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EU: Adopting Euro Could Prove Harmful To New Members' Economic Health

The European Union risks injuring the economies of the candidate members if it sets overly rigid standards for joining the euro. So says a recent report from an economic research group in London. The EU has said the new members will have to maintain nearly fixed exchange rates for two years to qualify for the euro. This, the report says, invites instability which could set back euro membership even further.

Prague, 27 August 2003 (RFE/RL) -- The European Union risks destabilizing the economies of the 10 accession countries if it imposes overly rigid conditions on new members for adopting the euro currency.

That's the conclusion of a recent study by the London-based Centre for Economic Policy Research. The study says an EU plan to require new members to maintain fixed exchange rates for two years before they adopt the euro could heighten -- not lessen -- risks of instability.

Charles Wyplosz, a professor with the Graduate Institute of International Studies in Geneva, is one of the authors of the report. He told RFE/RL that artificial fixed exchange rates, such as the EU's Exchange Rate Mechanism, are inherently unstable. "The problem is that the [EU's] Exchange Rate Mechanism, ERM, is a very unstable one. It requires that countries fix their exchange rates and not devalue for at least two years. We know very well for many years now that fixed exchange rate systems are dangerous and a source of occasional speculative attacks," he said.

He said artificial fixed exchange rates tempt speculators to launch attacks on a currency in the hope of forcing the central bank to devalue. In other words, since the speculators know the central bank is obliged to defend a currency, they simply start selling large amounts of the currency. The central bank must then choose between defending the currency by selling its reserves -- usually U.S. dollars or euros -- or devaluing the currency. Speculators then reap profits by buying back the devalued currency at cheaper rates.

"Once the [new members begin enforcing the fixed exchange rates] they are in a real bind. They are open to speculative attacks any day, for any reason -- good or bad. So the only thing they can do is to try to accumulate vast reserves to try to repel attacks. But we also know that no amount of reserves is big enough if the markets are determined to attack a currency," Wyplosz explained.

It's not clear yet how much fluctuation room the EU will give to the new members. The original, very tight band that the EU set for itself in the 1990s -- allowing members' currencies to fluctuate by no more than 2.25 percent with respect to a central parity -- proved unworkable in practice. EU monetary authorities were later forced to relax the band to 15 percent.

It had been generally thought that the looser 15 percent band would apply to the accession countries. But earlier this year, EU Monetary Affairs Commissioner Pedro Solbes said new members would be held to the tighter 2.25 percent band. It's not clear yet whether this was a personal opinion or official EU policy. Solbes' office did not comment for this report.

Supporters of the tight band say it is needed to enforce economic discipline and to minimize shocks to the euro area once the new members start using the common currency. But analysts like Vike Gronenberg at Smith-Barney in London say the tighter band would not allow for enough flexibility to cope with external and internal shocks.

"If the [European] Commission were to insist on a 2.25 percent band in which the Central European currencies have to move versus the euro, then it makes it even more difficult for the Central European countries to satisfy the condition for [euro] membership and it pushes euro membership even further into the future," Gronenberg said.

One option for the EU would be to differentiate among the candidate countries and to allow some of the new members to join the euro relatively soon. Others could be admitted once they are ready.

Wyplosz said it would make sense to bring in some countries -- like Estonia and Lithuania, for example -- quickly, since these countries' currencies are already pegged to the euro. "This would be very easy for countries like Estonia or Lithuania that have a currency board arrangement tying their currency to the euro," he said. "They have been effectively euro members for several years now."

For countries like Hungary or the Czech Republic, whose currencies now float freely against the euro, Wyplosz said a better solution than a fixed exchange rate would be to allow the currencies to continue to float. That would give monetary authorities more flexibility to fend off speculative attacks while restructuring budgetary spending to meet the EU's tight restrictions on deficits. Hungary's budget deficit was recently running at about 9 percent of gross domestic product, well above the EU's target of 3 percent.

Gronenberg, who specializes in the Central European economies, said in any event countries should not adopt the euro until they are ready. "If they were to adopt the euro real early and go for a major push right now in meeting all the conditions, then they might find that the economic structure is not there to maintain those conditions going forward," she said. She said she does not now anticipate the Central European countries adopting the euro until the end of the decade.

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    Mark Baker

    Mark Baker is a freelance journalist and travel writer based in Prague. He has written guidebooks and articles for Lonely Planet, Frommer’s, and Fodor’s, and his articles have also appeared in National Geographic Traveler and The Wall Street Journal, among other publications.