As the global financial crisis buffets smaller countries, joining Europe's common currency starts to look a lot more enticing
For most of the new European Union countries in Central and Eastern Europe, the euro is like that relationship they never really committed to.
All 10 countries knew their accession treaties bound them to euro adoption, and all set ambitious target dates before joining the EU. Yet the majority have failed to meet—or, in some cases, even seriously pursue—Brussels' fiscal austerity requirements, known as the Maastricht criteria, for entering the currency union, for fear that the attendant belt tightening would be politically unpopular. Of these new members, only Slovenia and Slovakia use the euro, the latter switching over on 1 January.
Suddenly, though, the euro laggards are warming to the currency.
In October Lech Kachynski, president of Poland, dropped his party's demand for a euro referendum and agreed to a plan for adoption by 2012. Czech Prime Minister Mirek Topolanek said on television two weeks ago that the government would set a date by November, an announcement so unexpected in a country known for its euro apathy that even the man charged with coordinating the Czech Republic's euro accession was taken aback. (Indeed, Oldrich Dedek called Topolanek's live television commitment a "positive shock.") Hungary and Latvia, the latter of which saw stratospheric inflation scuttle its earlier euro target of 2008, are also fast-tracking adoption.
SHELTER FROM THE STORM
What's going on here? The global financial crisis has proved the wisdom of former Federal Reserve Chairman Paul Volcker's oft-cited observation following the Asian financial collapse of 1997, fomented by the implosion of the Thai baht. In the sea of global capital markets, he said, it's best to be on a big ship when the waters get rough; an ocean liner can better negotiate the swells that would capsize a smaller ship.
Volcker said this more than a decade ago, but the metaphor aptly captures how the current economic slump undermined Central and Eastern European economies initially thought immune from the woes of the United States and Western Europe—and why they're re-evaluating the euro. Quite simply, as panic spread through markets at the end of last year and confidence dissolved, these countries became a dinghy in the perfect storm, unprotected by "the shelter effect of the euro," as Zsolt Darvas and Jean Pisani-Ferry of the Bruegel think tank in Brussels put it in a recent policy paper.
What happened, in effect, was rapid economic isolation. This began as investors moved money from more risky regional stock and currency markets into safer, often euro-denominated, assets, in what economists call a "flight to quality." At the same time, growing market uncertainty nearly paralyzed lending among European banks on the Interbank market. The European Central Bank rightly moved to become lender of last resort to commercial banks, but only to those in the euro zone, Darvas said in an interview.
This sapped regional economies of liquidity and undercut currencies. The Hungarian forint, for instance, lost 30 percent of its value against the dollar between August and the beginning of November.
The drop was particularly alarming because around 60 percent of Hungary's private debt, either to households or businesses, is in foreign currencies. (That figure is 90 percent for loans taken last year.) This was manageable as long as the forint was appreciating. But as it tumbled these loans became significantly more expensive to pay off, fomenting a nascent currency crisis that had Western lenders worried about defaults and questioning whether they should roll over loans, even to sound debtors.
Latvia has an even higher percentage of foreign exchange lending. A euro peg, which the country entered into in 2005 to begin the process of adopting the currency, offers debtors some protection. The central bank has nevertheless spent some 20 percent of its reserves defending the lat, and tightening credit markets have tripped Latvia's once-turbo charged economy, highly dependent on foreign lending, into recession.
With collapse threatening both economies, the International Monetary Fund, EU, and World Bank stepped in late last year, together loaning Hungary $25 billion and Latvia $9.5 billion. Euro zone membership would have made their economies less vulnerable to the crisis because the market would have judged them less risky, according to Darvas, which is one reason the IMF attached strict fiscal tightening conditions to each country's bailout package.
TOUGH DECISIONS AHEAD
The goal is to right their economies quickly so they can meet Maastricht. Under the criteria, aspirants cannot have annual inflation more than 1.5 percent above the average of the three lowest inflation rates of EU members, and they must keep finance deficits below 3 percent of GDP and public debt under 60 percent of GDP.
The IMF is forcing Hungary to reduce public wages and pension benefits to lower its public debt, today at 66 percent of GDP. Latvia is also expected to cut wages to begin paring down a fiscal deficit projected at 12 percent of GDP this year, while falling commodity prices and lower economic growth will help reduce inflation rates that saw double digits in recent years.
"The program is designed to help" Latvia adopt the euro, Christoph Rosenberg, head of the IMF's office for Central Europe and the Baltics, said at the end of December, as reported by Forbes.com. "Euro adoption is clearly the strategy for Latvia to get out of the situation where it's vulnerable to these kinds of capital flows."
Compared with Latvia and Hungary, Poland and the Czech Republic have stronger macroeconomic conditions and a lower volume of foreign currency loans. Now, though, they're seeing the evident benefit of euro-zone membership in a crisis, as EU countries within the currency union have proved less vulnerable to market panic than those outside it. And, with Slovakia already using the euro and at least two of their neighbors on deck, demurring would risk them becoming the region's non-euro islands, undermining their relative competitiveness, according to Jon Levy of the Eurasia Group global consultancy in New York.
Poland and Romania alone among the region's EU members have target adoption dates. Romania set its, 2014, before the financial crisis. But could we nevertheless see four or five new euro zone members by 2014?
Poland and the Czech Republic would breeze through Maastricht if political will holds, Levy said. With the IMF keeping a close eye on Hungary's debt, the country is also a safe bet. Romania will have more trouble, and Latvia is the biggest question mark—the streets of Riga have already seen rioting over the country's economic woes. Meeting the inflation requirement has been Latvia's biggest problem to date. Falling commodity prices and slower growth will bring price growth down, but the recession will lower government revenue, potentially inflating the deficit above the 3-percent Maastricht ceiling, Darvas said.
As Darvas put it, Latvia "is in a trap."
The IMF reckons setting course for euro adoption, which includes politically unpopular public wage reductions, is the best escape strategy. This path will be painful, but it might be the only way out.