Slovakia's path to Euro adoption - a blueprint for Poland*

1. Adoption cases

The Polish government plans to adopt the euro in 2015. As the policymakers think through the issues that Poland will face on its path to the euro, it is useful to take a look at the experience of our southern neighbor Slovakia, which is set to join the eurozone on January 1, 2009. Of recent eurozone entrants, Slovakia is clearly the most relevant precedent for Poland. It shares many of its characteristics in terms of geography and initial degree of income convergence with the old EU member states. Importantly, Slovakia had been operating an inflation targeting monetary regime before it entered the exchange rate mechanism (ERM2) - the two-year period before euro adoption when the exchange rate may only fluctuate within a narrow band. This is similar to Poland but unlike the other three recent euro adoption cases (Slovenia, Malta, Cyprus) where exchange rates were tightly controlled before and during ERM2.

Slovakia's economic performance in the run-up to euro adoption is widely considered a success. Not only did the country comfortably meet the Maastricht criteria, it managed to grow rapidly during this time while keeping inflation in check. Political tensions around the change in government in 2006 and sporadic shifts in emerging market sentiment led to some exchange rate volatility, but the intervention band under ERM2 truly tested only briefly, when the new elected prime minister briefly questioned the euro adoption target date. The fiscal deficit was reduced to below the limit of 3 percent of GDP, albeit not by a wide margin.

2. Factors analysis

Will Poland be able to repeat Slovakia's experience? Let's consider six factors that contributed to Slovakia's successful path toward euro adoption. First, euro adoption long enjoyed broad public support in Slovakia. Central Bank and Ministry of Finance devised a joint euro adoption strategy as early as July 2003 - 6 1 years before the targeted adoption rate - and collaborated closely throughout the process. The necessary legislative changes were implemented smoothly, no change in the constitution was necessary and there were no calls for a referendum. Compared to Slovakia, political support for euro adoption in Poland looks more tenuous. Moreover, its timetable for completing the necessary preparatory steps is considerably shorter.

Second, Slovakia implemented wide-ranging structural reforms before entering ERM2, actively supported by the IMF at the time. The share of the public sector in GDP was substantially reduced, the tax system was revamped (including its famous 19 - percent flat tax regime) and the labor market was liberalized. These reforms supported fiscal consolidation and, together with joining the EU, jump-started a surge in FDI inflows, notably in the car and electronics industry. Importantly, they removed supply-side constraints to investment. The resulting strong productivity gains, especially in export-oriented sectors, allowed Slovakia to maintain competitiveness in the face of two substantial revaluations of the koruna. Compared with Slovakia, structural reforms in Poland have been more modest to date, although some important measures (such as completing the government's privatization plans, removing red tape, a reduction in personal income taxes and tighter early retirement provisions) are now in the pipeline or have been recently completed. Nevertheless, as measured by the World Bank's -Doing Business? survey, Poland's business environment today is considerably weaker than Slovakia's in 2005.

Third, wage growth in Slovakia remained relatively modest throughout its membership in ERM2; it never exceeded productivity growth and therefore contained underlying inflation pressures. This may be partly related to the labor market reforms earlier this decade and a high rate of unemployment in 2005. Also, Slovakia did not experience net emigration like other new member states. In contrast, labor market conditions have been much tighter in Poland, with wage growth exceeding productivity measures, at least until mid-2008.

Fourth, the Slovak koruna was slightly below its equilibrium level in 2005, according to National Bank of Slovakia estimates. This provided a cushion to deal with the subsequent strong appreciation without undermining competitiveness. Following the recent sharp depreciation, the Polish zloty is now also believed to be on the weak side. Fifth, global inflation trends worked in Slovakia's favor. The era of - great moderation?, characterized by cheap imports from Asia, helped to bring down core inflation. While the recent commodity price boom partly fell into the Maastricht assessment period, it came too late to push inflation above the reference value. It is unclear if Poland will benefit from a similar constellation: inflation is now moderating along wit the global slowdown. This, however, may be a temporary phenomenon.

Last but definitely not least, conditions on global financial markets are very different today than in 2005. Slovakia's time in ERM2 coincided with a period of record high global liquidity and positive sentiment towards emerging markets, especially the new EU member states. Strong capital inflows easily financed Slovakia's large current account deficit and supported the steep nominal appreciation of the koruna against the euro (21 percent from ERM2 entry in November 2005 until the terminal parity was fixed in July 2008). While not decisive, this made it easier to meet the Maastricht inflation criterion. Needless to say, the outlook for financial markets is now far more gloomy. Not only will Poland be unable to count on sustained capital inflows, but will have to face conditions on money and foreign exchange markets that are extremely volatile.

3. Lessons learned

The main lesson for Poland from Slovakia's experience is that preparing for the euro means redoubling the reform effort. This is all the more important because the external circumstances in Poland today are more difficult than they were for Slovakia in 2005-2008. The structural and fiscal reform measures mentioned above, are a good first step to improve Poland's prospects to not only meet the Maastricht fiscal criteria against the background of a slowing economy, but to also to remove bottlenecks to investment and ensure net capital inflows to sustain a widening current account deficit. Further labor market reforms are essential if wage growth is not to exceed productivity growth, a key element in Slovakia's success story.

The Slovak experience has two lessons on when to enter ERM2. First, a broad consensus on the timing and modalities of euro adoption is a crucial precodition. The comprehensive euro adoption strategy, now under preparation in cooperation between Ministry of Finance and NBP is important in this regard. But support for euro adoption in 2015 has to reach beyond Swietokrzyska Street and result in a speedy resolution of potential constitutional obstacles. Entering ERM2 without such a consensus would be a mistake. Secondly, succesful ERM2 membership will need to rely on stable capital inflows. It may therefore be prudent to wait until conditions on financial markets have stabilized. The time can be used to push forward the above-mentioned structural and fiscal reforms, which in any event are necessary whether Poland enters into the euro zone in 2015 or not.

4. References

  1. Eichengreen, Barry and Ashoka Mody, 1998, - What Explains Changing Spreads on Emerging Market Debt: Fundamentals or Market Sentiments?, NBER Working Paper No. 6408, (Massachusetts: National Bureau of Economic Research).
  2. Faruqee, Hamid, 2004, -Measuring the Trade Effects of EMU, IMF WP/ 04/154, (Washington DC).
  3. International Monetary Fund, 2006, Global Financial System Resilience in the face of Cyclical Challenges, || Global Financial Stability Report, (Washington: IMF).
  4. Kashiwase, Kenichiro and Laura Kodres, 2005, -Emerging Market Spread Compression: Is it real or is it Liquidity?, (Unpublished, Washington: International Monetary Fund).
  5. Lipschitz, Leslie, Tim Lane, and Alex Mourmouras, 2005 -Real Convergence, Capital flows, and Monetary Policy: Notes on the European Transition Countries,? in Euro Adoption in Central and Eastern Europe: Opportunities and Challenges, proceedings of the 2004 IMF-Czech National Bank conference held in Prague, ed. Susan Schadler, (Washington DC).
  6. Luengnaruemitchai, Pipat and Susan Schadler, 2007 -Do Economists' and Financial Markets' Perspectives on the New members of the EU Differ? || IMF WP/07/65, (Washington DC).
  7. Pedroni, Peter, 2000, -Fully Modified OLS for Heterogeneous Cointegrated Panels, in Advances in Econometrics: Non stationary Panels, Panel Cointegration and Dynamic Panels, Vol. 15, ed. By Badi Baltagi (Oxford: Elsevier Science Ltd.).
  8. Schadler, Susan, ed, 2005 Euro Adoption in Central and Eastern Europe: Opportunities and Challenges, proceedings of the 2004 IMF-Czech National Bank conference held in Prague, (Washington DC).
  9. Schadler, Susan, Paulo Drummond, Louis Kuijs, Zuzana Murgasova, and Rachel Van Elkan, 2005, -Adopting the Euro in Central Europe-Challenges of the Next Step in European Integration,|| Occasional Paper 234, (Washington DC).
  10. Schadler, Susan, Ashoka Mody, Abdul Abiad, and Daniel Leigh, 2006 ,-Growth in the Central and Eastern European Countries of the European Union,|| Occasional Paper 252, (Washington DC).
  11. Szyjko Cezary, Electoral Law in Central Eastern Europe, [in:] The Law in the process of Constitutionalizing Europe, Law Review Journal n. 02/2002, p. 129-144, (Tetovo, fyrof Macedonia).


*The publication was prepared at Washington College under the 2009 Scholarship whithin the FAFTA grant program.

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