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The ERM II issues: an interpretation of the Slovenian approach.

Introduction

On the May 1, 2004, Slovenia joined the European Union. As with all the new accession states, it entered the EU with a derogation clause, the commitment to eventually adopt the euro for its domestic currency. While the adoption of the euro is binding, the timing and the policy strategy leading to it is a responsibility and a prerogative of the member states.

In the "Joint Program of the Slovenian Government and the Bank of Slovenia for the ERM II Entry and the Euro Adoption" (henceforth Joint Program) are presented and motivated the key elements for the euro adoption strategy. Both institutions agree that the Slovenian economy is ready for the adoption of the euro and, therefore, decide to implement the steps necessary for acceding the currency union as soon as possible. The Joint Program also discusses the key elements of the risks associated with the adoption of the euro, the policy mix to be implemented during the stay in ERM II, and the setting of the central parity.

Motives for Slovenia to join the euro area are numerous and benefit from a large political and public support. The most important reason to enter the euro currency union appears to be the substantial gains from trade. (1) The causes for these gains are usually attributed to the elimination of exchange rate risks, increased competition and room for technology adoption, lower transaction costs, and improved transparency of prices. Another reason is a decrease in the country's risk premium and, therefore, lower long-run cost of capital. Finally, the euro currency union provides a framework for strong policy discipline enforcement. Conversely, joining the currency union implies giving up monetary policy as a tool for macroeconomic stabilization and the exchange rate as a possible shock absorber. But since the macroeconomic fluctuations of the Slovenian economy are very much synchronized with that of the euro area, the common monetary policy is also expected to be adequate from a domestic viewpoint. Nevertheless, while there is a consensus that the adoption of the euro is a positive sum game in the long run, the strategies that are being set in place to arrive at this goal are very diverse from country to country.

This paper reviews the strategy of the Bank of Slovenia designed for ERM II entry and inside ERM II policy management. No single strategy on euro adoption is a priori optimal and the accession countries will select their approaches on a case-by-case basis, given the particular circumstances they face: the current macroeconomic situation, difficulties in fulfilling some of the Maastricht criteria, the design and adaptability of their current monetary policy framework, the ability of other macroeconomic policies, both fiscal and income, to substitute the monetary policy as shock absorbers. (2) In line with the Joint Program, the author argues that current and foreseen macroeconomic circumstances are favorable for Slovenia to enter ERM II and adopt the euro as soon as possible.

When in the ERM II, the main risks are connected with asymmetric demand boom, accommodated by an excessive credit expansion. Such a shock is plausible, in particular, because of a rapid convergence of interest rates to the lower euro area levels. It may endanger price stability, produce excess real appreciation and a consecutive loss in competitiveness, and deteriorate the country's external position and growth. To counteract adverse shocks, and given that the monetary policy will be mostly in charge of the exchange rate stability, a new policy mix is required and is presented in the Joint Program. As a consequence of the loss of monetary policy independence, the burden of the price stability and the role of a shock absorber will rely on fiscal policy and increased wage flexibility. Given the current macroeconomic prospects, the implementation of the Joint Program should result in a favorable outcome in the ERM II, with no particular difficulties or macroeconomic loses, and potentially high long run gains in the euro area.

The rest of the paper is organized as follows. Section two introduces the current stance of the Slovenian economy and its compliance with the Maastricht criteria. Section three presents the pros and cons of the early entry into the EMU. Section four reviews some elements to be taken into account in joint agreement on the central parity. The ERM II-connected risks and the policy mix likely to be implemented inside ERM II are exposed in section five. The last section concludes by discussing the "waiting" and the "training" room interpretations of ERM II in the context of the Slovenian economy.

The Current Economic Stance and Alignment with the Maastricht Criteria

Slovenia is a small open economy with a development level already surpassing the lowest among the current EU members. The current GDP per capita in PPP standards is roughly 73 percent of the EU average and is much larger than that of Greece or Portugal at their dates of EMU entry. (3) The structure of the economy is very similar to the EMU and highly heterogeneous across sectors. The business cycle fluctuations appear to be fairly synchronized with the EU, with the exception of some supply shocks in recent years, which were merely of a fiscal nature [Korhonen and Fidrmuc, 2003; Frenkel and Nickel, 2002]. (4) The openness of the economy to trade exceeds 120 percent of GDP and more than 60 percent of total trade is carried out with the EU. The real convergence to the more developed European countries is accompanied by a moderate real appreciation due to Balassa-Samuelson type of effects, which do not a priori constitute an obstacle for achieving price stability. (5) The economic structure, the synchronization of economic activity and the trade orientation towards EU provide strong arguments for Slovenia to enter the EU and eventually adopt the euro.

In comparison to most Central European acceding countries, Slovenia displays a somewhat particular situation with respect to the current compliance with the Maastricht criteria: the fiscal deficit criterion is fulfilled but the inflation (and exchange rate) criterion is not yet met. The situation is usually the converse in most accession countries. Table 1 shows the current compliance with the Maastricht criteria for the euro area, the Czech Republic, Hungary, Poland, and Slovenia.

The fiscal Maastricht criteria, the government deficit, and the debt to GDP ratio are fulfilled and sustainable. The government deficit is expected to remain around 1.5 percent of GDP in the forthcoming years. These deficit projections take into account the probable deterioration of the fiscal balance as a result of EU entry--the reshuffling on the expenditure side in connection with the EU transfers and the increased inefficiency of the VAT collection due to the abolishment of customs controls at the frontiers. The government debt-to-GDP ratio is below 30 percent of GDP. It is among the lowest in the enlarged EU and unlikely to jeopardize the corresponding Maastricht criterion of 60 percent in the medium run.

Conversely, the nominal convergence still has to be finalized. Although the last available inflation figure is 3.5 percent year-on-year, the figure corresponding to the Maastricht criterion on price stability is 5.2 percent. (6) As the time horizon to complete the disinflation process is short, the restrictiveness of the monetary policy stance is being reinforced by fiscal measures. The policy mix in place requires fiscal authorities and the government to limit the increases in administered prices so as not to exceed, on average, the inflation objective, to restrain the rise in excise taxes, and to avoid indirect tax increases. Maintaining administered prices inflation in the vicinity of the headline inflation implies unchanged relative prices and prevents the transmission from administered to free prices. This should result in an inflation-neutral fiscal policy before the ERM II entry. A neutral fiscal policy stance is necessary to accelerate the disinflation process and avoid the fiscal cost-push shocks that generate a persistence in inflation, as in the past few years. The recent disinflation performance and the current projections of the future inflation developments are in line with the fulfillment of the Maastricht criterion in due time.

The Bank of Slovenia evaluated the recent intense reduction in inflation as sustainable [Bank of Slovenia, 2003]. This is because the disiflation is being achieved with the preservation of the macroeconomic fundamental equilibria, in particular, the current account and the fiscal balance. Such an approach is crucial, since there is no need for corrective outbursts in inflation in the forthcoming years, which could arise from persistent or unsustainable macroeconomic disequilibria. That the disinflation process is credible and perceived as sustainable by the markets also shows up in the low, long-run nominal interest rates that are already in line with the Maastricht criterion (as shown in Table 1).

The Timing of the ERM II Entry--Why as Soon as Possible?

The objective advocated in the Joint Program is that Slovenia should enter the euro area as soon as possible. Given the required two years qualification period, ERM II entry must be no later than in the last quarter of 2004 if the euro is to be adopted in the beginning of 2007. The decision to enter as early as possible has many advantages in the Slovenian case but these had to be weighed against the reasons to wait for possibly better entry circumstances.

The reasons to wait are connected with potential macroeconomic effects of EU entry, the risk of an insufficient stabilization of inflation, or the adoption of more transition countries tailored interpretation of the Maastricht criteria. The most important risk connected with early ERM II entry appears to be possible aggregate demand developments related to the EU entry. A demand boom may overheat the economy and produce inflationary pressures above the Maastricht criterion. The particular danger is that such a shock may be asymmetric and, therefore, no ECB counteracting policy could be expected. The reasons this type of shock may hit the economy may be a rapid decrease in the nominal (and real) interest rates as the national monetary stance is converging to that of the ECB or the EU entry-connected effects on consumption, such as "feel good effects," and decreased risk premia. These are, however, business cycle effects and waiting for the ECB stance to be less expansionary, or the possible consumption shocks to die out, may be well advised.

The second reason to wait is the risk that the inflation process may not be finished upon ERM II entry. This may result in an excess real appreciation and the loss of competitiveness with all their harmful effects on the economy. If these two risks are not avoided, they may disequilibrate the economy during ERM II and, at least, lengthen its stay in a system where the economy's adjustment to shocks is not always easy, as argued later on. The final reason may be to wait and learn from the experience of other countries--in particular, the ex-post reinterpretation of the Maastricht criteria may be adapted to the specificity of the accession countries. It is well known that due to the real convergence process and the resulting real appreciation (for example, Balassa-Samuelson effects), an inconsistency is likely to arise between the inflation and exchange rate criteria. This is true even if the right policies are implemented, so that there may be cases where the compliance with Maastricht criteria would require one to artificially depress the economy and lower inflation to the (sub-optimal!) criterion level. (7) If the interpretation of price stability is adapted to these problems, a country with an opportunistic waiting strategy may spare itself a real loss in output. (8)

In the Slovenian case, the risks connected with an early entry are believed to be manageable and there exist strong arguments in favor of an early entry. One argument could be to benefit, as soon as possible, from the currency union. However, the difference in these long-run effects are assumed to be small between the alternatives and are not determinant in the decision to postpone ERM II entry for a few years. The arguments for an early entry are separated in two groups: those connected with the ERM II institutional setting and those more related to the current macroeconomic circumstances.

The first group of arguments in favor of an early entry envisages the ERM II as a "training room" or even as a "disciplinary devise" for available macroeconomic policies. Note first that upon entry into the EU, monetary policy, together with exchange rate management, must be conducted as a matter of common concern. A managed float regime resulting in a depreciation trend of the nominal exchange rate (decreasing in correspondence with the disinflation dynamics) could be misinterpreted as a competitive devaluation and not allowed.

Given the necessity of maintaining exchange rate stability, the independence of monetary policy is, therefore, basically lost after EU entry, leading to progressive (fearfully fast) equalization of nominal interest rates. (9) The management of the macroeconomic policy will, therefore, rely on fiscal policy. Entering the ERM II forces fiscal policy to behave optimally as there is no more room for corrective action from monetary or exchange rate policies. Perhaps even more important, not entering in the ERM II as early as possible gives a negative signal about the willingness to make fiscal policy adjustments and may, therefore, increase inflationary expectations. The clear commitment to an early entry seems to have, even beforehand, strongly reinforced the credibility of the current policy mix and the disinflation process. Finally, the commitment to the central parity is expected to help in anchoring inflationary expectations and lock inflation at low levels.

The second group of arguments considers the current and foreseen macroeconomic developments. Given plausible macroeconomic forecasts, in particular for the aggregate demand and inflation, the Maastricht criteria are expected to be met without (significant) costs in real activity [Bank of Slovenia, 2003]. Also, in case of increased demand, the negative output-gap (roughly, -1 percent at the moment) provides some room for the inflationary pressures to be restrained. In addition, the current account and a relatively favorable fiscal position are evaluated to bring a sufficient ability to absorb shocks, even if they are asymmetric, without backing up from the European counterparts. Finally, the very low exchange rate and inflation variability around their trend observed in recent years [Kontolemis, 2003] provide high confidence that the central parity remains unchanged during the stay in the ERM II.

The Agreement on the Central Rate

The agreement on central parity involves a mutual agreement between the ECB, the European Commission, the euro system central banks, and the national central bank and government. A dialogue should precede any communication on participation, making all information on the central rate confidential before the actual entry in the ERM II. This section, therefore, discusses some general guidance in setting the central rate.

There seems to be a wide consensus that the central parity should correspond as close as possible to the long-run equilibrium real exchange rate. A deviation from this equilibrium could lead to a sub-optimal economic performance. On the one hand, if the central parity is too depreciated, it could increase the inflationary pressures through import prices or an overheating in the economic activity. On the other hand, a too appreciated parity could deteriorate the country's competitiveness, depress economic activity, and open the current account.

Conceptually, the long-run equilibrium exchange rate to consider in setting the central parity is the Fundamental Equilibrium Exchange Rate (FEER). It is the level of the real exchange rate, simultaneously consistent with the internal and external equilibrium, when the economic fundamentals (GDP, foreign demand for imports, and so forth) are at their long-run equilibrium values [Williamson, 1994]. Of course, there are numerous difficulties related to the identification of this equilibrium exchange rate, necessitating a cautious interpretation of the obtained estimates. (10) The FEER estimates available for Slovenia up to now show that the current real exchange rate is fairly in line with the FEER estimates, with a tendency to be slightly overvalued in the last few years [Genorio and Kozamernik, 2003]. This result is expected, since the care for the nominal exchange rate stability has avoided major misalignment and has been, in the long run, a good guide for the price adjustment in the tradable sector. That the tradable sector relative price is found in vicinity of the equilibrium level is, therefore, not a surprise.

Should one incorporate the elements of the (expected) future evolution of the FEER in setting the central parity? The FEER may indeed vary over time due, for example, to the disequilibrium trend in the trade balance, long run developments in the terms of trade, and so on. Such changes may require the adjustment in the real exchange rate to equilibrate the current account in the long run. Nevertheless, these are long run and low frequency movements and should not enter the nominal exchange rate or central parity setting considerations. There is enough room for the price adjustment to equilibrate the real exchange rate in correspondence with the FEER in the long run. Therefore, the parity should be set as close as possible to the current FEER to get the best concordance of the real exchange rate over the longest period. This holds even if such a parity level may be missaligned respectively to the current short run business cycle effects.

The last element discussed is connected to the asymmetric risk, characterizing the inside-ERM II exchange rate dynamics. While the unilateral revaluation of the central parity is allowed, a devaluation must be renegotiated with all the parties involved and, in addition, restarts the two-year qualification period. Because of this asymmetric risk, some observers advocate a depreciated rather than appreciated central parity [Schadler et al., 2004]. In the context of Slovenia, such a strategy seems not to be worth undertaking. First, the good shape in the current and expected fundamentals do not indicate that there is likely to be a need for an exchange rate corrective adjustment in the forthcoming medium run. Second, a pass-through to inflation from a depreciated central parity can be rapid and complete, especially with a loss of monetary policy independence. In fact, the monetary policy is in this context accommodative of the simultaneous cost-push supply and expansive demand shock resulting from depreciation in the central parity. And third, in case of a tightly managed float, market expectations about deviations from the foreseen nominal exchange path may produce exchange rate pressures or even a speculative attack on the currency at the start of the ERM II entry. (11)

ERM II Risks and the Adapted Policy Mix

The Risks Faced During the Stay in ERM II

The risks connected with ERM II are regrouped into three categories: an asymmetric aggregate demand boom, exchange rate pressures, and possible inconsistency between exchange rate stability and the inflation criterion.

Credit generated demand booms are likely to break out at the offing of ERM II. The exchange rate stability required within ERM II implies convergence in nominal interest rates. In countries with high interest rates, reflecting the needs for a restrictive monetary stance, ERM II entry may, therefore, significantly reduce the nominal and thus real interest rates. It could, in turn, cause a fall in saving ratios, asset price bubbles, and an asymmetric demand boom. In this event, upward pressures on inflation may arise, in particular if the output is pushed above its potential. The EU entry-connected potential shocks on consumption, the "feel good" effects, and the decrease in the risk premium may further exacerbate the demand pressure. Such a shock may endanger the Maastricht criterion on price stability, but could also deteriorate the external position of the country. Purchases of durable goods on markets where foreign competition limits the possibilities for price increases moderate the inflation pressures but worsen the current account. Eventually, an unsustainable deterioration of the current account may generate speculations on the exchange rate and endanger the central parity.

The economy may also be subject to exchange rate pressures or exchange rate instability. Free capital flows can potentially generate an excessive instability in the exchange rate, which is not in line with the exchange rate stability criterion. One source of capital movements is the FDI or sales of assets from privatization or takeovers. These types of inflows are considered as exogenous and inelastic to the interest rate differentials on the domestic and foreign financial markets. They can, in principle, be successfully sterilized and do not represent an immediate threat to exchange rate stability. The second source are the portfolio investments or the speculative capital flows. Their effects are much more difficult to offset as they are driven by market expectations. The speculative flows are potentially unlimited if the market expectations do not concord with the exchange rate policy objective. In such a case, the central bank may not be successful in stabilizing the exchange rate at a desired level and market expectations may end up to be self-fulfilling. Not only the exchange rate stability or the central parity are in danger, the costs of a successful speculative attack to the financial sector and the real economy may be substantial.

The risks must, in addition, be put in perspective with the long run appreciation movement common to the transition economies, reducing significantly the maneuvering margin for policy response in the case of an inflationary shock. The real appreciation is a natural companion of the catching-up process in transition countries, independent in the long run from the nominal developments. The real appreciation trend is due to the Balassa-Samuelson effects, a rapid growth in private consumption increasing the non-tradable goods relative price, a non-tradable goods oriented government spending, price liberalization in monopolistic sectors, and so forth. Keeping the nominal exchange rate stable therefore implies a higher natural equilibrium level of inflation in comparison to the more developed European counterparts. That reduces significantly the maneuvering margin of domestic macroeconomic policies in response to an asymmetric inflationary shock. Indeed, the Maastricht criterion on price stability is in this context much more difficult to comply with. Not only is this criterion under threat in case of a demand expansion above the potential output, but cost-push shocks from taxation or oil shocks must also be considered with caution. (12)

Figure 1 illustrates the risk of inflation exceeding the inflation criterion in a country with a natural real appreciation trend of 1.3 percentage points per year, with otherwise similar business cycle and policy response dynamics. The average developed country inflation rate is set (arbitrarily) to 1.5 percent and the inflation criterion to 2.9 percent. In this case, a moderate long run appreciation generates an equilibrium inflation of 2.8 per year. The transition country inflation rate very often increases above the criterion.

In the Slovenian case, a Balassa-Samuelson effect evaluated to lay between 1 an 1.5 percent per year is consistent with an equilibrium level of inflation between 2.5 an 3 percent per year. Technically, the price criterion could, therefore, be met without additional policy intervention, in equilibrium. However, any shock on inflation requires an immediate offsetting macroeconomic policy reaction as there is no room for inflation to increase above its equilibrium level, if the inflation criterion is to be met.

The Design of the Policy Mix in the ERM II

The efficacy and the credibility of the policy mix are essential for successful participation in the ERM II. All macroeconomic policies should align with the primary objective, the adoption of the euro together with price stabilization and the fiscal consolidation it requires. The cooperative policy mix set in place in the Joint Program is a major advantage of the Slovenian economy respectively to many accession countries, where the monetary and the fiscal policy act in a less coordinated way. The Bank of Slovenia and the Slovenian Government are also committed to a mutual exchange of information of all the developments that may affect the implementation of the Joint Program.

A major change in the ERM II policy mix is in the monetary policy objective. In the spirit of joining the EMU, it will be primarily oriented towards maintaining exchange rate stability. Given the absence of capital flow constraints, it means that the Bank of Slovenia's interest rates will be predetermined by those of the ECB, with the difference of the risk premium that is already around 1 percent and may be rapidly shrinking towards virtually zero. The loss of the independent monetary policy will end up making the monetary conditions pro-cyclical, especially in case of an asymmetric (or a more intense) shock relatively to the EMU. Indeed, if the business cycle is synchronized with the one in the EMU, then the ECB's stance will also be optimal for the domestic situation. Nevertheless, additional policy restraint must be made available because the expected demand in-turn might be much more pronounced than the one expected in the EMU, for the reasons outlined in the previous section.

The burden of the macroeconomic management and the care for the inflation objective will rely on fiscal policy. The most important dimension of fiscal policy is the planning of the public non-investment spending so as to act as a counter-cyclical stabilizer. Again, such an action is crucial in case of an asymmetric demand shock, preventing the output to increase above its potential and produce inflationary pressures. In addition, the budget should foresee a sufficient buffer stock for the Stability and Growth Pact to be respected in case of adverse shocks. Another obvious dimension of fiscal policy is (the continuation of) the restraints on the fiscal cost-push effects on inflation. This, above all, precludes rises in excise duties and tariffs above the levels necessary to comply with EU regulations. Also, the administered price increases are to be bound so that they do not exceed on average the overall inflation objective, i.e., inflation in line with fulfillment of the Maastricht criteria in due times.

On the income policy side, the wage and transfer growth in the public sector should be restrained to prevent the deterioration of the fiscal deficit and to exert a signaling effect on other sectors, in particular monopolistic sectors unconstrained by foreign competition. In that perspective, the government should seek to abolish or limit (simple-rule) indexing of wages and social transfers to past inflation. Finally, to facilitate the management of the effects of foreign capital flows on exchange rate stability, a coordinated management with the Bank of Slovenia is to be implemented for the proceeds from the sale of shares of state-owned capital in firms to nonresidents.

Additional policy measures are expected to support the above core of the ERM II policy mix. Other social partners are expected to act in the same direction. The agreement on the wage increases aims at limiting the real wage growth at 1 percentage point below the growth of labor productivity, reducing the labor cost effect on inflation, but also generating a positive employment trend. Also, additional wage flexibility is needed for a successful absorption of asymmetric shocks. Another element in stabilizing the economy in the case of a credit-financed demand shock is a further improvement of financial supervision and the implementation of dynamic provisioning when the economy is on the expansion path of the business cycle. Finally, as already mentioned, a successful ERM II necessitates an appropriately chosen central parity.

A clear communication of the policy to the public provides a support for a successful expectation management. It is necessary that the market be convinced about the readiness of the policy makers to comply with their commitments. The credibility of the commitment to the Joint Program is high since there is an explicitly announced convergence in the objective of both institutions. To this end, efforts must be oriented towards maintaining the macroeconomic fundamental equilibria, the fiscal balance, the current account, and the competitiveness. In their Joint Program, the Bank of Slovenia and the Slovenian Government consider the risks to be manageable if the above policy mix is implemented.

Narrow Bands Versus Wide Bands

Once established, the central parity should be perceived as an irrevocable nominal anchor for the economy. In that respect, the public should expect through the whole stay in the ERM II that the central parity will also eventually become the conversion rate at the adoption of the euro. Inconsistent expectations about the final conversion rate and the central parity might end up to be self-fulfilling, leading to a speculative attack, destabilizing the economy, and lengthening participation in the ERM II. The optimal choice of the band width is most probably determined by the country's know-how in exchange rate management and by the way it can orient the expectations about the latter.

Many countries advocate the use of wide bands during the stay in the ERM II. This seems, in general, the case of the inflation targeters. They consider the exchange rate stability subordinated to the primary objective--price stability. In the case of wide bands, the monetary authorities can freely decide when to intervene to redirect the nominal exchange rate towards the central parity. Also, a quasi-floating regime decreases the vulnerability of a country to a speculative attack, at least as long as the exchange rate evolves inside the wide bands, i.e., the [+ or -] 15 percent bands. At these wide bands the interventions are, in principle, unlimited and automatically supported by the ECB. This is not the case with the narrow bands, where the interventions are unilateral, unless a bilateral agreement is negotiated with the ECB. And the ECB is at the moment fairly reluctant to enter such an agreement with the accession countries.

However, strong arguments also exist in favor of the narrow bands. They signal the commitment of the authorities to a hard peg and increase the strength of the nominal anchor. Also, they provide an unambiguous interpretation of the compliance with the nominal exchange rate stability criterion. Frequent or persistent fluctuations outside the 4 [+ or -] 2.25 percent bands around the central parity, or an explicit trend in the exchange rate dynamics, may (will?) not be qualified as exchange rate instability. In addition, if the exchange rate moves away from the central parity, the speculations on the terminal date of ERM II or an adjustment of the central parity may take place. This risk is minimized if the exchange rate is maintained close to the central parity. (13) Anyway, the independence of monetary policy is at least temporarily abandoned when the central bank intervenes to orient the exchange rate back toward parity. Finally, if the goal is to enter the euro, believing in the benefits of the currency union, it seems natural just beforehand to try mimicking the exchange rate regime that is closer to the currency union, i.e., the narrow bands, hard peg, or even a fixed rate.

There are some additional arguments, somewhat particular to the Slovenian situation, that may speak in favor of an installment of the narrow bands. In its implementation of the managed float exchange rate regime, the Bank of Slovenia has acquired experience and designed its instruments to stabilize the exchange rate around the desired trend. In that sense, the Bank of Slovenia has already achieved a sufficient exchange rate stability [Kontolemis, 2003]. Of course, in the ERM II no depreciation trend is allowed, which simply boils down for the Bank of Slovenia to stabilize the exchange rate dynamics around the horizontal trend. Yet another argument for narrow bands or a hard peg is the good record in economic fundamentals (low fiscal deficit and an equilibrated current account) and having sufficient room for adverse shock absorption. With 32.2 percent (14) of GDP, the condition of sufficiently high foreign currency reserves to maintain the hard peg is also fulfilled.

It seems from this discussion that in the case of Slovenia the arguments for the narrow bands prevail. Nevertheless, given the unlikely commitment from the ECB to support the narrow bands, the most probable behavioral strategy of the central bank will be unilateral, unannounced, and not binding narrow bands. The Bank of Slovenia is certainly keen to keep its discretion on the unilateral interventions that may be necessary to maintain the nominal exchange rate on the desired path

Conclusions

This paper on euro adoption concludes by discussing, from the Slovenian perspective, the "training room" or "waiting room" aspects of the ERM If. On the one hand, the "training room" aspect envisages the ERM II as the regime that enforces the implementation of sound and consistent macroeconomic policies. The ERM II incentive for the macroeconomic policies to behave is based on compliance with the Maastricht criteria, taken in a way as the definition for macroeconomic stability. Also, the ERM II countries are subject to monitoring and advice from the EU institutions. Finally, the "training room" aspect interprets the ERM II as the test of the appropriateness of the central parity before entering the currency union. (15) On the other hand, ERM II is often interpreted as a "waiting room" with no particular advantage for the economic policy conduct, but introducing potentially costly restrictions and risks in the country's economy.

The recent, more rigorous disinflation-oriented policy mix could be attributed to the "training room" aspect of ERM II. This ERM II policy mix has already been in part implemented in the last year or so with an acceleration of the disinflation process. In particular, the fiscal policy has ceased with intense tax increases that, acting as cost-push shocks, produced the impression of persistent inflation in Slovenia during the last few years. The clear commitment of the Slovenia Government to the ERM II early entry and the consistency of its policy with the restrictive stance of the Bank of Slovenia strongly improved the credibility of the policy mix. Together with the restrictive monetary policy, the slowdown in economic activity, and moderate wage growth, this shift in the fiscal policy was necessary for a sustainable reduction in inflation, i.e., without deteriorating the economic fundamentals.

The "training room" beneficial effects of the increased fiscal policy rigor have nevertheless to be evaluated with respect to the ERM II-connected risks. Some of the main risks connected with ERM II were presented in this paper, but it is fair to argue that for the new accession countries these risks are exacerbated. This holds especially for the necessary simultaneous compliance with inflation and exchange rate stability because of the natural appreciation trend these countries are subject to. By "natural" is understood that this is a real economic process, such as the Balassa-Samuelson effect, neutral in the long run to monetary policy or exchange rate interventions. The trend of real appreciation is, therefore, not a result of misbehavior of domestic macroeconomic policies and, therefore, should not be sanctioned as such. The "equal treatment" in the observance of the Maastricht criteria should take this element into account but it does not. In the case of Slovenia, these effects account for roughly a mark-up of 1 to 1.5 percentage points over the most developed EU countries. It does not a priori prevent the compliance with the criteria without unnecessary economic cost, but the margin of maneuver for the macroeconomic policies are significantly reduced.

The risk of the ERM II is not only a non-compliance with the Maastricht criteria and a consecutively longer stay in the regime. Because of a constrained exchange rate path, it can at any moment, at least theoretically, cause an attack on the currency with potentially devastating effects on the real economy. Of course, such an event, is in general, a result of inconsistent macroeconomic policies and a logical sanction of the markets. But the crises can occur even if a sound macroeconomic policy mix is implemented. It can be due, for example, to a contagion from other countries, a misperception of policies in place, or even because of self-fulfilling expectations.

The ERM II thus, paradoxically, presents more risks than the EMU itself. Sure, there is a possibility of parity adjustment, but in that case the qualification period starts again. (16) The implementation of the rigorous policy mix is at best accelerated by ERM II. It would have to be eventually set in place anyway with entry into the currency union. It is therefore argued that, from the Slovenian perspective, ERM II presents many more aspects of a "waiting room" than a "training room." A "waiting room" with a priori manageable but always present risks.
TABLE 1
The Maastricht Criteria

                            Inflation            Long Term Interest
                               (%)                    Rate (%)
                        last 12 months (1)      last 12 months (1,2)

Euro area                      2.0                      4.17
Convergence criteria           2.6                      6.13
Czech Republic                 0.4                      4.69
Hungary                        5.0                      8.74
Poland                         0.9                      6.97
Slovenia                       5.2                      5.01

                          Govt. Balance                 Debt
                             (% BDP)                   (%BDP)
                               2003                     2003

Euro area                      -2.7                     70.4
Convergence criteria           -3.0                     60.0
Czech Republic                -12.9                     37.6
Hungary                        -5.9                     59.0
Poland                         -4.1                     45.4
Slovenia                       -1.8                     27.1

Notes:

(1) Last 12 months average.

(2) Government Bond RS54 (issued in October 2003).

Sources: SURS, MF, EUROSTAT, Pre-Accession
Economic Programme, Central Banks.


Footnotes

(1) Frankel and Rose [2000], for example, claim that the trade volume increases significantly after the adoption of a common currency. In addition, there appear to be substantial spillovers from trade to economic growth.

(2) The polar cases in that respect, the Austrian and the Greek, are presented in Hochreiter and Tavlas [2003]. (3) Respectively 66.8 percent and 64.7 percent of the EU average. Source: Eurostat.

(4) A broader survey of convergence indicators is for example Backe and Thimann [2004].

(5) Kozamernik, [2003], Zumer [2002] and the references therein identify a Balassa-Samuelson effect of between 1 an 1.5 percentage points, in terms of a mark-up of the industrial leader's inflation. Kozamernik [2003] also explores some alternative scenarios related to plausible future catching-up processes of the real economy. See Balassa [1994] for the economic mechanisms underlying the real appreciation process.

(6) The Maastricht criterion is compared with the average of the last 12 years of inflation figures.

(7) Given the required stability in the nominal exchange rate.

(8) Ex-ante, a reinterpretation of the inflation criterion in this respect is unlikely because of the incentive constraints that EU institutions want to exert on the accession country's macroeconomic policies. Also, at the moment even such a event ex-post appears unlikely.

(9) Unless the Bank of Slovenia switches to free float inflation targeting, which can lead to substantial risks on the nominal exchange rate fluctuations.

(10) This is particularly so in the context of accession countries because of short spans of reliable data and possible structural breaks.

(11) There is, however, another argument in favor of a central parity depreciated with respect to the market rate. It generates the expectations about future depreciation in the nominal exchange rate and, therefore, allows maintaining higher nominal interest rates. Such a restrictive monetary policy stance may be welcome in case of excess aggregate demand risks. Nevertheless, a resulting nominal exchange rate path would necessarily present a depreciation trend, which is incompatible, a priori, with the ERM II exchange rate stability criterion. For this reason, this possibility is ruled out.

(12) To some extent the government can counteract the oil shock by an adequate excise tax adjustment. Such action proved successful in Slovenia after the 2003 Iraqi crisis oil shock.

(13) The EU warns of an inadequacy of a pure inflation targeting with ERM II. There is an inconsistency with maintaining the independence of the monetary policy, while stabilizing the exchange rate around the central parity. One instrument is used for two objectives, yet another aspect of the impossible trinity. See ECFIN-EFC /58-04-EN. (14) December 2003. Source: Bank of Slovenia.

(15) Padoa-Schioppa [2003] argues that ERM II should be considered as a "training" room, not a "waiting" room.

(16) The qualification period is not reset to zero in case of an appreciation of parity, but the central bank can, in principle, always avoid an appreciation by selling a sufficient amount of domestic currency.

References

Backe, Peter; Thimann, Christian. The Acceding Country's Strategies Towards ERM II and the Adoption of the Euro: An Analytical Review, European Central Bank, 2004.

Balassa, Bela. "The Purchasing Power Parity Doctrine: A Reappraisal," Journal of Political Economy, 72, 1964.

Bank of Slovenia, Government of the Republic of Slovenia, Programme for ERM II Entry and Adoption of the Euro, November 2003.

--. Monetary Policy Implementation Report, October 2003.

Fidrmuc, Jarko; Korhonen, Iikka. "Similarity of Supply and Demand Shocks Between the Euro Area and the CEECs," Economic Systems, 27, 2003.

Frankel, Jeffrey A.; Rose, Andrew K. "Estimating the Effect of Currency Unions on Trade and Output," National Bureau of Economic Research, Inc., NBER Working Papers 7857, 2000.

Frenkel, Michael; Nickel, Christiane. "How Symmetric Are the Shocks and the Shock Adjustment Dynamics Between the Euro Area and Central and Eastern European Countries (CEEC)?" International Monetary Fund, IMF Working Papers, 02/222, 2002.

Genorio, Hana; Kozamernik, Damjan. "FEER Estimates--The Slovenian Case," Prikazi in Analize, Bank of Slovenia, Forthcoming in Summer 2003.

Hochreiter, Eduard; Tavlas, George. S. "Two Roads to Euro: The Monetary Experiences of Austria and Greece," Prepared for the Meetings of Allied Social Science Associations, San Diego 2004, 2003.

Kontolemis Zenon. "Exchange Rates are a Matter of Common Concern: Policies in the Run-Up to the Euro," European Commission Economic Papers, No 191, 2003.

Kozamernik, Damjan. "Long-Run Growth and Price Convergence," Prikazi in Analize, Bank of Slovenia, July 2003.

Padoa-Schioppa T. "Trajectories Towards Euro and the Role of ERM II," International Finance, 6, 1, pp. 129-44, Spring 2003.

Schadler, S.; Drummond, P.; Kuijs, L.; Murgasova, Z.; van Elkan, R. "Adopting the Euro in Central Europe--Challenges of the Next Step in European Integration," IMF Occasional Paper Series, 2004.

Williamson John. Estimating Equilibrium Exchange Rates, Washington, Institute for International Economics, 1994.

Zumer, Tina. "Estimation of the Balassa-Samuelson Effect in Slovenia," Prikazi in Analize, Bank of Slovenia, 2002.

DAMJAN KOZAMERNIK, Bank of Slovenia--Slovenia. The views expressed by the author do not necessarily correspond to those of the Board of the Bank of Slovenia. This paper was prepared for the panel "Monetary Policy and EMU Enlargement: The Adoption of the Euro" at the International Atlantic Economic Conference held in Lisbon in March 2004.
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Title Annotation:Enterprise Resource Management
Author:Kozamernik, Damjan
Publication:Atlantic Economic Journal
Geographic Code:4EXSL
Date:Dec 1, 2004
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