by Rodica Calmuc

“Confidence in Romania’s prospects remains high” and the convergence to the European union (EU) is under way in spite of the slow down in the economic growth and the disinflation process, the widening of the current account deficit, the strong credit growth and the decrease in its external competitiveness (Preliminary conclusions of the IMF mission in Romania in early 2006). Despite these negative economic developments during the past year, Romania has recently been admitted, together with Bulgaria, to the EU in January 2007. Acceptance of the EU Treaty implies that Romania will have to enter the monetary union (EMU) as well, once it fulfills the Maastricht criteria, no opting out close being allowed. Given that the destination is known as well as many of the checking points along the road it might seem that there is little room for maneuver in the run up to the euro zone. However, non euro countries aspiring to enter EMU, Romania included, do have a word as far as the choice of an exchange rate regime is concerned.

The paper studies the relationship between the choice of exchange rate regime prior to the ERM 2 membership and performance in fulfilling the Maastricht criteria. The exchange rate arrangement has a major influence on the easiness with which a country can fulfill the convergence criteria as it practically sets the framework for macroeconomic policy mix with smaller or larger scope for either the monetary or fiscal policy. This investigation is used to assess the best strategy for Romania’s entry into the EMU.

EMU Entry Criteria

Acceptance into the Euro zone is conditional on compliance with the Maastricht convergence criteria, as formally stated in article 121 of the Maastricht Treaty of 1993. These criteria envisage exchange rate, inflation and interest rate stability as well as budget deficit and public debt sustainability thus indicating the degree of economic convergence (nominal convergence) new EU member states would have to achieve in order to be accepted to participate in the Euro area.

The public finance criterion settles a 3% upper limit to the ratio of the annual government deficit to GDP and also a 60% limit to that of the gross government debt to GDP. According to the interest rate criterion, the nominal long term interest rate should not exceed by more than 2 percents that of the three lower inflation countries in the euro area. In its turn, the exchange rate stability criterion requires at least two years membership in the ERM II, the exchange rate arrangement between the Euro area and EU members outside it. ERM II successful participation means limiting the exchange rate movements within a ±15 percent band around a mutually agreed central parity against the Euro, given no devaluations have been made. Finally, the inflation criterion limits the annual inflation rate in EMU candidate countries to no more than 1.5 percent above the average of the three lower inflation countries in the Euro area.

Are these last two criteria potentially conflicting? If yes, such a situation would make it quite cumbersome for EMU candidate countries to meet both of the criteria in terms of aggregate welfare and growth losses that ultimately define their performance as far as real convergence is concerned. The root of the problem is considered to be the sustained appreciation of the real exchange rate Central and Eastern European countries have experienced and are still expected to experience as a result of large productivity gains and capital inflows. This state of facts may impose a trade-off between exchange rate stability and inflation target. Flexibility of the ERM II is really key at this stage in the sense that is the ±15 percent band wide enough to allow for real exchange rate appreciation?

Inflation Criterion

In theory, floating exchange rate regimes make the fulfillment of the inflation criterion easier. The argument centers on the presence of a sizeable Balassa Samuelson (BS) effect which implies a continuous real exchange rate appreciation. Real exchange rate appreciation can translate into nominal exchange rate appreciation, higher inflation, or a combination of both, according to each country’s specific exchange rate framework. Generally, fixed or heavily managed exchange rate arrangements would result in larger inflation differential between the Euro area and the respective country, potentially leading to the violation of the inflation criterion. In contrast, countries adopting an inflation targeting regime might in turn not be able to comply with the exchange rate stability criterion as they are very much likely to experience a strong appreciation of the nominal exchange rate.

BS effect can be briefly defined as productivity driven appreciation of the exchange rate. In the catch-up process of the EMU candidate countries, the tradable sector, given its exposure to the world competition, experiences larger productivity growth than the non tradable sector. Higher productivity leads to higher wages in the tradable sector, but not exclusively, due to labor mobility across sectors and trade unions’ pressures based on fairness considerations. Therefore, wages in the non-tradable sector increase as well in spite of lower productivity gains. This forces firms in the non-tradable sector to raise prices which push CPI inflation up. The literature estimates with respect to productivity growth differential between the Euro area and the EU candidate countries’ tradable sectors range from 1% to 4% with most of the estimates above 2% (Natalucci and Ravenna, 2002).

CPI inflation increase induced by the BS effect has been found to be smaller under a flexible exchange rate than under a fixed exchange rate. The difference in outcomes between the fixed and flexible rates lessens when the elasticity of substitution between tradable and non-tradable goods in consumption and investment is high, thus leading to a smaller increase in the non-tradable inflation and ultimately in a smaller CPI inflation rate (Halpern and Wyplosz, 2001).

BS effect is the supply side’s reaction to the high relative productivity growth in the tradable sector. Increased productivity however implies increases in income and wealth which fuel consumption. Thus there is also a demand side effect putting pressure on the overall inflation rate; these pressures have been exacerbated by procyclical public sector policies. Actual 2005 CPI inflation stood at 8.6 percent y-o-y against the National Bank of Romania’s (NBR) inflation target of 7.5% (±1 percent). It seems to be the case that the BS effect does not play much of a role and that excessive domestic demand, fuelled by the direct tax cut, the strong credit growth and the increases in the public sector wages (none of these increases in incomes are productivity growth driven), is the main driving force of inflation. Using higher interest rates to tackle inflation is not without costs for NBR as high interest rates exert an additional pressure on the exchange rate.

Strengthening public confidence in its commitment to inflation targeting poses quite a challenge to the NBR, given that achieving the inflation target is more difficult due to the impact on inflationary expectations of the past year miss, the delayed impact of the monetary easing and higher wages over the second half of 2005 as well as 2006 increases in the administered prices. In order to ensure that inflation stays within the target range for 2007, primacy of inflation over other objectives should be clearly signaled especially by means of increased interest rates. In this light, a tightening of the fiscal and income policies appears essential to fighting inflation without excessive pressure on the exchange rate. The need for tight fiscal policies is reinforced by increased capital inflows as a result of full liberalization of the capital account in April 2005.

Romania benefited from important inflows of capital in the last couple of years. Inflows influence the real exchange rate via both the nominal exchange rate and the BS effect as foreign direct investment usually comes along with significant productivity growth gains. In 2005, rising FDI and EU transfers accounted for 90 percent of the rather large current account deficit (9.4 percent of GDP), with private capital inflows financing the rest and supporting substantial reserve accumulation.

The real appreciation is an inherent catch-up process that is likely to characterize the accession countries for a long period of time, extending well after their entry into the EMU (Halpern and Wyplosz, 2001). As the nominal exchange rate will be fixed at that time, the real appreciation will be fully absorbed by inflation leading to excess inflation as compared to the EMU average. A flexible exchange rate regime seems therefore the best choice as it allows for a convenient inflation-exchange rate trade-off.

Does this mean that countries with harder exchange rate regimes fare worse in terms of inflation? Evidence is somewhat contradictory. In 2005, the peg countries exhibited higher inflation-4.5%-than the average inflation in the countries with floating exchange rate regimes-2.29% without Romania (Mateusz Szczurek, 2006). This situation is however different from what it was a couple of years before: for example, in 2002, the peg countries exhibited the lowest inflation among the new member states.   

Public Finances Criterion

There can be identified several channels through which the choice of the exchange rate arrangement influences the fiscal performance of a government.

The most important difference between currency regimes in the pre ERM2 entry period is the commitment to tight fiscal policy. The presence of the “straightjacket” of a rigid exchange rate makes the policymakers in the respective countries very strict about their budget deficits. In 2005 all fixed exchange rate new member states (including Bulgaria) had budgets deficits below 2% of GDP while all the others (except for Slovenia and Romania) had higher budget deficits.

In 2005 the Romanian government consolidated its fiscal position in spite of its pro-cyclical public sector policies that exacerbated domestic demand pressures. The sharp increase in public consumption and the loss of revenue from the flat tax were offset by higher than budgeted indirect tax collections, thus keeping the overall government revenue constant in terms of GDP. A significant relaxation of the fiscal policy took place in last December which turned the budget surplus of 1 percent of annual GDP in January – November into a deficit of 0.8 percent of GDP for the whole year.

Second, nominal appreciation in the context of a flexible exchange rate regime, can negatively impact the profits and therefore the tax revenues from the tradable sector. On the other hand, real exchange rate appreciation increases wealth, imports and consumption leading to higher VAT intake which, in turn, can compensate for the losses in the exporters’ corporate income tax. The recent appreciation of the Leu associated with strong wage growth and declining productivity gains have negatively impacted the profitability and competitiveness in the tradable sector, narrowing Romania’s external competitive advantage.

The third channel through which the exchange rate regime can influence the budget deficit is debt servicing. Under a floating exchange rate regime, expectations of nominal appreciation as well as lower inflation act towards reducing the debt service cost. Such expectations can be however limited by the risk of a reversed depreciation just before EMU entry that can be used in order to wipe out the domestic currency denominated debt, stimulate the economy through real exchange rate depreciation and ease the burden of pending fiscal reform.

Finally, nominal appreciation has an immediate public debt reducing impact as the local currency value of the foreign currency denominated debt falls. The overall influence of the exchange rate regime depends on the currency structure of the public debt. For example, nominal appreciation would be negative for the Czech Republic whose public debt is almost entirely in domestic currency, while for Poland, the short term impact of appreciation would be positive since 29% of the state treasury debt is in foreign currency-March 2006 (Mateusz Szczurek, 2006).

Interest Rate Criterion

The fulfillment of interest rate criterion largely depends on the credibility of the EMU accession that is on the ability to fulfill all the other criteria. If investors expect the country to become an EMU member, then bond yields will converge. The presence of this so-called self-enforcing expectation of the markets makes the choice of the pre-ERM 2 exchange rate regime somewhat irrelevant for the ability to fulfill the interest rate criterion. Evidence on bond yields is mixed indicating that long term bond yields have not converged more in the floating exchange rate countries than in the pegging ones.

Exchange Rate Stability Criterion

The opportunity of a strong versus a weak parity level is usually judged according to its effect on the external competitiveness of the country. Romanian exporters have long benefited from steady devaluations of the domestic currency such that when the Leu started appreciating as a result of good macro fundamentals, they took to the streets and asked the governor of the NBR to devalue the local currency in order for them not to lose their businesses. Higher labor productivity growth in the tradable sector could alleviate the need for a weak parity. Too weak a parity however may alternatively pose threats to the inflation targets.

Arguments for both strong and weak final parity levels are numerous although the dilemma can be easily settled as Slovakia’s experience shows, by choosing the preceding day spot rate as the central parity. A strong local currency parity would probably be easier to negotiate as it does not impinge on the competitiveness of the member states with which negotiations are carried. In addition, a relatively strong parity can ease the achievement of the inflation criterion. Finally, depending on the currency composition of the public debt, a strong parity could reduce its local currency value at least in the short run given that the exchange rate-inflation pass-through is not very strong.

On the other hand, a strong parity needs a tight monetary policy to make it credible which can negatively impact growth. The primary deficit would be expected to rise as a result of growth related erosion of the tax base and debt service costs would also increase due to rising yields along with the official interest rates. 

The Maastricht Treaty asks EU member states to “regard their exchange rate policies as a matter of common interest” even before joining ERM 2. This rules out competitive devaluations but leaves the choice of an exchange rate regime free. While devaluations at the unilateral initiative of the non-euro country trigger failure in fulfilling the exchange rate stability criterion, revaluations are permissible. Nevertheless, in the absence of further structural reforms and increased labor productivity in the tradable sector, these revaluations will hurt even more the external competitiveness of Romania.

Conclusions

In sum, its managed floating exchange rate regime should help Romania in targeting inflation provided that tight fiscal policy aimed at stemming excess demand is implemented. The gradual disinflation path can contribute to the catching-up process through a smaller growth–inflation trade-off. An attempt to abruptly bring inflation in line with the benchmark in the euro zone by a faster close link to the Euro can harm growth significantly. Without a considerably higher growth rate than in the euro zone real convergence would only remain a distant objective.

Adoption of a CBA ( currency board agreement) at this point in time seems not appropriate. Giving up monetary sovereignty when adjustment instruments (i.e. the exchange rate) are still badly needed could prove very costly. It would also probably imply a longer period outside EMU as such an arrangement would have to operate for a large enough period of time in order to prove the viability of its target exchange rate with the euro and thus be deemed as acceptable by the ECB.

References:

Halpern L. and Wyplosz C, “Economic Transformation and Real Exchange Rates in the 2000s: the Balassa Samuelson Connection”, 2001

Natalucci F. and Ravenna F., “The Road to Adopting the Euro: Monetary Policy and Exchange Rate Regimes in EU Candidate Countries”, 2002

Szczurek M., “Exchange Rate Regimes and EMU Accession Strategies”, 2006

Romanian National Bank: www.bnr.ro