A Report on the Costs and Benefits of Poland’s Adoption of the Euro Warsaw, March 2004 Edited by: Jakub Borowski Authors: Jakub Borowski Micha∏ Brzoza-Brzezina Anna Czoga∏a Tatiana Fic Adam Kot Tomasz J´drzejowicz Wojciech Mroczek Zbigniew Polaƒski Marek Rozkrut Micha∏ Rubaszek Andrzej S∏awiƒski Robert Woreta Zbigniew ˚ó∏kiewski The authors thank Andrzej Bratkowski, Adam B. Czy˝ewski, Ma∏gorzata Golik, Witold Grostal, Andrzej Rzoƒca, El˝bieta Skrzeszewska-Paczek, Iwona Stefaniak, Piotr Szpunar and Lucyna Sztaba for their numerous and insightful remarks on earlier drafts of this Report. The authors thank professor Michael J. Artis for his excellent assistance with the English language version of the Report. The Report was submitted for publishing in March 2004. Design: Oliwka s.c. Printed by: Drukarnia NBP Published by: National Bank of Poland 00-919 Warszawa, ul. Âwi´tokrzyska 11/21, Poland Phone (+48 22) 653 23 35 Fax (+48 22) 653 13 21 © Copyright Narodowy Bank Polski, 2004 2 National Bank of Poland Table of contents Table of contents Executive Summary . .5 Introduction . .9 1. Conditions for accession to the euro area . .13 2. Risks and costs of introducing the euro . .15 2.1. Loss of monetary policy independence . .15 2.1.1. The effectiveness of the exchange rate adjustment mechanism . .18 2.1.2. Labour market adjustment mechanism . .25 2.1.3. The fiscal adjustment mechanism . .27 2.1.4. Convergence of business cycles . .30 2.1.5. Endogeneity of Optimum Currency Area criteria . .36 2.2. Short-term cost of meeting the inflation convergence criterion . .37 2.3. Summary . .40 3. Benefits of euro area membership . .42 3.1. Direct effects . .44 3.1.1. Elimination of transaction costs . .44 3.1.2. Elimination of exchange rate risk and decline in interest rates . .45 3.2. Long-term benefits . .46 3.2.1. Impact of the euro on investment . .46 3.2.2. Trade expansion . .49 3.2.3. Decline in macro-economic risk of the country . .52 3.2.4. Integration of the financial market . .53 3.2.5. Increased competition . .54 3.3. Estimate of long-term benefits stemming from the introduction of the euro . .56 3.3.1. Method . .56 3.3.2. Simulations . .57 3.3.3. Results . .58 3.3.4. Conclusions . .70 3.4. Summary . .71 4. Optimal macro-economic policy on the road to the euro area . .74 4.1. Challenges resulting from convergence criteria . .74 4.2. Simulation of macroeconomic policy scenarios . .80 4.2.1. The fiscal scenario . .81 4.2.2. The monetary scenario . .84 4.2.3. Conclusions . .85 4.3. Summary . .85 Summary and conclusions . .87 References . .91 A REPORT ON THE COSTS AND BENEFITS OF POLAND’S ADOPTION OF THE EURO 3 Table of contents Appendix 1. The Maastricht Criteria . .100 A1.1. Convergence criteria – remarks on methodology . .101 A1.1.1. Inflation criterion . .101 A1.1.2. Fiscal criteria . .101 A1.1.3. Exchange rate criterion . .103 A1.1.4. Interest rate criterion . .104 A1.2. Economic interpretation of the Maastricht criteria . .104 A1.2.1. Inflation criterion . .105 A1.2.2. Interest rate criterion . .105 A1.2.3. Exchange rate criterion . .106 A1.2.4. Fiscal criteria . .106 A1.2.5. Appropriateness of the convergence criteria for the accession countries . .107 Appendix 2. Assessment of Poland’s progress towards fulfilment of the nominal convergence criteria . .108 A2.1. Inflation criterion . .108 A2.2. Fiscal criteria . .109 A2.3. Interest rate criterion . .109 A2.4. Exchange rate criterion . .110 Appendix 3. Assessment of the short-term costs of the fulfilment of the inflation convergence criterion . .114 Appendix 4. Description of the model used in the simulation of benefits from accession to the euro zone . .116 A4.1. Description of the model . .116 A4.2. Equations used in the model . .117 A4.3. Variables . .120 A4.4. Parameters . .121 Appendix 5. Description of the ECMOD model . .123 4 National Bank of Poland Executive Summary Executive Summary 1. Accession to the European Union (EU) will open the way for Poland to start preparations for participation in the euro area, this being the next stage of economic integration. Upon joining the EU Poland will have committed to subsequently adopt the euro and, as a consequence, to accept a common monetary policy together with the other euro zone countries. However, the exact moment for the adoption of the euro has not yet been set. This Report has been prepared by economists of the National Bank of Poland with the aim of assessing the benefits and costs of introducing the common currency. The assessment also reviews the choice of an optimal strategy of euro adoption. The Report seeks to determine the moment of euro adoption most beneficial to Poland. This moment depends on fulfilling a number of conditions of monetary union participation (the Maastricht criteria). These criteria can be fulfilled earlier or later on. The analysis indicates that the sooner these criteria are met and the euro is introduced – with the support of an appropriate economic policy – the greater the benefits for long-term economic growth will be. 2. The Maastricht criteria include fiscal criteria referring to the general government deficit and public debt as well as monetary criteria, related to price stability, the level of long-term interest rates and exchange rate stability. The Maastricht convergence criteria are not only a formal requirement for Poland’s participation in the euro zone but also a basis for a sound macroeconomic stance, creating conditions conducive to long-term economic growth. Thus, meeting the criteria both opens the way to the euro and is beneficial to growth. 3. According to the fiscal convergence criteria a country wishing to join the monetary union cannot have a planned or actual general government deficit in excess of 3% of GDP. Moreover, its public debt should not be higher than 60% of GDP. The inflation criterion is fulfilled when inflation in the applicant country does not exceed by more than 1.5 percentage points the average inflation of the three best EU performers in terms of price stability. The interest rate criterion is fulfilled when the long-term interest rate does not exceed by more than 2 percentage points the average interest rate in the three best EU performers in terms of price stability. Moreover, an accession country is obliged to participate for a minimum period of two years in the Exchange Rate Mechanism II (ERM II). Over this period the exchange rate of the domestic currency against the euro should be maintained within fluctuation bands not wider than +/-15% around a central parity. Moreover, during ERM II participation no severe tensions in the foreign exchange market, and in particular no devaluations of the central parity, should occur. 4. In November 2003 Poland fulfilled the inflation, long-term interest rate and public debt criteria. The fulfilment of the general government deficit criterion requires the implementation of thorough reforms limiting public expenditures and increasing the efficiency of public finance management. The exchange rate criterion can only be fulfilled after Poland has entered ERM II. Meeting this criterion will depend on the conduct of a credible macroeconomic policy. 5. The decision on the acceptance of Poland as a member of the common currency area will be taken by the ECOFIN Council and will be.