Poland, Romania, Czechia, and Hungary lag in euro adoption, mainly driven by political factors, concerns over national sovereignty and potential economic drawbacks.
The four biggest economies in central Europe – Poland, Romania, Czechia and Hungary – have lagged behind the Baltic states, Slovakia and now Croatia when it comes to adopting the euro.
The main reason for that is politics. There are no sufficient parliamentary majorities in these countries in favour of dropping the national currency due to a mixture of fears of an erosion of national sovereignty and potential economic drawbacks.
Visegrad Insight editor Adam Jasser sat down with Zsolt Darvas, a renowned economist and Senior Fellow at Breugel, to discuss the extent to which euro adoption should be a priority policy and the balance of advantages and risks. You can listen to the whole interview in the link below.
Adam Jasser: To what extent is euro adoption an important issue for CEE countries which remain outside the eurozone?
Zsolt Darvas: In the medium and long term, euro membership would bring benefits to the current euro outs, but I wouldn’t say that this is a top priority at the moment. Let me elaborate on both points.
First, we [Breugel] conducted a study in which we analysed macroeconomic developments in central European countries inside and outside the euro and also compared these countries to southern European countries which joined the euro either in 1999, or, like Greece, in 2001.
The southern countries suffered major unsustainable developments and then a very deep crisis after the global financial crisis of the late 2000s and the euro crisis of the early 2010s.
Our findings show that while some central European countries had similar problems to southern European countries before the global financial crisis in 2008, these countries were able to adjust with their fixed currencies or within the eurozone.
Most notably, the three Baltic countries, which had even more extreme credit growth and more extreme house price increases than, let’s say, Spain, faced a tough adjustment but were ultimately able to achieve it, keeping their fixed exchange rates.
Since then, all three Baltic countries have become members of the euro area and are doing fine – they have very good growth and high employment, so their economic performance was really remarkable.
Another example is the Slovak Republic, which joined the euro in 2009. We have to recall that the exchange rate at which the Slovak koruna was fixed to the euro was decided in the summer of 2008, just three months before Lehman Brothers collapsed.
Back then, all central European floating currencies – the Polish zloty, the Slovak and Czech koruna, the Hungarian forint and the Romanian leu – were very strong, perhaps the strongest in nominal value ever against the euro.
That very strong exchange rate was fixed for Slovakia in July 2008, while a few months later, Lehman Brothers collapsed, and the currencies of Poland, Czechia and Hungary depreciated by 20-30%. The Slovak currency did not depreciate because it was already fixed to the euro.
So, Slovakia entered the euro at a very strong, very high exchange rate, and it has been doing fine without having an independent monetary policy and without having the exchange rate as a tool to adapt to macroeconomic shocks, which is a major argument many economists use in favour of having a floating exchange rate.
I can also mention Bulgaria, which has a fixed exchange rate under the currency board regime, which fixed the lev in the late 1990s to the German mark and then to the euro, meaning there has been no domestic monetary policy and no exchange rate fluctuation since.
If you look at Bulgaria’s export performance, it was as good as that of Poland or Hungary, so despite a completely fixed exchange rate in a small open economy, economic performance was really remarkable – similar, and in some aspects even better, than that of the floating currency countries such as Poland, Hungary and the Czech Republic.
These examples clearly show that it is possible to live inside the euro area for CEE countries which have converging economies and, at the same time, have good macroeconomic performance.
We can also look at what happened during the Covid crisis and the aftermath of the high inflation, including the impact of the energy shock following the Russian invasion of Ukraine.
Hungary, with its floating exchange rate, had the highest inflation in the European Union – the peak inflation rate was more than 25%, absolutely shocking.
This forced the Central Bank of Hungary to raise the main interest rate to 18%. At the same time, the European Central Bank raised interest rates to 4%.
Eurozone countries were able to operate at a 4% interest rate, benefiting businesses and households who would like to borrow, while in Hungary, the much higher interest rate disadvantaged anyone who would like to borrow. Also, lots of earlier borrowers had to pay much higher interest rates.
So again, during such crisis episodes, being in the eurozone was very beneficial for those countries that were in. Conversely, some countries that are out, including Hungary, in fact, faced major disadvantages of not having the euro, for example, fighting high inflation with only domestic policies.
Right, but at the beginning, you said that adopting the euro was not an urgent issue. What you just said would indicate that the outs would be better off if they were in the eurozone.
In the medium and long term, I’m convinced that these countries would be better off, but joining the euro takes time. First of all, both the formal economic criteria must be met – this includes the inflation criterion, which I think will be most difficult at the current stage.
It requires that the inflation rate in the applicant country cannot be higher than the average of the three countries with the lowest inflation rate, plus 1.5 percentage points. Meeting this criterion when we still battle the impact of the energy crisis could be very difficult.
I’m afraid this will make Bulgaria’s plan to join the euro [in 2025] much more difficult. For others, reaching a relatively low level of inflation would also be a tough task.
Moreover, this criterion is formulated in a strange way because the three countries with the lowest inflation rates are considered from the whole European Union. When Lithuania applied for euro membership in 2006, the three countries with the lowest inflation included Poland and Sweden, neither of which were in the eurozone.
At that time, Poland experienced a significant appreciation of the zloty relative to the euro, which explains why Poland had an unusually low inflation rate. So in the end, Lithuania missed this criterion by 0.5 percentage points, and the European Council concluded that it cannot join the eurozone.
So, meeting this criterion currently would be very challenging. It would require a major monetary contraction and a significant fiscal contraction. I’m afraid that these short-term costs could be very significant, so I think for the current euro outs, it would be better to wait a few more years until the general inflation trend everywhere moderates. I think it will be much less painful to meet the inflation criterion then.
So the timing is important and you need some basic macroeconomic stability across the euro area to make joining the single currency an easier process?
Yes, both in the euro area and also in the applicant countries. Without that, it would be very difficult. Another tricky criterion relates to the interest rate, which requires that the interest rate of the applicant country cannot be more than two percentage points higher than the interest rate of the three countries with the lowest inflation.
For some countries, this might prove to be challenging, given that interest rates depend on market expectations. So if the applicant country can convince markets that the euro prospect is a real possibility, interest rates will fall because investors will know that it will enter the eurozone in a few years, and its interest rates will fall significantly.
If markets are sceptical about whether a country can make it, its authorities cannot do anything to lower the long-term interest rate. Obviously, the country can reduce its public debt and budget deficit, but that’s not an easy task. Reducing public debt takes many years.
You mentioned the nominal criteria, and of course, they are formal, so it’s not so easy to skirt the issue. But some of the discussions about eurozone membership relate to real convergence. In other words, the similar level of economic development, similar levels of overall costs in the economy and so on and so forth. Real convergence should be increasing over time as CEE countries tend to have higher growth rates and increasing per capita income relative to their eurozone peers, so over time, this real convergence may bring them closer to a level where joining the eurozone is not going to be such an issue. How do you see that real convergence?
So let me explain when real convergence could be important and why I think that this is not relevant anymore.
Real convergence could be important in the context of what happened in southern European countries in the early 2000s. When those countries joined, their nominal interest rates suddenly fell but inflation remained high, so the so-called real interest rate – the nominal interest rate minus inflation – became negative.
That drove everyone, households and businesses, to borrow – households to borrow to buy houses, businesses to make investments and whatever else they wanted to do. Unfortunately, that process proved to be unsustainable and resulted in very large current account deficits and ultimately led to a painful adjustment period.
Now, how does this relate to real convergence? It relates to a very simple mechanism, namely that countries at a lower level of economic development tend to have lower prices. As lower-income countries gradually converge with higher-income countries, not only does economic performance improve but also the price level rises.
This means that in converging countries, it can be expected that inflation will be higher than in the rest of the eurozone. So, if a country joins the eurozone at a low level of development, it will continue to converge in real terms, which implies that inflation will likely be higher.
If what happened in southern Europe is repeated in CEE, the real interest rates will be negative again because the nominal interest rate will be determined by the European Central Bank, which focuses on the average of the eurozone area determined by Germany, France and Western European countries. The nominal interest rate will be low, inflation will be high, and that might encourage unsustainable housing and credit developments.
This, I think, is a clear rationale, but I will repeat that I don’t think that this matters looking forward. First of all, let’s look at what happened in those central European countries that already joined, the Baltics and Slovakia most notably.
These countries have continued their economic convergence, and yet they have not developed unsustainable credit bumps. So why is this? One reason is that an important lesson from the crisis in southern Europe in the early 2010s was that banking regulation and lending supervision must be much more prudent.
Now, whenever a bank lends to an individual, they look much more closely at how creditworthy that individual is. The so-called loan-to-value ratio is reduced everywhere, meaning that you can’t borrow the full value of a house. Banks also look at the regular income of prospective borrowers and don’t allow the borrower to spend more on loan instalments than a certain share of their monthly income. They also look at how interest rates could change in the future and predict some scenarios – for example, how much the loan payments could go up by for a customer.
Therefore, the financial regulation and credit policies became tighter and much more reasonable. The risk of a credit boom is lower because not just banks but also the authorities learned the same lesson, and the regulators have lots of new tools, called macroprudential instruments, which they can use whenever they notice adverse financial developments, such as too fast growth of credit.
These tools allow countries to avoid the risk of housing and credit bubbles, which characterised southern European countries in the 2000s. This means that somewhat higher inflation in new EU members within the eurozone would be acceptable and not create such problems as those we saw in Spain and elsewhere in the 2000s.
I presume one of the lessons was that prior to that crisis there was no longer any differentiation between country risk in the eurozone. The interest paid by individual governments on their euro-denominated debt was almost identical – there was virtually no difference between German debt and Greek debt – which was a mistake because the credit risk was different. The markets were over-enthusiastic about this. And so one of the lessons of the crisis is that markets need to watch and monitor macroeconomic performance even within the eurozone and attach different risk weights to different countries. We see today that governments are being disciplined by the markets within the eurozone depending on the quality of their fiscal position and overall macroeconomic policies. So there is a differentiation between what the German government pays for its debt and what the Greeks or Spaniards pay for theirs.
Is that another element providing checks on the risks of euro adoption?
That’s a very good point, and I very much agree with that. Indeed, before 2007/8, even the 10-year government borrowing costs were almost the same, or there were very minuscule differences or spreads. And that encouraged countries such as Greece to believe that this would last forever and that the government could spend as much as they wanted, even though we had fiscal rules which required public debt to remain below 60% of GDP.
Some countries like Greece and Italy had much higher debt than that, even when they entered. Even during the good years of economic growth in the early 2000s, there were only very small declines in these high debt ratios because markets simply financed everything.
Now the global financial crisis and the euro crisis were a wake-up call to everyone, and in fact, at that time, there was even too much market pressure. Then came Mario Draghi with his famous pledge that the ECB was ready “to do whatever it takes to preserve the euro,” and the spreads tightened again.
More recently, during the high inflation period of the past two years, the EBC invented a new tool, which they call the transmission protection instrument, which in principle could be used when a country has strong fundamentals but the market somehow speculates against that country and borrowing costs increase to a very high level. In such a case, the ECB can intervene even without any formal bailout programmes.
There is a lot of discussion about this instrument, whether it would work or not and how it would work because this was just an announcement so far, and there has been no need to use it. But I think such instruments are ultimately useful because, indeed, there could be self-fulfilling speculation, which can even push a fully solvent country to the brink of default. Yet, if markets know that a country has good fundamentals, then it might ultimately not be worth it to speculate against it.
A pendulum went the other way.
Indeed, indeed. So this will help to keep the interest rate differentials across eurozone countries under some control, but yes, we do see that Italy pays about two percentage points more than Germany on its long-term debt, which I, as an economist, would say is roughly the right magnitude.
It keeps pressure on the Italian government, as the country has more than 140% of GDP public debt ratio, more than two times the 60% required by the EU treaty. Unfortunately, the reality is that if a country has such a high debt ratio, it has to pay higher costs and work on reducing it.
I very much welcome that the markets are starting to function properly in this respect. I hope this ECB instrument will keep the markets under control, but markets will signal whenever a country is partaking in unsustainable policies.
So one could argue that it should be much easier now for the euro outs to join the eurozone because you can learn from the experiences and mistakes of the previous euro adoption episodes, there are new mechanisms in place, and the real convergence is also progressing. So at some stage, it should basically be just replacing the picture on the banknotes.
I agree, but I also think that this is ultimately a political decision. Economists can explain whatever they want to politicians, but it will be very much the politicians’ perceptions and beliefs which dictate whether they want to join or not.
So yes, as time passes and if the current high inflation episode moderates in the next 2-3 years, it might indeed be a chance for the current outs to join, but it will be an entirely political decision whether to do that.
This is an argument which is very often raised – that there are no tangible, clear-cut benefits of quick euro adoption, and at the same time that there is no visible punishment for not being in the eurozone because these countries continue to grow pretty well overall. But are they reaching a point where the absence of the euro is going to affect their ability to grow or attract investment? Are there going to be incentives for the politicians to actually speed up euro adoption?
I’m afraid the economic incentives are limited. So while I argue that all central European countries would do better inside the eurozone in the medium and long term, the difference is probably not that big.
Growth might be a little bit faster with the euro. Certainly, companies would benefit from not having a volatile exchange rate. Ordinary people would also benefit as they would not have to exchange their domestic currency to the euro and back when they travel, facing the exchange rate risk and various kinds of costs.
Lots of things would be simpler, lower risk would come, but a politician whose main goal is re-election is looking more at what to do to achieve that. Unless there is a very strong consensus among the population that, yes, we must introduce the euro, the political incentives for somewhat limited benefits in the medium term are limited.
If adopting the euro would require efforts both on the fiscal side and on the inflation side, vote-focused politicians might just delay.
But just imagine for a moment that you have a crystal ball, and you’re looking into it. What would be your best guess on when Poland, Czechia, Hungary and Romania join the eurozone?
Bulgaria would definitely like to join. They’ve already applied, but unfortunately, the country was not allowed to join along with Croatia. So my guess is that when inflation will be reduced, Bulgaria will be the first country to join.
Not least because before joining the euro, two years have to be passed in the so-called exchange rate mechanism, and Bulgaria has already done that.
But for the other countries to join, they have to apply first, then the application has to be accepted and approved and unfortunately, there are no clear criteria which determine whether such an application will be approved. Once a country is in the exchange rate mechanism, the process is unstoppable because if they meet the criteria, they automatically get in. But there are no formal criteria for joining the exchange rate mechanism – that’s a discretionary decision, so if the current members don’t want a country to join, they simply won’t allow it.
Coming back to my predictions, my expectations would be that Bulgaria would be the first country to join, perhaps Romania the second, and I think the game-changer would be Poland.
Now Poland has a new government but I haven’t heard about their intentions and whether the position on the euro has changed. If Poland were to join, that would put very strong pressure on Czechia and Hungary because these two countries would be the only remaining “outs” in CEE. So that might even change the views of the Hungarian government.
But as this is not yet discussed, not yet on the cards, I’m afraid there is little chance that this would happen during this decade.
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