The European Union: High Hurdles for New EU Members to Clear

On Apr. 16, 10 countries from Eastern Europe and the Mediterranean region signed on to become new members of the European Union. Their ultimate goal is full EU membership, including adoption of the euro. Most of the hopefuls have made tough changes to become free-market economies, but more reforms will be needed.

In order to begin the process of adopting the euro, candidates must meet a host of economic guidelines stipulated in the Maastricht Treaty. For several countries, reducing their annual budget deficits to below 3% of gross domestic product will be the first big hurdle. Economists say that larger candidates, such as Poland, Hungary, the Czech Republic, and Slovakia, will have budget deficits greater than 4.3% of GDP this year (table).

Hungary may be a harbinger for the other nations in need of fiscal reform. It pegged its currency, the forint, to the euro with a trading range of +/-15%. But government-driven, double-digit pay gains, strong domestic demand, and a wave of investors attracted by high interest rates put pressure on inflation and the forint. The central bank responded by cutting interest rates by 200 basis points this year, risking higher inflation.

All candidates must institute an even tougher currency peg with a 2% trading band for at least two years before adopting the euro. The peg will limit the powers of the central banks. In turn, taming budget deficits will become more important, especially in reducing inflationary risks that may arise as foreign investment and exports increase when the euro zone economies turn around.

The likelihood that all 10 hopefuls will be ready to introduce the euro in 2006, the earliest possible year, is scant. The Baltic countries, especially Estonia, are on track for a euro adoption in 2007. But Poland, Hungary, and the Czech Republic seem to be more focused on growth right now. Full entry for these three is more likely to come in 2008 or even 2009.

By James Mehring in New York

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