Friday, April 10, 2009

Major Players Debate Adding Eastern European Countries to Eurozone

Sources: Wall Street Journal, ECB Spokeswoman: Implementation of Euro Treaty Vital; Financial Times, ECB Dismisses Euro Short Cuts in East Europe; AFP, IMF Backs Euro for Eastern Europe; Reuters, ECB's Nowotny Says Forcing Euro Adoption a Bad Idea

On Monday, the Financial Times leaked an IMF report proposing that central and eastern European countries be added as "quasi members" to the eurozone. The European Central Bank quickly affirmed its position on the issue, which is that the Nice treaty should be fully implemented but not expanded. The treaty calls for adoption of the euro for Member States with a budget deficit lower than 3% GDP, total public sector debt below 60% GDP, and inflation a maximum of 1.5 percentage points above the average of the three lowest inflation rates among the member states. The treaty does not contain any provisions on the proposed "quasi membership," and the ECB believes that allowing adoption outside of treaty rules would lead to falling confidence in the euro.

After the leak of the IMF report, however, eastern European currencies rallied, and officials disagreed on the best currency strategy for these nations. One proposition was that only small countries with fixed exchange rates, such as the Baltic states, should adopt the euro. Another concern was that the countries adopting the euro have sufficient currency reserves. Many officials are sceptical about the practical effect of allowing quick partial adoption of the euro regime, and doubt the political viability of such a move.

The idea of "quasi membership" is to allow countries to adopt the euro as their currency without also allowing them seats on the Governing Council of the European Central Bank. The benefits would be resolving foreign currency debt and restoring confidence in troubled eastern European countries. However, it would be difficult to choose an exchange rate at which to make the switch, and going to the euro at a low rate could significantly harm individuals and businesses. Furthermore, the countries that have the greatest need for a currency rescue, such as Hungary and Poland, would be least likely to benefit from the switch.

Another option might be for emerging economies to speed up the process by joining the European Exchange Rate Mechanism early, but this is still a risky path for eastern European countries to take. This option would mean that the countries' currencies traded against the euro within a fixed band, and there would be a risk of counterspeculation against the eastern European currencies. One member of the European Central Bank's Governing Council said that the Bank would not use market intervention to support these currencies, but might start accepting non-euro denominated bonds as collateral.

1) Do you think that the ECB should support quicker adoption of the euro for these countries, or is it smart to stick with the existing framework to avoid a loss of confidence in the euro?
2) Do you think that a partial adoption, perhaps for the Baltic states but not for countries with more dangerously volatile currencies like Hungary and Poland, would be possible?

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