Rethinking the Euro

As Greece’s debt woes multiply, Central and Eastern Europe are delaying plans for adopting the euro.


Barely two years ago most countries in Central and Eastern Europe were hoping to adopt the euro as quickly as possible, seeing the single currency as a source of stability and prosperity. Polish Prime Minister Donald Tusk led his Civic Platform party to electoral victory in November 2007 after promising to bring his country into the euro area, while nations from Hungary to the Baltic states made early adoption a centerpiece of their economic policies.

Then Greece blew up everyone’s plans.

Today, CEE governments are having to delay their euro dreams, and may end up postponing them indefinitely. The

Rethinking the Euro

Rethinking the Euro

Greek fiscal crisis has dramatically altered the perceptions and politics of the euro, both in the 16 countries that share the currency and in the other 11 members of the European Union. The crisis exposed a big rift among euro-zone members over whether to provide a bailout to Athens and even prompted a few German politicians to suggest that Greece temporarily pull out of the currency. With euro-area leaders having difficulty managing their own affairs, the idea of expanding the bloc suddenly seems almost fanciful. Meanwhile, Greece is being subjected to the kind of speculation that the euro was supposed to end and will likely have to endure years of painful austerity without the option of devaluation. For CEE countries, euro adoption is now a very sobering prospect, not a one-way ticket to economic security.

“It raises the question, What will it take for a country to prosper in the euro zone?” says Marek Belka, the former Polish prime minister who now heads the European section of the International Monetary Fund. Adds Morten Hansen, head of the economics department at the Stockholm School of Economics in Riga, Latvia, “Behind closed doors, government officials are sometimes wondering what exactly we are getting ourselves into.”


To be sure, CEE governments are not giving up their goal of getting into the euro club — at least, not yet. The treaties of accession under which they joined the EU in the past decade commit them to adopting the single currency eventually. Besides, most governments still believe that the euro offers their small economies protection from market turbulence and access to the deep European capital market. But fulfilling that euro ambition looks further away now than at any time since accession. With the possible exception of Estonia, whose candidacy for the euro goes before EU leaders in June, it could be at least four or five years before any CEE nations enter the euro area.

The Greek case seems certain to toughen the admissions test for would-be entrants. Greece was allowed to adopt the euro in 2001, despite having a national debt far in excess of the euro ceiling of 60 percent of GDP, as political factors trumped a strict reading of the Maastricht Treaty’s criteria. Shaken by Greece’s subsequent experience, few euro-area members would countenance fudging the criteria for other countries. “Most euro-zone members don’t want to admit new applicants anytime soon, even if they satisfy all the conditions of admission,” says Paul De Grauwe, an economist at the Katholieke Universiteit Leuven in Belgium. The recession, in fact, has caused budget deficits in most CEE countries to surge well above Maastricht’s 3 percent-of-GDP limit. Bulgaria last month withdrew its application to enter the lev in the EU’s Exchange Rate Mechanism, a necessary precursor to adopting the euro, after the government revised its budget deficit sharply upward.

More profoundly, Greece’s debt crisis — and the threat of similar problems in Portugal, Spain and Italy — is causing policymakers from Warsaw to Bucharest to take a deeper, and perhaps more skeptical, look at the full consequences of adopting the euro. Many countries have tended to see the euro as a panacea: All they had to do was tighten their belts to pass the one-time test for getting into the club; then they could forever enjoy the benefits of low interest rates and the same sound money as people in France and Germany. Greece has exploded that myth, though. The country, like Spain and Portugal, got a huge growth boost when it entered the euro, but never tackled its structural problems of a bloated state, low productivity and wage and price inflation above that of Germany. Now the bill has come due. Even if Greece succeeds in getting emergency financing from the EU and the IMF, the government will have to impose spending cuts and tax increases on the order of 10 percent of GDP over the next few years, something no EU country has done in recent history.

András Simor, governor of the Magyar Nemzeti Bank, Hungary’s central bank, expresses the new monetary realism. “Euro adoption would benefit Hungary, and the crisis has not changed this view,” he tells Institutional Investor in an interview. “But if your economy isn’t competitive enough, then you will have problems even if you are a euro-zone member.” Hungary has already set and missed several target dates for adopting the euro over the past six years; former prime minister Viktor Orbán, who led the center-right Fidesz party to a sweeping victory in parliamentary elections last month, now talks vaguely about a target entry date sometime in the second half of this decade. The Hungarian economy suffered a harsh recession last year, with GDP contracting by 6.3 percent and unemployment rising above 10 percent. Simor acknowledges that the country has much work ahead to demonstrate its readiness to adopt the euro.

The situation is little better in most other CEE countries. Romania’s budget deficit surged to 8 percent of GDP last year, and inflation exceeded 5 percent, effectively ruling out euro ambitions anytime soon. Even before Bulgaria’s recent deficit revision, most economists regarded 2015 as the earliest date for euro adoption.

Although Estonia is maintaining its euro candidacy this year, it and its Baltic neighbors, Latvia and Lithuania, have suffered the worst recessions of any EU member. Because the three countries operate currency boards that fix their exchange rates to the euro, they have in effect carried out internal devaluations that have slashed real incomes. Output plunged by more than 14 percent in Estonia last year, by 15 percent in Lithuania and by 18 percent in Latvia; although Estonia has managed to keep its deficit under the 3 percent ceiling, budget gaps in the latter two countries ballooned to 9 percent of GDP last year and are projected to remain high this year.

Poland was the only EU country to have an expanding economy last year, with growth of a modest 1.7 percent. The Tusk government might have a freer hand to go for the euro if Civic Platform wins an early presidential election called to choose a successor to the late President Lech Kaczynski, an EU skeptic who was killed in a tragic plane crash in Russia last month. But few observers are betting on an early Polish move to join the euro zone. Tusk has already pushed back the government’s putative euro timetable to 2014 or later, compared with 2012 when he took office. Furthermore, the Polish economy has benefitted from the government’s freedom of maneuver outside the euro zone. Warsaw allowed the złoty to depreciate significantly against the euro during the worst of the crisis last year; the country’s budget deficit widened to more than 6 percent and is expected to exceed 7 percent this year.

The country’s former central bank governor, Sławomir Skrzypek, who died in the crash with Kaczynski, underscored the advantages of currency flexibility in a column published in the Financial Times a few days after his death. “Poland has been able to profit from flexibility of the złoty exchange rate,” he wrote. “Poland is committed eventually to entering the single currency. But recent experience — both the problems in the euro zone and our own generally positive circumstances outside it — makes us question whether we should submit quickly to a rigid exchange rate regime as a precondition for entry.”

In the Czech Republic, President Václav Klaus regards the crisis as a vindication of his long-standing opposition. “For me, as an economist, it was almost a laboratory experiment on the advantage of an independent currency and not to be in the straitjacket of the euro,” he told a conference earlier this year.

After entering the European Union in two waves, in 2004 and 2007, the former Communist countries of Central and Eastern Europe hoped to raise their living standards toward Western European levels and to adopt the euro as part of the process. But aside from Slovenia and Slovakia, which adopted the euro in 2007 and 2009, respectively, few countries have shown the willingness or determination to actually do so. Hungary reflects the ambivalence that many states in the region feel about the euro.

The Hungarians have typically talked a good game, asserting they were serious about euro-zone entry dates — first 2010, then 2012 and now sometime after 2015. But ever since the collapse of Communism in 1989, successive governments — whether led by Fidesz or by the center-left Socialists who ruled for the past eight years — have repeatedly failed to accept the fiscal discipline required for admission. A bloated retiree problem is a key driver of the deficit. The country has 3 million pensioners in a population of just 10 million. The average retirement age is 58, and only 13 percent of people aged 60 to 64 are working, compared with about 50 percent in the U.S.

Ahead of the previous election, in 2006, the government hid the scale of its deficit problems in a bid — successful as it turned out — to win reelection. In a closed-door speech to his Socialist party stalwarts in May 2006 that was disclosed only after the election, then–prime minister Ferenc Gyurcsány admitted that the budget deficit was hurtling toward 10 percent of GDP, or twice the official figure.

The global financial crisis brought Hungary to the brink of default. Economic chaos was staved off when a technocratic government led by Prime Minister Gordon Bajnai took office in April 2009. In October the government negotiated a €20 billion ($26.9 billion) international assistance package with the IMF and the EU in exchange for promises of steep budget cuts. Officials have also begun addressing the country’s big pension problem. After years of allowing pension payments to rise faster than inflation, the government last year tied pension increases to the consumer price index; it also adopted measures that will raise the official retirement age — currently 60 for women and 62 for men — to 65 by 2012. Those changes are expected to hold down total pension costs to 10 percent of GDP, compared with a previously projected 13 percent.

“We believe that we have been able to deal with the most politically difficult issues and allow the next government to move ahead,” Finance Minister Péter Oszkó told Institutional Investor just before the first round of elections in April. He insists that Hungary is now determined to meet the euro’s requirements because “it is in our own economic interest to lower our budget deficit and debt level.”

Euro adoption has consistently won the backing of roughly 60 percent of Hungarians, and it’s not hard to see why. Most mortgages and consumer loans made in recent years are denominated in euros or Swiss francs. The practice enabled consumers to circumvent Hungary’s relatively high interest rates, but when the crisis caused the forint to plunge in value, those consumers suddenly found themselves facing onerous debt payments. “Many Hungarians see the euro as a remedy,” says the central bank’s Simor.

But will Hungarians and their new center-right government be willing to accept the austerity measures necessary to meet — and sustain — the Maastricht criteria for euro-zone entry? Fidesz leader Orbán’s record suggests some reason for doubt. In both his first term as prime minister, from 1998 to 2002, and as head of the opposition for the past eight years, Orbán has tended to take nationalist, populist stances on economic issues and to oppose further integration with the EU. During the latest election campaign, he was vague on a new target date for joining the euro and how he intends to get there.

Fidesz won more than two thirds of the seats in Parliament in last month’s elections, giving Orbán the authority to override any opposition complaints and impose stiff budget cutbacks. But in his initial postelection comments, the prime minister–designate gave few hints about the new government’s economic policies and appeared to question an existing deficit target of 3.8 percent of GDP, which the Bajnai government had agreed to last year to win IMF funds, calling it “a thing of the past.” During the campaign, Orbán had contended that the real deficit was considerably higher because of hidden spending in large state entities such as MÁV, the national railway company. “Fidesz will first have to show that it has a credible fiscal plan for the coming four years,” says Zsolt Darvas, a Hungarian economist at Bruegel, a Brussels think tank.

Maintaining a stable exchange rate — another Maastricht requirement — has also been a struggle for Hungary, which allows the forint to float rather than linking it to the euro. The forint fell by 28.3 percent between July 2008 and March 2009, to a low of nearly 317 to the euro, before rebounding by 19.5 percent over the past 13 months, to about 265 in late April. “It makes business calculations much more difficult,” says László Wolf, deputy chief executive officer of OTP, Hungary’s biggest bank. “If you are an exporter, you don’t know what price you will be getting for your goods in four or five weeks.”

The floating exchange rate has also been the bane of Hungarian borrowers. Before the crisis erupted, foreign currency lending peaked at 85 percent of new bank loans to businesses and households. The forint’s plunge increased the burden of those debts on borrowers, and by the end of 2009, the loan-loss rate of Hungarian banks reached 4.25 percent, up from 1.75 percent a year earlier. Today banks have virtually stopped making foreign currency loans; lending in forints has also contracted and isn’t likely to resume growing until 2011, according to the central bank. “We hope lending will be more prudent and sustainable than it was before the crisis,” says Simor.

Neither the crisis nor the postponement of euro-zone membership have soured Western European banks — which hold more than 70 percent of CEE banking assets — on their investments in Hungary or the rest of the region. “The bet that Western banks have been making in Central and Eastern Europe is more on convergence and the greater growth potential that these countries have — and not specifically on euro adoption,” says Marco Annunziata, the London-based chief economist at UniCredit, the Italian bank group that is the largest CEE financial investor. “Of course, once a country adopts the euro — as in the case of Slovakia — it can accelerate the growth process because it eliminates exchange rate volatility in one stroke.”

Approved for euro-zone membership in 2008, Slovakia adopted the single currency in January 2009. The country’s economic output dropped by 4.7 percent last year, worse than the Czech Republic’s 3.1 percent drop but better than Hungary’s 6.3 percent contraction. The economy bounced back late last year, with GDP up 2 percent in the fourth quarter compared with the same period in 2008.

Particularly impressive was the 10.7 percent rise in Slovakia’s industrial output in the fourth quarter. The country’s main manufactures are automobiles and car parts, produced at a lower labor cost than elsewhere in the euro zone, which buys half of Slovak exports. “It is now obvious that becoming a euro-zone member offers advantages to a small, open and vulnerable economy like Slovakia,” says Vladimir Vanˇo, chief analyst for Volksbank Slovensko, based in Bratislava, the Slovak capital.

Estonian officials hope he’s right. The country pegs the kroon to the euro and has been in ERM-2 since 2004 as part of its bid to join the euro zone. Determined to fulfill the entry conditions, the government adopted further austerity measures last year — including cutting public-sector salaries by 15 percent — in the midst of a savage recession. “They have strangled their economy to meet the Maastricht criteria,” says Hansen of the Stockholm School of Economics. At the end of last year, Estonia’s real GDP had fallen back to the level of early 2005. Euro-inspired cutbacks have, in effect, wiped out almost all the economic growth that Estonia enjoyed after joining the EU in 2004. “That’s real sacrifice,” adds Hansen.

Those tough policies haven’t guaranteed that EU leaders and Finance ministers will admit Estonia to the euro club when they review the country’s application in June and July. The EU rejected Lithuania’s application in 2006 because the country’s inflation rate exceeded the Maastricht ceiling by 0.1 percentage point, and because ministers judged that the country’s then-low budget deficit wasn’t sustainable. Estonia’s budget measures succeeded only in reducing the deficit to 3.0 percent of GDP last year, the Maastricht limit.

“It will be difficult for anyone to argue against Estonia’s entry,” said Kenneth Orchard, vice president for sovereign risk at Moody’s Investors Service, in a credit ratings report on Estonia in March. Others are more skeptical. “The attitudes of euro-zone members toward outsiders are moving in the opposite direction,” says Daniel Gros, director of the Center for European Policy Studies, a Brussels think tank. “Quite a few members take the position that the Baltic countries should not be allowed in.” The opposition to any further euro-zone expansion is led by Germany, the Netherlands and to some extent France.

Poland would pose a much bigger test for the euro zone. Geopolitically, the country, with its large domestic market and more than 38 million inhabitants, is more important to the Germans than other potential CEE applicants. Poland has been able to finance its deficit with relative ease so far. In January the government sold a €3 billion Eurobond offering — its largest since 2006; the 15-year issue was priced to yield 5.25 percent, or 200 basis points more than comparable German bonds. By contrast, yields on ten-year Greek government bonds surged above 7 percent last month despite a pledge of support from other euro-zone members.

Notwithstanding Poland’s relative strength, Prime Minister Tusk has slowed his country’s drive toward the euro. After committing his government in 2008 to adopt the euro by 2012, he now suggests that Poland will only join the ERM in 2012 or 2013, which would postpone euro adoption until 2014 or 2015 at the earliest. The main stumbling block is a budget deficit that the government expects to rise to 7 percent this year before dropping. “Euro accession remains a very strong strategic objective for Poland,” says the IMF’s Belka. “Having said this, Poland still has to strengthen its fiscal position.”

Poland’s desire to achieve convergence with the productivity levels of more advanced EU economies also argues for a slower euro timetable. “Under the surface of the troublesome situation in Greece is the loss of competitiveness,” says Andrzej Sławin´ski, who until February was a member of the National Bank of Poland’s Monetary Policy Council. “Poland does not want this to be a problem.” That will mean pushing ahead with pension reforms and encouraging more business investment by improving the tax system, which in terms of friendliness toward business ranked a lowly 151st out of the 183 countries surveyed by the World Bank last year.

Polish officials are also wary because of the experience of Spain. That country had a housing boom and bust over the past decade, attributable at least in part to the euro, which kept interest rates lower than Spain’s growth and inflation record would have justified on their own. Sławin´ski, now a member of Poland’s Financial Supervision Authority, the country’s financial regulator, says the EU needs to tighten up banking supervision to prevent future real estate bubbles. “CEE euro entrants must be protected against the risk of unstable lending booms,” he says.

Hungarian officials also aren’t shy about pointing out the euro zone’s shortcomings. “Its fiscal policy is much less controlled,” says former Finance minister Oszkó. He expresses the hope that “the euro zone will again become strong and unified” after a few years of budgetary discipline. “If that is the case, Hungary will certainly want to join,” he says.