Third Round of the Euro Area Enlargement: Are the Candidates Ready?

Third Round of The Euro Area Enlargement: Are The Candidates Ready?

Milan Deskar-Skrbi´cˇ Karlo Kotarac Davor Kunovac

Modelling Department - HNB

Tirana, October 11th 2019 Disclaimer

The views expressed in this paper are those of authors and do not necessarily reﬂect the views of the Croatian National Bank. First round of the enlargement Second round of the enlargement Third round of the enlargement? Euro candidate countries - three monetary stories

20 Bulgarian lev 15 Croatian kuna 10 Romanian leu

5 %

y - 0 o - y -5 -10 -15 04 06 08 10 12 14 16 Key policy question

I What is the cost of giving up the monetary policy autonomy? I answer to this question depends on: I coherence of economic shocks in euro candidate countries and the euro area (meta property of OCA) I relevance of common chocks (shocks that ECB reacts to) in euro candidate countries I eﬀects of ECB policy on GDP and inﬂation in euro candidate countries I The aim of this paper is to address these questions using a new analytical framework Research questions

This paper formally addresses four main questions: I Do standard economic shocks hitting the euro area have similar eﬀects on three candidate countries?

I How important are shocks relevant for ECB policy making process for three candidate countries?

I Do monetary policy shocks of the ECB have the expected counter-cyclical eﬀects on euro candidate countries?

I Does the exchange rate regime matter for the transmission of euro area shocks to candidate countries? Methodology

I small open economy BVAR model (two blocks): block exogeneity assumption I variables I domestic: GDP, inflation, nominal exchange rate(HR, RO) and domestic interest rate (RO) I euro area: GDP, inflation, shadow rate (Wu and Xia 2016) I we propose a methodology that allows us to calculate the share of common shocks in GDP and inflation and compare these shares across countries I we extend and complement related literature such as Bayoumi and Einchengreen (1992/3/4), Peersman (2011) and Kotarac, Kunovac i Ravnik (2017) Identification - short run restrictions

Short run Shocks/Variables GDPEA HICPEA MPEA GDPD HICPD ERD MPD External shocks Demand + + + ? ? ? ? Supply + – ? ? ? ? ? Monetary policy + + – ? ? ? ? Domestic shocks (BG) Demand 0 0 0 + + Supply 0 0 0 + – Domestic shocks (HR) Demand 0 0 0 + + ? Supply 0 0 0 + – ? Exchange rate 0 0 0 ? + + Domestic shocks (RO) Demand 0 0 0 + + ? + Supply 0 0 0 + – ? ? Exchange rate 0 0 0 ? + + + Monetary policy 0 0 0 + + + –

Note: (+) = positive reaction; (-) = negative reaction; (0) = no reaction; (?) = no restrictions. Shocks are deﬁned as expansionary. Identiﬁcation - long run restrictions

Short run Shocks/Variables GDPEA HICPEA MPEA GDPD HICPD ERD MPD External shocks Demand 0 ? ? ? ? ? ? Supply ? ? ? ? ? ? ? Monetary policy 0 ? ? ? ? ? ? Domestic shocks (BG) Demand ? ? ? 0 ? Supply ? ? ? ? ? Domestic shocks (HR) Demand ? ? ? 0 ? ? Supply ? ? ? ? ? ? Exchange rate ? ? ? 0 ? ? Domestic shocks (RO) Demand ? ? ? 0 ? ? ? Supply ? ? ? ? ? ? ? Exchange rate ? ? ? 0 ? ? ? Monetary policy ? ? ? 0 ? ? ?

Note: (+) = positive reaction; (-) = negative reaction; (0) = no reaction; (?) = no restrictions. Shocks are deﬁned as expansionary. Results: historical decomposition example gdp-bg 0.1

0.08

0.06

0.04

0.02

-0.02 data -0.04 baseline EA MP -0.06 EA AD EA AS -0.08 BG AD BG AS -0.1 05 06 07 08 09 10 11 12 13 14 15 16 17 18

k I yjt - contribution of shock k to variable j in time period t t−1 k P I yjt = ψjk,h · εk,t−h h=0 Results: Contributions - illustrative example

EA MP

ECB-relevant EA AD shocks

Total

EA AS contribution of shocks

BG AD Idiosyncratic

shocks BG AS

Results: contribution of common shocks

(a) GDP (b) HICP

1.0 1.0

0.8 0.8

0.6 0.6

0.4 0.4

0.2 Bulgaria 0.2 Bulgaria Croatia Croatia Romania Romania

0.0 0.0 05 06 07 08 09 10 11 12 13 14 15 16 17 18 05 06 07 08 09 10 11 12 13 14 15 16 17 18

y k k | jt | P5 k yfjt = Pn l k=1 yfjt l=1|yjt | Results: contribution of common shocks - ﬂoaters vs peggers - GDP

.8 .7 .6 .5 .4 .3

.1 2006 2008 2010 2012 2014 2016

Albania Bulgaria Czechia Denmark Croatia Hungary Poland Romania Sweden UK Results: contribution of common shocks - ﬂoaters vs peggers - HICP

.1 2006 2008 2010 2012 2014 2016 2018

Albania Bulgaria Czechia Denmark Croatia Hungary Poland Romania Sweden UK Results: eﬀects of the ECB’s policy

(a)EA (b) BG

EA MP ==> gdp-ea EA MP ==> hicp-ea EA MP ==> gdp-bg EA MP ==> hicp-bg 0.2 0.15 0.1 0.1 0 0.1 0.1 -0.1 0 0 0.05 -0.2 -0.1 -0.1 5 10 15 20 5 10 15 20 5 10 15 20 5 10 15 20

(c)HR (d)RO

EA MP ==> gdp-hr EA MP ==> hicp-hr EA MP ==> gdp-ro EA MP ==> hicp-ro 0.2 0.4 0.1 0.2 0.3 0 0.15 0.1 0 0.2 -0.1 0.1 -0.1 0.1 -0.2 0.05 -0.2 0 -0.3 5 10 15 20 5 10 15 20 5 10 15 20 5 10 15 20 Results: eﬀects of the ECB’s policy - diﬀerences Conslusions

Our results indicate that: I common shocks are dominant determinants of GDP and inflation developments in Bulgaria, Croatia and Romania I contribution in Romania somewhat less pronounced - the role of different exchange rate regimes? I ECB’s policy has similar effects on GDP and inflation in euro candidate countries and the euro area Thus, we can conclude that: I costs of the loss of (already limited) monetary sovereignty should not be pronounced, even in Romania I common countercyclical policy should be adequate for three candidate countries I common countercyclical policy could be also suitable for other non-euro area countries? Thank you! Appendix Albania - impulse responses