “disheartening”, he said.

Though Hungarians now think they may adopt the single currency only in 2013, they are still keen to do so in principle, not least because so many firms and households have borrowed cheaply in foreign currency in the expectation that membership is inevitable.

In Poland, by contrast, reluctance to join the euro is growing. Many in the ruling conservative coalition see it as an unacceptable infringement of national sovereignty. Urszula Grzelonska, the favourite to become central-bank governor next year, said this week that she had “increasing doubts”. The government has already said it wants a referendum in 2010.

In theory, Poland does not have the right to question the principle of joining the euro: the EU's new members are supposed to join once they pass the membership tests. But it can hold a vote on the timing. Swedes voted against the common currency in a referendum in 2003, though the government portrays it as a postponement, not rejection. Brussels has huffed and puffed, but can do little.

Poland would in any case struggle to meet the 3% limit on budget deficits now set for joining the euro. The European Commission is already worried by Poland's public finances. When new rules on how to count pension costs bite in April, the budget deficit will jump, it predicts, by two percentage points to 4% in 2007. The next year it will be only a shade lower. The EU is also dissatisfied with the haplessly run finance ministry, which has seen six ministers since last year's elections.

The third big central European economy is the Czech Republic. Despite dire, deadlocked politics, it has the best macro-economic position, to the point that its interest rates are 75 basis points lower than those of the euro zone. Zdenek Tuma, the central-bank governor who, wags say, runs the country in the absence of a proper government, talks warmly of the benefits of an independent monetary policy, whereby his bank sets interest rates. That will be lost if his country joins the euro area. The single currency will also require stronger public finances and a more flexible labour market, he says; adopting the euro depends on political will both for reform and integration with the rest of Europe. “If there is a club, we want to be in it,” says a top Czech.

The case for small economies joining the euro is overwhelming, But for the (relatively) bigger ex-communist countries it is more complex. National currencies bring flexibility, but also vulnerability. Westerners are beginning to feel uncertain too. The euro zone may already have too many misfits (Italy, for example, or Greece). Even if prickly Poland and sleazy Hungary could eventually massage their statistics to meet the criteria, would bringing them into the inner sanctum really be advisable?

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