Is the Euro Ready to Adopt Estonia?
Eric Fishel
Brian Hall
Brian Kares Margarita Quintero Chandrashekar Tamirisa*
Abstract
Employing Estonia as a case study, this paper raises some provocative issues about the adoption
of the euro by New Member States (NMS) of the European Union (EU). The 1993 Copenhagen
Treaty requires that upon satisfying the convergence criteria of the Economic and Monetary
Union (EMU), countries acceding to the EU must adopt the euro. Having enthusiastically
embraced open markets and institutions since its independence from the Soviet Union in 1992,
Estonia stands out among the ten NMS that acceded to the EU in 2004. However, the current
status of Estonia’s euro adoption raises several interesting issues about the readiness of the
governance structure of the euro-zone, as much as the readiness of Estonia to adopt the euro.
______________________________________________________________________________
*Comments on this paper should be sent to the corresponding author Chandrashekar Tamirisa at
ctamirisa@gmail.com
. This paper was prepared by the authors toward fulfilling the requirements
for a graduate class in international finance at Johns Hopkins University, Washington, D.C. The
authors are grateful to Fabio Natalucci for his helpful remarks in the preparation of this draft.
1
Introduction
In 1957, the European Union (EU) began as a regional economic agreement between France,
Germany, Italy, Belgium, Luxembourg, and the Netherlands
1
. There have been five
enlargements, with the biggest occurring in 2004. Following the 1992 Treaty of Maastricht, the
1993 Copenhagen criteria opened the way for Central and Eastern European countries to accede
to the European Union. Besides cooperation in areas such as foreign, defense, judicial, and
internal policy, the Copenhagen criteria also require adoption of the euro
2
.
One of the ten countries that entered the EU in 2004 was Estonia. Estonia’s accession
process began in November of 1995 with their application for membership to the Council of the
European Union. Accession negotiations started in March 1998, with their conclusion occurring
in Copenhagen during December 2002. In September of 2003, 67 percent of Estonian citizens
voted to join the Union. Soon after, Estonia’s entry into the EU was ratified by the Estonian
parliament. Estonia’s accession to the EU was complete on May 1, 2004
3
.
The Euro Adoption Process
4
The Euro adoption process consists of three stages. In the first pre-accession stage, a candidate
country implements the necessary reforms to demonstrate irreversible progress toward a
functioning market economy, competitiveness, and sustainable macroeconomic stability. The
second post-accession pre-Euro adoption stage requires the NMS to comply with the EMU
convergence criteria
5
. These are:
1.
Public Finance: Government budget deficit not in excess of three percent of each country’s
GDP & gross debt to GDP ratio that does not exceed 60 percent.
2.
Exchange Rate: Participate in ERM for at least two years, maintaining stability against the
Euro. This is defined by the +/- 15% fluctuation band around bilateral central parities.
3.
Interest Rates: Nominal long term interest rates not exceeding by more than two percentage
points those for the three countries with the lowest inflation rates
4.
Legal Convergence: Central Bank Independence & Integration with the Euro-system.
1
http://ec.europa.eu/enlargement/questions_and_answers/background_en.htm.
2
http://ec.europa.eu/enlargement/enlargement_process/accession_process/criteria/index_en.htm
3
http://ec.europa.eu/enlargement/archives/enlargement_process/past_enlargements/eu10/estonia_en.htm
4
http://ec.europa.eu/enlargement/archives/questions_and_answers/11-22_en.htm#euro
5
http://www.ecb.de/ecb/orga/escb/html/convergence-criteria.en.html
2
5.
Price Stability: Inflation rate of no more than 1.5 percentage points above the average of
the three EU countries with the lowest inflation.
Estonia is currently in the second stage. In the third and final stage, the country adopts the Euro
and is admitted into the EMU.
Is Estonia ready for Stage three?
Estonia satisfies the first four convergence criteria. Its government debt is only 5% of GDP, and
since joining the ERM on June 28, 2004, Estonia has realized a hard peg (close to zero
fluctuations) of 15.6466 kroon (EEK) to the euro. The non-existence of a government bond
issue denominated in kroon with a maturity at least five years in length prevents the direct
measurement of long-term interest rates. However, “based on the low level of kroon interest
rates in the private sector, low public debt, and a good budgetary position, the European
Commission has expressed the opinion that Estonia should not have a problem fulfilling the
interest rate criterion”
6
. Legally, the Currency Law and the Law on the Security of the Estonian
Kroon conflict with the Maastricht criteria. The Currency Law states the kroon is the only legal
tender in Estonia and the Law on the Security of the Estonian kroon requires reserve money is
backed by gold or foreign exchange reserves and states the Bank of Estonia has no right to
devalue the kroon
7
. A Supreme Court ruling on May 11, 2006 requires that upon adoption of the
euro these two laws be repealed. The European Commission considers this ruling satisfactory
for compliance with the fourth criterion. This leaves price stability (inflation) as the only
criterion preventing Estonia’s adoption of the euro.
Over the past decade, inflation showed a strong downward trend in Estonia, bottoming out at
1.4 percent in 2003. In 2004 and 2005, inflation rose to 3 percent and 4.1 percent, respectively.
In December 2006, the Maastricht reference value of inflation was 2.8 percent (calculated as the
12-month average of inflation in Poland, Finland, and Sweden). The corresponding inflation rate
in Estonia was 4.3 percent, leaving Estonia 1.5 percent above the required value
8
. With a
consumer basket with nearly double the exposure of the EU to changes in international energy
6
European Commission Convergence Report Dec 2006
7
Definitions from Nikolay Nenovsky, Hristov, & Mihaylow Comparing the Institutional and Organizational Design
of Currency Boards in Transition Countries. Eastern European Economics, Vol 40 Feb 2002
8
European Commission Convergence Report, December 2006
3
prices, rising oil prices have contributed significantly to the increase in inflation. Additionally, a
rise in the prices of non-tradables relative to tradeables (known as the Balassa-Sameulson (B-S)
Effect)
9
, a tightening of the labor market, and tax increases (motivated by compliance with EU
minima) have all contributed to the inflation increase.
In March, the Estonian government revised its 2007 inflation forecast to 4.9%. Estonian
Finance Minister Aivar Soerd indicated that it would be unrealistic to expect Estonia to fulfill the
Maastricht criteria before 2011.
10
Still, the IMF Executive Board commended Estonia last year
for its tight fiscal habits, which have been at the core of Estonia’s disinflation strategy.
11
Ideally,
in order to meet the inflation criteria goal, low administrative burdens through Estonia’s
pioneering efforts with a simple flat income tax and corporate income taxes on dividends will
continue to accompany its strong fiscal discipline.
12
However, assuming an average of the three
best euro-zone inflation levels of two percent, a budget surplus and a low debt-to-GDP ratio
make further fiscal policy tightening artificial for bringing inflation down sufficiently.
The Inflation Criterion Dilemma
The inflation criterion dilemma arises from the necessity to simultaneously satisfy the
exchange rate and inflation criterion. The B-S effects alone, not taking into account external
factors such as energy prices, result in too strict of inflation criteria (based on the Euro-area
business cycle). Sterilization of FDI inflows under a hard currency peg increases the domestic
money supply, further increasing upward pressure on inflation. In all time horizons, given the
small size of the Estonian economy relative to the euro-zone (0.30%), and a sustained record of
solid economic performance, it is advisable for Estonia to adopt the euro sooner than later.
Rather than maintaining a hard peg and waiting to join the euro at a time of favorable
coincidence, adoption of the euro would help prevent the possibility of a crisis. Given the higher
than normal inflationary nature of transitional growth and integration (the B-S effects)
13
, all of
these circumstances render a strict evaluation of the Estonian inflation rate against the Maastricht
9
Box 1: What is the Balassa-Samuelson effect? Charting a Course Toward Successful Euro Adoption, Susan
Schadler, Finance & Development, June 2004.
10
Christensen, Estonia: Bad New on Euro Adoption, Danske Bank (March 2007), available at
http://www.fxstreet.com/fundamental/analysis-reports/flash-comment/2007-03-21.html
11
Public Information Notice (PIN) No. 06/134, International Monetary Fund (Novermber 2006)
12
Flat Taxes: Will more of eastern Europe adopt flat-rate tax regimes?, The Economist (January 2007)
13
http://www.europarl.europa.eu/comparl/econ/emu/20060220/sibert.pdf
4
inflation criterion too harsh, especially considering the performance of core euro-area economies
vis-à-vis the inflation criterion
14
.
It Takes Two to Tango: The Reform Imperative for Both the Old and the New Member
States in the Evolution of the “New” Europe
The enlargement process being the EC’s primary policy tool, if euro-area economies violate the
convergence criteria, can the 2004 fifth enlargement be completed in a sustainable manner?
While the ECB has a supranational mandate for maintaining price stability, the issue of public
debt for the long run sustainability of fiscal policy of EMU countries has been an issue of major
concern since the signing of the Maastricht Treaty in 1992, especially if fiscal policy is viewed
as an instrument by individual members to influence the macro-economy when constrained by
monetary policy in the short run. Four core euro-area economies-Germany, France, Italy and
Portugal-raise some potential divergence concerns given the long-run inflationary nature of
sustained high public debt and its negative impact on growth and inflation
15
.
A recent micro-economic analysis of the EMU by McKinsey
16
strongly suggests that the
euro-area countries, the large economies in particular, especially in light of the coming
population ageing, seriously consider reforming immigration, human capital development, the
welfare state and regulatory structure to raise EU productivity and competitiveness in various
industry sectors. Regulation affects relative prices among member countries and can potentially
have macroeconomic impact by raising the overall EMU price level. All enlargements until 2004
implicitly consented to a ‘join first, reform later’ approach and this appears to have caught up
with the EMU, especially since 2004. Therefore, it appears the Copenhagen criteria are ripe for
another revision to accommodate some kind of EMU fiscal federalism and other structural
reforms such as in regulatory, finance, labor and healthcare markets, and a case-by-case
evaluation of ERM2 participants if the EU is serious about weathering any economic downturns
in the future and harmonizing the EMU economic structure and policies.
14
Ales Bulir and Jaromir Hurnik. The Maastricht Inflation Criterion: How Unpleasant Is Purgatory? IMF Working
Paper WP/06/154
15
Alfred Greiner et al., Debt sustainability in the European Monetary Union: Theory and empirical evidence for
selected countries. Oxford Economic Papers 59 (2007), 194-218.
16
Martin Neil Baily and Diana Farrell. A road map for European economic reform. The McKinsey Quarterly,
September 2005.
5
Conclusion
Estonia appears to be ready to adopt the euro if it is evaluated flexibly vis-à-vis the convergence
criteria. This means the ball is in the court of the EC, and given its small size, Estonia may not be
enough of a motivator to push for EC flexibility, but the current EMU members are. A reform of
EU accession criteria to accommodate the reform realities of the current EMU members is
therefore very much in order. This could have a critical positive impact on the future evolution
of the EU, especially in light of the challenges with new candidate countries. We will be
proposing specific reform ideas in future research as an extension to this paper.