The enlargement of the euro area

Speech by José Manuel González-Páramo, Member of the Executive Board of the ECB
held at the conference on “EMU governance and euro changeover – Cyprus on the path to the adoption of the euro”
Cyprus, 30 November 2006

1. Introduction

[Slide 1 “Title”]

Ladies and gentlemen,

Let me first thank the organisers of this conference for inviting me to Nicosia today to speak on a very topical issue, namely the enlargement of the euro area. As you know, in one month’s time, Slovenia will become the 13th member of the euro area and the first of the ten Member States that joined the EU in 2004 to adopt the euro. The entry of Slovenia follows the conditions laid down by the Treaty establishing the European Community which are applied in an equal fashion to all euro area candidate countries. While each country will prepare for euro adoption at a pace in line with its own economic conditions, all of the new EU Member States are committed to strive to fulfil the convergence criteria as soon as possible and adopt the euro thereafter. Slovenia is consequently expected to be followed by other new Member States in the years to come.

Let me try to address some of the issues arising in relation to euro area entry by starting with an obvious question, namely “What are the expected benefits and risks of adopting the euro?” I would then like to turn to some general issues related to the formal convergence process and describe the role of the European Central Bank (ECB) in the examination of countries’ progress with convergence. Finally, I would like to concentrate on a few of the specific policy challenges which are facing a number of the new EU Member States, including Cyprus.

2. Benefits of joining the euro area

[Slide 2 “Benefits of euro adoption”]

The benefits of enlarging the euro area can be seen from two perspectives: from the perspective of the individual country and from the perspective of the euro area as a whole. For most countries, the first benefit of euro area membership is that it removes the risk of exchange rate volatility with regard to the currencies of major trading partners. For Cyprus, a small open economy with strong trade relations with the euro area, the economic case for seeking exchange rate stability against the euro is compelling. In addition, as has been shown in a number of studies,[1] trade integration has increased rapidly among countries that have introduced the euro. Second, euro area membership provides a credible framework for monetary policy, which in turn yields low risk premia and low long-term interest rates. Third, the replacement of national currencies with a single currency reduces transaction costs and increases price and cost transparency. Finally, a factor which may be particularly important for small open economies, adopting the euro may provide stronger protection against international financial disturbances, which often have a disproportional effect on smaller economies.

Turning to the euro area, the euro represents the completion of the internal market in the EU, providing full price and cost transparency. This enables economies of scale and a more efficient allocation of resources to be achieved, increasing economic efficiency in euro area as a whole.

3. Risks related to premature adoption of the euro

[Slide 3 “Risks related to premature adoption of the euro”]

Turning now to the risks related to a premature adoption of the euro, I would argue that most are related to insufficient preparation. Of course, differences in business cycles may lead to a situation in which the ECB’s interest rate policy is not the optimal one for a specific country. Among the euro area countries, business cycles are highly correlated and, given the increasing trade integration between EU countries and the pursuit of stability-oriented economic policies, business cycle correlation in the EU can be expected to increase further.[2] Nevertheless, country differences may arise, and it is consequently important that fiscal policies are sufficiently prudent to provide enough room for the automatic stabilisers to work and that domestic markets are flexible. Another risk relates to the sustainability of convergence. In the convergence examinations of the ECB and the European Commission, a great effort is made to assess the sustainability of economic developments. The reason for this is of course that an important instrument, namely the exchange rate, will no longer be available to address problems of competitiveness at the country level once the euro has been adopted. Of course, countries with a history of fixed exchange rates, like Cyprus, are familiar with these considerations. In this context, the need for a culture of sound and sustainable economic policies in line with the Treaty criteria and EU guidelines cannot be stressed enough. Such stability-oriented policies make perfect sense even for countries outside the euro area. Finally, a potential risk for the individual country relates to a possible lack of flexibility in the economy. Without this flexibility to adjust to changes in competitiveness, there is a risk of protracted economic downturns and long-term unemployment. Here in Cyprus, many of these issues are not in any way new. Cyprus’s fixed exchange rate policy dates back many years, implying that markets are very familiar with the need to adjust to changes in relative prices.

For the euro area, the risks posed by a country adopting the euro prematurely are mainly related to the overall credibility of the euro area, which could be negatively affected by a lack of sustainable convergence and flexibility in an individual country.

4. Enlargement of euro area – the formal process

[Slide 4 “The road to the euro”]

Let me now say a few words on the formal process for adopting the euro. As you know, the first step towards adoption of the euro after a country has joined the EU is to join ERM II. According to the Treaty requirements, a country must observe the normal fluctuation margins in ERM II for at least two years. In particular, it should not devalue its central rate on its own initiative. If, after these two years, the country is assessed by the EU Council as having fulfilled these requirements, it will start the technical preparations for adoption of the euro.

[Slide 5 “ERM II membership” ]

As you can see from this slide, only three of the new EU Member States are currently outside ERM II, together with Sweden and the United Kingdom. Within a year, all the other new Member States will have participated in the mechanism for more than two years, and their exchange rates have mostly been stable so far. Let me here also remind you that Denmark has been a member of ERM II (and its predecessor) for many years, even though, like the United Kingdom, it has a special status in the EU Treaty and is not obliged to adopt the euro unless it decides to do so – of course only once it complies with the convergence criteria.

For Slovenia, which received the green light in June, the last few months have been filled with numerous technical preparations relating to, for instance, the distribution of euro banknotes and coins and the launch of a euro information campaign. These technical preparations require careful attention, as they are crucial to ensuring a successful introduction of the euro, and may take a different amount of time depending on each country's situation.

[Slide 6 “Technical preparations”]

The ECB, while monitoring all technical aspects of the changeover that lie in its area of competence, carries out a public information campaign jointly with the national central bank of the country preparing to adopt the euro. The main objectives of the campaign are to familiarise the public with:

  • the visual appearance of the euro banknotes and coins;

  • their security features; and

  • the modalities of the cash changeover.

Drawing on the many years of experience of the European System of Central Banks in this area, as well as on pan-European qualitative and quantitative surveys, the ECB has developed a toolbox of creative material and communication activities aimed at preparing the public for a smooth cash changeover.

[Slide 7 “Communication tools used in Slovenia”]

As experience from the 2002 cash changeover shows, it is best to run the campaign providing information about the euro banknotes and coins in the last three months before €-day and therefore after the irrevocable conversion rate has been fixed. Here you can see the information material that was distributed at the beginning of November to all households in Slovenia or provided to the public via well-targeted distribution channels.

This brings me to the role of the ECB in the formal process of euro area enlargement.

4. The ECB's role

[Slide 8 “Formal enlargement process – the role of the ECB”]

The ECB, together with the European Commission, plays an important role in the examination of convergence. Every second year, we are obliged by the Treaty to examine all Member States with a derogation and present our findings to the EU Council in a convergence report. As the last examination of all countries took place in 2004, we are currently preparing the 2006 Convergence Report, which will be published in December. Should a country request an examination at another time, we will also produce a convergence report. This was the case earlier this year when Lithuania and Slovenia were assessed. The ECB carries out a case-by-case examination of each country’s performance in terms of the convergence criteria set out in the Treaty, relating specifically to inflation, public finances, exchange rate development, long-term interest rates and legal convergence. The results of this examination are then presented to the EU Council which, on the basis of a proposal by the Commission, decides which countries fulfil the conditions for adopting the euro. The Council also decides the final conversion rate to the euro, on the basis of a proposal by the Commission. The ECB has to be consulted on the proposals on the convergence rate and other necessary measures.

5. Challenges prior to adoption of the euro

[Slide 9 “Policy challenges in the run-up to euro adoption”]

As I have just mentioned, the ECB will soon release its December 2006 Convergence Report. Consequently, I cannot discuss the substance of the findings of this report today, but let me nevertheless say a few words on some of the policy challenges which have been identified for a number of the new EU Member States, including Cyprus.

The first challenge is to ensure that the convergence criteria are fulfilled in a sustainable manner. The convergence criteria constitute a coherent and integrated package, and they must all be satisfied. For a large group of countries, inflation is currently an important worry, but the fiscal situation also remains a concern in a number of countries.

Second, for several of the new Member States, there may still be lingering issues relating to economic transition and EU accession. While the fact of having joined the EU implies that most of the EU framework relating to market integration and liberalisation have been implemented, derogations were granted in some areas, such as the harmonisation of all VAT rates. In some countries, administered prices and price liberalisation in some sectors also continue to affect inflation developments to a large extent. This may in turn complicate the sustainable fulfilment of the convergence criteria, especially when combined with cyclical challenges to macroeconomic stability, which leads me to my third point.

Managing cyclical factors is an important policy challenge. In recent years, economic activity has been very strong in many countries, mostly fuelled by robust domestic demand. This in turn has been stimulated by low interest rates, strong wage growth and high capital inflows, and has in many cases led to rapid increases in asset prices and credit, as well as in current account deficits. Of course, some of these features represent a natural structural adjustment which is related to catching up and real convergence of income levels. Nevertheless, the very high growth of borrowing, sometimes with an increasing share of foreign currency-denominated loans, and large current account deficits, in some cases combined with fiscal imbalances, signal worrying trends which require the attention of policy-makers. Particularly in countries with rising inflationary pressures and emerging capacity constraints, these features may require robust policy action in order to avoid more painful adjustments in the future. To some extent, we need to remember that the past five years have been characterised by historically favourable global financial conditions, and the ability to service debt in many of the new Member States is largely untested under less favourable economic and financial conditions.

Finally, an ongoing policy challenge, also for most of the countries which are already members of the euro area, is to make progress with structural reform. As economic conditions develop rapidly in an ever more globalised world economy, for instance due to technological and demographical change, our economic structures must also evolve. By promoting flexibility in product and labour markets, countries will be in a better position both generally and specifically as regards participation in the euro area.

In conclusion, I would like to recall the importance of the sustainability of convergence. This aspect is crucial to a successful participation in the euro area. Consequently, it is preferable for countries to join the euro area only when trends in economic policy and economic developments are stable and clear. Specific measures aimed at boosting economic results in a particular year only carry the risk of problems at a later stage. For countries already close to entering the euro area, adequate attention needs to be given to issues such as the timing of eventual interest rate convergence in the final stages of the convergence process and possible compensatory measures should interest rate convergence be relatively rapid. In addition, measures to avoid potential negative effects of the cash changeover on inflation will need to be considered well in advance. In particular, government measures affecting inflation developments around this time should be avoided and the information campaign should be carefully prepared.

I am sure there will be many reasons to come back to these issues in a not too distant future here in Cyprus and I wish you all the best with your next steps towards adoption of the euro.

Thank you for your attention.

[1] For a review of the literature, see Baldwin, R, “The euro’s trade effects”, ECB Working Paper No 594, March 2006.

[2] See Giannone, D. and L. Reichlin, “Trends and cycles in the euro area – how much heterogeneity and should we worry about it?”, ECB Working paper No 595, March 2006 and Angeloni, I., M. Flad and F.P. Mongelli, “Economic and monetary integration of the new Member States – helping to chart the route”, ECB Occasional Paper, No. 36, September 2005.

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