Cablegate: Accession Countries and the Euro: Convergence

This record is a partial extract of the original cable. The full text of the original cable is not available.





E.O. 12958: N/A
SUBJECT: Accession Countries And The Euro: Convergence
Criteria Cause Dilemmas


This cable is sensitive but unclassified. Not/not for
Internet distribution.

1. (SBU) Summary: EU member states and acceding
countries (ACs) are beginning to face the dilemmas that
EU economic rules are likely to present them both as
soon as accession occurs in May 2004. EU rules require
ACs to adopt the euro as soon as they fulfill the
convergence criteria on inflation, public finances,
exchange rate stability and long-term interest rates.

2. (SBU) Meeting these criteria, however, could be
problematic for ACs: Catching up to per capita income
levels in other EU countries is likely to generate
relatively higher inflation; forcing inflation down
could slow down growth; increasing government
expenditures for infrastructure can bolster long-term
growth, but they could generate higher annual deficits
than permitted by the EU rules; and two-year-
participation in the exchange rate mechanism (ERM II)
could be a useful "waiting period" to find an
appropriate equilibrium rate, but also could subject
AC's to speculative currency attacks and deprive ACs
flexibility to adapt exchange rates in response to
structural changes and economic shocks.

3. (SBU) These dilemmas might be resolved by watering
down the rules, allowing a broad interpretation, or by
postponing participation in EMU. The ACs generally
prefer the second option; the current EU member states
the third. These alternatives have provoked intense
political discussion and speculation.

4. (SBU) A first clear signal of which way the
official line is headed should be when the European
Central Bank (ECB) and the European Commission present
their first convergence reports for the ACs, most
likely in the fall 2004. We expect that the rules will
remain the touchstone of the process, but also note
that the final decisions on joining the euro are taken
at the political level. As the decision was for
several of the current members of the Euro Group,
pragmatism is likely to rule the day. While EU Finance
Ministers want ACs to have a "solid foundation" for
their economies that will lend confidence to the euro,
they also probably wouldn't like to see economic fires
raging in their neighborhood either. End summary.

ACs to EMU: No Opting Out
--------------------------------------------- ------

5. (SBU) After signature of the Accession Treaty in
April 2003 for ten new member states to join the EU on
May 1, 2004, attention is now turning to the next big
step: entry of the Accession Countries (ACs) into
Economic and Monetary Union (EMU). When the ACs join
the EU in 2004, they will become "member states with a
derogation" concerning their participation in EMU.
This means that they are expected to adopt the euro as
soon as they fulfill the convergence criteria. They
will not have the right to "opt out" as the UK and
Denmark did through separate protocols.

Nominal Convergence: By the Rule Book
--------------------------------------------- -----
6. (SBU) In order to join the EMU, ACs need to fulfill
the convergence criteria set out in the Treaty on
European Union. This is referred to as "nominal
convergence." The criteria are:

--Achievement of a high degree of price stability,
apparent from an inflation rate close to that of, at
most, the three best performing member states;

--Sustainability of government finances apparent by the
absence of an excessive deficit in accordance with
Article 106(4) of the Treaty;

--Observance of the normal fluctuation margins provided
for by the exchange rate mechanism of the European
Monetary System (EMS) for at least two years with no
devaluation against the currency of any other member
state; and

--Durability of convergence achieved by the member
state and of its participation in the exchange-rate
mechanism of the EMS being reflected in the long-term
interest rate levels.
7. (SBU) The European Commission and the ECB will
assess each AC's performance in terms of these criteria
in so-called convergence reports. Commission officials
report that they are "leaning toward" doing the regular
convergence reports for Sweden before May 2004, then
prepare convergence reports for the ACs in the fall,
after they have become EU members. These officials
admit that these reports will "have to be clear" on the
criteria the Commission expects ACs to fulfill to adopt
the euro. If the ACs were to join ERM II towards the
middle or end of 2004, the criteria could be met in
2006 at the earliest, with data from 2005 and 2006 used
as a reference year. Thus, the first ACs could join
EMU in 2007 or early 2008.

Exchange Rates: A Tricky Business
8. (SBU) Interpretation of the exchange rate criterion
is tricky business. The Treaty refers to normal
fluctuations of the EMS. Protocol No.6 on convergence
criteria further specifies that the "normal fluctuation
margins" must be respected "without severe tensions."
The EMS had a fluctuation band of +/-2.25% that was
widened to +/- 15% in August 1993. In 1998 the EMS was
replaced by ERM II which has a band of +/-15%.
9. (SBU) The European Monetary Institute's (EMI, the
predecessor of the ECB) 1998 Convergence Reports
provides some insight on its interpretation of these
provisions. The EMI noted that the widening of the
band makes interpretation of "normal fluctuation" "less
than straightforward." But, it decided to "put
emphasis" on exchange rates being "close to the central
rates." Similarly, "severe tensions" was considered by
examining deviations from the central parities and
using indicators of exchange rate volatility and short-
term interest rate differentials.
9. (SBU) An ECB official stated that he interprets the
Treaty as referring to the narrower band of the
original EMS. Similarly, a Bundesbank official told us
that in his view it would not be sufficient for ACs'
currencies to fluctuate in the wider band of ERM II,
but should remain more or less within the +/-2.25%
band. He also admitted that appreciation over the band
would be less of a problem than depreciation. While
the Commission has not been very clear about its
interpretation of the Treaty, in May Commissioner
Solbes let slip that the narrower band is also what he
would expect from ACs. Privately Commission experts
admit that this has been their guiding rule to date.

10. (SBU) Getting the equilibrium exchange rate right
between the ACs national currency and the euro is
important for ACs and the ECB. For the ACs it is a
question of price competitiveness and long-term growth
prospects. For the ECB it could be a question of
inflation. Once in the ERM II, intervention at the
margin to keep a currency in its band is, in principle,
automatic and unlimited. Thus, the rate better be
right for the sake of the ECB the national central
banks that would be drawn into such intervention or its
financing potentially increasing money supply The ECB,
however, can suspend such intervention if it were to
conflict with its primary objective of price stability.
Doing so would likely be perceived as a vote of no
confidence in the exchange rate. Therefore it is no
surprise that ECB officials reportedly are working with
AC central bankers to ascertain the appropriate
exchange rate at which to fix their currency against
the euro.

Inflation: A Question of Catching Up or Being Too
--------------------------------------------- ------
11. (SBU) The inflation criteria present another set of
problems. Upward pressure on the price levels in ACs
is likely to come from macroeconomic factors such as
higher productivity growth and the associated Balassa-
Samuelson effect (relatively higher productivity and
wage growth in tradable goods contributing to upward
price pressures on non-tradable goods and services and
their associated wages) as well as from price
liberalization and deregulation. These factors lead to
inflation rates that are likely to temporarily remain
above the EU average. Inappropriate macroeconomic and
wage policies combined with structural weaknesses in
the ACs economies also exert upward pressure on price
levels. Divergent inflation rates between EU member
countries and ACs can be expected to remain a problem
until real convergence has been achieved.
12. (SBU) Given the current very low inflation rates in
some euro zone members, the inflation criterion would
require ACs to achieve inflation rates well below 2%.
The European Commission's spring forecast, for example,
projects average annual inflation of 1.7% for the euro
area in 2003 compared to 2.7% in the ACs. The average
inflation rate of the "three best performing member
states" would be 1.1%. According to the Commission's
forecast, only Lithuania and Poland would meet that
target in 2003. Tight monetary policies needed in the
other ACs to achieve the inflation target could have a
negative effect on the ACs' economic growth.
13. (SBU) The convergence criteria were designed for
developed, i.e. largely converged countries, and not
for transition economies. As ACs have generally
experienced real currency appreciations of 2-3%
annually there is a conflict between the inflation
criterion and the exchange rate stability required in
ERM II. Real appreciation takes place either through a
nominal appreciation of the currency or via relatively
higher inflation than in the country's main trading
partners. The convergence criteria do not allow the ACs
either. More generally, with full capital mobility and
only one instrument (interest rates), the central bank
cannot target the inflation rate and the exchange rate
14. (SBU) Commission officials point out that
persistent differences in inflation rates between
countries are a risk for fixed exchange rate systems.
They argue that keeping flexible exchange rates for the
ACs could limit the risk of overheating through the
option of a nominal appreciation and interest rates
that are in line with the national economic situation.

Long-Term Interest Rates: Market Expectations
15. (SBU) ACs have already experienced convergence of
long-term interest rates towards the levels of EMU
members. This may partly be due to market expectations
that these countries will join EMU soon, resulting in
investments in ACs bond markets (the so-called
"convergence play"). However, the drop in interest
rates is also the result of a considerable volume of
foreign direct investment, the gradual stabilization of
domestic price levels and slowing economic growth.

The Fiscal Side: SGP Rules

16. (SBU) The absence of an excessive deficit
according to Article 106(4) of the Treaty is defined as
a general government deficit of no more than 3% of GDP
and a debt level of no more than 60% of GDP. These are
the reference values in the Treaty and the associated
provisions referred to as the Stability and Growth
Pact. Most ACs have debt levels below the 60% of GDP
threshold of the Maastricht Treaty

17. (SBU) The average general government deficit in
ACs, however, was 5.3% in 2002, according to Commission
statistics. Only Estonia, Lithuania, and Slovenia have
deficits below the 3% reference value. In several ACs,
significant fiscal consolidation would be needed (Czech
Republic, Hungary, Malta, and Slovakia all had deficits
over 6% in 2002). The convergence reports will
identify most ACs has having "excessive deficits."
Unlike for EU member states, no sanctions can be
imposed for having an excessive deficit. However, it
also means the ACs can't join the EMU.

18. (SBU) Fiscal consolidation in order to meet the
convergence criteria as soon as possible could result
in lower public investment, particularly in
infrastructure, which could adversely effect long-term
growth. At the same time, reducing deficits might
become even harder in the near future: requirements
resulting from EU and NATO membership will lead to
considerable pressure on spending in the coming years.
The World Bank quotes estimates that put the overall
costs of EU entry to the ACs, not exclusively but
mostly budgetary, at as much as 3.5% of GDP for the
first three years.

18 (SBU) Growing appreciation that the exchange rate
requirement might make the road towards adoption of the
euro rather bumpy has sparked off criticism from market
participants, academics and policy-makers in the ACs.
19. (SBU) Daniel Gros of the Center for European
Policy Studies in Brussels calls ERM II "the most
dangerous exchange rate regime that one can imagine."
Fixed but adjustable exchange rate regimes are a
tempting target for speculators, in particular when the
underlying economic fundamentals are shifting, in his
opinion. Originally, capital inflows into the
accession countries were mainly direct investments,
either privatization or green-field investment.
Gradually, portfolio investments are becoming more
important, e.g. the "convergence play." These
investments are short-term and can quickly flow out.
This increases the risk of exchange rate volatility.
20. (SBU) Hungary's recent episode illustrates the
problem. The Hungarian forint significantly
appreciated over the last year due to strong capital
inflows. The stronger forint hurt exports and,
consequently, employment. In January, the National
Bank of Hungary (NBH) cut interest rates to prevent too
much portfolio investment and to protect the exchange
rate. However, on June 4, the NBH weakened the
central parity exchange rate by 2.26%. According to
ECB officials, this was the result of a deal between
the Government, which wanted a weaker exchange rate to
stimulate exports, and the Central Bank, that wanted
the government to fulfill the deficit convergence
criteria quickly.
21. (SBU) The move was poorly communicated and
misunderstood in the market that was spooked. The
considerable depreciation of the forint prompted the
NBH to increase interest rates again in the course of
June in order to regain credibility for its anti-
inflationary stance. These seesaw changes appear to
have damaged the NBH's reputation. The episode also
illustrates that a central bank only has one instrument
(interest rates) to aim at two targets: exchange rate
and inflation.

Debate Regarding Early Adoption of the Euro:
To Be In or Not To Be In.
--------------------------------------------- --------
22. (SBU) Positions in the debate on early or later
adoption of the euro are on predictable lines: ACs
think sooner is better; member states advise to take
time and do it right. From the ACs' perspective,
capital movements present a potentially destabilizing
force that could disrupt growth. This, in their view,
could be avoided by early adoption of the euro, i.e.
scraping the requirement of a two-year participation in
ERM II. Advocates of early euro adoption generally
also believe that the costs of a fixed exchange rate
are low for the ACs. They are mostly small open
economies and cannot really conduct an independent
monetary policy anyway. Entering EMU would give them a
say in monetary policy decisions.

23. (SBU) The Euro Group (finance ministers of the EMU
member countries) takes a very different view. At its
March 2003 meeting the Group discussed and reconfirmed
its position that ACs are expected to first participate
in ERM II for two years before being able to adopt the
euro. At the April 15 informal Ecofin Council,
ministers confirmed that they would neither accept
early membership of ACs in ERM II, nor early exit from
ERM II. According to the Ecofin approach, a certain
"waiting period" before the adoption of the euro would
allow ACs to cope with the shock of full integration
into the single market and to achieve a high degree of
nominal convergence.
24. (SBU) Commission research economists support the
Euro Group's view for somewhat different reasons. They
believe that ACs should wait to join ERM II to avoid an
influx of capital and lower interest rates that do not
reflect fundamentals. Lower interest rates could lead
to unproductive investments and asset bubbles that
would adversely affect the longer-term growth
performance of the ACs.
25. (SBU) ECB chief economist Otmar Issing argues that
as an intermediate regime, ERM II provides an anchor to
expectations, while countries retain the flexibility to
adjust the parity in case of asymmetric shocks and
exchange rate pressures. He concedes, however, this
option leaves countries exposed to changing conditions
in global capital markets.
26. (SBU) Issing stresses that any decision to join
ERM II must be consistent with an adequate level of
nominal and real convergence with the euro area. This
would reduce the risk of choosing an inappropriate
parity for the exchange rate. In his view, the optimal
timing of euro adoption may vary considerably between
ACs. Moreover, Issing argues that two years'
participation in the ERM is a minimum and a longer stay
would permit ACs exchange rates to adapt to differences
in productivity gains, wage growth and inflation
relative to the euro area. Once in EMU, these
differences would translate in costly changes in
competitiveness and economic activity, in his view.
27. (SBU) Interestingly, the IMF has tiptoed into this
debate. In its Article IV consultation on Hungary the
IMF staff stated that it "sees considerable merit in
early adoption of the euro, provided fiscal discipline
and wage restraint are vigorously pursued." The report
went on to state that "for Hungary, a small economy
already highly integrated with the EU, adopting the
common European currency has clear medium-term
benefits. This is particularly true given the
important role in Hungary of FDI and foreign-owned
enterprises, and their orientation mainly toward EU
markets. The commitment to early EU accession and
adoption of the euro not only hardens the authorities'
resolve to deliver the necessary fiscal discipline and
structural reforms, but it can also serve to strengthen
the credibility of the disinflation path and, by doing
so, can also help to minimize short-run costs that
might arise."

Real convergence: Growth and economic structures
--------------------------------------------- ----
28. (SBU) The Commission and the ECB have been publicly
discouraging the ACs from entering EMU very quickly,
recommending that they should first concentrate on
raising per capita incomes closer to the EU average and
moving towards comparable economic structures, e.g.
real convergence. Commissioner Solbes has stressed that
there are also significant risks associated with a
premature EMU entry while the process of structural
change, catching up and fiscal consolidation is not yet
29. (SBU) Economic theory suggests that an important
criterion for deciding whether to join a monetary union
is whether economic cycles in the participating
countries are pretty much in sync. This reduces the
likelihood of asymmetric shocks hitting one or a few
countries. Those subject to such shocks would have to
absorb them without using monetary policy or exchange
30. (SBU) How serious these limitations are for the
ACs depends on the type of shocks, the degree of
asymmetry of shocks compared to the euro area, and on
the speed at which economies adjust to shocks. Polish
and Hungarian central bank economists claim that
economic cycles of the euro area and the ACs are
basically aligned. An IMF staff study finds that there
are still differences in the shocks and the subsequent
adjustment processes between the euro area and the
CEECs. However, several individual CEECs exhibit
shocks and shock adjustment processes that are fairly
similar to some euro area countries. For instance,
Hungary, Estonia, and Latvia are not significantly
different from Greece.
31. (SBU) An ECB official reports that their research
continues to show a low correlation between cyclical
developments in e.g. Poland and the euro area
countries. Accordingly, he argued that an independent
monetary policy would be good for a country like
Poland. A Bundesbank official took the same view,
stressing that the ACs recently had much stronger
growth performance than the EU members, i.e. there is
no sufficient degrees of cyclical synchronization. He
also pointed out that even if this were the case, there
would be an ongoing need for structural changes in
relative prices during the catching-up process.
33. (SBU) ECB Executive Board Member Padoa-Schioppa
pointed out that the convergence progress seems to be
rather slow in most ACs when looking at per capita
income levels. On average, per capita income stands at
about 40% of the EU average as measured using
purchasing power parities. However, according to Padoa-
Schioppa, the most relevant concept of real convergence
is assessing whether economic structures are in line
with those of the euro area and whether new entrants
have set up appropriate institutions and adopted
international best practices and standards. He finds
remarkable progress in that respect in the ACs.

ACs' views
34. (SBU) Benefits from adoption of the euro entail
the elimination of exchange rate risk, reduction of
transaction costs in cross-border business, increased
trade, lower interest rates due to imported credibility
and lower vulnerability to external shocks. For ACs
with high debt levels and interest rates, such as
Hungary, euro adoption would imply fiscal savings once
interest rates are down to the euro zone level.
Moreover, a commitment to enter the EMU by a time
certain would intensify pressure on the government to
pursue sound fiscal policies, signaling investors that
public finances will be consolidated.

35. (SBU) The Slovenian central bank and government
have stated that they aim at joining ERM II at the
beginning of 2005. Thus the earliest date for the
adoption of the euro would be 2007. It would still
have to bring down its inflation rate (7.5% in 2002),
but otherwise is not expected to have any problems with
the convergence criteria. Meeting the criteria should
be completely unproblematic for the three Baltic states
(2002 general government deficit and inflation figures,
respectively were: Estonia, 1.3%, 3.6%; Lativa, 2.5%,
1.9%; and Lithuania, 1.8% and 0.3%).
36. (SBU) The NBH and the Hungarian government have
declared that they intend to adopt the euro as of
January 1, 2008. Hungary plans to join ERM II soon
after accession in 2004. Observers, however, doubt
that Hungary will be able to meet the deficit (9.5% in
2002 projected by the Commission to fall to 4.9% in
2003) and inflation (5.3% in 2002; new forecast by NBH
projects it to be 6.5% in 2004) criteria in time for
the planned entry date. Poland (deficit 4.2%;
inflation 1.9% in 2002) is aiming to adopt the euro by
2008 or 2009. Slovakia (deficit 7.7%; inflation 3.3% in
2002) has announced that it wants to join EMU as soon
as possible.
37. (SBU) The Czechs (deficit 6.5%; inflation 1.4% in
2002) have been the only country to indicate that they
are not in a hurry to join ERM II. They want to make
sure that they will be able to meet the other criteria
after two years of participation. However, should
Poland and Hungary move quickly, the Czechs do not want
to be seen as lagging. A strategy for the adoption of
the euro will be established by the end of September
2003. The Czech finance ministry and central bank
prefer to be prepared to adopt the euro by 2007, as
they believe that financial markets might punish those
ACs that are not ready when the other countries join
EMU. The IMF staff shared that view in its Article IV
Consultation with Czech authorities. The Prime
Minister thinks that 2010 would be more appropriate.

The Politics: Rules as Pretext or Guideposts?
38. (SBU) While it is clear that the EU rules will be
the touchstone to determine an ACs eligibility to adopt
the euro, one senior AC central bank official claimed
that strict adherence to the rules can be a pretext for
other reasons against early adoption of the euro. He
believes that the ECB is against early entry of the ACs
because it would make monetary policy as well as ECB
decision-making on other issues more difficult. "They
are just not ready for us."
39. (SBU) An unspoken concern is that the entry of
catching-up countries into EMU would result in a looser
monetary stance. Although the GDP-weight of the ACs is
negligible (6% of total euro area)under the new
rotation system for ECB voting, the ACs weight in
voting would be proportionately higher than their GDP.
They could thus have a more significant influence on
monetary policy decisions (even though the ECB has so
far reached decisions by consensus and never taken a
vote). In theory, however, ECB Council members should
be guided by considerations regarding the entire euro
area and not by national interests.
40. (SBU) On the other hand, the rules are not
ironclad, rather serving a guideposts. ECB
representatives have hinted that the Treaty leaves some
scope for political decisions on EMU entry. "We just
prepare the convergence report: it's just a report."
Finance Ministers, after discussion the convergence
reports, would direct the Commission to prepare a
proposal for a decision by Heads of State or
41. (SBU) In the application of the rules the
Commission has stressed that (1) each country will be
considered on its individual merits; and (2) each
country will be treated equally. With respect to the
first point, a Bundesbank expert doubted whether a
country-by-country decision on EMU entry would take
place. Rather he expects that there may be a group of
more advanced countries, mainly the Baltics, joining
early and another group following later. He also
expects that political pressures will be exerted by the
ACs to gain immediate entry into ERM II. To some ACs
this would be the beginning of a two-year process
leading directly to adoption of the euro.
42. (SBU) On the second point of equal treatment,
neither Finland nor Italy spent two full years in ERM
II before they joined EMU. Moreover, while the UK has
never agreed to join the ERM II, there is speculation
that it would nevertheless be admitted to EMU if it
wished to enter. Sweden is a more immediate case in
point. The Commission stated in its bi-annual report
on Sweden that "exchange rate stability during a period
of nonparticipation before entering the ERM II can be
taken into account". Thus, previous experience
suggests there is some leeway for ACs to be admitted to
EMU without participating in ERM for full two years.
43. (SBU) Similarly, Italy and Belgium did not meet the
debt criteria before being allowed entry and some
others may have used "creative accounting" to get their
books in shape to meet the entry criteria. All these
examples of interpreting rules are likely to be well-
known to ACs.

44. (SBU) The potential gains of adopting the euro
will be weighed against the potential risks, in
particular of a real appreciation, which could put a
brake on growth. The ACs themselves seem to understand
that monetary, exchange-rate and fiscal discipline
imposed by EMU can involve serious constraints,
impeding growth.
45. (SBU) At the end of the day, the decision on EMU
participation will be based on the rules and numbers,
with a healthy dose of political considerations.
However, watering down the convergence criteria for the
ACs could harm the euro's reputation as a stable
currency and would do the ACs no justice. Abiding by
the rules and risking currency troubles that could be
attributable, at least in part, to those rules also
would not be a good advertisement for the euro. As in
the past, some pragmatism could be used to reward those
ACs that have demonstrated a commitment to move
aggressively toward, if not actually meet, the Treaty
criteria. End comment.
46. (U) This cable coordinated with Embassies Berlin,
Budapest, Warsaw, Prague, Ljubljana, and USEU Brussels.

47. (U)POC: Claudia Ohly, Treasury Office, e-mail; tel. 49-(69)-7535-2367, fax 49-(69)-


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