How EMU Affects Central and Eastern Europe

A CEPR/EWI Report by 
David Begg, László Halpern and Charles Wyplosz

Recent speculative attacks on vulnerable currencies in emerging markets underline the need for Europe's transition economies to establish a robust macroeconomic strategy as they prepare to join the European Union and eventually its single currency. Three Research Fellows of the Centre for Economic Policy Research, David Begg, László Halpern and Charles Wyplosz, argue that the priority for these economies has to be structural adjustment and fiscal responsibility. This conclusion emerges in an examination of three issues that will have to be resolved along the way. First, as transformation continues, there is an approach that  policy-makers should adopt with regard to past and future developments in the real exchange rate. This report  provides new evidence on the evolution of equilibrium real exchange rates, a key piece of information as Central and East European countries struggle to establish key elements of macroeconomic policy. The second critical choice is the  nominal anchor for the currency. The authors reject a narrow-band anchor in view of their recent failures. And finally they stress the interaction between a credible monetary policy and a sound fiscal policy. 

These considerations reinforce the emphasis on structural adjustment and fiscal responsibility. Without this, those responsible for monetary policy will always be making the best of a bad situation. And without progress in these fundamental areas, early disinflation may prove difficult to sustain. Monetary policy must aim to secure an appropriate balance between the provision of a suitable nominal anchor, the avoidance of an uncompetitive real exchange rate and promoting structural adjustment.

These questions have vital implications for the appropriate speed of disinflation, for trade-offs between fiscal prudence and adequate government expenditure on infrastructure and regulatory capacity, and for capital flows and the stability of the banking system.

Countries in transition must place more emphasis on crisis prevention. The authors concede that although crises may be unavoidable, policy-makers must not stand in awe of financial markets however powerful they may appear. Past emphasis on liberalization has not been matched by adequate regulation: financial markets have inherent weaknesses for which prudential regulation is the best solution.  Currency markets are the only financial markets not subject to elaborate regulation but this does not mean that it is impossible to control them. In emerging markets policy-makers have to try. The difficulty they face is how to retain a measure of control until transition is better established, without signalling hostility to the development of market processes themselves. 

As they move towards full EU membership, the Associated Countries should be permitted to indicate their hopes as to the timescale of entry into EMU.  As is the case with the UK and Sweden, the countries of Central and Eastern Europe will presumably be expected to enter the EMS and maintain an unaltered parity for two years prior to EMU entry. Those countries seeking earliest entry could volunteer to maintain a fixed central parity within the usual wide band, and hope to make rapid progress on disinflation now an end is in sight. Countries for which the strain of rapid and early disinflation is too great could preannounce an initial and fixed period of crawl (still with a wide band) at the end of which they would enter the necessary period of fixed parities prior to EMU entry. It is here that the authors recommend that there be no attempt to adopt narrow exchange rate bands. In macroeconomic policy design, the prospect of a clear terminal objective is helpful. 

The authors conclude that in reality it is likely to be the speed with which Central and East European countries can comply with the regulatory responsibilities of the Single Market that is likely to determine the timing of their eventual EU entry.  And this raises the intriguing possibility that the prospect of entering EMU will not have an enormous macroeconomic effect because of the likelihood of some delay in meeting microeconomic and regulatory performance standards. 

Notes for Editors:

The EPI Report  

Monetary and Exchange Rate Policies, EMU and Central and Eastern Europe is the fifth Forum Report of the Economic Policy Initiative. It is the final version of a report initially drafted for presentation at the EPI Forum, which took place in Brussels on 20-22 November 1998. It was discussed by a distinguished Forum of academics and policy-makers, whose comments and recommendations served as an input into the final version of the Report. 

The Authors 

David Begg is Professor of Economics at Birkbeck College, London, and a CEPR Research Fellow. László Halpern is Deputy Director of the Institute of Economics of the Hungarian Academy of Sciences in Budapest and is also a CEPR Research Fellow. Charles Wyplosz is Professor at the Graduate Institute of International Studies, Geneva, and Programme Director of CEPR’s International Macroeconomics research programme.