What Will Be the Advantages and Costs to Transition Economies of Replacing their Currencies by the Euro - Report Example

What are the conditions for an optimum currency area? Do the transition economies satisfy the criteria for joining the Euro zone? What will be the advantages and costs to transition economies of replacing their currencies by the Euro? Twelve countries out of the fifteen European Union members that make up the Euro zone, also known as Euro Land, accomplished their conversion to a single currency called the Euro on the first day of the year 1999. This means that “they will use the common currency instead of their existing national currencies for large-scale trade and payments” (Frieden, 1998). Initially, the old national currencies became sub-units of the Euro, as part of the phase-in process of single currency conversion (Eurocoins, n.d.). In January 2002, as Euro notes and coins went in circulation, authorities started to withdraw the old national currency in each member of the Euro Zone and these notes and coins ceased to be a legal tender (Eurocoins, n.d.). What took place in the creation of the Euro Zone—the conversion into a single monetary currency of a dozen countries—was such in magnitude that it encompassed economic, political, and historical dimensions (Stark, 2001). It is, indeed, a momentous innovation considered to be of utmost importance in European monetary history (Stark, 2001). “The realization of a single European currency is the most significant monetary event to have taken place since the creation of the Bretton Woods system in 1944” (Stark, 2001). Because of the ramifications of the conversion—both positive and negative—it has become a topic of interest. This paper aims to answer the questions above and delineate if the Euro is an optimum currency area for transition economies. The Optimum Currency Area Much of the discussion about the appropriateness and suitability of employing a single currency among the twelve member countries of the Euro Zone has revolved around the debate of whether Europe is an optimum currency area (Caporale, 1993). An optimum currency area characterizes the optimal conditions for the unification of a region into a single monetary unit (caporale, 1993). This is often used to determine of a particular zone is ready to adopt a monetary union. In 1961, Robert Mundell pioneered the Optimum Currency Area Theory, which won him a Nobel Prize in 1999 (McKinnon, 2000). He originally defined an optimum currency area as having several properties: “the mobility of labour and other factors of production, price and wage flexibility, economic openness, and diversification in production and consumption, similarity in inflation rates, fiscal integration and political integration” (Mongelli, 2002). However, it has been found that “sharing these properties reduces the usefulness of nominal exchange rate adjustments within the currency area” and that there was an absence of a working paradigm and reliable empirical data to back up these properties (Mongelli, 2002). After almost four decades of reassessing and reconciling the different conditions of an optimum currency area, empirical data has finally surfaced to back up Mundell’s theory, with only a few additions. The conditions of an optimum currency area, as it is employed today are as follows: (1) Price and Wage Flexibility, (2) Labour Market Integration, (3) Factor Market Integration, (4) Financial Market Integration, (5) Economic Openness, (6) The Diversification in Production and Consumption, (7) Similarities of Inflation Rates, (8) Fiscal Integration, (9) Political Integration, and (10) Similarity of Shocks (Mongelli, 2002). These conditions, or most of them, must be met in order to ascertain that a particular region is an optimum currency area and is therefore, ready to employ a monetary union. The Maastricht Criteria After tackling many issues, including conversion rates, the Euro has finally become stable with 1 Euro = 1.3616 U.S. dollar. Because of this, and the benefits of being a member country, some European countries have already expressed their desire to become a member. There are four convergence criteria that a country has to meet in order to become a full pledged member of the Economic and Monetary Union of the European Union (Stark, 2003). These are: (1) The inflation rate is to be not more than 1.5 percentage points above the average inflation rate of the three best performing member states of the Euro systems; (2) Long-term interest rates are to be not more than 2 percentage points above the corresponding level in those three countries; (3) The public sector deficit must not exceed 3 percent of GDP and the level of public debt must not be above 60 percent of GDP; and (4) The country must have participated for at least 2 years in the European Exchange Rate Mechanism (ERM II) within the normal fluctuation margins, without any devaluation being required (Stark, 2003). The first three conditions are known as the Maastricht Criteria. The question now is if the transition economies—those European countries who have been transitioning from the Soviet-type economy to a free market economy and have thus applied for membership in the EMU—are eligible to become members. Transition economies are generally characterized by high inflation rates which can be attributed to the fast pace of liberalization and a U-shaped economic growth rate that presents a problem with criteria two and three (Wyplosz, 1999). These economies can be considered unstable and will unlikely meet the convergence criteria. In 2002, the European Council in Copenhagen resulted to successful accession negotiations for 10 new member states in the Euro Zone (Stark, 2003). The countries are: Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, the Slovak Republic, and Slovenia (Stark, 2003). They have become official member of the European Economic and Monetary Union in May 1, 2004 (Stark, 2003). In order to see if these transitioning countries into the Euro Zone will be able to pass the Maastricht Criteria, some data analyses will be presented. An analysis of the inflation rates of three transition economies in 2006 (shown in Figure 1), Estonia (3.6%), Lithuania (3%) and Slovenia (2.4%), proves that the first two countries will not be able to make it while the third barely does—with 2.6% as the cut-off value provided by the Maastricht Criteria (Transition Economies, 2006). Furthermore, a recent study of debt to GDP as per the Maastricht Criteria of not higher than 60% shows that Hungary and Poland are in danger of breaking the third criteria with the former having more than 60% already and the latter more than 50%, with trends showing that it could easily reach more than 60% (Transition Economies, 2007). Good news is that the Czech Republic and Slovakia are well below the 60% mark with both having only less than 40% debt to GDP (Transition Economies, 2007). However, all four (Hungary, Poland, The Czech Republic, and Slovakia) “have had problems with fiscal deficits in excess of 3% GDP practically through their entire history of EU membership” (Transition Economies, 2007). The rate that all of these countries will be able to meet the Maastricht Criteria is not good, as exhibited in the data above. It will definitely take a lot for most transition economies to be able to successfully meet the Maastricht Criteria and become a member of the Euro Zone. Furthermore, there are costs in transitioning into a single currency and some of these countries are just too poor to make it. There are just situations and times wherein the costs outweigh the benefits. This is especially true for some transition economies. The advantages and Costs to Transition Economies The conversion to a single currency provided the member European economies many benefits; the two most important are the added competitive advantage in trade and value-added in the economic and political influence of the Euro Zone. But moving towards a single currency has its downside. The member countries, by adopting a single currency, effectively submitted their power over their monetary policies to a single governing body–the European Central Bank (ECB) (Stark, 2003). Also, the implementation of the single currency has created domestic issues and concerns in each of the member economies making the foreign exchange transition. Moreover, since moving towards a single currency, the fiscal, monetary and structural policy requirements of the Euro Zone has increased the implications for the overall policy mix in each member country and has made the Euro Zone more vulnerable than ever to economic developments the structural deficiencies of each economy, not only at a global scale but at each domestic scale (IMF, 1998). Not all member economies are equal in terms of its development in financial markets, and these gaps between countries would be highlighted even more in a single currency regime. To ensure that no one is left behind, reforms must be undertaken to address these gaps. Unfortunately, structural policies are within the realm of the national level and the ECB does not have the power to coerce countries to ensure improvements in structural reforms. If left to their own devices, these deficiencies that cause gaps between countries within the Euro Zone, would adversely impact the sustainability and stability of the entire Euro Zone. While the general monetary policy decisions are decided by the ECB, the primary responsibility for fiscal, foreign exchange and structural policy making is at the national level., On the downside, this set-up also poses a challenge for policy coordination. National policies will have inevitable, and often pervasive, spillover effects on other member because of the single monetary policy of the ECB and the exchange rate of the Euro (IMF, 1998). An example of this is when a country, say France decides to increase its fiscal spending, incur budget deficits to finance infrastructure projects and spur investment growth, such a move could in the long-run rapidly increase inflation and encourage other member economies to pursue aggressive fiscal measures to remain attractive to foreign investors, subsequently putting the Euro Zone stability at risk. On the positive side, this type of set up enables the member economies to better adapt policies specific to their country circumstances. Slovenia: The 13th Member The case of Slovenia, the thirteenth and newest member of the European Union, showcases the benefits and costs of a single monetary currency and the delicate balancing act that member economies must perform in this single currency environment. In 2007, Slovenia entered full membership in the European Monetary Union (EMU). According to Pedro Solbes, European Commissioner for Economic and Monetary Policy, Slovenia’s membership was due to “healthy macro-economic conditions in the country and the fulfillment of convergence criteria” (Slovenia News, 2003). From the onset, Slovenia’s decision to apply for EMU membership has already given it some benefits. Its application meant that the country needed to address the issue of fiscal balance, structural deficiencies and ensure economic stability and improvement in social indicators such as quality of living, environmental compliance, and social welfare. By trying to meet the Maastricht Criteria, Slovenia, in the course of few short years, has managed to post an economic growth that has been markedly higher than the Euro area average over the past years—per capita income levels have exceeded those in Portugal; and labor productivity employment rates increased (Liebscher, 2007). It becomes apparent that the stringent application process to the EMU has pushed Slovenia to achieve macroeconomic stability and success even before accession. Slovenia’s accession to the EMU has its costs, however. Membership to the single currency meant additional fiscal pressures on the domestic economy of Slovenia. According to Antczak, Dabrowski and Gorzelak (2006), these fiscal pressures stem, in part, from the obligations of the national government to contribute to the budget of the EMU, the co-finance projects financed from EU structural funds, the need to pre-finance some EU transfers during the first period of membership and the necessity for the implementation of the status quo in certain costly areas such as environmental protection, infrastructure, border control and public administration . Of these mentioned fiscal costs, the most important and perhaps, one of the most costly, is the required membership contributions to the budget of the EMU. Since the member countries will be functioning as a group, at least in the sense related to foreign exchange and trade, members must pay their dues to ensure that the monetary governing body (Antczak 2006). ECB, for instance, can do its job well through sufficient funding. Slovenia, along with the other new member states (the Czech Republic, Hungary, Poland, Cyprus, Malta, Lithuania, Estonia and Latvia) had to pay contributions equivalent to 1.27 percent of their annual gross domestic product (GDP) in 2005 and 2006 (Antczak 2006). This is about 2 percent of annual domestic income that could have been allocated for domestic use. However, these fiscal costs are offset by the fiscal gains from the membership through increased in trade, price stability, interest rate convergence, and the elimination of exchange rate risk. . Moreover, the study conducted by Antczak, et. al. (2006) shows that accession to the EMU has an unfavorable net effect on the general government fiscal balance of all new member states. But these impacts depend on the EU transfer flows and estimated costs of required reforms and public investment programs in individual countries. If a country applying for membership is lagging in terms of financial market structure and governance, for instance, it is expected the its accession to the EU would have costs more to achieve than say, countries like Slovenia, which has a moderately good governance structure and sound economic fundamentals even coming into the EU application. Conclusion The adoption of the single currency in Europe has left the member countries with little power over its monetary policy. However, this does not mean that they have fully succumbed their individuality and their control over their own economic destiny. While the Euro Zone provides greater economic opportunities, it also poses some serious economic risks. To ensure that member countries fully benefit in the accession, countries, like Slovenia, would do well to make certain that its economic fundamentals remain sound and its decisions over fiscal policies are grounded with over-all sustainable growth in mind. In this way, transition economies can reap the benefits of becoming a member of the Euro Zone while fulfilling the Maastricht Criteria. Although many still debate if the Euro Zone is an optimum currency area, it can be said that its success, after several years of resolving conflicts and facing problems, makes the criticisms unimportant. References Antczak, M., Dabrowski, M., and Gorzelak, M. (2006). Fiscal Challenges Facing the New Member States. Comparative Economic Studies, 48(2), pp.252+. Caporale,G. M. (1993). Is Europe an Optimum Currency Area? Symmetric versus Asymmetric Shocks in the EC. National Institute Economic Review. 144, pp. 91+. Eurocoins (n.d.). The Eurozone. Retrieved April, 29, 2007 from http://www.eurocoins.co.uk/eurozone.html Frieden, J. (1998). The Euro: Who Wins? Who Loses. Foreign Policy. Fall 1998, p. 25. International Monetary Fund (1998). Economic Policy Challenges Facing the Euro Area and the External Implications of EMU. World Economic Outlook. International Monetary Fund: Washington, D.C. p. 123. Liebscher, D.K. (2007). Euro Partner Slovenia. Oesterreichische Nationalbank. Retrieved April 29, 2007 from http://www.oenb.at/de/presse_pub/reden/liebscher/re_20070320_euro_partner_slovenia.jsp Mongelli, F. P. (2002). New Views on the Optimum Area Theory: What is EMU Telling Us? European Central Bank Working paper Series, No. 138 Slovenia News (2003). Slovenia Relatively Well Prepared for the EMU, EU Official Says. Slovenia News. Retrieved April 29, 2007 from http://www.slonews.sta.si/index.php?id=618&s=27 Stark, J. (2001). Why the Euro Is a Long-Term Bet: The Reality Is That Europe Is Undergoing Radical Change. The International Economy. 15(6), pp. 20+. Stark, J. (2003). The Race for the Euro: The Central and Eastern Europeans Eagerly Seek Club Membership. The International Economy. 17(2), pp. 52+. Transition Economies (2006). Entering the EMU - not such an easy task? Retrieved April 29, 2007 from http://transitioneconomies.blogspot.com/2006/02/re-entering-emu-not-such-easy-task.html Transition Economies (2007). Fiscal spending reforms – if not now, then when? Retrieved April 29, 2007 from http://transitioneconomies.blogspot.com/ Wyplosz, C. (1999). Ten Years of Transformation: Macroeconomic Lessons. Retrieved April 29, 2007 from http://siteresources.worldbank.org/INTABCDEWASHINGTON1999/Resources/wyplosz.pdf Read More