Unilateral currency union with a high-income area: the case of Montenegro.

• Author: Razmi, Arslan

1. Introduction and background

   In an insightful analysis of increasing official dollarization in the 1990s and early 2000s, Edwards (2001) found it remarkable that this rather drastic piece of advice giving up the national currency--is being dispensed on the bases of very limited empirical and historical evidence. The dearth of empirical and historical evidence is, if anything, even more glaring in the case of countries that unilaterally euroized in recent years. An obvious underlying reason is the infancy of the euro itself. The fact that, unlike the United States, the Eurozone lacks a fiscal or banking union that help stabilize output within the currency area, makes analysis trickier. Moreover, the unusual circumstances accompanying the unilateral euroization by Montenegro and Kosovo, including a civil war and the Great Recession, make it challenging to gauge the consequences of euroization. This paper attempts to investigate Montenegro's euroization within the limitations imposed by these constraints.

   The euroization of Montenegro, not surprisingly, followed a period of turmoil involving civil war, the break-up of the former Yugoslavia, hyperinflation, and a series of dramatic depreciations of the Yugoslav Dinar (the domestic currency). To restore monetary stability, the Deutsche Mark was adopted as legal tender in parallel with the Dinar in November 1999. The Mark then became the sole legal tender in January, 2001 before Montenegro officially and unilaterally euroized in June, 2002. The main motive appears to have been the need to establish monetary stability following bouts of high/hyperinflation in the preceding decades. (1) To date there are no official agreements between Montenegro and the European Central Bank approving the use of the euro as an official currency and while Montenegro was given candidate status for European Union membership in 2010, the path to Eurozone membership is still unclear. (2)

   Have subsequent developments justified Montenegro's decision to euroize? To explore this question, this paper utilizes criteria suggested by the optimum currency area literature to investigate the evolution of the Montenegrin economy since the adoption of the euro and political independence. I explore both monetary and real sector developments in order to analyze the potential consequences of unilateral dollarization for Montenegro, especially in the years following the Eurozone crisis. In particular, I examine the degree of Montenegrin integration with the rest of the Eurozone, and compare it with other economies in the region. The severity and duration of the Eurozone crisis, especially in the PIIGS (Portugal, Spain, Ireland, Italy, and Spain) has given a new lease of life to interest in common currency issues. This is a good time to take stock in the Montenegrin context.

   To give a preview of the main conclusions, I find that while Montenegro is likely to have benefited from importing policy credibility, the Montenegrin economy is only weakly synchronized with the Eurozone, and by some measures, has become less so over time. Euroization has helped little in this regard. The absence of exchange rate flexibility and monetary autonomy may therefore have been quite costly. The analysis reaches this conclusion in 3 steps:

1. I begin by showing that there is very little synchronization between shocks in Montenegro and the rest of the Eurozone.

2. Given the idiosyncratic nature of Montenegrin shocks, monetary and fiscal policies gain added importance for stabilization. I then show that Montenegro has limited monetary autonomy.

3. Asymmetry of shocks and lack of stabilization tools make output and trade diversification an important issue. In the final step, I establish the lack of diversification and the absence of endogenous increases in structural similarity following euroization.

   The recency of Montenegro's euroization poses a challenge to data analysis. To overcome this problem, I use the other former Yugoslav republics as sources for counterfactual comparison. An additional advantage to this approach is that several of these countries share the experience of break-up, civil war, high inflation, and instability in the years preceding Montenegro's euroization. Moreover, these provide variety in terms of exchange rate regimes and income levels. Where useful for comparison, I also add other recent Eurozone/EU entrants such as the small open Baltic states.

   The organization of the rest of this paper is as follows. Section 2 briefly discusses the broad issues involved and the literature relevant to them. Section 3 analyzes the degree of structural symmetry that exists between Montenegro and the Eurozone in a regional context. Having established limited symmetry, Section 4 then narrows the focus to issues of monetary independence in order to gauge the costs of currency union. Section 5 looks at other measures of Montenegrin integration with the Eurozone as these have evolved since independence. The endogeneity of structural convergence to euroization is explored. Finally, Section 6 concludes.

2. The big picture issues

   The choice made by Montenegrin policy makers can be broken down into two steps: (1) the adoption of a fixed exchange rate regime vis-a-vis the Euro area, and (2) the unilateral adoption of the euro as legal tender. While step 2 can be seen as the most extreme form of exchange rate fixing, it does raise subtly different issues in the absence of a common fiscal authority that oversees transfers, and the lack of a banking union and a lender of last resort. In particular, due to its more binding nature, joining a monetary union renders more salient the role of asymmetries in economic conditions.

   A substantial body of literature now addresses the pros and cons of dollarization. (3) The advantages often cited include increased microeconomic efficiency (the liquidity services and network externalities provided by a single currency circulating over a wider area), reduced transaction costs, the elimination of currency risk and speculative attacks, enhanced policy credibility when it comes to inflation, development of the banking system, lower risk premia on sovereign bonds, reduced real interest rates, and increased trade linkages with other members of the monetary union. Disadvantages include the obvious and dramatic loss of monetary autonomy, the absence of seigniorage gains, lack of access to the exchange rate as a stabilizing tool in response to economic shocks, reduced room for the functioning of a domestic lender of last resort, and, as a flip side to the credibility argument, the voluntary limiting of the ability to use the inflation tax in exceptional circumstances.

   The context in which a country enters a monetary union matters. Joining a currency union is likely to pose problems in the presence of asymmetric shocks and nominal rigidities. This was recognized early on by the pioneering work of Mundell (1961) and others, who pointed out that a common currency is optimal if either: (1) countries are exposed to symmetric shocks, or (2) if shocks are asymmetric, feasible adjustment mechanisms exist to ensure stabilization. The mechanisms could take the form of factor mobility, wage and price flexibility, and fiscal transfers (Mundell (1961), integration of trade in goods and services (McKinnon, 1963), or a highly diversified economic structure that helps dilute and absorb the effects of shocks (Kenen, 1969).

   While the criteria that are typically seen to shape the decision to enter into a monetary union are often a focal point of discussion, whether or not these criteria are endogenous is itself a matter of controversy. For example, Frankel and Rose (1998), and earlier in a major report, European Commission (1990) argue that monetary integration may foster trade. Rose and Stanley (2005) provide a meta-analysis that concludes that currency union increases trade by 30-90 percent. Trade integration, the argument goes, will increase intra-industry trade, foster business cycle synchronization and reduce exposure to asymmetric real shocks. Meeting the preconditions for the introduction of a foreign currency, therefore, may be much less important as an ex-ante concern. A different point of view, associated with Krugman (1993), is captured by the so-called Krugman specialization hypothesis, which raises the possibility that closer trade integration will undermine synchronization among the countries in the monetary union. This view, which is based on trade theory, hypothesizes that reduced transaction costs through integration will lead countries to become more specialized in sectors in which they have a comparative advantage. An implication is that integration will increase the likelihood of union members experiencing sector-specific asymmetric shocks.

3. Is policy independence an issue for Montenegro?

   The loss of monetary autonomy that results from adopting a foreign currency as legal tender gains importance to the extent that a country is structurally different from the currency area, and therefore requires unique policy responses to idiosyncratic shocks. How important is this issue in the Montenegrin context? Let's start by taking a look at some basic measures of Montenegro's integration with the Eurozone. (4) Table 1 provides the raw (unconditioned) correlations of inflation (Inflation), GDP growth (GDP), GDP per capita growth (GDPPC), gross national income growth (GNI), GNI per capita growth (GNIPC), and the ratio of foreign direct investment to GDP (FDIGDP). The period covered begins from Montenegrin independence to the latest year for which data are available. The correlations are generally quite high for Montenegro, ranging between 0.78-0.87, with the exception of the FDI to GDP ratio.

   For comparison purposes, Table 1 also presents correlations for other countries, including former Yugoslav republics (Bosnia and Herzegovina, Macedonia, FYR, Croatia, Serbia, and Slovenia). (5) The correlations...