Adopting the Euro in Hungary: Expected Costs, Benefits and Timing

Adopting the euro in Hungary: expected costs, benefits and timing Edited by Attila Csajbók – Ágnes Csermely ON ASI AL C P C A O P E H R B 24 S N ADOPTING THE EURO IN HUNGARY: EXPECTED COSTS, BENEFITS AND TIMING EDITED BY ATTILA CSAJBÓK – ÁGNES CSERMELY NBH OCCASIONAL PAPERS (24) OCCASIONAL PAPERS 1 The views expressed are those of the authors and do not necessarily reflect those of the National Bank of Hungary. Written by Zsófia Árvai, Attila Csajbók, Ágnes Csermely, Zoltán Gyenes, Ágnes Horváth, Gábor Kiss, Mihály András Kovács, Viktória Kovács, Judit Krekó, Éva Papp, Zoltán Szalai, Balázs Világi and Balázs Vonnák Edited by Attila Csajbók and Ágnes Csermely E-mail: [email protected], [email protected] Published by the National Bank of Hungary Krisztina Antalffy, Director of Communications www.mnb.hu ISSN 1216-9293 2 OCCASIONAL PAPERS TABLE OF CONTENTS I. SUMMARY 5 Quantifying costs and benefits 6 Abandoning monetary autonomy and the effect on business cycles 9 Timing of joining the euro area 12 II. HUNGARY’S MATURITY FOR EURO AREA PARTICIPATION 15 II.1. Hungary and the less advanced EU member states five years prior to currency union membership 18 II.2. Equilibrium level of Hungarian inflation in the event of entry into monetary union 26 III. COSTS OF JOINING THE EURO AREA 36 III.1. Integration and structural similarity 44 III.1.1. Similarity of economic structures 44 III.1.2. Integration of the Hungarian economy into the euro area 52 III.1.3. Business cycle linkages 61 III.2. Adjustment to asymmetric shocks 72 III.2.1. Price adjustment 72 III.2.2. Wage adjustment 74 III.2.3. Labour mobility 76 III.2.4. Adjustment via fiscal policy 78 III.2.5. Financial integration, international risk sharing and asymmetric shocks 82 III.3. Effects of the common monetary policy 83 III.3.1. Optimality of the uniform interest rate policy for the Hungarian economy 83 III.3.2. Efficiency of monetary transmission 89 III.4. Seigniorage loss as a result of entering monetary union 97 OCCASIONAL PAPERS 3 IV. BENEFITS OF JOINIG THE EURO AREA 104 IV.1. Gains from reduced transaction costs 104 IV.2. Gains from foreign trade expansion 112 IV.3. Benefits of a reduction in exposure to financial contagion 121 IV.4. Effect of falling real interest rates and more favourable opportunities to borrow abroad on economic growth 125 IV.4.1. Expected fall in real interest rates as a result of joining the euro area 127 IV.4.2. NIGEM model simulation 133 IV.4.3. Compact, calibrated exogenous growth model simulation 136 IV.4.4. Summarising the results of the NIGEM simulation and the compact calibrated model 138 V. TIMING OF EURO AREA ENTRY 140 V.1. Time schedule of accession 149 V.2. Elements of the Hungarian convergence programme and prospective costs of convergence 149 V.2.1. Fiscal adjustment 150 V.2.2. Reducing inflation 155 V.2.3. Prospective costs of convergence in the light of international experience 161 VI. APPENDICES 170 VI.1. Effects of negative external demand shocks on Hungarian gross domestic product 170 VI.2. Identifying supply and demand shock using structural VAR estimates 176 VI.3. The model used to estimate foreign trade expansion 183 VI.4. Description of the calibrated growth model 185 GLOSSARY 189 REFERENCES 193 4 OCCASIONAL PAPERS I. SUMMARY Accession to the Economic and Monetary Union is one of the most important steps in Hungary's European integration, which will entail abandoning the national currency and adopting the euro as domestic legal tender. For Hungary as a new member state in the EU, introduction of the euro will not be an option but an obligation. Nevertheless, new EU members will have some leeway to set the date of adopting the euro1. Therefore, it is useful to analyse the likely costs and benefits of joining the euro area for Hungary and to define the choice of medium-term economic policy strategy in the light of the results of this analysis. The National Bank of Hungary would like to contribute to the formulation of an economic policy strategy by issuing this volume, which contains a cost-benefit analysis of the likely effects of the country's joining the euro area. This analysis is confined strictly to the economic benefits and costs of introducing the euro and is not intended to examine its other possible impacts, including, for example, the implications for politics and national security. Adopting the euro will likely have a permanent impact on Hungarian economic growth. This impact will become evident through numerous channels. Bank staff have attempted to quantify and sum up the extent of this impact transmitted through the various channels. The findings of this analysis suggest that the introduction of the euro will bring about significant net gains in growth. However, welfare is influenced not only by the level and rate of GDP growth, but their stability as well. A widely fluctuating national income will produce lower welfare than a more stable one, even if on average the two income levels are identical. For this reason, it is important to examine whether joining the euro area will increase or mitigate the volatility of business cycles. In other words, the key question is whether Hungary and the euro area form an optimum currency area, that is whether the monetary policy of the euro area is capable of adequately substituting independent Hungarian monetary policy in smoothing out cyclical fluctuations. In the findings of this analysis, the euro area seems to be in most respects at least as optimal a currency area for Hungary as for less developed euro area member countries. 1 One example of the current EU member states is Sweden, which even though committed to joining the euro, has been postponing it by staying outside the ERM II. By contrast, Great Britain and Denmark have an official opt-out. The new EU members did not request an opt-out, and probably they would not have received one. OCCASIONAL PAPERS 5 Quantifying costs and benefits In estimating the likely costs and benefits of monetary union, it is very important to clarify to which alternative path those costs and benefits are related. The alternative path used in our study reflects possible economic developments if Hungary enters the EU at a relatively early stage, but refrains from adopting the common currency for some reason, pursuing independent monetary and exchange rate policy strategies. This study assumes successful disinflation and continued income convergence towards the euro area even in the staying-out scenario. However, if Hungary stays out from currency union, disinflation will entail higher real economic sacrifices, due to the costs of accumulating and preserving central bank credibility. Disinflation undertaken with a well-defined purpose and time-horizon of joining the euro area would probably enjoy higher credibility and thus would be less costly. As this credibility gain arising from the presence of an early EMU-entry date cannot be quantified, it has not been accounted for in our cost-benefit analysis, but its significance will be stressed when determining the optimal timing of joining the euro area. The methodology of estimating the costs and benefits is necessarily eclectic, but Bank staff have attempted to confirm the calculations from several aspects, taking account of recent theoretical and empirical findings in the international academic literature. The analysis quantifies three key benefits arising from euro area membership, in the form of gains from reduced transaction costs, expansion of foreign trade and a drop in real interest rates (and the simultaneous easing of the current account constraint). Maintaining a country’s own currency can be viewed as an administrative restriction causing welfare losses to society, since part of the physical and human resources are tied up due to this very restriction. These losses appear in the form of transaction costs incurred by firms and households. One group of transaction costs is conversion costs, comprising fees and commissions charged by banks and other financial intermediaries for converting euros into forints (and vice versa) and of bid-ask spreads. The other group contains in-house costs incurred by firms engaged in foreign currency transactions, due to extra administration and risk management 6 OCCASIONAL PAPERS tasks associated with these transactions. Giving up a national currency will reduce these transaction costs and the reallocation of resources released in this way may raise the level of GDP. Estimates of the magnitude of transaction costs are partly derived from data for Hungarian foreign exchange market turnover and from the size of commissions, and partly from international estimates. Thus, Bank staff estimate that the gains from reduced transaction costs will cause a one-off rise in the level of GDP of 0.18-0.30 of a percentage point. The bulk of international empirical research suggests that maintaining an independent currency will also have an adverse effect on external trade. In contrast, currency union with major trading partners will boost a country’s external trade, leading to higher growth via various externalities (such as technology and know-how transfer). In this analysis, we have used a methodology that has recently gained popularity to gauge such effects on external trade and growth. The approach is based on gravity models and large panel data to estimate the effect of a currency union. Accordingly, the adoption of the euro may raise GDP growth by 0.55-0.76 of a percentage point over the long run, via the expansion of external trade. Domestic interest rates currently contain a risk premium component to compensate non-resident investors for the uncertainty about movements in the exchange rate.

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