European Commissioner for Economic and Monetary
Conference on Hungary and the Euro organised by Figyelö and Heti Valasz
Ladies and Gentlemen,
I am honoured to be here today to share with you some thoughts on Hungary and the euro. Recently this subject has been the focus of much debate, and rightly so. Euro-area enlargement represents a significant new chapter in the history of European monetary integration, and today I will consider Hungary's place in this ongoing process. However, before addressing the Hungarian position in some detail, it is useful to begin by recalling the benefits of participation in the single currency and the principles and rules governing the enlargement of the euro area.
What are the benefits of euro adoption?
I am confident to state from the outset that euro area enlargement is beneficial for both future and current euro area members.
In particular for the potential, new members of the single currency, the advantages are numerous. First and foremost, joining the euro area means the consolidation of an environment of macroeconomic stability involving the elimination of exchange rate risks and a reduced vulnerability to external shocks. Euro adoption will deliver the reduction of currency-related transaction costs, and correspondingly, higher levels of trade and foreign investment. New euro-area members will experience increased price and cost transparency, in turn increasing competition to the benefit of consumers. What is more, for certain countries with a history of volatile macroeconomic conditions, aligning to a strong currency such as the euro means 'importing' credibility from the anchor currency and thus profiting from lower interest rates and risk premia.
However, it is not my intention to paint an overly idealistic picture of euro adoption. As is often the case, where there are benefits to reap, there could be certain costs to pay.
In this case, the single main cost is undoubtedly the loss of an independent monetary policy and the exchange rate instrument.
However, in most new Member States the scope for autonomous monetary policy decisions is already rather limited, given the size and openness of their economies and the choice of exchange rate regime, where many countries have pegged their currencies to the euro. Moreover, where these economies are increasingly integrated with the euro area in terms of trade and investment flows, the benefits of pursuing an independent monetary policy become less evident.
In light of potential drawbacks, one question naturally arises. Could the costs of euro adoption outweigh the benefits? My categorical answer is no, provided of course that the right conditions are in place before joining.
To be precise, this means guaranteeing a high degree of macroeconomic stability and sound economic polices, accompanied by flexible labour and product markets. Only by meeting these pre-requisites can a country fully prosper in the euro area. Accordingly, euro adoption must be regarded as the final step in a process of progressive economic and monetary integration. Before reaching this final stage, countries are required to follow a specific route to euro adoption, a route which includes qualifying and meeting certain formal criteria. It is to these criteria that I will now turn.
What is the road to the euro?
Euro enlargement is governed by clear and detailed Treaty provisions. By signing the Accession Treaty, the new Member States have made a commitment to become members of the euro area, once the necessary pre-conditions are fulfilled. Until they do so, they continue to use their own currency and have freedom to decide their monetary policy. In the Treaty jargon these countries are known as "Member States with a derogation”.
Nevertheless, Member States with a derogation participate in multilateral coordination and surveillance procedure, such as the Stability and Growth Pact, the Lisbon process, and the Broad Economic Policy Guidelines. Moreover, they are required to treat their exchange rate as a matter of common concern and should not embark on competitive devaluations.
Eventually, these Member States are expected to participate in the Exchange Rate Mechanism, the so-called ERM II, which will link their currency to the euro. Currently eight Member States participate in this exchange rate mechanism, including Slovenia which is set to join the euro area in January 2007. At present, Hungary is not a member of ERM II, even though the forint is unilaterally formally pegged to the euro, meaning that it is allowed to fluctuate in a limited range around a set, central parity.
To officially enter the euro area, a Member State has to meet the Maastricht criteria. The convergence examination decides whether a country is fit to join the euro area, assessing whether a Member State has established an environment of sustainable price stability, exchange rate stability and sound public finances, and whether convergence is credible with financial markets. The criteria are complemented by qualitative assessments on developments in balances of payment, unit labour costs and other price indices, as well as the degree of market integration.
Compliance with the criteria is clearly in the interest of both the prospective and existing members of the euro area. It is the only way to maintain a truly stable environment that allows all of the participating countries to profit fully from the advantages of the single currency. To illustrate this principle of mutual benefit, allow me to focus for a moment on just two criteria, namely the much discussed price stability criterion and the criterion on budgetary position.
Firstly, the EU Treaty sets price stability as a key objective of the Economic and Monetary Union. The importance of low inflation and the resultant price stability is beyond doubt. Together they encourage the long-term investment which delivers sustainable growth and a strong economy in the long term. If proof for this argument is needed, one should consider the experience of those countries that joined the euro in 1999. Member States that entered the single currency with relatively high inflation have witnessed a loss in competitiveness year after year.
Turning to public finances, fiscal discipline is essential in a monetary union to prevent a weakening of the single monetary policy. Imagine that a country's fiscal indebtedness is excessively high. This would raise the cost of borrowing for that country until the debt service becomes unsustainable, prompting a high default risk. In such a situation, financial markets will sanction the individual Member State but some contagion effects could be experienced in the rest of the euro area. In the worst case scenario, this could mean higher borrowing costs, a fall in the external value of the euro and even lower growth rates. Moreover, a country without sound public finances is intrinsically more vulnerable to all types of shocks, having little leeway to let public revenues and expenditure cushion cyclical downturns.
Undoubtedly, the pursuit of sound public finances is in the interest of any country, regardless of the euro. Yet euro adoption supports the attainment of this goal. For Member States already in the euro area, constraints imposed by the public finance criterion have served as an external anchor to much-needed budgetary consolidation.
While meeting the Maastricht criteria is challenging, I would like to emphasise that the Treaty framework guarantees equal treatment between current and future euro area members, and ensures the integrity and credibility of the euro enlargement process. No special obstacles have been set for new Member States, and likewise it would be inappropriate to weaken the entry conditions for these countries.
Ultimately, the convergence assessment is as relevant and appropriate now as when it was first established in the early 90s. It continues to be a vital instrument for ensuring each Member State is prepared for life in the euro family, the importance of which should not be underestimated. There is no trial period for Euro adoption; it represents a permanent and historic change. Therefore it is essential that each country has attained sustainable convergence and is fully ready before undertaking such a significant transition.
What is the specific situation of Hungary with respect to convergence?
This brings me to my evaluation of Hungary's status as regards convergence. At present, the country is not meeting the conditions for euro adoption. To demonstrate this point, I will address each of the four economic criteria one by one, assessing Hungary's progress against the yardstick provided by the Treaty. These criteria refer to inflation levels, public finances, exchange rate stability and long-term interest rates. In doing so, I also want to show how the Hungarian economy can benefit in a broader sense from close observation of the criteria.
First, Hungary has undergone a long disinflationary process: inflation fell from over 25% in the mid-1990s to 3.5% in 2005. However, to date, annual inflation has not fallen below the reference value for price stability. In fact, the inflation rate in Hungary picked up during the course of this year and is expected to remain at relatively elevated levels in 2007. Given that higher inflation is a partial reflection of price shocks as well as exchange rate movements, price pressures will need to be kept under control in the medium term. To this end, Hungary should contain wage pressures and employ structural reforms that boost productivity and the flexibility of the economy.
Regarding the condition of public finances, it will come as a surprise to no-one that the budgetary situation in this country is somewhat grave. Last year, Hungary had the highest government deficit among EU Member States at 7.8% of GDP. The recent, major fiscal slippages now bring this year's deficit to around 10% of GDP, generating a pressing need for action. In particular, the ambitious budgetary consolidation strategy of the Convergence Programme, adjusted in September and aimed at curbing public deficits and debt, requires rigorous implementation.
The Hungarian government now seems to be aware that only a sustained and sustainable fiscal adjustment will allow Hungary to correct the excessive deficit and create the basis for sustainable growth. In October 2006, the European Council granted an additional year to achieve this objective, extending the deadline for deficit correction from 2008 to 2009. If Hungary's efforts are successful, which I very much hope they will be, the benefits should extend to other areas beyond fiscal consolidation. They could help reduce the risk premium on interest rates, support the credibility of the exchange rate, and improve the attractiveness of the country for foreign investors.
Regarding exchange rate stability, Hungary is not a member of ERM II and does not meet the exchange rate criterion. Furthermore, Hungary's currency has been under pressure for a large part of this year. The forint depreciated by over 12% vis-à-vis the euro between August 2005 and August 2006. As a consequence, while the forint has been strengthening since June, the exchange rate has remained relatively volatile.
To ensure a stable currency and to minimise the risk of volatility in the future, it is of critical importance that fiscal consolidation is pursued successfully, fixed in a broader framework of stability-oriented policies. Only then can investor confidence be assured and risk premia on interest rates fall substantially.
This brings me to the fourth and last convergence criterion, which specifies maintaining long-term interest rates below the reference value. As economic policies cannot directly influence long-term interest rates, they reflect the expectations of market participants regarding the trends and sustainability of macroeconomic developments and consequently the credibility of economic policy. In this way, long-term interest rates can provide important information on the sustainability of nominal convergence. In particular, they provide an indication of the markets’ assessment of the sustainability of fiscal and inflation developments.
From this perspective, it is indeed regrettable that Hungary currently has the highest long-term interest rates of all EU Member States. Nor is this a new phenomenon. Long-term interest rates are a long standing problem for the country, having remained well above the reference value since EU accession. The problem is emblematic of the high risk premium that Hungary has to bear, due to its weak macroeconomic fundamentals and fiscal policy slippages. As a painful consequence, Hungary is expected to pay out more than 4% of GDP annually over the coming years to service her debt. In turn, this will make implementing the already overdue structural reforms more difficult from a budgetary perspective. Here again, a successful consolidation effort will go a long way to restore investor's confidence in the Hungarian economy and reduce risk spreads, which would be very conducive to economic growth in the longer term. Indeed I cannot stress too highly the value of deficit and debt reduction. It establishes a veritable 'virtuous circle', boosting confidence in the economy and producing a decrease in interest rates, which in turn facilitates further budgetary consolidation.
Overall, my review of Hungary's progress towards convergence may appear somewhat disheartening. Yet there is a key message to take from the rather unfavourable assessment presented here; it is in your country's interest to remain committed to a solid, stability-oriented medium-term policy strategy. There can be no dilemma for policy makers given the strong incentives for implementing the necessary measures. Indeed, not only will the required policies enable the country to fulfil the criteria for euro adoption, but the same measures will ensure a sound macro-economic environment allowing Hungary to prosper in the long-term.
In striving for this goal, your country will receive support and co-operation, the Commission and the Hungarian authorities remaining in close and constructive consultation for the period ahead. On the specific issue of public finance, the Government will inform the Commission and the Ecofin Council on a semi-annual basis of budgetary developments until the excessive deficit is removed. The Commission will also be informed of progress regarding the structural reform agenda and, in the event of departure from the designated fiscal path, necessary measures to assure its resumption.
Ladies and gentlemen, let me conclude. Euro area enlargement is a significant and ongoing process for the European Union, one that opens a new chapter in European economic and monetary integration. Moreover, the single currency serves as a catalyst for progress in other areas of integration, such as completing the single market and enhancing economic policy coordination. Furthermore we anticipate a strengthening of the shared "European identity" within the Union.
Euro area enlargement will create new opportunities for citizens and businesses, and will add welcome dynamism to the single currency area as a whole. To fully exploit this potential, existing and future euro area members will need to gear policies towards stable public finances and well-functioning product and labour markets. For new Member States, this is key to sustaining strong and balanced growth.
The prospective gains are great, but will not be attained without effort. It is clear that to be beneficial, euro area entry should only take place when the conditions are right, based on an objective and impartial assessment under the provisions of the Treaty.
There may be speculation among you as to when Hungary will be ready to finally adopt the euro. It should be clear from my comments here that neither I, nor anybody else, can answer this question today. Your country evidently has much progress to make towards convergence. While we at the EU level can assist, ultimately the extent of this progress is dependent upon those within the country. The date for finally joining the single currency is therefore Hungary's responsibility. What I certainly can say, however, is that I strongly encourage Hungary to remain committed to a firm and credible medium-term policy strategy. This is the best choice for both the long-term health of your country's economy, and to improve prospects for achieving euro adoption.