Studies Eastern European Markets
Eastern European Markets
December, 2005

Tauno Tiusanen, Jatta Kinnunen
Northern Dimension Research Centre
Publication 23- c

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A limited number of rather clear preconditions were fixed for potential EMU members in the1990s. After the launching of euro (1999), it became clear that one of the main rules of the eurozone game, the 60% public sectors debt (of GDP) was not strictly applied. In the short history of eurozone, it has become obvious that the second most important rule of EMU, the 3% annual maximum of budget deficit of GDP has not been strictly obeyed by all member states of the monetary union.

As shown above (Table 1), six of twelve EMU members had overvalued currencies in 1998 (before the irrevocable fixing of ERs). Germany’s overvaluation was close to 20%. Two countries, Italy and the Republic of Ireland had an equilibrium rate, while four countries had undervalued currency, Portugal with highest ERDI value of 1,35. In 2001, before circulating euros in banknotes and coins, all EMU countries had an ERDI value higher than one. Portugal had the highest mark of 1,62, while Germany’s figure was the most modest, 1,08. Thus, in the eve of launching euro notes on the market (January 1st, 2002), the common currency area showed signs of undervaluation (see Table 2 above). Figures in Table 1 and 2 originate from the World Bank, which provides new data for 2004. It is interesting to compare the situation now in the eurozone countries after three years of euro circulating in twelve countries.

The above table gives the results of the euro-system in its third year of existence. It is extremely interesting to observe that within the eurozone there are six countries with ERDI values less than one (indicating overvaluation) and five countries with ERDI values over one (indicating undervaluation), even though common currency (euro) ought to have abolished price differentials in the zone as a whole and ought to have established equilibrium ERs in every member country of the currency area.

Actually, there are five countries in the eurozone which are very close to an equilibrium in the above calculation. In France, ERDI value is 0,97 indicating that GNP at official ER deviates only 3% of the PPP adjusted one (indicating 3% overvaluation). In the Netherlands ERDI value is even closer to one (0,98) witnessing a moderate overvaluation of 2%. Austria has exactly the same situation, as Netherlands. Belgium is closest to the equilibrium rate with 1,01 ERDI value, and thus, her figure shows an undervaluation of only one percent. Ireland is with her ERDI of 0,97 in the same position as France.

Germany’s ERDI in the above table is 0,93 which indicates 7% overvaluation. ERDI in Finland is 0,90 indicating that her overvaluation is with 10% even higher than in Germany. In Italy, ERDI value is 1,07 pointing out that euro in that country deviates 7% of the equilibrium rate in the direction of moderate undervaluation.

The most severe deviations from equilibrium can be found in Portugal, Greece, and Spain, which have the lowest living standard figures in the above table (measured in GNP per capita figures at PPP). In the Spanish case, ERDI is 1,18 indicating 18% undervaluation. The equivalent figures in Greece are even higher (ERDI value 1,32, and thus, 32% undervaluation). Portugal has the highest ERDI value with 1,34 in the countries under review in the above table.

It is interesting to observe that Portuguese ERDI has hardly changed since 1998 (Table 1), while at the same time Spanish ERDI has grown somewhat, and Greek ERDI has increased strongly from 1,12 in 1998 to 1,32 in 2004.

External balance of goods and services (for eurozone countries) is part of the above table. In the three countries with most severe undervaluation figures, Spain, Greece, and Portugal, this balance (a proxy for current account) is in deficit: in Spain -2% of GDP, in Greece -8% of GDP, and in Portugal -7% of GDP.

On the other side of the scale there is Ireland with the highest living standard of the zone, and far the most substantial surplus in her external balance of no less than 19% of GDP. Finland has the second highest CA surplus with 7% of GDP. The equivalent figure in Germany is 4%.

External balance is very well in equilibrium in both France and Italy: there is a modest surplus of 1% of GDP in both cases. The equivalent figure in Austria is 2%, and in Belgium 3%, while in the Netherlands the surplus is with 5% somewhat higher in relative terms than in Germany.

Thus, it can be concluded that Portugal and Greece in 2004 have rather clearly undervalued currency within the eurozone, and still have rather high current account deficits of 7-8% of GDP. Membership in the monetary union has in these two cases not guaranteed equilibrium in external economy.

Portugal has a bit lower and Greece a little higher living standard than Slovenia (GDP per capita at PPP, in US dollars). Other eurozone candidates in the sphere of transitional economies are clearly behind Slovenia in welfare.

On the basis of statistical data brought up in this short research report, it can be concluded that Slovenia is an excellent candidate for eurozone membership: Slovenia’s ERDI in 2004 is not higher than equivalent figures in Greece and Portugal, which are already EMU countries. More importantly, Slovenia has reached almost precise equilibrium in her external balance (CA), while the poorest eurozone countries, Greece and Portugal, have rather high CA deficits.

The three Baltic States with ERM II status are rather clearly behind Slovenia (and Greece and Portugal) in living standard. ERDI values in Latvia and Lithuania are relatively high. Estonia’s ER shows also a remarkable undervaluation, even though it is more moderate than in other two Baltic States. However, Estonia has the highest relative CA deficit among NMSs: Estonia’s CA deficit of 15% of GDP indicates that the ER is not on an appropriate level.

The exchange rates of the three Baltic currencies ought to be measured properly by market forces in the framework of ERM, which is meant to be an antechamber of eurozone full membership. During this trial period of ERM scheme, suitable exchange rates ought to be looked for via economic, and not via administrative methods in every single case of a potential eurozone membership.

Estonia’s share of EU’s GDP (25 countries) is 0,01%. The equivalent figure in Latvia is also 0,01%, in Lithuania 0,18% and in Slovenia 0,25%. Thus, the share of EU’s GDP (at official exchange rate) in these four euro candidates taken together is 0,45 percent. The country with the highest percentage in this comparison, Slovenia, has a living standard which compares well with Greece and Portugal. Slovenia has relative equilibrium in her CA.

These figures here are brought up in order to show that the four euro candidates can hardly cause substantial disturbances on EU affairs because of their relatively modest size (taken together). From this point of view, eurozone enlargement with these four countries in this decade can be described as a rather easy exercise.

Those four transitional economies, which are EU members, but not yet in ERM II (Poland, Slovakia, Hungary, the Czech Republic) have together a 3,9 percent slice of EU’s GDP (of 25 countries). This calculation is made at official exchange rate basis (without PPP adjustment). The figure of less than 4% is rather low. In comparison, the equivalent share of EU’s GDP (25 countries) of those three “old” EU members, which are not in eurozone (United Kingdom, Denmark, Sweden) is about 22%. Thus, about one quarter of EU’s total output (of 25 members) is created outside of the eurozone. The possible eurozone enlargement comprising Slovenia, Estonia, Latvia, and Lithuania, is only marginally affecting the scene (measured with the mentioned circa 0,5% of EU’s GDP created in the potential new eurozone countries).

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