Eastern Europe finance: Queuing up to join a sinking ship?

FROM THE ECONOMIST INTELLIGENCE UNIT

Estonia has won European Commission approval to join the euro zone from the start of 2011, because it has met the Maastricht criteria. The Commission’s recommendation overrides the stated reservations of the European Central Bank and all but guarantees Estonia’s entry. Four other east European states are eager to adopt the euro too; this may seem odd in light of the currency zone’s troubles, but it makes sense because most of their currencies are pegged to the euro and they stand to gain influence and support by entering. Seemingly this outweighs the downside of having to contribute to future bailouts; although the other candidates remain so far from meeting the strict criteria that this is probably a secondary issue.

The European Commission on May 12th announced its backing for Estonia’s accession to EMU from the start of 2011. Estonia comfortably met all the criteria: it has spent the requisite two-years in the exchange rate mechanism (ERM2) without problems; public debt is a measly 7.2% of GDP; the budget deficit last year was just 1.7% of GDP; long-term interest rates are in line with EU averages; and it met the inflation criterion too—inflation on average was negative in the last twelve months. Inflation is the main sore point for the ECB, which has raised doubts about the sustainability of low inflation inEstonia. The ECB’s case has been strengthened by a surge in headline inflation this year, from 0.4% in February to 1.7% in March and 2.9% in April. The Estonian government insists this is a temporary phenomenon, related to an increase in taxes undertaken to narrow the fiscal deficit.

The ECB’s reservations will not be sufficient to thwart Estonia’s ambition, however. It is the Commission’s opinion, not the ECB’s, which holds ultimate sway. Ecofin, the council of euro-area economy and finance ministers, will rubber-stamp the Commission’s verdict in July.

A negotiable commitment

All of the ten former Communist states who joined the EU in the last decade have a treaty obligation to adopt the euro. Slovenia did so in 2007 and Slovakia followed in 2009.Estonia will be the third. Without a deadline, however, there is a great deal of wiggle-room for the eastern members. Successive governments in the Czech Republic have made euro-adoption a relatively low priority, and a similar pattern has been observed in Polandin recent years. The onset of crisis conditions in the euro zone, with Greece at the forefront, has further weakened Poland’s interest in rapid entry to the currency union. ForPoland and the Czech Republic, and perhaps also for Romania, 2015 looks the earliest possible date for entry.

In light of the euro’s troubles, doubts over its future existence and the fact that Slovakiaand Slovenia are together obliged to contribute over €1bn to help rescue Greece, it may be surprising to see any enthusiasm for euro adoption among those eastern members not yet in the club. And yet there is no sign of the commitment of Estonia, Latvia, Lithuania orBulgaria wavering; Hungary too seems determined to join within the next few years.

Titanic attraction

How to explain this desire to join a potentially sinking ship—especially as states might well be asked to pay for the privilege (by bailing out the profligate southern members)? Three reasons stand out.

First, the Baltic and Bulgarian currencies have actual or de facto pegs to the euro. If the single currency goes under, they will go with it. For Greece, which is yet to begin any serious fiscal adjustment, default and devaluation remain an option. The Balts, by contrast, have already walked the walk: public-sector wages have been cut by 10% or more in the last year in all three states. Having invested in this internal devaluation, there is less need to adjust their currencies. Moreover, having invoked the euro as part of the reason for undertaking austerity, governments could pay a high price politically for shifting course now.

Second, and in light of their currency pegs, there are advantages to being inside EMU rather than outside, in terms of the level of support that can be expected from fellow member-states. Hungary actually got a hand from the ECB when it got into trouble, and in likelihood so would the Balts and Bulgarians. But there would be more certainty inside the club.

Third, as members of the euro zone these small states would be represented at the ECB and together they would have the potential to exert influence. Although Germany and the other big countries have enormous sway over the ECB, in theory decisions at the bank are made by consensus.

An expensive club?

Set against this is the strong chance that Estonia, once in, will be asked to contribute to the bailout of other members. This is particularly galling for the small east European states eager to enter EMU, because they are poorer than Greece and have run tighter fiscal policies. Moreover, they have actually embraced austerity in order to enter EMU.

For Hungary, Bulgaria, Lithuania and Latvia, however, the prospect of handing over taxpayers’ money to free-spending Mediterranean governments is some way off. It is open to doubt whether any of them will be able to join before 2014 and by then, one way or another, the problems currently afflicting the euro zone might have been resolved.

By backing Estonia’s application the European Commission has sent out a message: countries that meet the Maastricht criteria will be admitted. Yet it is also clear, not least from the fact that Lithuania was barred a few years ago because its inflation rate was one-tenth of a percentage point too high, that even the slightest blemish on an applicant’s record is likely to result in rejection.

All of the other eastern EU members aspiring to adopt the euro have problems in meeting the criteria. Bulgaria has little public debt and one of the smallest budget deficits in the EU; however, it is struggling to keep inflation within a percentage point of the EU’s three lowest-inflation states and it is not yet in ERM2. Moreover, the government recently admitted that some expenditure by its predecessor was not included in the budget calculations, so the deficit figures will need to be revised. Latvia and Lithuania are some way from meeting the fiscal-deficit criterion and have little chance of growing out of their fiscal troubles anytime soon. Tax rises could also threaten their ability to meet the inflation criterion.

Hungary has made strong progress towards the deficit target but scepticism is rising inside the country and outside concerning the official target to make the grade by 2011.Hungary, moreover, does not meet the Maastricht criterion on public debt and might struggle to keep its currency sufficiently stable over a two-year period. ERM2 observes a wide fluctuation band, of ±15 percentage points from the central rate, but the EU has left a door open that could enable it to put a much tighter definition on “currency stability”.Romania’s deficit and inflation problems put it well behind the Balts in the queue for EMU, while the Czech Republic and Poland are evidently in no hurry to join. After Estoniaenters, the EMU membership will have plenty of time to sort out its internal troubles before another credible applicant knocks on the door.