Economic flexibility more important than exchange rate

During the depths of the eurozone crisis just a few months ago, anyone suggesting that Poland ought to seriously start considering joining the euro would have been a candidate for a mental health check-up. But that is exactly what is happening, as Premier Donald Tusk and President Bronisław Komorowski kick off discussions on Poland's path to the common currency.

With some analysts now predicting that Poland could be in the Exchange Rate Mechanism as early as next year in preparation for euro accession by 2016 or 2017, it makes sense to take a look around the region to get a sense of how euro adoption has worked out for other central European countries, with the caveat that Poland’s much larger economy gives it a size and complexity unmatched by other CEE nations.

The first ex-communist country to join the common currency was Slovenia in 2007, just three years after joining the European Union.

The mechanics of adoption went smoothly, with a “Big Bang” transition period in which the euro immediately replaced the tolar following an extensive public education period.

Fears that introducing the euro would lead to inflation due to the “round-up” effect proved to be unfounded, as has been the case in other countries joining the euro. The actual initial level of euro-induced inflation in Slovenia was 0.3 per cent, and prices actually fell in January and February 2007.

The larger problem was with Slovenia’s institutional readiness to join the common currency. It went in at the peak of the economic boom, with GDP growth averaging at around 4 per cent, but the former Yugoslav republic was also saddled with a generous pension system, a very rigid labour market and a lacklustre corporate environment.

That translated into sharply slowing GDP growth as the country had a difficult time remaining competitive. The economy grew by 6.8 per cent in 2007, but that was down to 3.6 per cent in 2008 and the crisis year of 2009 saw the economy contract by 8 per cent. It has since sunk into recession again.

Slovakia, the next ex-communist country to join in 2009, did so at an exchange rate that was seen as overvalued and much less favourable than Slovenia’s, the result of a strong appreciation trend in the final months of the economic boom.

But fears that Slovakia had made itself uncompetitive proved to be overblown, thanks to the deep economic reforms that the country undertook at the end of the 1990s that made it one of the world’s best-performing economies.

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Robert Fico, the left-wing prime minister who shepherded his country into the common currency, ended up calling the euro a “shield” which defended his country from the wild currency swings that hit the rest of central Europe in late 2008.

Although Slovakia did not get the boost from depreciation enjoyed by countries like Poland and Hungary, it quickly returned to growth after suffering a 4.9 per cent contraction in 2009. By 2010 growth was back at 4.2 per cent, and Slovakia is now one of the EU’s most robust economies.

When joining the euro, Fico was very careful about the prospect of a spike in inflation, even setting up a commission to monitor prices and running a programme called: “We’re changing the currency, not the price”. For several months after adopting the euro, prices were listed in both euros and korunas to allow shoppers to make easy price comparisons, and inflation was not a problem.

Estonia joined the euro in 2011, a testament to its success in retianing its fixed currency peg against the common currency. During the crisis, many economists advised Estonia, as well as its neighbours Latvia and Lithuania, to drop their pegs as a way of regaining competitiveness.

Instead, all three countries undertook very painful internal devaluations, slashing wages and boosting competitiveness – but the programmes worked. Estonia undertook a fiscal consolidation totalling about 14 per cent of GDP and saw a contraction of 14.3 per cent in 2009, but was back to growth by 2010. In 2011, its first year in the euro, the economy grew by 7.6 per cent.

For Estonia, there was little reason to hang on to the kroon because its currency board system meant that it had no independent monetary policy anyway, and the country did not want to devalue.

“It is anyway very doubtful if an independently floating currency is a stabilising force or actually an additional factor of unnecessary volatility in the economy,” writes Marten Ross, former deputy governor of the Estonian Central Bank. “For Estonia, it was a a particularly questionable argument as we had been used to living under a fully fixed exchange rate regime since 1992.”

Again, fears of an inflationary spike proved to be exaggerated, with short-term price variations of only about 0.2 per cent during the changeover.

Estonia also saw some benefits from joining, such as a drop in interest rate spreads.

Finally, for Estonia, which still has fresh memories of being a Soviet colony, the main imperative of being in the euro is not economic but strategic – cementing itself fully into west European institutions to prevent the danger of Russian revanchism.

“The euro is a long-term strategic project. It is not just a device to steer our macroeconomic policies,” writes Ross.

Estonia joined just as the eurozone crisis was gathering speed, which at first seemed to cool enthusiasm for joining the common currency in Latvia and Lithuania.

But Latvia is still on track to join in 2014, although prime minister Valdis Dombrovskis admits that it will take some work to convince his sceptical public that joining is a good idea. Lithuania recently said it plans to join by 2015.

That is not the case for Bulgaria, the other CEE currency board economy. It also meets the Maastricht criteria for joining the euro, but Boyko Borisov, the prime minister, recently confirmed that his country had no plans to join until the eurozone crisis was over, worrying that the EU’s poorest country would be forced to help rescue much richer economies like Greece and Spain.

Steve Hanke, the economist who helped create Bulgaria’s currency board, wrote recently that “it doesn’t make any sense for the country to join the euro,” saying that in the event of a meltdown of the euro Bulgaria could quickly peg the lev to another currency like the dollar.

But Bulgaria has a much different view of the Soviet past than the three Baltic countries and Poland, which makes joining the euro less of a political and strategic imperative for the Balkan country than for the northern CEE tier.

Poland also sees the euro project as being as much about politics – becoming more closely integrated in the EU and gaining a seat at the Union’s top table – as it is about economics.

However, when looking just at the economy, the best example for Poland comes from the differing experiences of Slovakia and Slovenia, writes Peter Attard Montalto of Nomura.

“The lessons of Slovakia and Slovenia are more relevant for Poland in the need for ensuring correcting entry tempo and entry parity rate, even if politics is the main driver – however those two cases also show that underlying competitiveness, institutions, politics and policymaking are actually far more important determinants of success than the specifics of joining criteria,” he writes.

That means Poland has to get its institutions into shape and ensure that its economy is efficient and well-run before taking the plunge to join.


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