THE IMPACT OF THE EURO ADOPTION ON SLOVAKIA

Thesis

by

Anna Gajdošová

Submitted in Partial Fulfillment

of the Requirements for the Degree of

Bachelor of Science

in

Business Administration

State University of New York

Empire State College

2019

Reader: Tanweer Ali

Statutory Declaration / Čestné prohlášení

I, Anna Gajdošová, declare that the paper entitled:

The Impact of the Euro Adoption on Slovakia was written by myself independently, using the sources and information listed in the list of references. I am aware that my work will be published in accordance with § 47b of Act No.

111/1998 Coll., On Higher Education Institutions, as amended, and in accordance with the valid publication guidelines for university graduate theses.

Prohlašuji, že jsem tuto práci vypracovala samostatně s použitím uvedené literatury a zdrojů informací. Jsem vědoma, že moje práce bude zveřejněna v souladu s § 47b zákona č.

111/1998 Sb., o vysokých školách ve znění pozdějších předpisů, a v souladu s platnou

Směrnicí o zveřejňování vysokoškolských závěrečných prací.

In Prague, 06.08.2019 Anna Gajdošová

Acknowledgement

I would like to express my special thanks to my mentor, Prof. Tanweer Ali, for his useful advice, constructive feedback, and patience through the whole process of writing my senior project. I would also like to thank my family for supporting me during this whole journey of my studies.

Table of Contents

Methodology ...... 8

1. Historical Overview ...... 10

1.1. Economic and Monetary Union ...... 10

1.2. History of the Economic and Monetary Union ...... 10

1.3. The European currency snake ...... 11

1.4. The European Monetary System ...... 12

1.5. The Delors report ...... 13

1.6. The three stages of Monetary Union ...... 13

1.7. Benefits of monetary integration ...... 17

1.8. Meeting the Maastricht criteria ...... 17

1.9. Slovakia and the EMU ...... 20

2. Expected benefits of Euro ...... 21

2.1. Direct benefits ...... 22

Transaction costs eliminated ...... 22

Exchange risk ...... 23

Price transparency ...... 23

Capital costs and interest rates ...... 24

2.2. Indirect Benefits ...... 24

Foreign trade ...... 24

Foreign direct investments (FDI) ...... 26

3. Disadvantages and Costs ...... 28

3.1. Monetary policy ...... 28

3.2. Rounding the prices ...... 29

3.3. Exchange rates ...... 29

3.4. Inflation ...... 30

4. Slovakia after the Euro adoption ...... 32

4.1. The Effect on Inflation ...... 32

4.2. Banking Sector and Interest Rates ...... 34

4.3. Competitiveness ...... 36

4.4. Foreign Trade ...... 37

4.5. Foreign Direct Investment (FDI) ...... 39

4.6. GDP growth ...... 41

4.7. Tourism ...... 44

5. Conclusion ...... 46

Works Cited ...... 49

Bibliography ...... 55

Abstract

10 years have passed since Slovakia adopted the euro and joined the Eurozone. Prior to adopting the euro, the National Bank of Slovakia made predictions about the effects of adopting the common currency on various aspects of Slovak economy. Some of them were supposed to manifest immediately, but some of them would be visible rather in the long run. The thesis provides brief insight into Slovakia’s journey towards the euro, and the theory of optimal currency areas. The euro adoption affected all Slovak citizens along with institutions, businesses and organizations. The primary purpose of this thesis is to compare the predictions versus reality and explore if the optimistic scenarios became reality.

Methodology

Slovakia joined the euro area on the 1st of January 2009. It became the 16th member of the euro area.

The government of Prime Minister Mikulas Dzurinda has paved the way towards the euro in Slovakia. In November 2005, the Slovak koruna was involved in the ERM II exchange rate mechanism. In addition to technical preparations and efforts to meet the Maastricht criteria, the government has also implemented a number of reforms that are necessary to draw the benefits of introducing the euro.

The topic of my bachelor thesis is the impact of the euro adoption on Slovakia. I divided my work into several parts. The first part is the introduction and historical overview that led to the euro adoption. In that part, I tried to characterize the process of monetary integration, namely the European Economic and Monetary Union (EMU). This part also explains, Slovakia’s attitude towards the EMU, and how the country fulfilled the criteria to become a member of the euro area. The next part is going to be about predictions versus what happened in reality. In 2006, The National Bank of Slovakia issued a document about the effects of the euro adoption on the Slovak economy. It was a certain prediction of what it might look like after joining the euro area. I will compare the aspects from these predictions with actually happened over the 10 years since the euro adoption. In my work, I am drawing conclusions from secondary research, that is, mostly data and information from

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the documents, publications, journals, websites and books concerned with this topic. The main goal is to briefly analyze the steps leading to Slovakia’s entrance to the euro area, and also to find out how Slovak people view the advantages and disadvantages connected to the new currency. I will look into several aspects in the Slovak economy. After the comparison between the predictions and reality, I will decide if the impact on several sectors of economy was positive or negative, and will discuss the current situation. I am expecting that the advantages will outweigh the costs after my comparisons. The euro adoption affected all Slovak citizens along with institutions, businesses and organizations. The change of currency has effects that are visible immediately, but some of them have to be evaluated after longer period of time, which is why I think this topic could be interesting for readers from the countries that adopted the euro, and also those who did not do so yet.

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1. Historical Overview

1.1. Economic and Monetary Union

The Economic and Monetary Union (EMU) is a result of gradual economic integration of

European Union. The Treaty of Amsterdam considers the EMU as one of the goals of the

European Union. The Economic and Monetary Union consists of European countries that have agreed to use a common currency – the euro, and common economic and fiscal policies. There are currently 28 EU Member States participating in the economic union, while only 19 of them have adopted the euro. The goals of the EMU are increasing employment, more economic growth, and directing benefits towards EU citizens.

1.2. History of the Economic and Monetary Union

Gustav Stresemann, a German foreign minister during the Weimar Republic, initiated the first idea of the Economic and Monetary Union. After World War I., there was a number of new states in Europe and there was an increase in economic division. His idea was to have a

European currency. However, it was a long journey before the successful creation of the

EMU in 1999. There were several attempts to create the EMU before 1999.

The first attempt was in 1969 at the summit of European Community in Hague. The team of experts was led by the Luxembourg prime minister, Pierre Werner. He and his team prepared the so-called Werner Report. This report was the first unified concept, and plan for the creation of the EMU within a decade. It was anticipated that there would be liberalization of

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movement of goods and capital, irrevocable fixing of exchange rates, unlimited currency convertibility, and implementation of a common currency. (Wilhelmova & Klik, 2000, p.4)

However, this first attempt did not work because of the collapse of the Bretton-Woods system in 1971, when the US decided to suspend the dollar’s convertibility into gold. That caused instability in foreign exchange market, which challenged the parity of European currencies.

1.3. The European currency snake

In 1972, the European Economic Community (EEC) tried to bring new dynamics into monetary integration at the summit in Paris. The currency turmoil in the 1970s weakened

Europe. European markets were destabilized by the events such as devaluation of French franc, the upward revaluation of the German mark, and the collapse of the Bretton-Woods

International Monetary system. Moreover, the Member States’ currencies had to be fixed in order to create a common market. (The European Currency Snake, n.d.)

The response to the devaluation of the US dollar and the widening of its exchange rate band, was so called “snake in the tunnel” mechanism. It kept the exchange rates coordinated, and was aimed to keep the exchange rates of Member States’ currencies stable among themselves and flexible with respect to the US dollar. (Wilhelmova & Klik, 2000, p.5)

The “snake” was not feasible, because some currencies were leaving and then rejoining again.

The European Monetary System replaced the snake as a form of monetary coordination in the European Economic Community.

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1.4. The European Monetary System

The European Monetary System (EMS) aims to protect US dollar fluctuations and create an area of monetary stability in Europe. The introduction of stricter monetary rules, intervention of responsibilities, the creation of foreign exchange reserves and favorable credit conditions resulted in a shift in the coordination of monetary policy within the Community. The basic elements of the EMS are the Exchange Rate Mechanism (ERM), the European Currency

Unit, and the credit mechanism. With the political agreement from 1985 about the Single

Market, it became clearer that if the relatively high transaction costs associated with the currency transfer and uncertainty about exchange rate fluctuations remain, the potential of the internal market would have not been fully exploited. (Lex Access to Union Law, 2011)

In addition, many economists criticized the so-called magical triangle, since the free movement of capital, exchange rate stability, and independent monetary policies have been contradictory in the long term. It is called a Mundell-Fleming’s trilemma, also known as the impossible trinity. A country must decide between free movement of capital, exchange rate management, and an independent monetary policy. All three options are not possible, only two of them. “A country that wishes to fix the value of its currency and also have an interest- rate policy that is free from outside influence cannot allow capital to flow freely across its borders. If the exchange rate is fixed but the country is open to cross-border capital flows, it cannot have an independent monetary policy. And if a country chooses free capital mobility and wants monetary autonomy, it has to allow its currency to float.” (The Economist, 2016)

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1.5. The Delors report

The Committee of governors of central banks, Commission president Jacques Delors and other experts were appointed by the European Council to draft a monetary union. The Delors report states that integration towards the union is conditional on the convergence of national macroeconomic results and requires close coordination of budgetary and monetary policies.

Delors’ report proposes to achieve EMU in three stages, which will described later.

(Wilhelmova & Klik, 2000, p.6) As in every community, this Community has gone through various challenges until it has reached the desired goals. The first objective was to work together with Member States, The Community has also sought to coordinate exchange rate management, protect against US dollar fluctuations, and finally create the Monetary Union.

1.6. The three stages of Monetary Union

Economic and Monetary Union was established in the following stages:

First stage: the cancellation of restrictions on the movement of capital in the EU (1 July

1990 – 31 December 1993). In June 1989, the European Union decided that the first stage of the Economic and Monetary Union would begin on 1 July 1990, when all member states abolished the restrictions on movement. At that time, the Committee of Governors of the

Central Banks of the Member States of the European Economic Community, which had an increasingly important role in monetary cooperation, was given new roles as set out in the

EU Council decision on the 12th of March 1990 (Lastra & Jean-Victor, 2013, p.111). The

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aim was to achieve price stability, including the provision of advisory services to Member

States in the field of monetary policy and the promotion of cooperation in this area.

Second stage: the establishment of the European Monetary Institute and the European

Central Bank (1 January 1994 – 31 December 1998). The start of the second stage of the

Economic and Monetary Union is linked to the 1st of January 1994, when the creation of the European Monetary Institute (EMI) took place. The creation of EMI has shown the truth about monetary integration in the European Community. EMI was neither responsible for the execution of monetary policies in the EU nor for the execution of foreign exchange interventions. EMI had two main roles: Enhancing cooperation between central banks in the area of monetary policy to establish a European System of Central Banks (ESCB) in order to create a single currency and the implementation of a single monetary policy. The

European Council in December 1995, approved the name of the currency unit, euro, which was introduced on the 1st of January 1999, at the beginning of the third stage. In December

1996, EMI submitted a report to the European Council that formed the basis of the

European Council Resolution in June 1997 on the Principles and Fundamentals of the New

Exchange Rate Mechanism (ERM). (Lastra & Jean-Victor, 2013) Subsequently, in

December 1996, the EMI submitted a series of drafts of euro banknotes to the European

Council and to the public. They were supposed to begin the circulation on the 1st of January

2002. On the 2nd of May 1998, the European Council decided that eleven out of fourteen member states (Germany, Belgium, Spain, Austria, Portugal, Finland, the Netherlands,

Luxembourg, Italy, France and Ireland) fulfilled the conditions for the adoption of the common currency starting from the 1st of January 1999. With effect from the 1st of June

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1998, the governments of the eleven member states agreed on the Executive Board of the

European Central Bank (ECB), which in fact indicated the start of ECB and end of the role of the EMI. The ECB and the national central banks of the participating Member States have jointly established the Eurosystem, which identifies and defines a single monetary policy in the third stage of the EMU (European Central Bank, n.d.).

Third stage: determining irrevocable exchange rates (since the 1st of January 1999). The single currency replaced national currencies in non-cash payments in early 1999. National banknotes and coins continued to be paid in cash. The introduction of physical euro banknotes and coins was in 2002. The transition to euro did not mean monetary reform but it led to currency conversion. In this period, 17 countries had adopted the euro as their national currency. (European Central Bank, n.d.) The condition under which countries can adopt the euro as their national currency is that they must fulfill the convergence

(Maastricht) criteria. The third stage is also the gradual adoption of the euro as the single currency of the Member States and implementation of a common monetary policy under the direction of the ECB. The transition to the third stage was dependent on achieving a high degree of sustainable convergence, which is measured on the basis of several criteria set out in the Treaties. Budgetary rules should become binding and a Member State that did not meet them would be penalized by sanctions. (Bunyaratavej, 2004, p.19) The Maastricht criteria for the countries that wanted to adopt the euro on the 1st of January 2002 were as following:

- exchange rates must remain at least two years within the limits set by the ERM

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- long-term interest rates should not be more than two percentage points above the

interest rates of the three best-performing Member States

- inflation must be below the reference value (over a three-year period, prices may

not grow by more than 1.5% than those with the best results)

- the government debt must be below 60% of the GDP threshold (or close to that

target) and the budget deficit must be below 3% (Bunyaratavej, 2004, p. 21-23)

However, the Economic and Monetary Union also had its opponents. According to

some concerns, weaker countries have been damaged by a tight connection to the

German mark in the monetary area. The Germans, on the other hand, feared that

inflation could be passed on from the partner countries. Even though central banks

and the finance ministries were keen on cooperation, there were also people who

were not willing to give up macroeconomic policies. Amongst politicians, the

British Prime Minister Margaret Thatcher was the biggest opponent of this project.

Above all, the success of Exchange Rate Mechanisms (operating without British

participation) has contributed to the fact that in the end, the development was not

reversed. Thatcher, like John Major’s government, hoped that their proposals to

develop non-inflationary “hard ECU” as a parallel currency will divert other

members from the intention of creating an EMU with a single currency and a

federal bank. The ability of the British governments to change the direction of their

development depended largely on how Germany was involved in it. The

Bundesbank was, in principle, in favor of the EMU. It had doubts focused on

specific steps leading to monetary integration until other countries are as successful

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in fighting inflation as Germany. Support for the idea of the common currency remained very strong in Germany. And after the country’s unification, the German government emphasized the need for a political union that would hold stability in

Europe. France also supported a political union.

1.7. Benefits of monetary integration

Monetary integration brought several positive things, such as elimination of transaction costs, faster financial and economic integration, excessive volatility between Member States and their currencies, lower interest rates and capital resources, and better access to them, strengthening of international stability or greater economic and political importance in international affairs. The higher the likelihood of demand and supply shocks, the higher the benefits of introducing a single currency. Economic growth should be driven by an increase in foreign trade, mostly regarding the automotive industry, electronics, services and goods.

1.8. Meeting the Maastricht criteria

Preparations for introducing the euro in Slovakia started before the Slovak Republic joined the European Union. On the 16th of July 2003, the Slovak government

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approved the euro adoption strategy in the Slovak Republic, prepared by National

Bank of Slovakia (NBS) and the Ministry of Finance. In a joint statement, the

government and the NBS noted that the benefits of introducing the euro clearly

outweigh the disadvantages in Slovakia. This means that the country would have to

enter the Eurozone as soon as possible – as long as it could sustainably fulfill the

Maastricht criteria that are mandatory for joining the Eurozone.

The government appointed the Ministry of Finance as the national coordinator of

the euro adoption process in the Slovak Republic. At the same time, it instructed the

Czech minister of finance and the NBS governor to negotiate with the European

Union institutions about entering ERM II and establishing the central rate of the

exchange rate of the Slovak koruna against the euro. (National Bank of Slovakia,

2018)

Table 1. Maastricht criteria DEFINITION REFERENCE SLOVAKIA 2008 CRITERIA VALUE

Cannot be higher INFLATION than 1.5% above

the inflation 3.2 2.2

average of the three

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EU countries with

the lowest inflation

Cannot be higher PUBLIC than 3% of GDP 3.0 2.2 BUDGET

DEFICIT

Cannot be higher STATE DEBT than 60% of GDP 60 24.4

Cannot be higher LONG-TERM than 2% above the 6.5 4.5 INTEREST rates of three RATES countries with the

lowest inflation

Minimum of 2 Membership in MEMBERSHIP years without major ERM II from 2005 IN ERM II exchange

fluctuations

Source: National Bank of Slovakia, 2008

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1.9. Slovakia and the EMU

Slovakia has been trying to integrate into the EU since the beginning of the republic, but it has submitted an official application for admission to the EU on the 27th of June 1995 in

Cannes. Slovakia joined the European Union on the 1st of May 2004, along with nine other

European countries. After joining the EU, a decision was made as whether the Slovak economy would meet the nominal convergence criteria that were conditional for the entry into the EMU. (National Bank of Slovakia, 2008, p.7)

The 1st of January 2009 was chosen as a date for Slovakia to join the Eurozone. As mentioned in the methodology, The National Bank of Slovakia made some predictions or forecast of how it may look like after the adoption of the common currency. Firstly, we will look at the expected advantages and disadvantages. There are two types of advantages in this case – direct and indirect. Direct ones should be seen instantly after adopting the euro, and their effect on GDP growth or costs saving will be one-time but the GDP level will stay changed permanently. The indirect advantages may not be seen directly after the euro adoption, and the effects may not be even. These may include increase of foreign trade, FDI increase, improved economic performance of the country and living standards.

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2. Expected benefits of Euro

In 1961, Robert Mundell pioneered the idea of the monetary union. In his work, he suggested that maintaining a separate national currency is not always the most adequate economic arrangement. Instead, he proposed the concept of an optimal currency area, which can be considered as a geographic region where the largest economic benefit would be created by a common currency. Mundell’s suggested criteria for an optimal currency area were the following: labor mobility, capital mobility, a risk-sharing system, and similar business cycles. Alesina and Barro (2000, p. 41) elaborated Mundell’s theory, and arrived to the conclusion that there are real and monetary effects arising from currency unions.

According to them, a common currency decreases trade costs. They also outlined the costs and benefits of losing monetary flexibility. A country that abandons its own currency loses its own monetary policies that can stabilize domestic shocks. However, it may attain credibility and also decrease inflation. Determining an optimal currency area depends on several variables and interactions. They also remarked that small countries tend to have the biggest incentive to abandon its currency if they had high inflation in the past and if they are close to a larger and more monetarily stable country. However, some critics say that the

European Economic and Monetary Union is not a successful optimal currency area because of the European sovereign debt crisis.

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2.1. Direct benefits

Transaction costs eliminated

The common currency eliminates transaction costs associated with conversion rates within the EMU. However, to some extent, it depends on the size and openness of the economies.

For larger and more closed economies, the benefits from transactional costs saving will not be as prominent as with smaller open economies, where more intense exchange services take place. Slovakia is considered to have open economy. Exports and imports represented around 160% of GDP in 2005. (Šuster et al, 2006, p.5) Since Slovakia joined the European

Union, the trade between Slovakia and other EU member states intensified. There was also anticipated growth of openness associated with production within the car industry.

Households and businesses had to accept transaction costs when exchanging domestic currency into foreign currency. Transaction costs occurred in cash exchange when travelling abroad, in bank card payments, or traveler checks. These transactions were just a small fraction of foreign exchanges in economy. The bigger part of the transactions were those that took place on inter-bank market and were interconnected with international trade and speculations on the exchange market. The estimated transaction costs were 0.3% of the

GDP that could be saved after the euro adoption. However, some businesses also had administrative costs because human and capital resources were needed for the foreign exchange operations, additional financial reporting, and delayed payments. The estimated amount of these costs that could be saved after euro adoption was 0.6% of the GDP, thus the estimated total costs were about 0.36% of the GDP.

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Exchange risk

The exchange risk between the Slovak koruna and the euro was supposed to be eliminated after the euro is adopted. Transactions with foreign countries are susceptible to exchange risk. The estimation of the volume of transactions that are subject to exchange risk by the

National Bank of Slovakia was 10.11% of the GDP in 2004. This number represented all transactions in foreign currencies, not just the ones in euros. The estimated volume of transactions directly susceptible to exchange risk is about 8.3% of the GDP. (Šuster et al,

2006, p.10)

Price transparency

After the adoption of the new currency, there was expected a greater transparency and comparability of the prices of goods in different countries in the monetary union. The same currency would allow for a better comparison in the corporate sector, and it would increase competition while preventing increases in prices. This should have an impact on certain price reductions. However, this reduction would not be very noticeable, and it would probably be overshadowed by a completely opposite phenomenon. It could probably happen because of the inflationary pressure that would affect Slovakia after the adoption of the euro would result in significant economic growth, and that growth is connected to balancing the level of the economy. Catching up with the western economies could

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manifest itself in a possible rise in the price level, as it will no longer be possible to correct these changes by changing the exchange rate. (Šuster et al., 2006, p.11)

Capital costs and interest rates

With the adoption of the euro, the effectiveness and competition on financial markets were expected to escalate. This should remove additional charges due to country risk. It would help the real interest rates. This would manifest in expansionary policies, and it should bring slightly lower capital costs, thus supporting a variety of investment activities. If we take a look at the previous experiences of some countries of the Eurozone, the level of investment was approximately 2.5% higher than in the rest of Europe. The subjects that benefited the most from the euro adoption were small and medium-sized businesses, as observed by the findings from Greece, Slovenia, and Cyprus. Reducing the rate of interest should result in an overall larger inflow of investment and an increase in foreign trade, leading to GDP growth in the long run.

2.2. Indirect Benefits

Foreign trade

Direct benefits that have been mentioned will create various possibilities for other long term benefits of the new currency. These should not be visible immediately, but rather in

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the long run. The National Bank expected increased foreign direct investments (FDI) and increased foreign trade. This should have resulted in economic growth and improved living standard.

Andrew Rose talks about the effects of being a part of a monetary union on foreign trade in his study from 2000. He used the gravity model of bilateral trade. He primarily investigated smaller countries that decided to adopt dollar as their currency. He came to the conclusion that becoming a part of a monetary union does increase foreign trade, but he did not know the size of the effect. Rose and Stanley (as cited in Šuster et al, 2006, p.16) used a meta- analysis in 2005, consisting of studies on this issue using several methods and sources.

They came to the conclusion that the estimated increase of foreign trade would range from

30 to 90%. Micco et al (as cited in Šuster et al, 2006, p.17) was also analyzing the effects of the same currency on foreign trade. They used a sample size of 22 countries, and concluded that according to their estimations, the foreign trade would increase in range from 5 and 20%. Another study by Barr et al (as cited in Šuster et al, 2006, p. 16) estimates an increase in foreign trade by about 29%. Hence, we can see that results from each of the studies differ. As previously mentioned, Slovakia is an example of a small and open economy that is well integrated into global business and financial flows. If we were to estimate the effects of the common currency on foreign trade, we have to consider the fact that more than 85% of Slovak export proceeds to European Union. Slovakia expects the foreign trade with the Eurozone to increase by about 60%, which would mean overall increase in foreign trade about 50%. Even if the increase was not so significant, eventually,

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any increase will definitely have a positive effect on economy. However, this effect will not be immediate. (Šuster et al., 2006, p.18)

Slovakia’s adoption of the euro should increase the economic stability for foreign investors, who will save on transaction costs and exchange rate risks. An increase in foreign investments and international trade should lead to a growth in GDP. An increase of foreign trade by about 1% will result in an increase in GDP by about one third of a percent.

Slovakia estimates a 7 to 20% increase in GDP as a result of adopting the euro. An annual increase is estimated to range between 0.7% and 0.3%. It is less than a percent because the increase will be gradual over the next twenty years.

Foreign direct investments (FDI)

Foreign direct investments can also contribute to economic growth, especially with the help of capital inflow and an overall increase in productivity. The most important foreign direct investments are those that bring increased productivity with the help of modern technologies, production processes, or new managerial skills. Haskel et al (2002) claims that if FDI increases by ten percent, that leads to half a percent increase of total productivity of other local firms. There is also a note that the effect on Slovakia should be even more prominent since technologies of foreign and local producers usually differ.

There is also expected growth in labor productivity because foreign firms will try to adopt the same technologies as in their parent companies. We should also not forget the fact that foreign investors seek certain conditions in that particular country. The investor is usually

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looking for economic advantages, and qualified workers. Foreign direct investments can also increase employment.

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3. Disadvantages and Costs

3.1. Monetary policy

If originally independent central bank integrates into the euro system, it loses its power to a certain extent, especially in the area of monetary policies. This is considered to be a disadvantage of joining the euro zone. Banks in these countries cannot use some monetary tools; such as amount of money supply, interest rates, and exchange rates. Common monetary policy also means that the European Central Bank has certain goals and targets for the entire Eurozone. This may be a disadvantage from the view of some states. One issue is, for example, inflation rates. Member states with higher inflation rates reach lower or negative real interest rates if the inflation rate exceeds the interest rate, whereas states with lower inflation rates reach higher real interest rates. Moreover, the central bank can use monetary policy as a reaction to curb shocks. Due to the fact that Slovakia is in OECD and European Union, the country’s international capital flows are liberalized, and their size is exceeding the possibility of monetary policy to influence it. The central bank was not able to stabilize price levels, the exchange rate of Koruna and the overall real economy.

The koruna’s exchange rate, usually affected by foreign events, was the source of shocks rather than some tool for stabilization. There is a prediction for the symmetry of shocks in the euro zone, together with an increase in business cooperation. Slovakia losing its independent monetary policy will result in loss of about 0.04% GDP.

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3.2. Rounding the prices

One of the other possible disadvantages from adopting the euro is the fear of citizens that prices would be rounded up. From previous experiences from the countries that adopted the euro, there was a price increase because of the wrong rounding, and Eurostat estimated a price increase of 0.02%. However, it is questionable whether it was intentional or not. This aspect should be eliminated in Slovakia because of the retail competition and dual prices at the beginning. That is why the estimation is that overall increase of prices will be minimal.

3.3. Exchange rates

Another policy that the state has to let go of after joining the Economic and Monetary

Union is exchange rate policy. The loss of this policy is reflected in the fact that the economy can no longer rely on the exchange rate as a means of adjusting the economy when it comes to external imbalance caused by asymmetric shocks. This imbalance then has to be dealt with by changing the wages, mobility of workers or by fiscal transfers.

Mundell was studying this in his theory of Optimum currency areas. (Šuster et al., 2006)

The question remains, if the Eurozone and European Union are the optimal currency area, and if there is some sort of harmony of business cycles among the countries, or if there is strong convergence of economies.

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3.4. Inflation

The living standard is expected to grow and the prices of real convergence will move closer to the EU average. However, this would be rather gradual change. The prices cannot go up to the EU average automatically after the Euro adoption because the demand would not accept it. Price convergence is more likely to happen after some developments - productivity needs to be increased along with increase of purchasing power and wages. In

2004, Slovakia’s price level amounted to 54% of the EU average.

Inflation is one of the closely monitored phenomena when entering the monetary union.

Inflation represents a rise in the price level, which is reflected in a decrease in the purchasing power of money. One of the biggest questions for Slovak citizens is if the price levels will rise after the adoption of a new currency. There is diversity and a competitive business environment in Slovakia, like in a majority of European countries, which should protect the Slovak economy from uneven and disproportionate rise of price level by sellers and manufacturers. One problem that could arise from adopting the new currency is the poor knowledge of a new price environment. Some businesses could use that by trying to raise prices or to round up as I mentioned earlier. The change of the Koruna to Euro itself should only be a mathematical problem. The prices should be rounded according to mathematical rules, which should not increase prices in the end. However, if all the businesses decided to round the prices up, the estimated price rise of basket of goods would be 0.73%. The predictions for the inflation for the next years after the euro adoption were

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that it would reach 1.5% higher than average inflation rate in the Eurozone. (Šuster et al,

2006).

Furthermore, it is important to bear in mind, that consumers might perceive the inflation rate inaccurately. They are usually used to comparing prices of the same products they buy regularly over a longer period of time. From the experiences of other countries, goods that were purchased frequently were crucial in the perception of inflation rate. “When the prices in cafés and restaurants increased in January 2002, i.e. immediately after euro cash changeover, more than is usual the consumers registered it. Hardly anybody noticed the fact that prices of other good remained unchanged or even decreased. For instance, only a low percentage decrease of the price of clothes, shoes or electronics and household appliances would be contrasted with each increase of the price of a cup of coffee, which could be attributed to euro changeover, so that such change could be equalized in aggregate price index” (Šuster et al., 2006, p.54). The behavior of consumers happens to have a strong asymmetry when they assess profits and losses regarding price changes. Usually, the reasonable and comprehensible statistics are not available to ordinary consumers, so they judge the situation based on their experiences from the past. They only look at the small sample of prices that are connected to their consumer basket. As a result, they usually attribute price increase of some goods to wrong reasons, because some price changes were not caused by euro adoption.

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4. Slovakia after the Euro adoption

Slovakia adopted Euro on the 1st of January 2009. The analysis of the first effects on

Slovak economy needed some time, because more data on this topic were necessary.

Moreover, it was crucial to distinguish if the effects were due to a new common currency, a world financial crisis, or economic recession; which the Slovak economy would have had to face either way. When introducing the new currency, the aim was to make the changeover smooth and without the price level increasing inadequately. To ensure this, it was emulated in the General Code, and also in the Ethical Code for the euro introduction.

The prices were displayed dually (in Euros as well as in Slovak korunas) five months before the euro adoption, and one year after. In addition to that, from 2008, selected goods were monitored by the Statistical Office of the Slovak Republic. So, what are the effects

Slovakia observed after adopting the Euro?

4.1. The Effect on Inflation

Statistics showed that the changeover effect was existent in every country that introduced the euro. The changeover effect means that prices converted into the euro might be associated with the price increase of some goods and services. There are analyses that were made about price development of the countries that joined Eurozone in 2002, and the

Eurostat made estimations of 0.09 to 0.28 percentage point to overall inflation. (Doliak &

Karmazin, 2009, p. 4) At first glance, there was no record of inflation in the first month of the new currency, which would significantly differ from the long-term trends. Inflation, measured by the Harmonized Index of Consumer Prices (HICP), amounted to 0.3% in

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January 2009. Even though HICP increase in January 2009 was historically the lowest

January increase in Slovakia in terms of consumers prices, prices of some goods or group of goods reportedly increased. The aforementioned changeover effect could have appeared in these goods. According to National Bank’s report by Doliak and Karmazin (2009, p. 4), the conclusion is that, “the euro introduction effect to the HICP overall inflation reached the level of under 0.2 of percentage point (or 0.15 of a percentage point as the middle of the interval 0.12 to 0.19 of a percentage point), which is also comparable to the estimates of the influence of the euro introduction effect in other countries.” The opposite phenomenon might have also occured – a decrease in prices, caused by rounding effect, however, that was present primarily in food sector, probably as a consequence of retail chains’ campaigns. The report by the National Bank of Slovakia explains that price makers might have been influenced by the general Euro Act, controlling authorities, and sanctions for the price increases that were not authorized. The National Bank used five methods to calculate the effects of the euro changeover and concluded that if there was a price increase then it was not due to introducing the new currency.

It has been 10 years since Slovakia started using the euro, and the press release by the

National Bank of Slovakia (2018) also confirmed that the adoption of the new currency did not have a major impact on prices in the following years, and as the press release remarked,

“the average annual inflation rate in Slovakia has been only 1.3%”. Just to compare, the average annual inflation rate during ten years before the euro introduction was about 6.1%.

Below, I provided graph comparing inflation rate between Slovakia and Czech Republic within 10 years range.

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Figure 1 Inflation rate - Slovakia and Czech Republic

4.2. Banking Sector and Interest Rates

After the euro adoption, Slovakia entered the euro area with a base interest rate of 2.5%.

During 2009, the base rate set by the European Central Bank (ECB) fell from 2.5% to a historical minimum of 1% due to financial crisis. This significant drop was not caused by the introduction of euro, but rather the ECB’s anti-inflationary measures. These measures cut interest rates for both loans, as well as for deposits. Interest rates for consumer credit loans were in decline for the first half of the year following the euro adoption. According to the

National Bank of Slovakia, the reason for their increase in the second half of the year was due to an increased number of loans that were not repaid because of the financial crisis.

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The introduction of the euro affected the profitability of the banks. Banks lost a great portion of their income from their foreign exchange operations. On the other hand, according to the analysis from the journal Biatec (2008) by the National Bank of

Slovakia, due to lower ECB interest rates and GDP growth, the volume of loans might increase, thus increasing the interest income of banks. In this analysis, the National Bank of Slovakia found that the profitability of the banks in Belgium increased after the euro adoption, there were no major changes in Netherlands, and the profits of banks declined in Austria, Germany, and Portugal. National Bank of Slovakia and Slovak Banking

Association (Slovak Banking Association, 2010) claimed that the net profit of the baking sector was 509 mil. euros in 2008. It consisted of interests (66.9%), fees (19.8%), and the rest was miscellaneous, for example trading (13.3%). However, the net profit of the banking sector dropped by 45.2% to 279 mil. euros in 2009. The reason for the decline in profit was mainly due to the impact of the financial crisis on the Slovak economy and the loss of income associated with the introduction of the euro. The biggest contributor to the decline in profit was stagnating income from interest, a decline in income from foreign exchange operations and adjustments for the failed loans. The biggest part of the banks’ income, interest income, increased by only 1% in 2009 when compared to 2008.

Stagnation of interest income was mainly due to an increase in outstanding loans. Neither households nor companies were unable to repay due to rising unemployment and the effects of the financial crisis. Income from foreign exchange operations fell by 77% in

2009, by 240 mil. euros in volume. (Slovak Banking Association, 2010) Nevertheless, according to the central bank, the Slovak banking sector was claimed to be stable and ready to resist possible worsening of the macroeconomic environment.

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4.3. Competitiveness

It is not that easy to define competitiveness. According to Lalinsky (2010, p.11), it is connected to leadership, growth, development, success, prosperity or productivity. It is based on interconnection between various subjects. Surveys showed that businesses had generally positive expectations before the euro introduction. Bigger companies understood that the strengthening of the Koruna had a negative impact, and that the euro as a new currency was supposed to become a positive factor in their competitiveness. A survey by the National Bank of Slovakia, done before the euro adoption resulted in 70% of large companies expecting to improve their competitiveness. (Lalinsky, 2010, p. 6) After the euro introduction, there was a significant drop in export and industrial production. Authors of the study pointed out that major negative changes in business results could be observed in a majority of EU countries, whether they were euro area members or countries with their own currency. The main factor behind this negative development was the global decline in demand. Regarding the impact of the introduction of the euro, and not being able to weaken the exchange rate, rather in the productive sectors, a decline in price and cost competitiveness was observed in some selected segments of the service sector, but that was only a temporary phenomenon. The tradable sector, represented mainly by industrial production, seemed to be sufficiently competitive. This was demonstrated in the process of a gradual global recovery, with long-term factors behind the competitiveness of Slovakia, including research, development, education, and innovation. In short, it would be too simplistic to think that the concept of national economy competitiveness can only be based predominantly on the use of a weakened currency exchange rate in the long-term.

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4.4. Foreign Trade

Slovakia is considered a small and open economy, and thus, foreign trade is an important aspect for the country. Slovak industry is mostly oriented on export, it is a leader in the share of production that exports to another member states of EU, which is about 85% from the overall export. The average in the EU is about 64%. Slovakia is also high on the list of intra-EU imports, in the third place with 80% of country’s imports from the EU in 2016.

The biggest business partner is Germany, the country to which Slovakia exports and import from the most, and Czech Republic is the second one. (Furik, 2017)

Figure 2 Share of intra-EU exports, 2016

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Figure 3 Share of intra-EU imports

Slovak companies’ data on foreign trade allow to answer more detailed questions about the impact of euro introduction. Estimates based on a sample of industrial enterprises with 20 or more employees indicated that the introduction of the euro in Slovakia has had a positive impact on corporate exports of goods to the euro area. According to Lalinsky and Meriküll

(2019, p. 38), adopting the euro increased Slovak export to the euro area by 14%.

Businesses that benefited from the changeover to the euro were mostly enterprises from traditional supply sectors. More sophisticated industries producing new technology and innovation sectors have shown smaller, or statistically insignificant effect of the euro on their exports. At the same time, the micro-data results showed that in addition to the average value of exports of existing enterprises, the number of companies exporting to the euro area has also increase, especially in the group of small businesses. Other features of the company, such as age, foreign ownership, debt burden, and import intensity did not

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affect the benefits of euro adoption. (Lalinsky & Meriküll, 2019, p. 38) The biggest portion of benefits to foreign trade in Slovakia was associated with a decline in transaction costs.

For the comparison, Estonia had a fixed exchange rate for a long time prior to the introduction of the euro, so Estonian companies had already faced significantly lower exchange rate than Slovak businesses before adopting the euro.

Figure 4 Slovakia exports

In the graph above, we can see that there was a significant drop in export in 2009, during the transition period. Lalinsky (2010, p. 38) claims that export from V4 countries (Czech

Republic, Poland, Hungary, Slovakia), and other EU countries declined at comparable rate as well.

4.5. Foreign Direct Investment (FDI)

Foreign direct investment (FDI) plays and important role in development and overall performance of the Slovak economy. Through its direct and indirect influences, it affects its

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performance and structure, the labor market, regional, technological and innovative development. Due to its small domestic market, most of the foreign investors are export- oriented. However, due to FDI inflow, several industries in the country are more dominant, the automotive sector in particular. On the one hand, the economy can gain the benefits of specialization but on the other hand, it increases its vulnerability in case of cyclical fluctuations. Foreign investors decide on the location of their investments on a basis of attractiveness factors where Slovakia has many reserves, whether it is business environment, education system, research and development system, infrastructure or other factors. Additionally, potential support from the state also influences decision-making.

In 2015, global FDI flows increased by 38%, reaching the highest level since the global economic and financial crisis in 2008-2009. While the global FDI flows grew in 2015, the situation in Slovakia was different. The adoption of the euro was expected to have a positive impact on the further development of its macroeconomic indicators, including an increase of movement of capital, and hence higher foreign direct investment. FDI inflow to

Slovakia reached value 6.16 billion EUR, in 2006 the inflow dropped to 3.74 billion EUR, in year 2007 to 2.618 billion EUR and in 2008 increased to 3.2 billion EUR. In the period between 2009 and 2015, FDI inflows did not reach the numbers from the period before the euro adoption. However, it should be noted that the development of the economy has been affected not only by the adoption of the new currency but also by the global financial crisis, and that foreign direct investment inflows are affected by other factors, not just by currency. In 2009, the FDI inflow dropped to a value of -4.38 mil. EUR. It increased again in 2010 and 2011, but started dropping again from 2012 until 2015. (Bačová, 2016, p. 3)

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The paper also discussed the Pearson’s correlation coefficient, because various studies showed that there should be positive effect of FDI on economic growth expressed by GDP growth, labor productivity, employment increase, and wage increase. Based on Pearson’s correlation coefficient, Bačová (2016, p. 6) argued that the development of FDI inflow in the years 2009 – 2015 did not show such a positive relationship and effect as some other academic literature might indicate.

Figure 5 FDI in Slovakia

4.6. GDP growth

As it was mentioned couple of times above, the global financial crisis was culminating during the transition period from koruna to euro in Slovakia. Slovakia was facing a major drop in foreign trade and GDP followed the similar trend in 2009. However, after initial

GDP decline that was more significant than in EU countries outside of euro area, the

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overall growth of productivity and performance during years 2009 – 2013 was higher than it would have been without euro. It is difficult to show how differently Slovak economy would have evolved if the country did not adopt the euro. It is not possible to assess the effect of the new currency by simply comparing macroeconomic indicators from the period before and after. Instead, the effect of the euro can be measured by comparison of domestic development with the development of countries similar to Slovakia before the euro adoption, but outside of the Eurozone. The method for this analysis is called synthetic control method. As a result of using this method, Žúdel & Melioris (2016, p. 16) found that

“by 2011 euro adoption increased the real GDP per capita in Slovakia by approximately

10%. Two thirds of the positive gain is observed already by 2008, emphasizing a strong anticipation effect.” Further, they found that “had Slovakia kept the floating currency regime during the recession in 2009, the economy would have been temporarily better off by roughly 2%.”

Figure 6 Slovakia and EU GDP growth rate

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Lalinský & Šuster (2018, p. 2-3) from the National Bank of Slovakia also used the synthetic control method to make some estimations. According to them, the real GDP per capita was higher by 0.17 percentage point annually, than it would have been without euro.

In the case of labor productivity, the difference is even higher, in the first five years after using the new currency accounted for almost 1% per year. Higher economic growth was associated with benefits of the new currency in foreign trade. The first estimations indicated that the amount of exports and imports was higher by almost one percent than in the scenario without the euro.

Some of the benefits could have been present even earlier than before 2009. It might have been the result of a discipline in fiscal policy and additional structural reforms that were beneficial for the economy on their own, but it would have been more difficult to enforce them if it was not for the euro. Also, some foreign investments were made before the euro introduction, in the anticipation of the investors that there will be a new currency. However, these effects cannot be quantified.

Furthermore, according to Eurostat, Slovak GDP per capita was stagnating at 77% of the

EU average for the last four years. Even though the Slovak economy is growing by an average of 1.5 percentage point faster than one of the EU. The reason for the difference is that in the first case, the price level is determined by purchasing power parity, while in the second case by a GDP deflator. Result of these methodological differences is the short-term deviation between the particular indicators of price levels and the indicators of real economic performance. Slovakia continues to converge towards the European economy, although at a slower pace than before the crisis. (Habrman, 2018, p. 3)

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4.7. Tourism

Adoption of the euro has been beneficial also for the tourism sector. For the country, it means strengthening Slovakia’s natural potential in creating attractive tourism opportunities and overall tourism sector recovery. The attractiveness of the country increased along with the introduction of the euro – there is better price transparency and the tourists do not have to exchange the money. Slovak Tourism Agency participated in exhibitions and workshops to communicate the euro changeover abroad. The new currency in Slovakia was particularly interesting to tourists from the Eurozone, because it had simplified their travelling. Slovak Tourism Agency also observed increased demand for travelling to

Slovakia. Country became more attractive to German, Austrian, and British tourists.

However, many of the visitors were interested if the prices in tourism were going to rise after the euro adoption. The negative effect was that the exchange rate became disadvantageous for the Czech, Polish, and Hungarian tourists for a while. (TASR, 2010)

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Figure 7 Number of tourist arrivals in Slovakia (in millions)

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5. Conclusion

Slovakia is evaluating their ten years after euro adoption. What did the euro give them and what did it take from them? The opinions about the common currency are generally positive in the country. Slovaks view the common currency in terms of the number of benefits it has brought. However, there are also negatives.

Survey conducted by Eurobarometer revealed that 68% Slovaks think of the euro as a good thing. At the same time, 79% of Slovaks surveyed think that the euro is good for the

European Union as a whole. The euro is even more popular among the businesses.

According to the ČSOB survey, 83% of entrepreneurs are satisfied with the common currency. If they were to decide to join the euro area again, they would do so. (Apolen,

2019)

One of the biggest advantages of the euro is exchange rate stability, lower inflation, and transaction cost savings. Slovakia adopted the euro at the time of the financial crisis. In

2009, neighboring local currencies depreciated by up to 20%. However, the euro remained stable. If Slovakia did not introduce the euro at that time, the Slovak koruna would also fall.

Some economist say that thanks to the euro, the financial crisis has not shaken Slovakia as much as other members of the Visegrad Four. Another advantage of the euro is price stability. The decline in exchange rates of the neighboring countries meant that prices of imports rose and thus inflation increased. However, prices in Slovakia remained stable.

Conversely, inflation decreased after the euro was adopted. Over a decade, average annual price increase was only 1.3%. A big portion of Slovak exports go to the euro area markets.

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By handling transactions in one currency, companies are not subject to exchange rate risk.

The NBS estimates that euro has helped to increase Slovak exports by up to 10%. Imports also improved. It made the country more attractive in the eyes of foreign investors.

Although my findings did not really prove the positive effect of the euro on FDI, I still think that the common currency is a competitive advantage regarding foreign investments.

Ordinary people from Slovakia also benefited from the euro changeover. When travelling abroad, they do not have to change korunas to euros anymore, and pay banks a fee for exchange. According to the NBS calculation, by reducing transaction costs in tourism and foreign trade, residents and companies saved about 0.3% of GDP per year, which is more than 200 million euros annually. Additionally, there is also ability to easily compare prices of products and services abroad and at home, which increased competition between entrepreneurs. It is also easier to compare salaries in Slovakia and abroad.

What about the disadvantages? Critics would point out that the country lost its own monetary policy, and thus cannot influence the exchange rate of its currency to support its domestic economy. Another loss is the inability to set interest rates, now it is in hands of the European Central Bank. On the other hand, the low interest rates of the ECB brought cheaper loans to Slovakia. The average interest rate for housing loans was 1.54% in

November, while in Czech Republic it was 2.78% at that time. (Apolen, 2019) Another negative aspect is the necessity to participate in rescue mechanisms in case of the financial problems of other countries of the Eurozone. This was fully apparent in the case of Greece, when Slovakia was involved in rescue mechanisms and financial support for the country.

However, without joining the euro area, Slovakia would have not been involved in

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decision-making, the country would have had position similar to Poland and Hungary; they depend on the euro area but they do not decide about some issues in it. This way, Slovakia can participate in decision-making not only in the monetary policy of the euro area but also in its future reforms. Likewise, Slovakia’s political influence increased by joining the euro area. To sum it up, the overall benefits of the euro were due to the effects of the global financial crisis and the euro area debt lower than predicted, but we can still conclude that the decision to adopt the euro had positive effect on Slovak economy, businesses, and standard of living.

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