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How to achieve sustainable convergence on the road to EMU

Speech by Lucas Papademos, Vice President of the ECBdelivered at the eighth CEPR/ESI Conference on “EMU enlargement to the East and West”Budapest, 25 September 2004


Looking again at the topic of our conference “EMU enlargement to the East and West” on my flight to Budapest, one thing struck me as novel: We are gathered here in Hungary, a new EU Member State, to discuss a subject not specifically related to the recent enlargement of the European Union or to the central European economies, but a forward-looking pan-European theme. And I am delighted to have been invited to address this distinguished group of academics and policy-makers at the Magyar Nemzeti Bank, which has hosted and organised so many intellectually inspiring conferences on topical issues over the last decade. The eighth CEPR/ESI conference on EMU enlargement is very topical indeed following the recent EU expansion and the declared intention of almost all new Member States to join EMU as soon as is feasible.

The general issue which I felt it would be worthwhile discussing today can be expressed in terms of a question: “How can sustainable convergence on the road to EMU be achieved?” The answer to this question is of obvious relevance to future euro area members, since sustainable convergence and successful monetary integration are inseparable. In discussing this general issue, some specific, pertinent questions must be addressed:

  • What kind of convergence is needed before a country can join the euro area?

  • What is the role and relative contribution of macroeconomic policies and structural reforms in attaining nominal and real convergence in a sustainable manner?; and

  • To what extent can we expect convergence to continue after euro adoption as a consequence of the “inherent dynamics” within a monetary union?

The EU framework for monetary integration regards the achievement of a high degree of sustainable convergence as a precondition that a country must fulfil in order to adopt the euro. The well-known Maastricht criteria focus on the degree of nominal convergence required to join EMU. Several indicators, such as current account and unit labour cost developments, are used to provide additional information with which to assess the sustainability of convergence.

The sustainability of nominal convergence is also linked to the progress made in attaining real convergence. This is usually defined as the convergence of living standards or of real GDP per capita. More broadly and, in my view, more appropriately, it can be defined as the adjustment of the economy’s structures and institutions to those prevailing in the euro area. Structural and institutional convergence can foster a catching-up of real incomes and strengthen economic cohesion within EMU. Over the medium and longer-term, real convergence can support the sustainability of nominal convergence in various ways: by helping to decrease the economy’s exposure to asymmetric shocks and by reducing differences in the transmission of symmetric shocks. Likewise, nominal convergence can facilitate real convergence by providing stable macroeconomic conditions and by anchoring expectations.

I will examine these issues primarily from the perspective of the new Member States, which face a set of similar challenges partly related to their position in the convergence process. I will start by presenting a snapshot of the state of convergence in the new Member States. Then I will focus on a number of key policy issues and challenges faced by these countries in their efforts to attain sustainable convergence. These relate to monetary policy strategy, the attainment of sound fiscal positions, the control of credit growth, and structural reforms. Finally, I will briefly illustrate these challenges in a more tangible way by relating them to the case of Hungary.


Looking first at real convergence, it can be observed that the new Member States as a group have made substantial progress. As a result of the more dynamic growth of the new Member States than that of the older ones (the EU15) over the previous ten years[1],average GDP per capita (in purchasing power parity terms) in the new Member States increased from 41% of the euro area average in 1994 to 50% in 2003.

There are, however, marked differences between the new EU member countries, both in terms of the level of real convergence already achieved and the speed with which it has been accomplished. Differences in current GDP per capita levels in purchasing power parity terms range from 38% of the euro area average in Latvia to 79% in Cyprus. Over the last ten years, Estonia, Latvia and Slovenia have (according to European Commission data for the period 1994-2003) made the most substantial progress towards closing the GDP per capita gap relative to the euro area.

What have been the key elements behind this impressive catching-up of real GDP per capita? It has been driven mainly by productivity growth. Its contribution to GDP per capita growth in most new Member States has been well in excess of that of the EU15. At the same time, the role of changes in the employment rate (i.e. total employment divided by working age population) has been negligible or even negative in most new Member States. It should be noted, however, that also with regard to these indicators, a great deal of heterogeneity can be observed. Hungary appears to be a notable exception, where the improvement of the employment rate has been a more substantial contributor to per capita income growth than in the EU15 as a whole. [2]

Convergence in real GDP per capita levels has been fostered by far-reaching structural and institutional change, with the prospect of EU membership serving as a powerful incentive and driving force since the mid-1990s. The EBRD Transition Indicators show significant progress in the areas of privatisation and liberalisation of markets and prices; in these areas, conditions in the new Member States now broadly match those prevailing in the other countries of the European Union. Progress with regard to financial institutions has also been solid, albeit less pronounced; in some countries, for example, the supervisory framework still needs to be strengthened (Slovakia, Lithuania).

In addition, the relative size of the three main economic sectors in total output has been gradually converging towards that of the euro area, although there are still some country-specific deviations from the average, as is the case for the older EU members. Of course, convergence of economic structures is not sufficient to guarantee that the economies of the new Member States will perform successfully and benefit from future membership of the euro area. It is, however, essential to increase the capacity of these economies to absorb shocks, and to decrease the likelihood and impact of asymmetric shocks.

Where do the new Member States currently stand with regard to nominal convergence? I will concentrate on inflation developments and fiscal performance. A comprehensive analysis and assessment, covering all key aspects of nominal convergence, will follow in October, when the European Commission and the ECB release the 2004 Convergence Reports.

Substantial progress has been made in reducing inflation from the very high levels prevailing at the beginning of the transition process. In 2003, the weighted average of (HICP) inflation in the new Member States was 2.1%, virtually the same as last year’s inflation rate in the euro area. This demonstrates the extent to which the new Member States have benefited from the adoption of macroeconomic policies, and in particular of monetary policy frameworks, that are focused on fighting inflation. However, in some countries, such as Hungary, Slovakia and Slovenia, inflation was still a mid to high single-digit figure in 2003. Moreover, inflation developments in that year must be assessed in the light of the favourable short-term impact of such factors as cyclical developments, strong exchange rate appreciation (vis-à-vis the euro and in effective terms), some easing of energy prices and a decline in food prices.

Recently, a combination of negative supply shocks and positive demand shocks has resulted in a marked rise in inflation in a number of new Member States. Some of the factors driving price dynamics, such as the rise in energy prices, have been at work elsewhere as well. However, the recent increase in inflation in most new Member States is in part also related to policy measures and adjustments associated with EU accession. More specifically, three aspects stand out in this context:

  • First, food prices have increased, partly as a result of the removal of sectoral trade barriers due to the integration of the new Member States into the Common Agricultural Policy. Moreover, rising demand for certain basic food products by domestic consumers before EU accession contributed to the price dynamics in this sector. While a normalisation of demand conditions and enhanced competition in retail trade should at least partly reverse the latter price rises, integration-related food price adjustments are likely to persist.

  • Second, indirect taxes have been lifted to achieve harmonisation with EU-wide VAT rates and excise duties, but also with a view to raising budget revenues or to compensating revenue losses from cuts in direct tax rates.

  • Third, administered prices have been substantially increased in some countries (e.g. in Slovakia) in order to complete the adjustment to cost-recovery levels.

Moreover, in several countries exchange rate developments have contributed to inflation pressures (notably in Poland and Latvia). Although most of these factors appear to have had a one-off impact on price levels, there is a risk of second-round effects if inflation expectations and wage formation are adversely influenced. And inflation expectations have picked up in a number of new Member States, showing that such expectations still tend to be fairly adaptive. Finally, rising unit labour costs also appear to have contributed to inflation pressures in some (but not all) of the new Member States.

There has been considerable variation across countries with regard to progress towards fiscal consolidation, and the overall picture is fairly mixed. While public debt ratios are at low or intermediate levels in most new Member States, six of these states had excessive budget deficits in 2003. In a number of cases, these deficits were substantially above the threshold of 3% of GDP. Moreover, in a number of new Member States fiscal positions have been deteriorating in recent years. It is a cause for concern that the worsening of the fiscal balances in these Member States has primarily been due to structural factors, such as very generous public sector wage rises and the extension of additional welfare benefits. In 2004, fiscal performance seems to date to have been on track in most new Member States, with the exception of Hungary and possibly Slovenia where targets are not expected to be met It should be noted, however, that buoyant GDP growth in 2004 has boosted revenues and that the fiscal targets in a number of countries are not sufficiently ambitious.

Overall, the new Member States’ progress towards convergence has been remarkable, although the achievements have been somewhat uneven across countries and, in particular, across policy areas. Against this general background, I will now address a number of policy issues and challenges confronted by many of the new EU countries in their quest to achieve sustainable convergence on the road to euro adoption.


Monetary policy strategy

You will not be surprised that, being a central banker, I will first focus on those aspects of the convergence process which relate to the conduct of monetary policy. These are closely related to the process of monetary integration of new Member States. Let us therefore explore these issues in the order in which they will unfold on the road towards euro adoption. As you know, the monetary integration process is taking place within the context of a well-defined institutional framework and comprises several phases.

Without going into too much detail, I would nevertheless like to emphasise three core aspects and principles applicable to this process:

  • First, there is no single trajectory towards the euro and there is no single policy approach which can be considered appropriate for all new Member States. All assessments will, therefore, take place on a case-by-case basis and according to the specific merits of the country concerned. This is a consequence of the significant diversity characterising the new Member States in nominal, real and structural terms.

  • Second, the multilateral nature of the institutional framework implies that all major policy decisions concerning a particular country or currency will be made collectively by all EU members or the euro area countries, and with the involvement of the ECB.

  • Third, the principle of equal treatment will be applied. Comparable situations and cases will be treated in a comparable manner throughout the monetary integration process.

In the period before ERM II membership, monetary policy remains a responsibility and prerogative of the country concerned, even though a number of Treaty obligations already apply at this stage. Price stability has to be the main objective of monetary policy, and exchange rate policy is to be treated as a matter of common interest.

Within this institutional setting, the new Member States have so far followed a broad variety of monetary policy and exchange rate strategies with a view to achieving and maintaining price stability. Some countries, such as Cyprus, Latvia and Malta, are following an exchange rate targeting strategy. Others, such as the Czech Republic, Hungary, Poland and Slovakia, are pursuing variants of inflation targeting. While in Poland inflation targeting is combined with a freely floating exchange rate, the Czech Republic and Slovakia are combining inflation targeting with a managed float. Hungary’s strategy, in turn, represents an inflation targeting framework with an explicit exchange rate objective pursued within a wide band.

I speak from personal experience at the Bank of Greece when I stress that achieving and maintaining price stability can be a formidable task. This is vividly demonstrated by rising inflation pressures in a number of new Member States and also by difficulties in completing the disinflation process in a few countries. In an environment of increasing inflation pressures, containing inflation expectations will be a key means of avoiding (or at least minimising) second-round effects of recent price increases and of ultimately achieving and/or maintaining price stability. In the new EU countries in which disinflation still needs to be completed, the key challenge is how to break inflationary expectations with as little output sacrifice as possible. To contain inflation expectations and complete the process of disinflation, monetary policy has to be effective and credible. This requires, among other things, a constitutional setting and political practice in which the central bank’s independence is safeguarded as well as a proper communication of monetary policy decisions.

Moreover, a key element of establishing an economic environment conducive to price stability is the orientation of other economic policies, in particular fiscal policy, and the implementation of structural reforms aimed at raising potential growth and enhancing the flexibility of labour and product markets. It is also vital that wages are set in line with productivity developments. It is worth noting that wage and unit-labour cost developments in the new Member States have been very diverse indeed in recent years. In some countries, wage increases have substantially exceeded advances in productivity growth, being driven by minimum wage rises and public sector wage hikes. These developments have made it difficult for monetary policy to promote price stability. In a number of other new EU member countries, however, unit-labour costs have been remarkably stable or have even been falling, thus helping monetary policy to achieve its goals. Of course, if life becomes easier for us central bankers, we will welcome this. But there is a more fundamental point, which cannot be overemphasised: the implementation of sound and mutually consistent policies is a sine qua non for the attainment of price stability; and only on that basis will convergence be achieved in a sustained manner.

I would also like to stress that in the pre-ERM II phase it is important to undertake major necessary policy adjustments – for example with regard to price liberalisation and fiscal policy – and advance towards policy consistency by adopting, in particular, a credible fiscal consolidation path. This is necessary in order to ensure that subsequent membership of the exchange rate mechanism is smooth. These observations already lead me to the second phase on the road to the euro, the ERM II participation phase.

As I am sure you are aware, ERM II participation imposes constraints on the choice of a monetary policy strategy. No exchange rate pegs other than to the euro, no crawling pegs and no free floats are compatible with ERM II. Participation in the exchange rate mechanism is sometimes perceived as a mere waiting room before euro adoption. However, it is more than that, for it can offer a number of advantages. First, it can foster policy discipline aimed at achieving stability. By requiring the adoption of a consistent economic policy framework, it can help establish a stable macroeconomic environment and act as a catalyst for structural reforms. Second, it can enhance policy credibility and help guide expectations. The central parity of a currency provides guidance to foreign exchange markets and contributes to greater exchange rate stability. Moreover, by anchoring inflation expectations, ERM II membership can also speed up disinflation and reduce inflation volatility. Third, unlike other exchange rate arrangements, ERM II functions within a multilateral policy framework with a clearly defined general objective which at the same time is a specific exit point: entry into the euro area. Fourth, the standard fluctuation band leaves enough room for policy-makers to adjust to asymmetric shocks and structural changes. If the catching-up process leads to and requires a change in the equilibrium exchange rate, the mechanism allows for a realignment of the central parity to the appropriate level. This possibility may be especially important in view of the eventual permanent locking of the currency’s conversion rate to the euro.

Having sung the praises of ERM II participation, I would not, of course, wish to deny that there could conceivably be complications during this phase – for instance if shocks lead to a temporary trade-off between exchange rate and price stability. How should monetary policy react in such a case? Our view is that, within the framework of ERM II, exchange rate stability should be subordinated to the primary objective of price stability.

The issue of facing potentially conflicting targets is especially relevant for those countries that intend to enter ERM II with an inflation targeting framework. In principle, it can be feasible to participate in ERM II and retain, for a while at least, some form of inflation targeting strategy. Whether or not such a strategy is compatible with the requirements of ERM II will depend on the specific characteristics of each individual case. A high degree of nominal convergence and policy credibility before entering ERM II would certainly reduce the likelihood of a conflict of targets. I would also emphasise that such a policy dilemma is less likely to be faced in a small and very open economy with a strong exchange rate pass-through.

Let me give you an example from a country I know very well. The successful participation of the drachma in the exchange rate mechanism was underpinned by a restrictive monetary policy stance that gave priority to achieving price stability. This helped to counteract the inflationary pressures stemming from the devaluation of the drachma at the time of ERM entry in 1998, and from certain shocks. The permitted appreciation of the drachma within the wide band also played a major role in mitigating the effects of substantial capital inflows on liquidity.

Other countries have followed different strategies on the road to EMU. Denmark is a further successful example. Whatever the strategy chosen, however, the eventual assessment of exchange rate stability against the euro for the purposes of the convergence examination will focus, in line with past practice, on the exchange rate being close to the central rate, while taking into account factors that may have led to an appreciation.

Staying in ERM II for a sufficient period of time also helps to assess the sustainability of the central parity of a country’s currency against the euro. In that sense, ERM II is not so much a waiting room before euro adoption, but rather a testing room, especially with respect to the currency’s eventual conversion to the euro. This is particularly useful for economies which are catching up, in which the underlying economic fundamentals are undergoing continuous change, often at a relatively rapid pace.

Achieving and maintaining sound fiscal positions

A key area of nominal convergence is, of course, fiscal policy. The Maastricht criteria require that a country’s fiscal position be sustainable. The sustainability of public finances, as judged by the budget deficit relative to GDP and the level and dynamics of the debt-to-GDP ratio, also plays a key role in ensuring that the overall convergence process will be sustainable. This role will gain even more importance as the new EU countries progress towards monetary integration, which will increasingly limit the number of available policy instruments and adjustment mechanisms. Under these circumstances, fiscal policy will need adequate room for manoeuvre to both cope with shocks and cyclical fluctuations and contribute to external sustainability.

What is therefore essential for a country with fiscal imbalances – an excessive deficit as defined in the Treaty – is not only to achieve a budget deficit that does not exceed the ceiling of 3% of GDP but to achieve fiscal consolidation in a credible and sustainable manner. To that end, durable reforms which address underlying weaknesses in public finances are required rather than one-off measures with a temporary impact.

How can fiscal consolidation in the new Member States with excessive deficits be made sustainable? It seems clear that the ongoing economic recovery will not help to advance fiscal consolidation in a lasting manner, because deficits are mostly structural and automatic fiscal stabilisers have a limited effect in most of these countries. Moreover, since the level of public debt is still relatively low (except in Hungary where it is near the Maastricht threshold) and interest rate convergence has advanced considerably in most of these countries, the decrease in interest payments will not have as substantial an effect on fiscal balances as it did in some of the present euro area countries during their own convergence process. Consequently, a strong improvement in primary budget balances is needed in a number of new Member States in order to advance consolidation. Since the overall tax burden (especially income taxes) and the size of government budgets compared to GDP are already high, especially in the central European countries, this should be achieved by cutting current expenditure. Experience strongly suggests that successful fiscal consolidation has been based, in most cases, on reductions in public consumption and not on cutting public investments that can be beneficial for long-term growth. Such fiscal consolidation is also more likely to have positive confidence effects and to favourably influence expectations of a lower tax burden in the future, thus creating additional room for private consumption and investment.

Some observers have expressed concerns that fiscal stabilisation is likely to dampen growth and employment in the short run, even if it is generally agreed that it is still a key condition for successful real and nominal convergence over the medium and longer term. In fact, the experience of the current EMU members shows that the reduction in inflation rates in the run-up to Monetary Union, which was supported by a steady and substantial tightening of fiscal policies, allowed the gradual easing of the monetary policy stance and the downward convergence of interest rates, thus lending support to economic activity. And, in some cases, fiscal consolidation was accompanied by faster economic growth.

If we look beyond the medium term, it is clear that the efficiency and quality of public finances can also contribute directly to growth in many ways, especially in the longer run. In a period in which the new Member States will continuously need to upgrade the skills of their labour force in order to remain competitive as factor prices – in particular wages –catch up, the efficiency and quality of education systems and health care systems will be important determinants of long-term growth. Of course, one should not hide the fact that public finance reforms involve costs and may temporarily weigh on fiscal outcomes. This is one of the reasons why it is important to use the current cyclical upturn as a window of opportunity to advance these reforms. Let me sum up these arguments with an Olympic metaphor: the “fitter” and “leaner” a country’s public finances are, the greater the confidence in the sustainability of its economic convergence, and the better the likely performance of its economy before and after joining Monetary Union.

This brings me to the issue of the sustainability of fiscal positions within EMU and to the role and effectiveness of the Stability and Growth Pact. The fiscal framework of EMU is an essential component of its institutional structure. It aims to promote sound and sustainable public finances and to enhance the coordination of budgetary policies. The experience of five years of EMU shows that the Pact has not succeeded in preventing the occurrence of excessive deficits in a number of countries; and we have witnessed a number of serious problems with its implementation. Nevertheless, the Pact has contributed to macroeconomic stability in the euro area. And, overall, we have not observed the high budget deficit ratios recorded in the 1990s. Moreover, although some countries have not complied with their commitments, significant adjustment efforts have been made, which would probably not have been undertaken without the Pact.

The European Commission recently communicated proposals aimed at strengthening and clarifying the implementation of the Pact. These proposals relate both to the “preventive arm” and the “corrective arm” of the Pact. The Commission will further elaborate its ideas and provide details on how they will become operational. This is important for assessing some of the proposals, as often “the devil is in the detail”. The ECB’s position is that the Stability and Growth Pact is appropriate in its current form, and that the Treaty and the respective Regulations should not be changed. At the same time, it is evident that the implementation of the Pact should be improved. Although the rules of the fiscal framework should be based on an appropriate economic rationale, they should also be characterised by clarity and be enforceable in an effective manner. The principle of equal treatment should also be preserved. Allowing more country-specific circumstances to be taken into account in the definition of the medium-term deficit objectives or in the enforcement of the correction of excessive deficits involves risks that should be avoided. Improving the implementation of the Pact should not result in a weakening of fiscal discipline. On the contrary, it should strengthen the credibility of the fiscal framework and its effectiveness in promoting sound and sustainable public finances. To this end, it is essential to enhance the enforcement of the common rules, to improve the quality and reliability of fiscal statistics and to ensure that a common and consistent methodology is applied in measuring and reporting budgetary positions.

Credit growth and convergence

A specific aspect of the convergence process which is of particular relevance to most of the new Member States and their central banks relates to credit growth. Rapid credit growth is a typical phenomenon of economies in a catching-up process. As such, it is especially relevant for the new Member States, since all of these countries, with the exception of Malta and Cyprus, have the lowest degree of financial intermediation in the Union relative to domestic output. Bank assets – in particular domestic credit to the private sector – as a share of GDP are only a fraction of what they are in other EU countries. There are a number of explanations for this low level of financial intermediation: First, it is certainly the result of initial conditions and several banking crises during the transition process. Second, it is a consequence of the relatively short track record of domestic enterprises, which left many of these enterprises with little choice other than to rely largely on internal sources of financing in the form of retained earnings or trade credits. Finally, it is also related to the FDI-based growth pattern which can be observed in some of the new Member States.

Why do we need to monitor these developments so closely? Because the expected process of real convergence will have sizeable effects on the financial sectors and, as I know from my own experience, that may not always be easy to manage. Real convergence will lead to financial deepening and a strong expansion of the balance sheets of financial institutions. In this context, two effects will be operating in parallel: the deepening of financial intermediation to levels that are comparable with those of countries with similar income levels, and the expansion of financial intermediation as incomes grow further. As a result of these two factors, banking sector assets and liabilities are expected to expand substantially in most new Member States over the next two decades.

Conceptually, strong growth of financial intermediation is a necessary corollary of the real convergence process and provides the necessary external financing. Access to credit for small and medium-sized enterprises is especially important, as these are typically borrowers with a short track record and limited collateral, but a strong potential for job creation. Likewise, households will engage in added consumption smoothing, in addition to improving their future earning prospects and creditworthiness.

And indeed, we are observing high or very high rates of expansion in credit to the private sector in a number of new EU countries. Although the stock of credit remains low, and much of it is securitised in mortgages, very strong credit growth raises intermediation challenges, as it could give rise to imprudent credit-risk assessment and lax lending behaviour on the part of commercial banks. More generally, rapid credit growth remains one of the most significant leading indicators of financial instability. Rapidly rising financial deepening and expanding financial sector balance sheets may also entail a higher volatility of financial outcomes, for both individual institutions and the sector as a whole. The main challenge will be to accompany the catching-up process through an expansion of financial intermediation without risking the stability of the sector and the economy as a whole. This will require, inter alia, a credible and well-implemented supervisory and regulatory framework for the financial sector.

Finally, high credit growth can also lead to macroeconomic imbalances, including external imbalances, inflation pressures and higher output volatility. Strong growth of credit to the private sector could contribute to a sharp increase in domestic demand, which, in turn, could cause an acceleration of inflation and undermine the sustainability of the convergence process. Vigilance should therefore be the order of the day for the authorities in the countries concerned. Monetary policy, for example, may need to play a more active role in stabilising the economy by dampening output fluctuations. This can be particularly challenging in countries with fixed peg exchange rate regimes, where the room for manoeuvre of monetary policy is limited.

That said, although high credit growth will involve challenges for central banks in the new Member States in the medium term, from a longer-term perspective the deepening of credit markets can also be seen as an important contributor to a more efficient conduct of monetary policy. In particular the development of mortgage markets can serve to strengthen the effectiveness of the interest rate channel of the monetary transmission mechanism. This will be especially important in the period following the adoption of euro, when reliance on the exchange rate channel of monetary policy, which is currently the main transmission channel of monetary policy in the new EU countries, will no longer be possible.

Structural reforms for sustainable convergence

The question of how to achieve sustainable convergence cannot be answered by looking only at the broad macroeconomic aggregates. Fostering the catching-up of per-capita incomes and a gradual adjustment of market structures and institutions requires an explicit focus on the structural reform needs of the new Member States. Let me concentrate on one specific challenge, namely the low rate of labour utilisation. This is a structural problem in most new EU countries – as it is, in fact, in a number of the older Member States – and manifests itself in the form of high structural unemployment and/or low participation rates.

What can economic policy do to improve the utilisation of the labour force and thus raise potential growth? Although in general the labour markets of the new EU countries do not appear to be more rigid than those of the older Member States, there are a number of specific problems. The low geographical mobility of labour, skill mismatches and the high tax wedge on labour. Of these, the high tax wedge on labour appears to be especially striking, not least because it is even greater in the new Member States than in the older ones, where it is already too high. There is no need to lecture an audience of economists on the consequences of high labour taxation: perverse economic incentives, a sub-optimal allocation of labour and an increase in the scope of the grey economy. Of course, solving the problem is not easy in countries which suffer from significant fiscal imbalances. If the decrease in labour taxation is compensated by an increase in other tax rates (e.g. VAT rates), this will create other distortions and have a potentially inflationary impact. Thus, any measures to decrease labour taxation will only be sustainable if there is a parallel adjustment of the expenditure side of the budget.


Until now, I have addressed the question of how to achieve sustainable convergence in rather general terms, with reference to the group of new Member States as a whole. Being in Budapest, it is, of course, appropriate to take a look at where Hungary stands with respect to achieving sustainable convergence. From the many issues that could be examined, allow me to focus on two particularly pertinent ones, namely the need to contain inflationary pressures in a sustainable manner, and certain issues related to fiscal policy and the efficiency of public finances.

Even though Hungary has made enormous strides on the path towards real convergence over the last decade, tangible progress towards nominal convergence appears to have come to a temporary halt, mainly on account of policy choices in the past few years. In fact, Hungary has experienced nominal divergence in recent times. As regards its inflation performance, breaking inflation expectations, which have remained stubborn in a setting of inconsistent policies, should be a key priority, especially at the current juncture at which negative supply shocks and positive demand shocks have led to a rise in inflation. Wages continue to grow dynamically (at around 10%), despite some deceleration as compared with recent years, and a renewed increase in wage growth – instead of the further moderation required – would further complicate the achievement of disinflation.

Of course, a key measure that would help to reduce the pressure on monetary policy and allow it to focus more effectively on disinflation and, in particular, on containing second-round effects of the acceleration of inflation in 2004 is fiscal restraint. Although fiscal deficits have narrowed somewhat last year and this year, the improvement has largely been the result of a series of “stop-gap” measures on the expenditure side and of indirect tax increases rather than of a medium-term consolidation strategy. A number of fundamental weaknesses in the public sector and in the social security system will have to be addressed if fiscal sustainability is to be achieved in the long run. The level of state redistribution and the share of public sector employment in total employment are among the highest in the OECD. At the same time, the level of public investment has fallen and may possibly be too low to lend adequate support to the catching-up process.


A famous American actor once said that “[t]he secret of a good sermon is to have a good beginning and a good ending and have the two as close together as possible.” Now, I believe I did not deliver a sermon but a central banker’s lecture and, as I come to the end, I realise that I may already have made considerable demands on your attention in the part between the beginning and the ending. Nevertheless, please permit me to conclude with a few, brief remarks which sum up the points which I believe to be of particular relevance to the new Member States on the road to EMU:

  • First, a key condition for sustainable convergence is policy consistency over time and across policy areas. This will help to stabilise expectations, avoid shifts in market perceptions and improve credibility, which, in turn, will facilitate disinflation and progress towards real convergence.

  • Second, it is important to advance towards policy consistency and undertake the necessary policy adjustments promptly and already in the pre-ERM II phase of the convergence process.

  • Third, nominal and real convergence are interdependent and can be mutually reinforcing. They should therefore be pursued in parallel. In doing so, however, an appropriate assignment of policy instruments to final objectives is also important (as is policy consistency). It is crucial both for policy effectiveness and for the sustainability of the outcomes.

  • Fourth, monetary policy should focus on its primary objective of price stability, both before and after ERM II entry. Participation in ERM II can play a very useful role in fostering policy discipline and consistency, but also in assessing the appropriateness of the “central parity” of a currency’s exchange rate against the euro. This is essential for a decision on that currency’s permanent conversion rate to the euro.

  • Fifth, the growth of financial intermediation is a necessary component and corollary of the catching-up process. In economies with less developed financial sectors, however, rapid credit expansion can contribute to excessive output and inflation volatility as well as to a widening of external imbalances. Monetary and financial supervisory authorities should monitor credit developments carefully and avoid risks to financial stability and the sustainability of convergence.

  • Sixth, reforms should focus on the attainment of real convergence, thereby also facilitating nominal convergence. Structural and institutional convergence aimed at enhancing the flexible and efficient functioning of markets will also improve the economy’s capacity to absorb shocks and will reduce differences in economic dynamics and in the transmission of the effects of the single monetary policy after a country has adopted the euro.

  • Lastly, sound public finances and appropriate fiscal structures are essential for promoting efficiency and long-term growth, for supporting a stability-oriented monetary policy, and for enhancing the ability of fiscal authorities to respond to shocks.

Adherence to these policy propositions – or should I say, commandments – will be instrumental in attaining sustainable convergence on the road to EMU. Thank you very much for your attention.

  1. [1] Average annual real GDP growth in the new Member States was 3.8% in the period from 1994-2003, compared to 2.1% in the euro area.

  2. [2] Based on ECB internal calculations.


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