CONTENTS EDITORIAL Mitja Gaspari: Jumping the Last Hurdle Towards the Final Stage of Convergence 1 MACROECONOMIC FRAMEWORK OF SMALL OPEN ECONOMY Willem H. Buiter and Anne C. Sibert: When Should the New Central European Members Join the Eurozone? 5 George Kopits: Policy Scenarios for Adopting the Euro 12 Dejan Krušec: Common Monetary Policy and Small Open Economies 17 Lars Calmfors: The Revised Stability and Growth Pact – A Critical Assessment 22 Fabio Mucci and Debora Revoltella: Banking Systems in the New EU Members and Acceding Countries 27 Mathilde Maurel: The Political Business Cycles in the EU Enlarged 38 FINANCIAL MARKETS AND FINANCIAL INSTITUTIONS IN EMU Kevin R. James: Small Countries, Big Markets: Achieving Financial Stability in Small Sophisticated Economies 43 Garry J. Schinasi and Pedro Gustavo Teixeira: Financial Crisis Management in the European Single Financial Market 47 Franjo Štiblar: Consolidations and Diversifications in Financial Sector 56 Fabrizio Coricelli: Financial Deepening and Financial Integration of New EU Countries 70 THE CASE OF SLOVENIA Ivan Ribnikar: Slovenian »Transition« and Monetary Policy 75 Igor Masten: Expected Stabilization Effects of Euro Adoption on Slovenian Economy 83 Velimir Bole: Fiscal Policy in Slovenia after Entering Euro – New Goals and Soundness? 87 Božo Jašovič and Borut Repanšek: Application of the Balance Sheet Approach to Slovenia 95 STATISTICAL APPENDIX Matjaž Noč: Selected Macroeconomic and Financial Indicators 105 EDITORIAL Jumping the Last Hurdle Towards the Final Stage of Convergence Mitja Gaspari * n 1 January 2007, Slovenia will join the 12 current members of the euro area and adopt the single European currency. This is a historic moment for Slovenia and for euro area enlargement. It shows that the Treaty criteria are objective and allow new entrants to adopt the euro in due course once they fulfil the requirements. Slovenia’s fulfilment of the Maastricht criteria and its adoption O of the euro are part of a well-prepared project that saw all of the rele- vant policymakers fulfilling their task to ensure a positive outcome. The government kept fiscal deficit and public debt within the Maastricht levels with sufficient safe margin and contained the impact of administered prices on inflation by encouraging monopolistic struc- tures to care about costs while preparing further steps to increase competition in such sector. Furthermore, it led a careful public wage policy that, among others, spurred employers and employees to settle for wage increases that lag productivity growth and hence reduce cost-push as well as demand pressures on inflation. By lowering infla- tion in a sustainable manner to enable smooth entering in ERM II, the Bank of Slovenia succeeded in keeping key interest rates high, while reinforcing anti-inflationary policy by stabilising tolar exchange rate to euro after ERM II entry. Resulting convergence of inflation to the Maastricht levels allowed also convergence of nominal interest rates towards the level of euro area interest rates without affecting the achieved macroeconomic balance. Minor current account deficit and a growth rate very much in line with Slovenia’s economic fundamentals are indicators of the fact that fulfilling the inflation and exchange * Mitja Gaspari, rate criteria for euro adoption has not triggered other disequilibria, Governor of the Bank of Slovenia supporting the long-term sustainability of this achievement. BV 11/2006 EDITORIAL Once Slovenia formally adopts the euro it will be able to fully reap the benefits of membership that it partially enjoys already. On the macroeconomic level this in particular involves the elimination of currency risk, generating potentially significant effects on invest- ment. By microeconomic standards, the benefits of euro adoption are arguably even more pronounced, albeit more difficult to measure and to be observed in a longer-term horizon. A larger market enables to benefit from economies of scale and leads to further trade intensifi- cation, especially where small companies are concerned, since in general they cannot afford to hedge against currency risks. Moreover, price transparency brought about by the euro is likely to give another boost to competition and decrease the clout of certain rigid market structures. In the financial sphere, the switch to the euro helps to make capital markets more liquid and transparent by increasing the circle of potential market agents to all those who are reluctant to invest in a foreign currency. Finally, adopting the euro as the first of the new EU member states may highlight Slovenia’s sound economic performance in the eyes of foreign businesspersons and certainly enhances the perception of Slovenia also by a wider foreign public. Yet, the adoption of the euro also poses some short– to medium– term risks that must be addressed with caution to avoid an early disappointment. The most important is to maintain the tight fiscal stance in line with the recommendations issued within the framework of the assessment of the convergence programme under the Stability and Growth Pact and to deal properly with the risks identified in the May Convergence Report on Slovenia. In the longer term, Slovenia’s benefits of euro adoption will depend on the economy’s structural adjustment to the new environment. Especially product market reforms to step up competition and bring further improvements to the functioning of the labour market are necessary elements to smooth asymmetric shocks which national monetary policy can no longer prevent. Some factors such as Slovenia’s trade openness, its geographical and cultural proximity to the euro area’s core countries, and an economic cycle that is well tuned to the euro zone, already point to Slovenia’s fundamental readiness for the currency union. I am confident that Slovenia will overcome these new challenges skilfully and be well positioned for the future. 2 BV 11/2006 MACROECONOMIC FRAMEWORK OF SMALL OPEN ECONOMY UDC 339.923:061.1 EMU When Should the New Central European Members Join the Eurozone? Willem H. Buiter and Anne C. Sibert * The eight new EU n 1 May 2004, eight Central European former members from Central and Eastern Europe (the CEE8) should all aim communist states, together with Cyprus and Malta, to join the Eurozone as soon as possible. Even joined the 15-member European Union. Estonia, the largest among them, Poland, is too small, to Lithuania and Slovenia joined the Exchange Rate open and too vulnerable to destabilising capital OMechanism (ERM) of the Economic and Monetary Union (EMU) flows to be an optimal currency area. With in June 2004 and hoped to become members of the Euro area by unrestricted labour 1 mobility with the EU15 no 1 January 2007. Latvia joined the ERM in May 2005 and targets later than 2011, the CEE meet all the conventional full membership of the EMU in 2008. Slovakia also joined ERM Optimal Currency Area criteria for membership in 2005 and hopes to join the Eurozone in 2009. The Czech in the Eurozone. In some of the larger Republic, Hungary and Poland have not yet joined the ERM. In CEE8 countries, especially Hungary, Poland, the May 2006, only Slovenia was recommended, by the ECB and the Czech Republic and Slovakia, fiscal sustain- European Commission, for Eurozone membership on 1 January ability is not yet soundly established. It is in the self-interest of countries 2007. Estonia had been bullied into dropping its request for with question marks behind their fiscal-finan- membership on 1 January 2007 and Lithuania was judged not cial sustainability to defer Eurozone membership to be ready. In this article we consider whether or not the new until that issue has been resolved. member states would benefit from joining the Eurozone and any The inflation criterion for EMU membership – is (a) potential economic grounds for excluding them. stupid because it is based on the inflation perform- SHOULD THE NEW MEMBERS JOIN THE EUROZONE? ance of the 25 EU mem- bers rather than on that of the 12 member Euro- The benefits to the new members from Central Europe zone; (b) stupid because of membership it ignores Balassa-Samuel- son equilibrium inflation differentials, and (c) in From the point of view of the economic fundamentals violation of both the spirit and the letter of the emphasized by optimal currency area theory, it is in the interest Treaty because of the definition of ‘best of all eight new Central European members (the CE8) to join the performing in terms of price stability’ for Eurozone as soon as possible. They are all too small, too open candidate EMU members that amounts to ‘the three and too vulnerable to speculative attacks against their national member states with the lowest inflation rates * Willem H. Buiter, Professor of European Political Economy, European Institute, London School of Economics and (barring anomalies)’ that Political Science, Universiteit van Amsterdam, CEPR and NBER. is different from and tougher than the Anne C. Sibert, Professor of Economics, Birkbeck College, University of London and CEPR. definition used for the 1 The European Monetary Union has 12 members. The UK, Sweden and Denmark, as well as the 10 new EU Eurozone itself. members that joined the EU on 1 May 2004, are not members of the Eurozone. BV 11/2006 5 MACROECONOMIC FRAMEWORK OF SMALL OPEN ECONOMY currencies to be optimal currency the new member states and should foreign savings to augment their areas. For the smallest ones among become significantly higher. These domestic capital stocks. It permits them, it is indeed doubtful whether a countries still trade significantly less foreign direct investment, which national currency is a viable option in than would be expected, given their brings financial resources and trans- the medium to long run. size, per capita income, distance fers skills, knowledge and technology. In terms of economic size, as from trading partners and man-made It increases the efficiency of financial measured by their percentage share barriers to trade.4 The latter impedi- intermediation and permits cross-bor- of world GDP, the new member states ment is primarily the legacy of misdi- der risk sharing.