Hitting and hoping?

European Journal of Political Economy 25 (2009) 508–524

Contents lists available at ScienceDirect

European Journal of Political Economy j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / e j p e

Hitting and hoping? Meeting the exchange rate and inflation criteria during a period of nominal convergence John Lewis ⁎ Economics and Research Division, De Nederlandsche Bank, Postbus 98, 1000AB Amsterdam, The Netherlands

a r t i c l e

i n f o

Article history: Received 16 May 2008 Received in revised form 20 March 2009 Accepted 23 March 2009 Available online 5 April 2009 JEL classification: E52 (Monetary policy) E61 (Policy designs and consistency) E31 (Price level, inflation)

a b s t r a c t This paper analyses the effect of the nominal convergence process on the ability of Central and Eastern European Countries (CEECs) to meet both the inflation and the exchange rate criteria for Eurozone entry. The size of these convergence effects on the exchange rate (for inflation targeters) and for inflation differentials (under a fixed exchange rate) is estimated for a variety of different convergence scenarios. The key result, robust across all scenarios, is that countries with fixed exchange rates will find it much harder to simultaneously meet the criteria than inflation targeters. Probit estimates on the ability of a country to get inflation below the reference value under a fixed exchange rate show a strong effect for the relative price level. © 2009 Elsevier B.V. All rights reserved.

Keywords: Central and Eastern Europe Nominal convergence Euro adoption Exchange rate regime

1. Introduction The Central and Eastern European countries (CEECs) who joined the EU in recent years are all obliged to join the euro at some point in the future. Slovakia joined on January 1, 2009, and the eight who remain outside the single currency are at varying stages on the road to the Eurozone membership. Admittance to the Eurozone is based on the fulfilment of the Maastricht Convergence Criteria. In addition to nominal interest rate convergence and sound public finances, candidate countries are also required to demonstrate both exchange rate stability and low inflation. These are defined as 2 years in ERM II within the normal fluctuation margins without devaluing and inflation of no more than 1.5% above the average of the lowest three (positive) rates in all EU member states.1 This article examines how the inflation and exchange rate criteria can be simultaneously met during a period in which the price of goods and services in CEECs is rising towards the Eurozone level. In this article the “relative price level” is defined as the ratio of the price of goods and services in the CEEC relative to the Eurozone. If purchasing power parity (PPP) holds, this ratio would be one. In the case of CEECs, this is less than one, because it typically takes fewer euros (converting at the prevailing exchange rate) to purchase a given basket of goods in the CEEC than in the Eurozone.2 Convergence in relative price levels means that euro denominated price of the basket in the CEEC will rise over time. For countries that have a fixed exchange rate, this convergence takes place through an inflation differential; for countries whose ⁎ Tel.: +31 20 524 2835; fax: +31 20 524 2506. E-mail address: [email protected]. 1 Previous convergence reports have excluded countries with negative inflation from the reference group, although this qualification was not explicitly mentioned in the treaty of Maastricht. See Lewis and Staehr (forthcoming) for a discussion of this point. 2 This should not be confused with the relative price of tradeable and non-tradeable goods, which is sometimes termed “the relative price level” in the literature. 0176-2680/$ – see front matter © 2009 Elsevier B.V. All rights reserved. doi:10.1016/j.ejpoleco.2009.03.002

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monetary authorities target inflation (and have the same inflation target as the ECB), this occurs via nominal exchange rate appreciation. In either case, this “convergence effect” on either the exchange rate or inflation may pose a threat to the simultaneous achievement of the exchange rate and inflation criteria. Eichengreen (2003) and a number of other authors3 have argued that convergence effects may pose a problem for New Member States, and this has led some to call for reforms of the existing criteria.4 What these studies typically lack is a direct evaluation of the likely size of convergence effects, a consideration of whether they are large enough to pose a serious problem with compliance and an estimate of for how long these convergence effects may pose a problem. However, the belief that convergence effects do pose a problem is not unanimous. Some academics5, policymakers and others6 have argued (usually on the basis of low empirical estimates of the Balassa–Samuelson effect) that convergence effects may not be large enough to seriously hinder compliance with the Maastricht criteria. However, these studies do not consider other frameworks for quantifying the effects of nominal convergence. Whether or not such convergence effects will pose a problem is clearly intimately bound up with the issue of how big these convergence effects are. A related question is which entry strategy best copes with the problems posed by nominal convergence. De Grauwe and Schnabl (2005) consider the whether CEECs should opt for a tight peg or a gradual appreciation of their currency once inside ERM II, but do not consider explicitly how large the convergence effects might be, or for how long they may pose a problem. On the other hand, Jonas and Mishkin (2003) examine whether the Czech Republic, Poland and Hungary should persist with inflation targeting once inside ERM II, but do not consider explicitly the effects their choice of regime may have on achieving the exchange rate criterion. Natalucci and Ravenna (2002) do consider how the choice of exchange rate regime affects the ability to meet the exchange rate and inflation criteria as well as for the variance of output and inflation. However, their work does not consider for how long convergence effects may be a problem, nor does it consider alternative convergence scenarios and it only considers a stylised “representative CEEC”, rather than analysing countries individually. In a similar vein to this article, Hughes Hallett and Lewis (2007) investigate the effects of real and nominal convergence on debt dynamics in CEECs, and the influence they have on the ability of CEECs to meet the fiscal criteria for EMU entry. However, to the author's knowledge, no attempt has been made to quantify the size and longevity of convergence effects, and their corresponding consequences for countries meeting the exchange rate and inflation criteria. Accordingly, the contributions of this article are as follows. First, it provides an estimate of the likely size of convergence effects under a range of different convergence scenarios. Second, it analyses how much of a problem these might pose for meeting the Maastricht criteria under both fixed and floating exchange rate regimes. Third, it examines the length of time for which convergence effects may pose a problem. Fourth, the paper explicitly quantifies the effect of price levels on the probability of meeting the inflation criterion. The paper is organised as follows. Section 2, looks at the domestic price level of the CEEC denominated in euros—outlining the modelling framework and generating convergence scenarios. Subsequent sections look at the effects of these convergence scenarios on domestic inflation and the nominal exchange rate: Section 3 conducts four “what if” experiments based on different convergence scenarios to examine how significant convergence effects are likely to be, and for how long they may pose an obstacle to meeting the Maastricht criteria. Section 4 presents an ordered probit analysis of the effect of the price level on ability to meet the inflation criterion. Conclusions are presented in Section 5. 2. Modelling nominal convergence in CEECs Nominal convergence in CEECs is often discussed with reference to Balassa Samuelson (BS) effect, which postulates that price level differentials are explained by relative productivity differentials between the tradeable and non-tradeable sectors. This framework offers a simple way to relate nominal and real convergence, and to replicate the stylised fact that countries with lower per capita incomes tend to have lower price levels. However, this approach is not used in this paper for a number of reasons. Firstly, no consensus has emerged in the empirical literature on the size of the BS effect in CEECs. Most studies estimates place the likely real exchange rate appreciation at somewhere between 0 and 5%, and some studies find an insignificant or even a negative effect (see Égert et al., 2003, 2006; Égert and Halpern, 2005; Égert, 2007). Moreover, the observed real exchange rate appreciation in CEECs in the past 10 years is around 6%, which is typically higher than the largest empirical estimates of the BS effect and considerably higher than the average estimate. Lastly, empirical work on the BS effect typically estimates what the BS effect “has been” over some previous sample period. To make an inference about the size of the BS effect in the future based on these results requires some form of assumption about the path and functional form of future productivity convergence. In a comprehensive article, Égert (2007) provides a number of alternative factors which may explain the observed rise in relative price levels in CEECs, including shifts in preferences to higher quality goods, changes in regulated prices and higher weights of food and energy prices. A key finding of this and other papers is that price level convergence is clearly taking place, but that it is difficult to provide a simple account of the causal processes since a variety of factors are involved, many of which have not

3 4 5 6

See also De Broeck and Sløk (2001), Halpern and Wyplosz (2001). See for example, Brooke (2005), Kenen and Meade (2003), Buiter and Grafe (2004), Buiter and Sibert (2006) Szapáry (2000), Gros (2004). See, for example, Durjaz and Burowski (2003), Klau and Mihaljek (2004), and Rawdanowicz (2005). Noyer (2001), De Roose (2006) and Bonello (2005).

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Fig. 1. Price level and γ convergence.

yet been modelled formally. This makes formal modelling of the convergence process based on economic theory very difficult, and it means there is great uncertainty associated with forecasts of future relative price level movements. Given these considerations, this article builds on the framework developed by Kattai (2005; 2007) for modelling the nominal convergence process.7 This approach assumes that the convergence process follows a certain functional form, but the modeller is free to input their own assumptions about the duration and endpoint of the convergence process. One important feature of this model is that it allows the investigation of a variety of different convergence scenarios. This is particularly important given the uncertainty over the size of these effects since it provides a framework for performing a robustness test. This enables the modeller to check under what assumptions about the convergence process the results hold, and how sensitive the results are to the specific convergence scenario assumed. In addition, this framework connects both the length of the convergence period and size of the current convergence effect. Estimates of convergence effects at one point in time are useful, but if convergence effects exert a significant effect, then this naturally raises the issue of for “how long” these convergence effects may be significant. By tying together the two, this framework enables such questions to be directly answered. Since the goal of the paper is to investigate the consequences rather than the causes of price level convergence, it makes sense to adopt a framework that enables the consideration of a variety of different convergence paths. This is also consistent with some earlier attempts to quantify the interaction of convergence effects with the Maastricht criteria–see Hughes Hallett and Lewis (2007) and Natalucci and Ravenna (2002)–which consider one (or a variety of) exogenously given convergence scenario(s). 2.1. A framework for analysing price level convergence In this section, a framework is outlined which models the evolution of the relative price level of each CEEC. The next section considers what this means for the evolution of domestic inflation and the nominal exchange rate. In the model used here, relative prices are determined by a relative price level convergence story. In reality, many short-run factors may exert an effect on the relative price level and other nominal variables. This model abstracts from such factors, because it aims to capture the long-run evolution of relative price levels. As in its original use by Kattai (2005), the story outlined below should be thought of in terms of an account of the evolution of the underlying trend relative price level- or convergence path- around which the observed relative price level will fluctuate.8 The convergence process is defined relative to a base year, 0, and is completed in period T. The relative price level, relP, (in country j at time t) is therefore: Sj;t Pj;t ð1Þ Pez;t where S is the nominal exchange rate (defined as the number of euros per unit of j's domestic currency), and P is the price index (expressed in local currency for country j, and in euros for the Eurozone, ez). Thus, the numerator on the right hand side gives the number of euros required to purchase the basket of goods in country j, and the denominator, the cost of this basket in the Eurozone. Price level convergence implies that the number of euros needed to purchase a given basket of goods in country j will rise steadily over time until the convergence process is complete. The change in the euro-price of this basket is referred to as eurodenominated inflation and is denoted by γ. The change in the price of the basket in the country's own currency–the own-currency inflation rate–is referred to with the conventional π. If the price level in the CEEC is rising towards that of the Eurozone, then it follows that9 γj N γez = πez. relPj:t u

7 This framework was originally developed for use within the Bank of Estonia's macromodel as a way of modelling the convergence path of price and output to Eurozone levels. For a full account of how it is used in a full macromodel see Kattai (2005). 8 To avoid notational clutter, no special notation is used to denote these “trend” values. Similarly, to avoid needless repetition, the verbal exposition simply refers to “the relative price level” rather than “the trend relative price level”. 9 For the Eurozone, the euro is the “own currency” and hence πez = γez in all periods.

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Fig. 2. Stylised convergence paths.

At a given time, τ, the relative price level of country j is thus given by: Rτ Sj;τ Pj;τ γ −π dt = Sj;0 Pj;0 · e 0 ð j;t ez;t Þ Pez;τ

ð2Þ

The approach used in this article is based on two key assumptions about the path of price level convergence. The first is that euro-denominated inflation converges linearly towards Eurozone inflation over time. The second is that the convergence process stops when the relative price level reaches a certain level. For now, the end point of the process is when price levels have fully equalised (later on in the paper this assumption is relaxed and the case of incomplete price convergence is considered). This convergence path is illustrated in Fig. 1. This replicates the stylised fact that γ tends to be higher during the initial phases of the convergence process, and then slows as price levels get closer. Moreover, it imposes an economically reasonable endpoint to the process: equalisation of price levels. Mathematically speaking, this implies that:   ST Pj;T S0 Pj;0 R T γj;0 − ðγj;0 − πez Þ t dt T = e 0 =1 Pez;T Pez;0

ð3Þ

If it is assumed that in the long run the ECB meets a 2% inflation target10 then, πez = 0.02. Two unknowns remain: convergence time, T, and the initial value of γ. To close the model, one must assume a value for one of the unknowns, and then solve the model for the other. In this paper, four separate convergence scenarios are simulated. Two of them estimate γ and then solve for T; the other two fix T and solve for γ. 2.2. Convergence scenarios 2.2.1. Convergence scenario 1: full convergence In this scenario the model is calibrated based on observed relative price level dynamics. Since the HICP is not comparable in levels across countries, the relative price level is captured by the relative price of household consumption (RHPC).11 Throughout this paper, data for “the Eurozone”, refers to the original twelve members (EZ12).12 The source of the data is Eurostat, which publishes relative price data for sub-subcomponents of GDP over the period 1999–2007. Since the inflation criterion is assessed on the basis of consumer price inflation, household consumption was chosen as the closest conceptual analogue.13

10

From December 1998 to December 2007 the average annualised HICP inflation rate was 2.01%. Thus 2% is also a very close fit to the observed average rate. This approach is consistent with Eurostat's own advice: ““In essence, PPPs and indicators derived from PPPs are spatial price level indicators, and thus primarily suitable in comparisons referring to several geographical locations at a given point in time….The interpretation of a time series that includes PPPs should be guided by the purpose of the analysis. The qperfectq, multi-purpose indicator that simultaneously captures both spatial and temporal aspects adequately simply does not exist. For example, a time series of price level indices do not provide a reliable measure of the development of prices in a given country. For that purpose, the consumer price index should be applied instead. Similarly, if we want to compare the rate of price change in two or more countries, the Harmonized Index of Consumer Prices (HICP) is readily available, at least for most European countries.” (Eurostat, 2008). 12 This gives a constant reference group. Conducting the analysis with Malta, Cyprus and Slovenia included in the Eurozone would make little difference since these countries have a combined weight of less than 1% in Eurozone GDP. 13 The RPHC is compiled jointly by Eurostat and the OECD and is used to measure deviations from PPP across countries. It measures the prices of final household consumption, and thus excludes government consumption (as does the HICP). For each country, it measures the relative price of an equivalent volume of consumption in two countries. An “equivalent volume of consumption” does not necessarily imply an identical consumer basket across the two countries, as the two baskets will reflect differences in tastes, income levels, product availability and so forth. However, the two baskets should in principle provide equivalent utility. For more on the construction of the measure see OECD (2007). 11

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Table 1 Estimated convergence times. Country

CZ EE LV LT HU PL SK BU RO

Methodology Full convergence

Partial convergence

25-year convergence

(Scenario 1)

(Scenario 2)

(Scenario 3)

50-year convergence (Scenario 4)

γ0

Conv

γ0

Conv

γ0

Conv

γ0

Conv

5.37 5.24 5.41 5.25 6.32 4.39 6.86 4.42 7.24

2040 2033 2038 2042 2029 2049 2032 2077 2033

5.37 5.24 5.41 5.25 6.32 4.39 6.86 4.42 7.24

2028 2019 2024 2027 2019 2031 2023 2059 2021

7.01 5.93 6.67 7.14 6.59 6.43 7.70 9.19 8.23

2028 2028 2028 2028 2028 2028 2028 2028 2028

4.51 3.97 4.33 4.57 4.29 4.22 4.81 5.60 5.11

2053 2053 2053 2053 2053 2053 2053 2053 2053

Source: Eurostat, Authors own calculations, (figures rounded to nearest whole year). CZ = Czech Republic; EE = Estonia; HU = Hungary; LV = Latvia; LT = Lithuania, PL = Poland; SK = Slovakia; BU = Bulgaria.

Following Kattai (2005), the calibration is done by estimating trend values for relative prices and euro-denominated inflation in the year 2003. Since the relevant concept is trend rather than actual price levels (euro-denominated inflation), these trend values are estimated by averaging data over the period 1999–2007. Since γ converges linearly over time, averaging observed γ over the period 1999–2007 gives an estimate of γ in the year 2003.14 By similar logic, since the log of relP converges linearly over time, averaging the log of relP over 1999–2007, and then taking antilogs give an estimate of the trend relP at the mid-point of the sample, 2003. Given these values it is then possible to project the convergence scenarios forward from 2003 onwards. A simple diagrammatic representation price levels is shown in Fig. 2. 2003 is thus the “year zero”, and convergence is completed T years later. After plugging in the appropriate values the system can then be solved for T. A closed form solution is not possible due to the functional form involved. Therefore, the system is solved instead numerically using the Mathematica software package. 2.2.2. Convergence scenario 2: partial convergence The second scenario relaxes the assumption that the endpoint of the price level convergence process is full price equalisation. This is motivated by the stylised fact that significant price level differentials are observed across current Eurozone members. Accordingly, the endpoint of the convergence process in this scenario is a relative price level of 80% of the EZ12. This is somewhat lower than the relative price levels observed in Spain, Portugal and Greece (the lowest three relative price levels in the original Eurozone members) which average 87% of the EZ12 figure. 2.2.3. Convergence scenario 3: 25 year convergence In this scenario, convergence is assumed to take 25 years (from the year 2003). This corresponds to the most optimistic of (real) convergence scenarios generally found in the literature (see Appendix for details). T is thus fixed at 25, and the relative price level in 2003 is estimated as before. The model is then solved for the initial value of γ. 2.2.4. Convergence scenario 4: 50 year convergence As above, but where convergence time is fixed at 50 years. This roughly corresponds to the most pessimistic assessments of likely convergence times. The estimated convergence times for each scenario, along with the initial value of γ in each scenario are shown below in Table 1: The white columns give the 2003 value of γ for each scenario, the grey columns give T+2003, the estimated year in which convergence is achieved. These numbers are broadly comparable to estimates elsewhere of likely convergence times for real GDP per capita.15 If the endpoint of the convergence process is a price level of only 80% of the EZ12 (5th column), then the convergence happens approximately 10 years sooner. This reflects the fact that in the case of 80% convergence, the price level has less far to go than when the endpoint is 100% convergence. The 25 year and 50 year cases (7th and 9th columns) show convergence dates of 2028 and 2053 by construction.

14 Suppose X = a + bt + εt, where εt is a mean-zero error term. The average value of the variable between 0 and T is equal to X = a + b⁎(0.5)T, which is its trend value in the midpoint of the sample. 15 These results are generally quite close to those obtained in Lewis (2007) based on a sample period of 1995–2005. Only in the case of Romania is there a big change. Specifically, the convergence times for Romania are brought forward significantly. Over the period 2005–2007 Romania experienced substantial appreciation of the real exchange rate (almost 50%) and so adding these years to the sample does have a significant effect. In any event the results are robust across a variety of other convergence scenarios. See the appendix of Hughes Hallett and Lewis (2007) for a comparison of convergence estimates.

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3. The effect of nominal convergence on meeting the Maastricht criteria This section considers whether and under what circumstances these estimated convergence effects on inflation and the exchange rate may be large enough to constitute a problem for the fulfilment of the exchange rate and inflation criteria.16 Following Brooke (2005), Égert and Kierzenowski (2003) and the apparent logic of recent convergence reports (see ECB, 2006, 2008; and European Commission, 2004, 2006), the exchange rate stability criterion is interpreted to mean a nominal appreciation17 of less than 15% from initial central parity during the stay in ERM II.18 This also supported by the recent experience of Slovakia shows that strong upward movements of the exchange rate are not necessarily incompatible with the exchange rate stability criterion. In keeping with recent ECB convergence reports, inflation reference value is taken to mean 1.5% plus the average of the lowest 3 EU members, excluding all countries with negative inflation rates. Applying this formula to the EU25 from January 1999 to December 2007 and then averaging the difference between the reference value and actual Eurozone inflation yields the result that the reference value is on average 0.5% above Eurozone inflation. Combining this with the ECB's inflation target yields the benchmark figure of 2.5%. Simply averaging the reference value (based on a 25 member EU) over the period 1999–2007 also yields a figure of 2.5%.19 The next step is to consider how much inflation and exchange rate appreciation are allowed. Euro-denominated inflation, γ is given by20: γj = πj + sj

ð5Þ 21

where s is the percentage change in the exchange rate . If sj is zero, then γj ≡ πj. The maximum permissible inflation is πj = 2.5% which implies that γj = 2.5%. Thus the maximum euro denominated inflation rate that the Maastricht criteria permits an exchange fixer is 2.5%. Alternatively, this can be expressed in terms of the maximum permissible annual appreciation of the real exchange rate. Expressing (1) in percentage change form gives an expression for the percentage change in the real exchange rate, rer:   rerj = sj + π j − πez

ð6Þ

Given that sj = 0, and πez = 2%, the maximum permitted inflation rate πj = 2.5% can be substituted in (4) to yield the maximum permitted real exchange rate appreciation, which comes out at 0.5%. The inflation targeter is allowed to appreciate upwards by 15% over 2 years—an annualised nominal appreciation of 7.2% (rounding to one decimal place). Substituting the maximum permitted appreciation, sj = 7.2% and the actual inflation rate πj = 2% into the equation: γj ≡ πj + s, implies that γj = 9.2%. In other words, an inflation targeter is permitted over 3 times as much euro denominated inflation as an exchange rate fixer. In terms of the real exchange rate, substituting sj = 7.2% and πj = πez = 2% into Eq. (6) implies a real appreciation of 7.2%. Comparing this to the maximum permitted real appreciation allowed to an exchange rate fixer (0.5%), it can be seen that an inflation targeter is permitted over 10 times as much real exchange rate appreciation. One measure of the importance (and longevity) of convergence effects for exchange rate fixers, is to calculate the time, τS, beyond which convergence effects imply inflation of below 2.5%. One interpretation of this date is as the point beyond which convergence effects are not strong enough on their own to imply failure of the inflation criterion. A second interpretation would be the date beyond which a country can “sustainably” meet the inflation criterion, in the sense that before this point, they can only meet the criterion on a temporary basis by virtue of below trend inflation. The relevant rate for assessing the inflation criterion is the 12 month average of the past 12 months' year on year inflation rates. This sustainability requirement is shown diagrammatically in the left hand panel of Fig. 3. Similarly, for an inflation targeter, τS is the time beyond which the cumulative nominal exchange rate appreciation is less than 15% (Fig. 3). This shown in the right hand panel of Fig. 3. The line s′ shows the cumulative appreciation over the previous 2 years and the dotted line corresponds to the 15% upper bound. Compliance means the cumulative appreciation is lower than 15% (Table 2).22 Tables 2 and 3 show the year of sustainable compliance, (2003+τS) under inflation targeting and fixed exchange rate regimes for the four convergence scenarios shown.23 Under fixed exchange rates, it is evident that the current size of convergence effects on 16 The formal process for the determination of the criteria is that European Commission and the ECB prepare convergence reports and that the EC makes a recommendation to ECOFIN. 17 In what follows the maximum tolerated depreciation need not be specified, because these calculations imply only an upward movement of the nominal exchange rate. 18 The recent experience of Slovakia suggests that strong appreciations may be tolerated, and may even extend to those which are more than 15% over the 2 years. 19 2.5% is also the figure obtained by Lewis and Staehr (forthcoming) who use Monte Carlo methods to estimate the “average” reference value. In any event, the results in this section are robust to alternative assumptions about the reference value (see Appendix A for tabulations). Assuming the reference value is 2.75% or even 3% makes little difference. 20 Time subscripts are omitted here for simplicity. 21 Given the definition of the exchange rate used here, a positive s implies an appreciation of the domestic currency against the euro. 22 This notion of compliance assumes first that the candidate country has in fact joined ERM II at time t-2, and with a central parity equal to the prevailing market rate—as was the case with Slovakia. 23 Strictly speaking, Eq. (6) only holds as an equality, if the same consumption basket is used to measure γ and π. For the countries in this sample, the real exchange rate appreciation implied by the relative price of household consumption is close to that implied by HICP and nominal exchange rate data. As a robustness check, the sustainable compliance times were re-estimated under the assumption that the γ implied by HICP and exchange rate data converges to 2% in the same time as the price level converges. The results are very similar to those shown here. A full set of calculations is available from the author on request.

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Fig. 3. Simultaneous compliance with both criteria.

inflation is much larger than the maximum allowed by the Maastricht Treaty. In general, sustainable compliance is only possible a short while before the convergence process comes to an end. Under scenario 1 (100% convergence, estimate T, 2nd column), the first countries to meet the inflation criterion sustainable would be able to do so only in about 2 decades time. Assuming that CEECs converge only to 80% of the Eurozone price level (3rd column) brings these dates forward, but sustainable convergence would still be a decade away for the first countries, and 2 decades away for the rest. In the 25 year case (4th column), sustainable compliance occurs between 2021 and 2024, and under the 50 year case (5th column), between 2042 and 2045. The two striking things about these results are first that they are robust across all convergence scenarios, and second, they imply that the Baltic states–often

Table 2 Sustainable compliance under a fixed exchange rate. Methodology Estimate time to convergence

CZ EE LV LT HU PL SK BU RO

Fix time to convergence

Full convergence

Partial convergence

25 year convergence

(Scenario 1)

(Scenario 2)

(Scenario 3)

50 year convergence (Scenario 4)

2036 2030 2033 2037 2027 2041 2030 2063 2031

2024 2018 2022 2026 2018 2026 2022 2048 2023

2026 2026 2026 2027 2026 2026 2027 2027 2027

2044 2041 2043 2044 2043 2043 2045 2047 2046

Source: Authors own calculations, (dates rounded to nearest whole year). CZ = Czech Republic; EE = Estonia; HU = Hungary; LV = Latvia; LT = Lithuania, PL = Poland; SK = Slovakia; BU = Bulgaria; RO = Romania.

Table 3 Forecast 2 year appreciations within ERM II under inflation targetting, % (by date of ERM entry).

CZ EE LV LT HU PL SK BU RO

Full convergence

Partial convergence

25 year convergence

50 year convergence

(Scenario 1)

(Scenario 2)

(Scenario 3)

(Scenario 4)

2005

2010

2015

2005

2010

2015

2005

2010

2015

2005

2010

2015

6.4 6.0 6.4 6.2 8.0 4.6 9.1 4.5 9.9

5.5 4.9 5.4 5.3 6.3 4.0 7.4 3.7 8.1

4.5 3.9 4.4 4.5 4.6 3.5 5.7 2.8 6.4

6.2 5.5 6.1 5.9 7.4 4.4 8.7 4.7 9.2

4.8 3.5 4.4 4.5 4.6 3.5 6.2 4.2 6.2

3.4 1.4 2.8 3.1 1.9 2.7 3.7 3.8 3.2

9.2 7.2 8.6 9.5 8.4 8.1 10.5 13.4 11.5

7.1 5.6 6.6 7.3 6.5 6.3 8.1 10.3 8.9

5.1 4.0 4.7 5.2 4.6 4.5 5.8 7.3 6.3

8.1 6.6 7.7 8.4 7.7 7.3 8.7 10.2 8.7

7.2 5.9 6.8 7.5 6.8 6.5 7.7 9.1 7.8

6.3 5.2 6.0 6.6 6.0 5.7 6.8 8.0 6.9

Source: Authors own calculations. CZ = Czech Republic; EE = Estonia; HU = Hungary; LV = Latvia; LT = Lithuania, PL = Poland; SK = Slovakia; BU = Bulgaria; RO = Romania.

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viewed as being at the front of the queue to join–would in all likelihood struggle to meet the inflation reference value on a sustained basis for almost 2 decades.24 The situation under inflation targeting is shown in Table 3, which reports the convergence effect on the nominal exchange rate over a 2 year spell in ERM II. Because the size of convergence effects varies over time, these are shown for three ERM II entry dates: 2005, 2010 and 2015. These results show that under all four scenarios, convergence effects alone will never be big enough to imply an appreciation of more than 15% over the course of a 2 year stay in ERM II. (i.e. under inflation targeting τS is never positive). This also means that CEECs who target inflation have at least some (and mostly a good deal of) leeway to cope with short term shocks to the exchange rate. Alternatively, this leeway could be used to stay in ERM II for longer than 2 years without breaching the 15% upper bound. 4. The effect of the relative price level on achieving inflation below the reference value: an ordered probit analysis For those countries who (credibly) fix their exchange rate, the key issue is the meeting the inflation criterion. The analysis of the previous section concentrated on a theoretical model of trend inflation and/or nominal exchange rate appreciation based on a price convergence story. However, in reality inflation can, and does, depart substantially from the trend rates implied by nominal convergence. This section investigates empirically the role of price level differentials in determining the ability of a country to get their inflation rate below the reference value. This is done using data from aspiring members who fix to the euro, and from existing Eurozone countries. To assess this the variable Cj,k is constructed which records the proportion of the past k months in which country j has had inflation below the reference value. Since the treaty also requires sustainable low inflation, the model is estimated for k = 1,3,6,12. Ck is a discrete variable which can take k + 1 different values and so it is estimated as an ordered probit model.25 Formally speaking, a latent regression is estimated: yj;t = βrelPj;t − 24 − k + ej;t

ð7Þ

along with a series of cut-off points Z1,Z2…Zk where, as before, relP is the relative price level, and time t is measured in months.26 The probability that Ck takes a given value is thus: PC = 0 = P ð y b Z1 Þ   P x = P Zx b y b Zx + 1 ; C=

j

8x b k

ð8Þ

PC = 1 = P ð y N Zk Þ The reference value is calculated using the average of the lowest three positive inflation rates in the EU27. As in the previous section relative price levels are captured by the relative price of household consumption was used, with linear interpolation to yield monthly figures. The model is estimated using a sample consisting of four aspiring euro members—Estonia, Latvia, Lithuania, and Slovenia plus the twelve original countries.27 For the latter, the sample begins from January 1st 1999, for the former the time frame is restricted to cover the time frame in which their national currency was tightly fixed to the Euro. The results are summarised in Table 4. The upper half of the table gives the results of the regressions for k = 1,3,6,12. In each case the relative price co-efficient is highly significant. The lower half of the table shows the probability implied by the estimated coefficients of having inflation below the reference value at a given price level. Roughly speaking, the probability of meeting the reference value in any single month (k = 1) improves by around 0.5% for every additional percentage point that relP increases by. As k increases two things happen. First, the more consecutive months of compliance required, the lower the probability of success. Thus, a country with a low relative price level may be able to meet the reference value in a single month, but they find it much harder to meet it for longer periods of time. Second, the larger is k, the more sensitive the probability is to the relative price level. For example when k = 1 (first column), a country with a relative price level of 100% of the Eurozone is about one and a half times more likely to meet the reference value in a single month than one with a relative price level of 50%. But if k = 12 (last column), the probability of success for a country

24 The Baltics would be able do this sooner if they only converged to 80% of the Eurozone price level. However, given their proximity to Scandinavian countries, 80% of the EZ12 price level looks like an unrealistically low endpoint for the convergence process when Sweden and Finland have relative price levels of around 110% of the EZ12 level. 25 As a robustness check, an ordered logit model was also estimated. The implied probabilities of C = 1, were within ± 1% of those obtained under the probit specification. A full set of results is available from the author on request. 26 A 12 month moving average measure of year on year inflation measures changes in the price level over a 24 month period. Therefore, for k months' compliance, price movements over 24+k months are being assessed, and thus a lag of 24+k months gives the price level at the start of period of interest. 27 For part of the sample period Slovenia was in ERM II and for a later part was a member of the Eurozone.

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Table 4 Probability of hitting the inflation criterion under a fixed exchange rate.

β̂ (p-value) zk N Pseudo R-squared P|C = 1 if Relp is 50% 60% 70% 80% 90% 100%

k=1

k=3

k=6

k = 12

0.0120 (0.000) 0.7670 1113 0.0258

0.0355 (0.000) 3.2927 1103 0.1415

0.0346 (0.000) 3.3412 1070 0.1116

0.0339 (0.000) 3.5070 1004 0.0861

0.434 0.482 0.529 0.577 0.623 0.668

0.064 0.122 0.209 0.324 0.460 0.600

0.053 0.103 0.178 0.282 0.409 0.546

0.035 0.070 0.128 0.213 0.323 0.452

with a relative price level of 100% of the Eurozone is nearly fifteen times as great as the probability for the country with a relative price level of 50%. To see what the results might mean in terms of probabilities for CEECs, the estimated co-efficients from regression are matched up with the relative price levels implied by each of the convergence scenarios. For a given relative price level in a given year, it is possible to compute the probability of success. These probabilities are graphed below: Fig. 4 shows that the prospects for sustained compliance under a fixed exchange rate are relatively poor, for at least the next decade. Estonia and Hungary have the highest probabilities (between 0.2 and 0.25)—on account of their having higher price levels than the other countries according to these stylised convergence scenarios. However, the probabilities are significantly greater than zero, suggesting that if a CEEC is patient enough, sooner or later, a negative shock could come along which reduces inflation below the reference value for 12 consecutive months. The analysis is also repeated for the 25 year and 50 year convergence scenarios. The results are shown in Figs. 5 and 6: These figures also present a relatively pessimistic figure. First of all, in the near future, the probabilities of having inflation below the reference value for twelve consecutive months are relatively low—Second, it can be difficult to meet the inflation criterion under a fixed exchange rate even when the convergence process has come to an end. Even when all countries have converged (after 2028 in Fig. 5), the probability of having inflation below the reference value for 12 consecutive months is still less than 0.5. Even when no structural inflation differential exists, a country with a fixed exchange rate may still find it difficult to comply with the reference value in each and every month because of their inability to “fine-tune” inflation. 5. Concluding remarks This article investigates the likely size of convergence effects in CEECs under a variety of different convergence scenarios and examines how these might affect their ability to meet the Maastricht criteria. A key result is that there is that the convergence criteria are not neutral with respect to the choice of exchange rate regime. Countries with fixed exchange rates will find it difficult to keep inflation below the reference value on a sustainable basis, not just currently but for at least a decade, and in some cases

Fig. 4. Probability of C = 1, k = 12; 100% convergence, estimated T (Scenario 1).

J. Lewis / European Journal of Political Economy 25 (2009) 508–524

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Fig. 5. Probability of C = 1, k = 12; 100% convergence within 25 years (Scenario 3).

much longer. Empirical estimates of the probability of achieving inflation below the reference value confirm this view. However, they do suggest that short term deviations from trend values of inflation might allow a country to meet the criterion ahead of the end of the convergence process. Even if inflation is below the reference value, such countries nevertheless may run into difficulties on sustainability grounds, given that the trend value of inflation will remain well above the likely reference value for many years to come. On the other hand, countries who target inflation and allow nominal convergence to take place via an exchange rate appreciation should find that the room allowed the 15% bands of ERM II is sufficient. The recent experience of Slovakia demonstrates that quite large appreciations may be tolerated, and it is not impossible that larger appreciations of more than 15% may be tolerated. That would further reinforce this asymmetry result. The probability analysis backs up the asymmetry result as well. Estimated probabilities for 12 months of inflation below the reference value are quite low at the price levels currently observed in CEECs. Even when the convergence process is finished, the probability is still less than a half. This means that the inability to fine tune inflation creates a difficulty for exchange rate fixers even in the absence of a trend inflation differential. This article reinforces the conclusion of De Grauwe and Schnabl (2005) that gradual appreciation is a better way of coping with convergence effects, by explicitly quantifying the likely size of these convergence effects and finding that they will be large and relatively long lasting. These results are also highly robust to different convergence scenarios. That means that if convergence to price levels takes anywhere between 25 and 50 years (and the literature on convergence suggests the convergence time is unlikely to be outside these bounds), then the results hold. They also hold in the case that countries only converge as much as existing Eurozone periphery has. Although convergence effects are difficult to pinpoint empirically, the basic result holds for a very wide range of convergence scenarios. To overturn the conclusions, one would need to assume that convergence is either extremely fast,

Fig. 6. Probability of C = 1, k = 12; 100% convergence within 50 years (Scenario 4).

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J. Lewis / European Journal of Political Economy 25 (2009) 508–524

extremely slow or that differences in relative price levels considerably bigger than currently observed between EZ12 countries will persist indefinitely. The oft repeated critique of the criteria–that they are incompatible with nominal convergence–is only true for fixed exchange rates, but not for inflation targeters. This means that Slovakia's success in meeting the criteria under a non-fixed exchange rate was in line with what the model would predict, and that other CEECs could successfully emulate the Slovak strategy. Similarly, the current difficulties experienced by the Baltic States are also consistent with the model. Further, the results here show that if there is a strong emphasis on meeting the criterion for a sustained period of time, and/or a forward looking element in the assessment of the inflation criterion, the Baltic states could be out of the euro for at least a decade, and possibly two. This implies that the Baltics, often held to be at the front of the queue to join, could get leapfrogged by other countries who are yet to even join ERM II. The findings also lend support to the view that larger central European inflation targeters should keep this regime in the run up to EMU, as the convergence criteria are, ceteris paribus, easier to hit with this setup, than under a tightly fixed exchange rate. However, the question of whether the Baltic countries should switch from a currency board to an inflation targeting regime is not directly considered. Whilst this does allow for more leeway to accommodate nominal convergence, inflation targeting has its own difficulties in very small and open economies. One possible solution to the problem faced by exchange rate fixers is using other instruments to control inflation. For example, indirect taxes and/or administered prices could be manipulated to ensure that rate of inflation was temporarily brought down below the reference value. However, such an action would only generate a temporary fall in inflation and may fall foul of the sustainability requirement—especially since the fall could be traced to easily identifiable policy actions. Alternatively, fiscal policy could be deployed to reduce aggregate demand, provoke a recession or slowdown and hence reduce inflation. That would be sufficient to meet the reference value numerically, but could well be judged insufficient to meet the sustainability part of the criterion. Acknowledgements The author is grateful to Marloes Foudraine for excellent research assistance, to Peter Vlaar for help with empirical section and to seminar participants at the Bank of Estonia, the Bank of Latvia and the Czech National Bank for their feedback. Successive drafts of this paper benefited from the helpful comments of Kerstin Bernoth, Maria Demertzis, Rasmus Kattai, Pierre Lafourcade, Silvia Sgherri and two anonymous referees. None of the above are responsible for my interpretation of the results. The views expressed are those of the author and not necessarily those of De Nederlandsche Bank. Appendix A. Meeting the inflation criterion under alternative reference values Notes: (1) In all tables, figures are rounded to the nearest whole year. (2) CZ = Czech Republic; EE = Estonia; HU = Hungary; LV = Latvia; LT = Lithuania, PL = Poland; SK = Slovakia; BU = Bulgaria; RO = Romania. Case 1: 100% convergence, estimate time Country

CZ EE LV LT HU PL SK BU RO

Reference value for inflation 2.5% (Reported in paper)

2.75%

3.0%

2036 2030 2033 2037 2027 2041 2030 2063 2031

2033 2027 2031 2034 2026 2036 2029 2055 2029

2030 2025 2028 2031 2024 2031 2027 2047 2028

Case 2: 80% convergence, estimate time Country

CZ EE LV LT

Reference value for inflation 2.5% (Reported in paper)

2.75%

3.0%

2024 2018 2022 2026

2023 2017 2020 2024

2021 2015 2019 2022

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519

Appendix (continued) A (continued) Country

Reference value for inflation

HU PL SK BU RO

2.5% (Reported in paper)

2.75%

3.0%

2018 2026 2022 2048 2023

2017 2023 2021 2042 2022

2016 2020 2020 2037 2021

Case 3: convergence takes 25 years

Country

Reference value for inflation

CZ EE LV LT HU PL SK BU RO

2.5% (Reported in paper)

2.75%

3.0%

2026 2026 2026 2027 2026 2026 2027 2027 2027

2025 2024 2025 2025 2025 2025 2026 2026 2026

2024 2023 2024 2024 2023 2023 2025 2025 2025

Case 4: convergence takes 50 years Country

Reference value for inflation

CZ EE LV LT HU PL SK BU RO

2.5% (Reported in paper)

2.75%

3.0%

2044 2041 2043 2044 2043 2043 2045 2047 2046

2039 2035 2038 2039 2037 2037 2041 2043 2042

2034 2028 2032 2034 2032 2031 2036 2040 2038

European Commission

Appendix B. Estimated real convergence times from other studies Estimated time to convergence with EU-15, in years Table taken from Hughes Hallett and Lewis (2007).

Source

EIU

Wagner & Hlouskova

World Bank

GDP/head

Years from 2004

Years from 2005

Years from 2000

(75%)

(100%)

(100%)

(100%)

(100%)

2001

Mean

Optim

38 60 46 74 68 72 48 80 85

25 41 33 51 46 47 34 55 64

13 29 19 35 35 29 26 40 45

11 15 7 22 27 28 16

Czech Rep Estonia Hungary Latvia Lithuania Poland Slovakia Bulgaria Romania

38 30 33 57 52 58 37 N/A N/A

Sources: EIU (Economist Intelligence Unit), Economist (2004)–methodology not given. Wagner and Hlouskova (2005): growth rate regression for EU-14, applied to CEEC data. World Bank (2000)–assumes 5% real growth/annum in each CEEC country. European Commission (2001)–growth forecasts for EU-15; 2004 CEEC growth forecasts. Mean denotes central projection of W&H, Optim denotes projection based on top 10% percentile of estimated distribution of country growth rates.

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Appendix C. Relative price levels

Fig. C1. Evolution of relative price levels in CEECs: 1995–2007.

Appendix D. Other measures of nominal convergence In theory, the relationship between euro-denominated inflation, domestic currency inflation and the change in the nominal exchange rate is given by: γj = πj + sj and the real exchange rate appreciation is given by:   rerj = sj + πj − π ez

ð5Þ

ð6Þ

Strictly speaking, (5) and (6) only hold as an equality if γ and π are calculated using the same basket of goods. However, the HICP is not comparable in levels across countries. For that reason, a different basket of goods is used to measure relative prices—and hence find the starting value of γ. The measure used is Eurostat's relative price of household consumption (RPHC) which is the closest conceptual analogue to the HICP. However, one can also calculate an alternative measure of rer using HICP inflation and the change in the nominal exchange rate. If these measures were calculated using a common price index, then they would be identical. This appendix analyses how close the two measures are, and whether the discrepancy between the two matters for the results of the paper. The year to year changes in the RPHC are not fed in to the model, only the estimates of trend values. Therefore, what really matters is not the year on year congruence of the two measures, but that these trend effects are similar across both measures. The γ given by the RHPC measure28 is given by29: RPHC

γj;t

=

RPHCj;t − RPHCj;t − 1 + 0:02 RPHCj;t − 1

28 In this appendix, a subscript is introduced to distinguish the two measures of gamma. RHPC denotes the gamma derived from the relative price of household consumption and the subscript HICPEX denotes the measure of gamma derived from HICP and nominal exchange rate data. 29 For extra clarity, this appendix uses superscripts to denote the price index from which the measure is calculated.

J. Lewis / European Journal of Political Economy 25 (2009) 508–524

521

where t is measured in years. Recall that 0.02 was the assumed long run trend value of Eurozone inflation. The average of this measure is the one used in the main text to generate the convergence scenarios. The alternative, γ, given by the HICP and nominal exchange rates, is given by:

HICPEX

γj:t

=

HICPj;t − HICPj;t − 1 Sj;t − Sj;t − 1 + HICPj;t − 1 Sj;t − 1

which can be re-written as HICPEX

γj;t

HICP

= πj;t

HICP

− πEZ;t + sj;t

where πHICP denotes inflation as measured by the HICP. Fig. D1 plots. the trend gamma for each country, under both methodologies. The darker line denotes γRPHC (i.e. the value actually used in the main text to calibrate simulations 1&2), the lighter line denotes γHICPEX.

Fig. D1. Gamma using different price indices.

Averaging across all countries, the two yield quite similar figures. Thus there is no large systematic difference between the two measures. However, on a country by country basis there are some differences. The two measures are quiet close for the Czech Republic, Lithuania and Hungary, but not less close for Slovakia and Romania. The key question is whether or not these differences matter for the results discussed in this paper. To determine this, the relevant calculations in the paper were re-done using the alternative measures of γ. Scenarios 1 and 2 For the convergence simulations, the starting relative price level was given by the average of the RPHC over the period 1999– 2007. The convergence times were calculated in the same way, and are hence the same. However, the crucial difference is that the assumption of a one for one relation between relative prices and the HICP is relaxed.

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The starting value of γ0 is given by the average value of γHICPEX. γHICPEX is then assumed to converge to 0.02 in the same time as it takes relative price levels to converge. For example, in the case of Slovakia, γHICPEX N γRPHC. This is shown diagrammatically below:

Fig. D2. Convergence with γHICPEX.

Scenarios 3 and 4 In these scenarios, convergence time is fixed, and the value of γ is estimated. Since these values of γ are based on relative price levels, they refer to γRPHC. These estimated values are thus re-scaled by the ratio of γHICPEX to γRPHC. For example, in the case of Slovakia, the calibrated value of γ2003 in the main text is 7.7%. As Fig. D1 shows, γHICPEX is 1.37 times greater than γRPHC, so the calibrated value of 7.7% is rescaled by a factor of 1.37, to give a new value for γHICPEX of 10.51%. 0 For ease of comparison these are presented in the shaded column (alt), side by side with the results reported in the main text.

Table D2 (c/f Table 2 in main text). Methodology Estimate time to convergence to

CZ EE LV LT HU PL SK BU RO

Fix time to convergence

Full convergence

Partial convergence

25 year convergence

50 year convergence

(Scenario 1)

(Scenario 2)

(Scenario 3)

(Scenario 4)

Main text 2036 2030 2033 2037 2027 2041 2030 2063 2031

Alt 2036 2026 2031 2038 2028 2044 2031 2069 2032

Main text 2024 2018 2022 2026 2018 2026 2022 2048 2023

Alt 2024 2016 2021 2026 2018 2028 2023 2053 2024

Main text 2026 2026 2026 2027 2026 2026 2027 2027 2027

Alt 2027 2024 2025 2027 2027 2027 2028 2028 2028

Main text 2044 2041 2043 2044 2043 2043 2045 2047 2046

Alt 2049 2044 2046 2049 2049 2050 2051 2051 2051

The estimated years of compliance are quite similar across the two sets of calculations. Thus, the key message of Table 2–the difficulty of meeting the inflation criterion under a fixed exchange rate–remains.

J. Lewis / European Journal of Political Economy 25 (2009) 508–524

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Table D3 (c/f Table 3 in the main text).

CZ EE LV LT HU PL SK BU RO

Full convergence

Partial convergence

25 year convergence

50 year convergence

(Scenario 1)

(Scenario 2)

(Scenario 3)

(Scenario 4)

2005

2010

2015

2005

2010

2015

2005

2010

2015

2005

2010

2015

6.7 3.6 4.4 6.5 9.0 7.3 13.9 7.8 14.5

5.7 2.9 3.7 5.6 7.1 6.4 11.3 6.4 11.9

4.7 2.3 3.0 4.7 5.2 5.6 8.6 4.9 9.3

6.5 3.3 4.2 6.2 8.4 7.0 13.3 8.1 13.6

5.0 2.1 3.0 4.7 5.2 5.6 9.4 7.4 9.1

3.6 0.9 1.9 3.3 2.1 4.2 5.6 6.6 4.7

9.6 4.5 6.1 9.9 9.5 12.0 15.9 20.5 16.7

7.4 3.5 4.8 7.6 7.4 9.3 12.3 15.8 12.9

5.3 2.5 3.4 5.4 5.2 6.6 8.7 11.1 9.1

8.8 7.7 8.4 8.9 8.3 8.2 9.3 10.9 9.9

7.8 6.9 7.5 7.9 7.4 7.3 8.3 9.7 8.9

6.9 6.0 6.6 7.0 6.5 6.4 7.3 8.6 7.8

Comparing D3 with Table 3, it is apparent that the two approaches yield relatively similar appreciations for a given country, convergence scenario and ERM entry date. In almost all cases, the appreciation is less than 15%, and for most cases, it is considerably less, giving quite some leeway. Only in the case of very fast convergence (scenario 4), do a couple of countries have an appreciation of more than 15%. The central result that convergence effects imply less than a 15% appreciation carries over in virtually all cases.

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