Real convergence in the new Member States of the European Union (Shorter and longer term prospects).

• Author: Halmai, Peter
• Position: Report

1. Real and nominal convergence

   1.1. New challenges of convergence during the crisis

   The potential advantages of adopting the euro are of great importance for new Member States (NMSs). Euro adoption can contribute positively to long term growth and stability. It has an impact on economic performance through several macro- and microeconomic channels: the stability-oriented macroeconomic framework, access to liquid markets, more trade and foreign direct investment, lower transaction costs and increased competition.

   Indeed, Eurozone membership has to be assessed in a broader context when considering it from the point of view of economic policy. The static view on the state of nominal convergence is not enough (Angeloni, Flad and Mongelli (2007)). In order to take full advantage of the single currency--taking into consideration the restrictions of the common monetary policy and irrevocably fixed exchange rate--the economic policy needs to ensure the proper functioning of the internal adjustment mechanism safeguarding stability. Adequate labour- and product market flexibility, as well as sufficient fiscal buffers were identified as the preconditions of successful euro adoption (Rybinski (2007), Darvas and Szapary (2008)). Closer economic integration with the Eurozone might contribute to mitigating vulnerability against asymmetric shocks.

   Considering the special conditions of the NMSs, special attention needs to be paid to the risks related to convergence. Countries accumulating huge internal and external deficit are very vulnerable under the conditions of the present crisis. At the same time there has been a progressive price level convergence and real equilibrium appreciation as part of the process. On the other hand the catching up process of the NMSs is effected by globalization and financial integration. The NMSs are highly sensitive against shock impacts due to their relatively small size, high level of openness and greater need for external financing. These risks have become apparent during the current crisis. The retreat from risk and the search for liquidity by investors might contribute to heavy pressures on the financial markets of the NMSs.

   1.2. Price level and real convergence

   The majority of the NMSs achieved remarkable convergence (taking into account the advancement of macroeconomic stability and the supply side reforms related to EU-accession). Nevertheless, a broad difference among certain member states remained. The new MSs have to face a shortfall caused by the crisis and sharp decline in growth (often accompanied by a decrease in GDP). Certain countries, which had a significant catch-up growth during the past years (e.g. the Baltic States) entered into a recession. Growth in the region has slowed down permanently. Therefore real convergence--within and outside the Eurozone--remains a determinant factor shaping the economic policy strategy for most NMSs in the medium term.

   The equilibrium real exchange rate appreciation (price level convergence) is considered a natural consequence of the economic catch-up (De Grauwe and Schnabl (2005)). Real exchange rate appreciation--depending on the monetary policy and exchange rate levels--might occur following two paths (or through the combination of the two): by nominal exchange rate appreciation and/or a higher internal (domestic) inflation. The pace and the channels of the equilibrium real appreciation are of great importance as regards the trajectory of nominal convergence. The fixed exchange rate system (which was introduced by the Baltic States) excludes the nominal exchange rate channel of the real appreciation. Therefore, higher trend inflation is evolving for converging economies than for the anchor area.

   Beyond the Balassa-Samuelson effect further factors effect significantly the dynamism of real appreciation. The pace of the income convergence, the domestic demand growth exceeding GDP growth and the exchange rate regime are significant determinants of the price level convergence dynamics. (Darvas and Szapary (2008)). In the short term certain factors (e.g. the nominal exchange rate movements, the effect of the changes in the global resource and food prices) might temporarily deflect the inflation rates from the trends supporting price level convergence. (Certain structural factors--e.g. trade liberalization, boosting competition on the product markets, etc.--might have similar effects.) At the same time not all inflationary differences might be consistent with the need for ensuring competitiveness and external stability of the economy in the medium term. In certain NMSs the unsustainable domestic demand growth caused the high inflation. This process was fuelled through too optimistic future expectations of the economic agents and/or insufficient economic policies.

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   1.3. Financial integration and real convergence

   The growth dynamism in the NMSs was generally accompanied--sometimes controlled--by rapid financial deepening and credit expansion. The financial integration of the NMSs has advanced. The NMSs were able to mobilize their external savings to a great extent due to ongoing convergence and the high returns on investment. The short-term and the long term interest rates have been converging to the Eurozone level. (see Figure 2)

   This interest rate convergence mirrored the preceding favourable global environment. On the other hand it showed that EU-accession resulted in increasing confidence. EU-accession and the prospect of joining the single currency mitigated significantly the risk premia. It provided strategy focus and at the same time, a protective screen for trustworthy economic policies. (There were no such factors in the other developing market economies.) In the new MSs the sovereign risk ratings kept improving before and after accession. Following the financial turmoil the risk perception increased more generally.

   There was higher capital inflow (including FDI)--expressed as a percentage of GDP--in MSs with tight pegs and currency boards (hereafter 'fixers') than in the floating currency countries. At the same time the fixed exchange rate regime resulted in a higher current account deficit. In the case of the 'fixers' the interest rate convergence was stronger. This process often led to negative real interest rates, especially in the case of strong inflation and rapid credit expansion. The 'fixers' started the real convergence process at a lower output level. Therefore the capital return was potentially higher that in turn forced higher capital inflow during the earlier periods of catching up. (European Commission (2008a))

   [FIGURE 2 OMITTED]

   The rapid financial deepening and high capital inflow are considered a significant challenge to be faced during adaptation. (Darvas and Szapary (2008)). The rapid credit expansion and the capital inflow in the non tradable sectors (especially housing) might change the composition of final demand. As a result a significant movement of the real exchange rate might come about. The real appreciation and the external deficit might become excessive due to unjustified optimistic expectations of the economic agents and insufficient economic policies.

   An 'overshooting' of the real exchange rate may hinder the achievement of fast and sustainable nominal convergence. It might cause further difficulties on the road towards the Euro. In the coming years painful macroeconomic corrections could be required due to the increasing deficit. The credit growth has slowed down under the circumstances of the global crisis. Liquidity conditions have become tighter. The risk perception of credit providers and credit takers has intensified. The financing conditions have become worse in those countries where high external and internal deficit has developed and foreign currency lending was significant. (e.g. Baltic States, Bulgaria, Hungary, Romania.)

   Following EU enlargement in 2004, four new countries fulfilled the criteria required for the adoption of the Euro. The other counties mostly made some steps as regards the fulfilment of the nominal convergence criteria. Their economic structure got closer to that of the Eurozone, but there are significant differences among the MSs.

   NMS countries prepare themselves for euro adoption under very different conditions. It is of great importance to outline adequate national strategies. As a fundamental factor of these strategies the sustainability of the convergence should be ensured. Nominal convergence needs to be achieved and sustained by taking into account globalization and financial integration which are peculiarities of the environment.

   The main current challenge is the crisis management in countries with high domestic and external deficits. A well-balanced macroeconomic policy-mix and responsible wage policy is required to avoid painful macroeconomic corrections in the coming years. Strong financial supervision is needed and at the same time all counties should keep progressing towards convergence.

   The proper functioning of internal adjustment mechanism of economic policies and the focus on prudent macroeconomic aspects could ensure that NMSs take better advantage of the single currency. Flexible domestic production factors and product markets favour smooth adjustment to economic and financial shocks. The future members of the Eurozone have to push on with adequate fiscal and structural policies according to the Stability and Growth Pact (SGP), the Lisbon Program and beyond.

2. Convergence and catching up

   Convergence and catch-up cannot be considered as an automatic result of EU-accession. The catch-up processes of the MSs can be analysed methodologically by means of growth accounting, through a production function approach and the calculation and interpretation of the catch-up rate.

   The pace of catching-up and convergence are not identical concepts. Both concepts may be interpreted in a negative light. However, their dynamics are not identical...