Is CEE fit for the Eurozone? Bulgaria and Romania on their way to the Euro
- Juncker pledges for a more complete integration of the EU with a focus on Euro adoption
- Among CEE countries Euro optimism is highest in Romania and lowest in the Czech Republic
- Romania and Bulgaria have met most of the convergence criteria but more work needs to be done
In his State of the Union Address, the president of the European Commission Jean-Claude Juncker, pledged for a more complete integration of the European Union: Europe must breathe with both lungs, East to West. Particularly his thoughts on monetary integration provoked discussions whether the lessons from the Eurozone debt crisis have been learned and monetary integration should be decelerated rather than accelerated. Juncker, however, emphasised that “the Euro is meant to be the single currency of the European Union as a whole. All but two of our Member States are required and entitled to join the Euro once they fulfil all conditions.” As outlined in the Maastricht treaty, these conditions are set to ensure economic convergence with the countries of the Euro Area. Besides the well-known criteria for the soundness and sustainability of public finances (limits of 3 % for government deficit as a share of GDP and 60 % for government debt), the Maastricht criteria also comprise price stability, exchange-rate stability and long-term interest rates.
From an economic perspective, entering a monetary union implies giving up the possibility of conducting independent monetary policy to achieve exchange rate stability and free capital flows, known as the macroeconomic trilemma. The exchange rate can no longer operate to counteract imbalances between countries emerging from asymmetric shocks. Alternative adjustment mechanisms need to be in place. The seminal contribution by Mundell (1961) argues that the success of currency areas depends crucially on factor mobility. Also, federal systems of taxes and transfer payments can act as automatic stabilizers counteracting imbalances. Without these alternative adjustment mechanisms in place, domestic prices need to be adjusted via internal devaluations, which have proven to be costly both in terms of economic growth and employment as the example of Greece shows.
In the CEE region the ambition to quickly join the Euro Area has faded. For now, the monetary union is perceived as being too costly for many countries. In the latest Flash Eurobarometer (April 2017) the Czech Republic shows the greatest opposition with only 32 % of survey respondents thinking that ‘the introduction of the Euro would have positive consequences for’ their country. Figure 1 shows the evolution of the sentiment towards the Euro in 5 CEE countries, indicating that the perception towards the Euro of having positive consequences for these local economies has worsened since the financial crisis. The Euro Crisis in 2011/12 marks the low point of Euro optimism since when some improvements in sentiment can be observed. Compared to the Czech Republic, which is the most Euro pessimistic country within the sample, the situation proves to be quite different in Romania where 49 % think that the Euro would have positive consequences while 43 % share the opinion that the effects would be negative. On the question whether the respondent is ‘personally more in favor or against the idea of introducing the Euro’ Romania (64 %), Hungary (57 %) and Bulgaria (50 %) share a more positive sentiment towards introducing the Euro than the Czech Republic (29 %). The political establishment is, however, clearly more Euro friendly in Romania and Bulgaria than in Hungary.
Romania and Bulgaria are substantially poorer than the average Euro Area member state. In purchasing power standards GDP per capita is 45 % and 56 % of the Euro Area level, which is below the poorest Euro Area countries with Greece at 64 % and the Baltic countries at 70 % (2016, AMECO). However, catch-up growth is well underway. Since joining the EU in 2007 considerable progress has been made. In 2007 GDP per capita was at 37 % of the Euro Area level in Bulgaria and 39 % in Romania. Moreover, public finances have been within the deficit and debt limits. Bulgaria had a balanced budget in 2016 and its public debt to GDP was at 30 %. Public debt in Romania was at 38 % in 2016 and the deficit criterion of 3 % has just been met with 3.5 % being forecasted for 2017 (AMECO).
A main indicator for evaluating the suitability of joining the Eura Area is the development of the exchange rate. Within the EMR II procedure, in which countries willing to join the Euro Area must participate for two years, the local currency is allowed to fluctuate by up to 15 % above and below an agreed central exchange rate. Neither Bulgaria nor Romania have joined EMR II yet but Bulgaria already follows a fixed exchange rate regime at 1.96 (BGN/EUR). The Romanian Leu currently trades at 4.6 (RON/EUR). The two-year average (since January 2015) is 4.49 with a standard deviation of 0.05 and the minimum-maximum deviations are well within the +/-15 % boundary.
The ECB’s main policy objective is price stability. Countries willing to join the Euro Area, therefore, must show that inflation is under control. Even though, the ECB has recently struggled to reach its inflation target of ‘below, but close to 2 %’, the Euro Area’s core inflation rate, which excludes exogenous effects from energy and unprocessed food prices, has been quite stable at around 1 % since 2013. Both Romania and Bulgaria show much more volatile price developments (Figure 2). However, it is not inflationary pressure but deflationary dynamics which is driving volatility. In Bulgaria core inflation has only left negative rates in Q2 2017 and in Romania VAT cuts dampened price developments. From 2013 onwards, the Romanian central bank has set a 2.5 % target inflation rate with a band of +/- 1 %-points. After having adjusted inflation targets downwards, in 2005 the inflation target was at 7.5 %, the new multi-annual inflation target is set to ensure compatibility with the ECB’s quantitative definition oof price stability
With respect to long term interest rates, we compare 10 year government bond yields (Figure 3). Romania shows the highest bond yields throughout the period closing at 4 % in September 2017. Its long-term spread to the German 10yr bund yield fluctuated around 300 basis points. Bulgarian 10yr government bond yields are considerably lower than its Romanian counterpart. Its spread to the German benchmark was at 200 basis points until the end of 2016 and has recently declined to almost 100 basis points. Compared to Italy and Spain, the Bulgarian long term interest rates have followed a similar trend and close at comparable levels. Romanian long term bonds yields are substantially above Italian and Spanish yields being more comparable to an average of Greek (09/2017: 5.4 %) and Portuguese (2.8 %) yields.
Overall, the Bulgarian and Romanian economies are on a good way to reach eligibility of joining the Euro Area. Both economies, however, have not yet entered EMR II and legislative compatibility has not been achieved. Moreover, the political desire to adopt the Euro as quickly as possible has weakened after the turbulences of the Euro Area crisis in 2011/12. Despite considerable economic growth prior to the financial crisis of 2008/09 and solid, though lower, economic growth during the last three years, Bulgaria and Romania remain to be among the poorest EU member states. Additional convergence in living standards would be desirable to ensure a smooth monetary convergence and avoid additional economic divergences within the Euro Area.