Accession to the EU and prospects for participation in EMU:
The case of Hungary
In the forthcoming years, Hungarian economic policy will face new challenges with respect to its international financial/economic environment. First, with the start of Stage III of the Economic and Monetary Union (EMU), a zone of genuine monetary stability has been established in major part of the traditional Western Europe. Second, with the envisaged Eastern enlargement, a huge and homogenous market (of goods, services and factors of production) will be created in Europe, whose size and market potential will exceed that of the present major trading blocs of the world economy. Third, as the acquis communautaire includes the adherence to the objectives of EMU, it is obvious that Hungary's entry into the euro-zone has to be regarded as one of the "strategic" goals of the Hungarian economic policy.
From the perspective of the EU, both the introduction of the euro and Eastern enlargement are ambitious far-reaching tasks, and they serve a common purpose, namely the strengthening of the EU's competitive position in the global marketplace. The introduction of the single currency and Eastern enlargement will put, of course, different mechanisms in place in order to enhance the international competitiveness of Europe. Nevertheless, one should be well aware of the fact that the two projects are supplementary with respect to achieving this end rather than being mutually exclusive.
From a Hungarian perspective, both the introduction of the euro and the accession process as well as (in a later stage) our joining the euro-zone pose new tasks for the economic policy, including the monetary and exchange rate policies and other areas that belong (at least partially) to the competence of the central bank (the National Bank of Hungary - NBH, for short).
I. THE INTRODUCTION OF THE EURO AND ITS EFFECTS ON HUNGARY
The immediate impact of the introduction of the euro is the creation of a huge and liquid financial market to which the Hungarian money and capital markets will gradually be integrated. The demand, by Hungarian issuers, for euro-denominated funds is also likely to increase. Policies related to the management of foreign debt and international reserves have explicitly to take into account the emergence of the single currency. From its introduction, the euro plays a central role in the Hungarian exchange rate policy.
The introduction of the euro and the implementation of a single monetary policy of the euro-zone by the European Central Bank (ECB) has also changed the economic and financial policy set-up within the EU itself, and this impact has to be considered also from the point of view of a country being in the accession phase to the Union.
The introduction of the euro has important implications not only for the EU Member states but for the rest of the world, as well. The size of the euro-zone, the stability orientation of its policy framework and the integration of the financial markets imply that the euro is likely to become a major world currency.
The main channel of transmission through which the introduction of the single currency will have impacts on the economic conditions of non-EU countries runs via these countries' international trade relations with the euro-zone. Trade creation results from the positive impact on economic growth in EU that is linked with the completion of EMU. Furthermore, economic growth in the euro-zone will increasingly affect other (non-EU) countries given the increasing degree of synchronisation of business cycles within the euro-zone. The impact of the euro on non-EU countries will depend on the share of these countries' trade with the countries of the euro-zone in their total external trade, and on the trade elasticity of these countries' economic growth. In Hungary more than 70 per cent of foreign trade is conducted with EU countries (the overwhelming part with the members of the euro-zone).
It is expected that the role of the euro as an exchange rate anchor for non-EU countries will gradually increase in the future. Trade relations with the euro-zone will intensify after the introduction of the euro. Not only the size of the trade flows will increase, but also the invoicing practices will change towards a bigger use of the euro. Non-EU countries therefore, trading with the countries of the euro-zone, will be able to reduce the exchange rate risk of their foreign trade by pegging to the euro. In the Hungarian currency basket, the euro replaced the DEM (with a weight of 70 per cent) at the beginning of 1998, and the HUF will solely be pegged to the euro from the beginning of 2000.
II. THE ENLARGEMENT PROCESS
In March 1998, the accession process was formally opened, and, in the case of Hungary1 the actual work started in April with the first rounds of the acquis screening, while accession negotiations stricto sensu were convened in November. The opening of the accession process was preceded by the decision of the Luxembourg European Council (December , 1997) which, in turn, was based on the opinions (avis) on accession applications from ten Central and Eastern European countries issued by the European Commission in July 1997.
In addition to the opinions on the applicant countries, the Commission also issued an overall assessment of the impact of enlargement entitled "Agenda 2000 - For a stronger and wider Union". In this assessment, the Commission clearly states that the economic effects of enlargement will undoubtedly beneficial for the Union in the longer run. In the enlarged Union -- coupled, eventually, with the single currency -- a higher growth / lower inflation scenario could be realised, improving the EU's competitive position in the world. The main channels of reaching potential benefits from enlargement can be summarised as follows:
· through enlargement, rapidly growing income in the acceding countries will translate into continuous rapid growth of the West European export industries2 ;
· the emergence of competitive suppliers in Central and Eastern Europe could have a dampening effect on input prices in the whole area of the enlarged Union, thus reducing costs and increasing global competitiveness;
· modernisation needs of the applicant countries and the creation of a pan-European infrastructure should stimulate investment expenditure;
· increased competition on products and factors markets (including the labour market) should contain inflation facilitating a stability-oriented monetary policy with relatively low interest rates.
The attainment of the potential economic benefits from Eastern enlargement depends on a number of pre-conditions set towards both the EU (present Member states) and the applicant countries. The Commission documents (both the opinions and the regular reports issued last November) correctly point out the differences among the applicant countries with respect to their capacity to meet the pre-conditions for accession.
II.1. Pre-conditions for accession and convergence criteria
As defined by the Copenhagen European Council in 1993, the pre-conditions for EU membership include the existence of a functioning market economy; the capacity to cope with competitive pressure and market forces within the Union; and the ability to take on the obligations (community policies and legislation in force, i.e., the acquis communautaire) from membership which also implies the adherence to the aims of the Economic and Monetary Union. The accession criteria are, thus, mainly about institutional-legal, as well as about real convergence (in particular competitiveness).
With the Copenhagen criteria kept in mind, the Hungarian integration strategy rests on the interlinked objectives of maintaining sound macro-economic policies combined with a concentration upon real convergence (i.e., closing the income gap vis-à-vis developed market economies) and the transposition, implementation and enforcement of EU rules in national legislation3 .
There is common understanding among EU and applicant countries that the Copenhagen criteria of EU membership and the Maastricht criteria of entering Stage III of EMU represent two distinct sets of pre-conditions. In the case of countries wishing to join the European Union, the Maastricht convergence criteria can serve as medium and longer-term points of reference for stability-oriented macro-economic policies, rather than "operational" (short-term) macro-economic targets. As the 1995 Madrid European Council correctly emphasised, policies in the acceding countries should concentrate on the "creation of a stable economic and monetary environment", as this is one of "the conditions for the gradual, harmonious integration" of the candidate countries.
As the applicant countries are in the process of transition/catching-up, the strict application of the standards of nominal convergence as set by the Maastricht criteria might not be adequate to evaluate their economic performance for several reasons. First, the catching-up process inevitably implies a closing income gap vis-à-vis developed countries which will obviously be reflected by the real appreciation of their currencies in the longer run. However, real appreciation might not be compatible with the simultaneous fulfilment of the inflation and the (nominal) exchange rate stability criteria, since it results either from a similar inflation pattern combined with nominal appreciation, or from a (nominally) stable or depreciating exchange rate combined with higher inflation. Second, the deepness of structural changes taking place during the transition period itself justifies higher inflation for a certain period of time, as the need for relative price/wage adjustments is substantially larger than in
mature market economies.
In the area of real convergence, efforts concentrate on strengthening Hungary's competitive position, both at economy-wide and at sectoral level. The most important areas where substantial progress have already been made include comprehensive enterprise and banking sector reforms, the stimulation of inward direct investment (both through the sale of state-owned assets and via greenfield investment), privatisation of major sectors of the economy (including the financial sector, telecommunications and large part of the energy sector), the implementation of trade liberalisation commitments taken on in the Association Agreement and within the CEFTA group as well as the introduction of the current account convertibility of the Hungarian currency and a substantial, albeit not complete, liberalisation of capital movements, the adherence to the competition policy and the state aid control standards of the EU, etc.
The ongoing liberalisation and structural reforms have to be continued and completed in fields like the complete liberalisation of cross-border services and capital movements, transformation of the welfare systems (including the introduction of a fully funded pillar in the pension system which was implemented at the beginning of 1998, and a comprehensive reform of the health system), increasing the flexibility of labour markets, etc. The implementation of these measures will pose additional challenges for the macro-economic policies, as the Hungarian economy will be exposed to an even greater extent to swings in international financial flows, due to these reforms and liberalisation measures.
Equally crucial for achieving EU membership is legal convergence. This implies not only the adjustment of the Hungarian legislation to EU standards, but also continuous efforts to ensure the enforcement of the respective pieces of legislation.
II.2. Monetary, exchange rate and fiscal policies in Hungary up to the accession to the EU
The stabilisation package (of March 1995) corrected the major external and internal imbalances prevailing in the Hungarian economy in the 1993-1994 period, while the implementation of the accompanying structural reforms created the pre-conditions of sustainable growth which is inevitable to narrow the income gap vis-à-vis developed market economies. (GDP growth: 4.6 per cent in 1997, above 5 per cent in 1998).
Monetary and exchange rate policies have contributed to favourable developments through putting in place a coherent macro framework with a predictable exchange rate policy and succeeded in increasing the credibility of the central bank. Fiscal and income policies acted in a concerted manner with monetary and exchange rate policies, in order to contribute to a sustainable reduction in inflation. The gradual, but permanent disinflation accelerated in 1998. Inflation, measured by y-o-y CPI, fell from the peak of over 30 percent in the summer of 1995 to slightly above 10 percent in December 1998, and at the beginning of 1999, single-digit inflation rates were recorded, the first time in the past decade in Hungary.
The rate of the crawl was cut to a monthly 0.6 per cent from January, 1999 (down, in several steps, from 1.8 per cent in March 1995), and further reduction is conditional upon the evaluation of economic developments. The crawling peg system -- with gradual reductions in the rate of the crawl -- is intended to be maintained until inflation differential vis-à-vis Western Europe comes down to a level consistent with the differential in productivity growth.
Over the past few years, remarkable progress has been made in fiscal consolidation. In the context of a comprehensive public sector reform -- which has to be continued in certain fields (health, local governments), the primary expenditures of the general government fell from 52 to 39 per cent of GDP between 1994 and 1998. Simultaneously, the debt to GDP ratio has rapidly declined, standing slightly above 60 per cent in 1998. Nevertheless, continued restraint is necessary. The 1999 budget passed by the Parliament calls for a 4 per cent general government deficit/GDP ratio in 1999 (with a primary surplus of ca. 2 per cent), facilitating a further drop in the debt/GDP ratio.
The medium-term Hungarian economic strategy reckons that by the end of the period, i.e. in 2002 -- which may coincide with the start of Hungary's full membership in EU -- some of the convergence criteria (debt and deficit) will be fulfilled, while the economy will be put on such a sustainable growth path that will make it possible to meet the rest of the criteria within a foreseeable period of time.
III. EU MEMBERSHIP WITH PRE-IN STATUS IN STAGE III OF EMU - PREPARING FOR THE ENTRY INTO THE EURO-ZONE
Assuming Hungarian membership in the EU, Hungary's position until its participation in EMU will be similar to those member states having derogation (i.e., pre-in status). Hungary will have to adopt the rights and obligations applicable from the start of Stage III of EMU with respect to member states with derogation.
III.1. Exchange rate policy
According to the Treaty, pre-in countries shall treat their exchange rate policies as a matter of common interest. This means that exchange rate policies should aim at the avoidance of disruptive movements in nominal exchange rates and misalignments that could threaten the proper operation of the single internal market. Lasting distortions in real exchange rates (as a result of the gradually decreasing inflation differentials between the catching-up countries and the euro area) -- which could produce undesirable effects on the balance of payments - will not be allowed, nor will be exchange rate devaluations in order to gain competitive advantage. This will provide a powerful incentive for Hungarian producers to control their costs and modernise their products and production processes. Due to the catching-up process described above, it is expected that the Hungarian currency will gradually appreciate in real terms.
In order to provide an appropriate institutional framework for the exchange rate policy co-operation between the euro zone and the pre-in countries, a new exchange rate mechanism (ERM II) was put in place from the beginning of 1999. It has been emphasised by various EU institutions that the monetary and exchange rate co-operation should be flexible enough to accommodate different degrees and strategies of economic convergence. Hence, membership in the new exchange rate mechanism would be voluntary; nevertheless, member states with derogation can be expected to join the mechanism once they have achieved a satisfactory degree of economic convergence. Given the above-described trade-off between exchange rate stability and price stability during the catching-up process, an early entry into the new exchange rate mechanism (implying the loss of the exchange rate instrument) might be too constraining for the transition economies4 . Therefore, an alternative institutional design
for the exchange rate policy du
rin and shortly after the accession period -- providing sufficient flexibility and simultaneously ensuring the avoidance of competitive devaluations -- has to be considered5 .
As known, a large number of Community mechanisms have been put in place in order to implement the co-ordination of economic and exchange rate policies. These mechanisms will also ensure that exchange rate policies in all member states with derogation -- irrespective of their participation in the new exchange rate mechanism -- are closely monitored and assessed with a view of the above requirement of treating exchange rate policies as a matter of common concern and the smooth operation of the internal market.
III.2. Foreign exchange policy
In the past couple of years, Hungary implemented the current account convertibility of the domestic currency and adopted a large number of liberalisation measures with respect to the capital account. However, we retained, for a limited period of time , some restrictions in the field of short-term capital movements.. In the pre-accession period, we will have fully liberalised capital movements, including short-term capital. The new Act on allowing foreign banks and other financial institutions to establish branches in Hungary came into force on January 1, 1998. Regarding the ownership structure of the financial sector, Hungary is one of the most open economies in the world: the share of foreign ownership in the banking sector is around 60%.
III.3. Monetary policy
The primary goal of the NBH is to protect the internal and external purchasing power of the national currency. This, in practice, means that the focus of monetary policy is on the gradual reduction of inflation as the primary goal which is in line with the requirements stipulated by the Treaty with respect to the primary objective of the ECB and the national central banks of the member states.
The amendment to the Act on the NBH, that came into force on January 1, 1997, rendered the NBH a truly independent central bank complying with most of the requirements of increased independence of central banks in the light of EMU. Legal, institutional and personal independence of the NBH from the government has widened considerably. E.g., the NBH is not allowed to buy government debt instruments on the primary market, its governor and vice-governors are appointed for 6 years, etc. The remaining -- minor -- inconsistencies in the central bank law with the requirements of the EMU will be eliminated by the time of Hungary's accession to the EU.
During the transitional period to market economy, the NBH developed its own set of monetary instruments which are by now very similar to the instruments applied in the European System of Central Banks.
Monetary strategy and operations of the ECB will affect our monetary policy. A stable currency in our main trading partners may force us to bear an interest rate premium over the prevailing rate within the euro area. This is the price we have to pay for exchange rate risk and country risk as being outside EMU and therefore it will create strong incentives for Hungary to join EMU as early as possible.
All in all, monetary policy will be conducted according to the principles set in the Treaty and will be subject to continuous monitoring by the ECB, the Commission and ECOFIN. There will be a close co-ordination of economic policies between Hungary, the other pre-ins and the EMU (based on Article 103 of the Treaty). This will increase our credibility and minimise interest rate premium of HUF over the euro.
III.4. Possible policy dilemmas during the transition to EMU
Due to the several features of the Hungarian economy (as well those of the other applicant countries from Central and Eastern Europe) stemming partly from the transition / catching-up character of these economies, a number of policy dilemmas may occur, while moving along the path to EMU. A far from complete list would contain the following ones6 :
· The catching-up process inevitably implies a closing income gap vis-à-vis developed countries which will obviously be reflected by the real appreciation of the currency in the longer run. However, real appreciation might not be compatible with the simultaneous fulfilment of the inflation and the (nominal) exchange rate stability criteria, since it results either from a similar inflation pattern combined with nominal appreciation, or from a (nominally) stable or depreciating exchange rate combined with higher inflation.
· Due to the size and complexity of structural changes still ahead of the Hungarian economy, it is hardly possible to stick to a strict deadline by which the whole set of convergence criteria will be met. Relative price changes -- due partly to the catch-up process to the EU -- are still considerable for a number of years, thus preventing the Hungarian economy to reach the around 3 percent inflation threshold ensuring the fulfilment of the inflation criterion. In addition, the difficulties with respect to the determination of the real equilibrium exchange rate in a transition/catching-up economy will further complicate the fulfilment of the exchange rate criterion.
· There is trade-off between joining the EU with a relatively low number of transitory arrangements and keeping the budget deficit on a continuously downward path. As the further progress in the catch-up process necessitates to enter the EU relatively early, these conflicting requirements are expected to prevail in the forthcoming period. In addition, the comprehensive reform of the public sector -- e.g., in the field of health services -- may cause temporarily larger deficits in the current budgets (experience with the pension reform -- introduction of the second pillar with compulsory private pension funds -- confirms the possibility of such situations).
· Under these circumstances, the relatively rigid provisions of the Stability and Growth Pact (or similar requirements) may hinder the use of fiscal policy as shock absorber in the case of a possible negative external (asymmetric) shock.
18-03-1999
* Department of International Economic Organisations, National Bank of Hungary -laszlo.toth@mnbpost3.mnblan.mnb.hu
1 As well as the Czech Republic, Estonia, Poland and Slovenia plus Cyprus.
2 As the Commission documents points out, this has partially been experienced already in the first half of the decade, since the trade between the EU and the applicant countries more than tripled in the period of 1989-1995.
3 For a detailed elaboration on these issues see, e.g., Backé, Peter and Isabella Lindner, "The European Monetary Union: Prospects for EU member states and selected candidate countries from Central and Eastern Europe." In: Focus on Transition, Oesterrechische National Bank, Vienna, 2/1996. pp. 20-45.
4 This consideration is also reflected in the Commission document evaluating the impact of enlargement (Commission of the European Communities, Agenda 2000 - For a stronger and wider Union, July 1997).
5 This is implicitly recognised in the Composite Paper (attached to the regular reports from the Commission on progress towards accession by each of the candidate countries) which states that in the accession phase (i.e., when the country concerned is the member of the European Union, but does not yet participate in the euro area) obligations with respect to exchange rate policy include the "Treatment of the exchange rate policy as a matter of common interest and, later, participation in the exchange rate mechanism" [Commission of the European Communities, COM (1998) 712 final, p. 11].
6 Some of these policy dilemmas were discussed at length, by Kopits, George, "Implications of EMU for exchange rate policy in Central and Eastern Europe." Working Paper of the International Monetary Fund (WP/99/9), January 1999.
