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Thesis work

Zsolt Szab 2011

Corvinus University of Budapest Faculty of Business Administration International Study Programs

The consequences of Hungarys accession to the Economic and Monetary Union should we join or NOT?

Zsolt Szab BA in International Business International Business 2011

Thesis Supervisor: Tams Halm

I, Zsolt Szab in full knowledge of my liability, hereby declare that all the texts, figures and tables in this Thesis Work are based solely on my own individual work. Where I have drawn on the work, ideas and results of others, this has been appropriately acknowledged in the thesis in the form of citation and references. I declare, furthermore, that the thesis has not been presented to any other institution before.

Table of content
1. 2. Introduction ..................................................................................................................... 5 Optimum Currency Areas................................................................................................ 7 2.1. 2.2. 3. Possible benefits from joining a currency area ........................................................ 8 Costs of joining a currency area ............................................................................... 9

The history of the Economic and Monetary Union ....................................................... 11 3.1. 3.2. 3.3. 3.4. 3.5. Stage One of the EMU ........................................................................................... 11 Stage Two of the EMU .......................................................................................... 12 Stage Three of the EMU ........................................................................................ 13 The Maastricht convergence criteria ...................................................................... 14 The EMU as Optimum Currency Area .................................................................. 15


Hungary and the Economic and Monetary Union ......................................................... 19 4.1. 4.2. 4.3. 4.4. 4.5. 4.6. The Benefits of joining the EMU ........................................................................... 20 The costs of joining the EMU ................................................................................ 21 The timing of the accession.................................................................................... 23 Hungarys EMU maturity ...................................................................................... 26 The experience of some other EMU members ....................................................... 29 Should Hungary join or not? .................................................................................. 31

5. 6.

Conclusion ..................................................................................................................... 32 Appendices .................................................................................................................... 33 Appendix 1 Fixed euro conversion rates ........................................................................ 33 Appendix 2 Euro banknotes ........................................................................................... 34


Bibliography and references .......................................................................................... 36



The introduction of the euro as the currency for more than 300 million people was one of the biggest and most tactile steps in the history of the European Union, and was also the most important economic, political and social event in the past decade. The euro first appeared on 1 January 1999, but in the beginning was used only for accounting purposes and electronic payment. On 1 January 2002 the first euro banknotes and coins went into circulation. From February 2002, the euro officially replaced the national currencies of twelve1 member states of the European Union and became a symbol of the European integration and the European Union. Today the Euro is the official currency in 17 of 27 member states of the EU. By joining the European Union in 2004 Hungary has also committed itself to the common currency, as for the newly joined countries the introduction of the euro will not be an option, but an obligation as soon as they fulfil the Maastricht criteria. The only exceptions are the United Kingdom and Denmark, which countries have opt-out rights. This means that these member states are not obliged to join the euro zone, even if they fulfil the necessary criteria. Sweden has not negotiated for opt-out, however the country deliberately fails to fulfil the criteria, because of a 2003 referendum in which voters voted against the introduction of the euro in Sweden. The issue of introducing the euro in Hungary has caught my attention for two reasons. The main reason was that in the past decade, every now and then the timing of the countrys euro-accession came up to the front, turned up in the news and was a popular topic for discussions. However in the recent years the possible date of introduction of the Hungarian euro seemed to be farer in the future than before. The other was to find out what makes developed countries like Sweden, Denmark of the United Kingdom think that they are better off sticking to their own currencies, while others say that introduction of the euro has so much benefits. The aim of this paper is to assess the possible costs and benefits of giving up the national currency and replacing it with the euro.

Countries that introduced euro banknotes and coins on 1 January 2002: Austria, Belgium, Germany, Finland, France, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain.

In the first part of the thesis I will introduce the theory of optimum currency areas, with a special emphasis on what can be the benefits and drawbacks of joining a single currency zone. Furthermore I will try to highlight the relationship and interdependence between a countrys economy, internal qualities and the consequences of joining a monetary union. After this I will take a look at the history of the European Monetary Union and examine whether is fulfils the criteria of being an optimum currency area. In the second half of the thesis I will take a closer look at Hungarys current economic situation and compare it to the EMU and some selected countries. In these chapters of thesis I will also give some proposals regarding the timing of the euro accession and argue whether Hungary should join (if so) the monetary union with a strong or a weak currency. As one of the hottest economic issues today is the current euro-crisis that emerged right after the global financial crisis, I believe it is unavoidable to address this issue as well in a paper, which is closely related to the euro. However, when writing my thesis, I assumed that the euro as one of the main achievements and symbol of the EU - will stay as the legal tender of the union and throughout the integration process Hungary and other new member states of the EU will be able to join the monetary union sooner or later.


Optimum Currency Areas

The theory about optimum currency areas emerged in the 1960 s out of the debates

about fixed versus flexible exchange rate systems, throughout the works of Robert Mundell, Ronald McKinnon and Peter Kenen. By this time the deficiencies of the Bretton Woods system became clear, the current account deficit of the member countries was rising constantly. The works of Mundell, McKinnon and Kenen addressed this issue and provided a solution. Their theoretical analysis can be used to measure how mature and well-prepared a group of countries is to create an economic and monetary union. Based on their theories an optimum currency area has the following attributes (Palnkai, 2004): Flexible and properly functioning factor markets, mobility of factors High degree of internal homogeneity no threat of asymmetric shocks Possibility of appropriate budget transfers

According to Mundell (1961) the most important feature of the optimum currency area is the free movement of production factors (capital and labour), which implies that the adjustment of prices and wages take place without significant losses or shocks. Also, it must be possible to handle economic disruptions with appropriate budget transfers, which means the necessity of good and adequate fiscal policy. Mundell also highlighted, that the introduction of a fixed exchange rate system can be beneficial for those regions, which are highly integrated through the movements of goods and factors. Since in a fixed exchange rate system or in a monetary union the room for individual monetary policy is very limited, it is necessary that the business cycles are the same in the member countries. In contrast to Mundell, McKinnons argument places more emphasis in on the openness of the economies, but he also admitted the importance of free movement of capital and labour. In his argument he approached the issue from a whole other point of view than Mundell. According to McKinnon (1963), exchange rate fluctuations have specifically negative effect on both competitive sectors, because they constantly need to adjust to the changing exchange rates, and to non-competitive sectors, through the reallocation of resources. McKinnon also stated that a fixed exchange rate system is indispensible for the optimal operation of factor movements.

Kenen (1969) pointed out, that the most important feature is the high level homogeneity of the countries creating a currency union. The high level homogeneity minimizes the possibility of emerging asymmetric shocks 2, which is crucial for the optimal operation of such unions. This homogeneity means that there is a significant similarity in the countries economic structure and characteristics. As Palnkai (2003) states, whenever a country joins a monetary union, it loses its power to change the exchange rate of its currency. With the elimination of exchange rate interventions the economic stability and competitiveness depends on the flexibility of prices and wages. What can be noted as a common idea of all of the arguments above is the necessity of high level integration and similarity of the countries. This similarity does not only mean economic, but cultural similarity as well. All in all, an optimum currency area can only be formed by member states that act and function like being one big country.


Possible benefits from joining a currency area

Both fixed and flexible exchange rate systems have positive and negative effects on the economy. Flexible exchange rates can prevent the development of economic shocks, although it makes prices more unpredictable. Fixed exchange rate systems or currency areas tend to be more predictable, making a more stable ground for decisions involving international transactions. The benefits stemming from being a part of a monetary union occur as monetary efficiency gains at a microeconomic level in the joining country. This means that the country can achieve a lower level of inflation and a better price stability, simply because of the disappearing exchange rate risk (FX risk). Furthermore the eliminated FX risk also reduces the risk-premium required by foreign investors, leading to lower interest rates and cheaper financing costs. The necessity of hedging the FX risk also ceases. At the same time a higher risk country like Hungary can get a better country risk

Asymmetric shock: Shocks that affect only some of the member countries in a monetary union, or shocks that are contrary to each other in the different member states.

rating. The financing benefits and the better integration to the international goods market can let the country to sustainably run a higher current account deficit matched by an increased capital account. (Palcz, 2004) As a consequence of the above the countrys ability to attract capital is likely to increase. The level of monetary efficiency gains are determined by the joining countrys integration to the monetary union, while the integration depends on the extent of the countrys trade with the union, the possibility of free movement of production factors and structural similarities.


Costs of joining a currency area

While the benefits of giving up the national currency can be detected at microeconomic

levels, the costs occur at macroeconomic level as economic stability losses. Similarly to the benefits, the extent of these costs is highly correlated with the level of integration to the monetary union. The higher the level of integration, the lower the costs and stability losses will be when a country decides to join a currency area. The losses stem from giving up monetary autonomy, which results that the country sacrifices one major tool that can reduce the effects of asymmetric shocks, stabilize output and employment. Furthermore the country will not be able to devaluate its currency anymore. In this respect the integration of the country and the fluctuation of business cycles are crucial, since the common monetary policy will have to work in all member states of the currency zone. Krugman (2003) illustrates this situation on a real simple example in his book, which I am about to describe in short. Lets imagine that the external demand for products of country A falls. If country A is not part of a monetary union and has flexible exchange rates , its currency can simply depreciate to the equilibrium, where demand for its products returns to the original level. However, if country A was member of a monetary union or a fixed exchange rate system and was the only member to face a drop in demand for its goods, the common currency would not depreciate (or at least not as needed for country A). Consequently as demand for the products drop the employment rate will drop as well, and can only be restored to the original level by decreasing prices and wages of workers. If country A is highly integrated to the monetary union, even a small decrease in prices will generate extra demand within the union for its goods fairly quickly, 9

Figure 1
economic stability loss (LL) for the joining country.




The GG and LL curves

employment rate to the original level. This quick reaction for price

The monetary efficiency gain (GG) and


differences will come from the fact, that the country can easily trade its goods with member states of the currency area and


consumers in the other countries can easily

Degree of integration between the joining country and the exchange rate area. Source: Krugman (2003)

compare prices, because of the common currency. Another possible or

alternative solution would be, that the workers of country A simply move abroad to find work, which in the end also would restore employment rate. Figure 1 shows the relation between the degree of integration and monetary efficiency gains and economic stability losses. It can be seen on the diagram that as the degree of integration raises so does the gains from joining the currency area, while at the same time economic stability losses decrease. At the point where GG and LL curves intersect each other, the gains and losses of giving up the own currency will cancel each other out. From this level of integrity the country is better off joining the monetary union. At an integrity level lower than at the point of intersection costs exceed benefits, implying that it is best to keep the own currency. Another type of cost, which a country has to face when joining a monetary union, is the loss of seigniorage income that comes from issuing their own money and minting coins. In the Economic and Monetary Union each member states have their own euro (the backsides of notes and coins differ from country to country), and also receive a part of the seigniorage from the European Central Bank based on the contribution to the registered capital of the ECB. The contribution is calculated the countrys population and GDP compared the EUs population and GDP. In the case of Hungary the seigniorage it would receive after its contribution is less, than the seigniorage income today. (Csajbk Csermely, 2002)



The history of the Economic and Monetary Union

The traces of the creation of the Economic Monetary Union go back to the 1960s,

namely the 1968 Barre plan, and a 1969 initiative by the European Commission for the better coordination of economic policy making and monetary cooperation. The consequence of this was the Werner plan, a three-stage program which would result in locked European exchange rates and the integration of national central banks into a common European system of banks. The two major reasons behind these moves have remained motives for the adoption of the euro, and are the following: enhancing Europes role in the international economy and the monetary system and to turn the European Union into a genuinely unified market. However the project suffered setbacks in 1971, after the dollars convertibility to gold was suspended by the US government. The debate was re-launched at the Hannover Summit in June 1988 and the objective of the progressive realization of the Economic and Monetary Union (EMU) was confirmed by the European Council. The Council then mandated a committee to study and propose stages leading to the union. As a result the committee led by Jacques Delors, president of the European Commission, proposed that the economic and monetary union can be established through three evolutionary stages. (Delors-plan)


Stage One of the EMU

Based on the Delors report the first stage of the implementation process of the EMU

started on 1 July 1990. As the main principle of this chapter all restrictions on capital movements between member states were abolished on that date. Further tasks of the first stage included increasing co-operation between central banks, free use of the European Currency Unit (ECU, the predecessor of the Euro) and the improvement of economic governance.


In March 1990 the Committee of Governors of the central banks was given new responsibilities of organizing consultations for promoting the coordination of monetary policies of the different member states to achieve the necessary price stability. Additionally, to be able to realize stages two and three, some legal preparations were also started at an early stage, for example the revision of the Treaty of Rome in order to establish the required institutional framework. This was done on the Intergovernmental Conference on EMU in 1991. Other preparatory steps included the identification of key issues, the elaboration of a work program by 1993, the establishment of working groups and the definition of mandates of sub-committees accordingly.


Stage Two of the EMU

The start of the second chapter of the EMU was marked by the establishment of the

European Monetary Institute (EMI) on 1 January 1994. With this step the Committee of Governors of central banks ceased to exist. This new, transitory institution has also shown how the monetary integration process within the Community progressed. The main tasks of the EMI was to further strengthen central bank cooperation and monetary policy coordination and to make preparations required by the establishment of the European System of Central Banks (ESCB) which would be the key in the creation of the single monetary policy and single currency in the third stage of the EMU. The EMI had no competence for carrying out foreign exchange intervention and the conduct of monetary policy also remained the preserve of national authorities. Actually, the EMI could be seen as a forum for consultation and exchange of views on policy issues. This forum has also specified the regulatory, organizational and logistical framework of the ESCB. In December 1995 the European Council agreed that the name of the new currency unit to be introduced in Stage Three would be euro and confirmed that the third stage would start on 1 January 1999. Based on the detailed proposals of the EMI a chronological sequence of events for the conversion to the euro was pre-announced.


Simultaneously, the EMI carried out a preparatory work on the future of monetary and exchange rate relationships between the euro zone and other EU member states. The report presented in 1996 formed the basis for the new exchange rate mechanism system (ERM II), adopted in June 1997. On 2 May 1998 the Council of the European Union decided that 11 MS had fulfilled the necessary conditions and can participate in the third stage of the EMU. This also meant that they would adopt the single currency on 1 January 1999. Also in May the ministers of finance of the 11 member states alongside with the heads of national central banks, the European Commission and the EMI agreed that the current bilateral central rates of the currencies would serve as the irrevocable conversion rates for the euro. On 25 May 1998 the President, Vice-President and four other members of the Executive Board of the European Central Bank (ECB) was appointed. This took effect from 1 June, which date also marks the establishment of the ECB. As the EMI has completed its task in good time it went into liquidation in accordance with Article 123 of the Treaty establishing the European Community. The rest of 1998 was used to final testing of newly built systems and procedures.


Stage Three of the EMU

On 1 January 1999 the third and final stage of the EMU started with irrevocably

fixing the exchange rates of the currencies of 11 member states to the euro and with the conduct of a single monetary policy under the responsibility of the European Central Bank. The initial participating countries were Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. Around this time, the euro functioned only in accounts. The actual physical usage of euro notes and coins began on 1 January 2002. The number of countries which adopted the euro as a legal tender has been increasing ever since. In 2001 Greece was next to adopt the euro, followed by Slovenia in


2007. In 2008 both Cyprus and Malta joined the euro zone. Slovakia and Estonia became members in 2009 and 2011 respectively.


The Maastricht convergence criteria

The Treaty on European Union (or as better known, the Maastricht Treaty), entered

into force on 1 November 1993, defines 5 convergence criteria regarding price and exchange rate stability and sustainable financing of the country, which must be fulfilled by every candidate before the accession to the European and Monetary Union. The reason behind the criteria is to ensure that the EMU as a group of countries fulfils the requirements of being an optimum currency area as much as possible. The Maastricht convergence criteria are the following: The rate of inflation cannot exceed by more than 1.5% the average inflation rate of the three countries with the best price stability. Also, this low rate of inflation needs to be sustainable. Annual budget deficit cannot exceed 3% of GDP Gross national debt level should not exceed 60% of GDP, however a country with a higher debt level may still adopt the euro provided its debt level is falling steadily The national currency must have stayed within a certain pre-set band, and the currency cannot be devaluated against any of the member states within a 2 year period. This means The average long-term nominal interest rate must not be by more than 2 percentage points above than the average of the three member states with the lowest inflation over the previous year.

However, it is not enough to reach the above criteria before the adoption of the euro; they are to be kept afterwards as well, except for the inflation, which is not regulated within the EMU. The monitoring of the member states, whether they maintain to keep

themselves to the criteria or not, and possible sanctions for the latter case are regulated by the Stability and Growth Pact (SGP), adopted in 1997. (Palcz, 2004) The SGP ensures, that member states continue to observe the Maastricht convergence criteria even after they have adopted the euro. This guarantees that member countries remain committed to strict fiscal policies and dont endanger the stability neither of the common currency nor of their own economy. It can be seen that during the creation of the Maastricht convergence criteria the member states had to intention to include criterion, which are relatively easy to measure and compare. Many critics of the Maastricht criteria highlight that it takes into consideration only quantifiable data, while it does not account for the real economy and structure, although these are equally important factors for a currency area. In the cases of the newer member states, the EU takes into consideration real economic factors as well.


The EMU as Optimum Currency Area

The opinions of experts differ concerning the extent to which the European

Monetary Union can be considered as an optimum currency area and in the recent crisis the voice of those who say that the introduction of the common currency was a mistake emerged. What is common, that the number of experts, who say that the monetary union is an optimum currency are is very limited. As Pter Rna in a recent (01.07.2011) interview to ATV highlighted the common currency is not a tool to, but a fruit of integration, and according to him the necessary level of integration within the Economic and Monetary Union is missing. Rna admits that there is a competitive core within the EMU (Germany, France, Austria, Finland, Netherlands and Luxemburg), but the rest of the countries are on the periphery. The countries on the periphery lose their competitiveness and suffer, because the euro is overvalued for them, while in case of the competitive countries, the euro is undervalued. Consequently for the less developed countries in the current situation the euro in itself hinders the integration to the developed countries. Also, a great difference in the structure of the economies can be

discovered. In the interview Mr. Rna used Greece as an example, which relies heavily on tourism; while other countries like for example Germany rely on their automobile industry. This and similar types of structural differences weaken the euro zone, and lead to instability as this is a source for asymmetric shocks to emerge. In the 2008 financial crisis the income from tourism in Greece dropped significantly. This appeared as an asymmetric shock compared to the core countries, which did not perceive such an impact on their economies. The loss of income played a significant role in the indebtedness of Greece, which now affects the whole euro zone and the European economy. Asymmetric financial shock, symmetric economic shock (Barry Eichengreen, 2009) In case of Germany as we know the situation of the automobile industry became worse than before as during the financial crisis the demand for their high quality vehicles decreased. Thanks to Germanys fiscal stability the government could support internal demand by the Wreck Premium program. (Anonymus, 2009) As a solution Mr. Rna suggests that integration of members of the EMU needs to deepen through common taxation, fiscal policy and a higher level resignation of sovereignty. Years before this argument Gspr and Vrhegyi (1999) also stated that the EMU lacks some of the most crucial tools and level of integration to handle shocks, like high level of labour mobility and central budget transfers. Both Palnkai (2004) and Krugman (2003) admit that according to traditional economic theories the EU and the EMU cannot be considered as an optimum currency area, mainly because of the limited mobility of labour, although migration among EU countries is technically feasible, hence there are no country borders. The immobility of labour is rather a result of language barriers and cultural differences among the member states, which makes it difficult for individual countries to adjust to economic shocks. In addition, movement of labour within the EU is also set back by unfavourable regulations and housing policies in some countries. (Palnkai 2004) The inefficiency of the housing market, the lack of clarity in the cross-border recognition of professional qualifications and the limited portability of pension rights are all barriers to geographical labour mobility in the EU. (Heinz-Warmedinger, 2006)


Compared to this, in the United States currency union this is just the opposite, as the language and is the same in all states, cultural differences are not that significant and labour force seems to react much more flexibly and rapidly to regional changes. The Americans not only have the possibility to move, but also willing to move, creating equilibrium at regional labour markets. (Bks, 1998) Regarding the mobility of the other production factor, capital the EU can be considered as perfectly mobile, since in the early 1990s member countries abolished all restrictions on capital flows. The development of the IT sector has also contributed to more efficient operation of capital markets. If we go back to the criteria checklist of optimum currency areas in the second chapter of this thesis, we can easily assess the properties of the EMU accordingly and conclude whether it can be considered as an OCA or not. The following table helps in this comparison. Table 1 OCA Checklist and the EMU Flexibility of factor markets Capital market: Yes Labour market: No3 High degree of internal homogeneity Budget transfers No No

About the flexibility of factor markets the previous give a comprehensive picture, but I believe the degree of internal homogeneity and the issue of budget transfers need some more clarification. The degree of internal homogeneity can be described in many ways. And perhaps this is the area where most experts and analysts have different opinions. Krugman (2003) stated that the euro zone countries are similar in their manufacturing structure, which is evidenced by the large volume of intra-industry trade. However he also admitted that there

Technically feasible, but language, cultural and other barriers are significant.


are important differences as well. For example northern countries are better endowed with skilled and educated labour, while products that use low-skilled labour are likely to come from southern Europe. It is also true that northern countries are more abundant in capital as well. The newer members of the EU, who are waiting for the adoption of the euro, are also more likely to have a development level of the southern countries. In this case their accession to the euro zone can further increase differences within the monetary union. The last point in the checklist is budget or fiscal transfers. This basically means shifting a part of the fortune of better performing countries to those, which are performing worse and have higher than optimal budget deficits. The no bail-out clause4 of the Maastricht Treaty limits the possibility of such transfers to a very low amount. However as we have seen in the current bail-out packages for Greece, there are some possibilities, although they take long negotiations. Also as the example of Greece shows, the access to a bail-out package does not the problems of the real economy, only delays bankruptcy. As a the result of the above we can conclude that, despite the fact the accession Economic and Monetary Union is only possible through the compliance with the Maastricht criteria, the EMU does not fulfil the requirements of optimum currency areas. However as the process of joining the monetary union was considered irreversible from the beginning there is no elaborated way a country can return to its original currency and own monetary policy making. Also, a step like this would have unpredictable effects on the euro and financial markets and thus would not likely to be supported by any of the member states. For this reason chances are that the euro zone will stay together, but it needs to improve to be able to operate optimally as it was planned in the beginning.

Article 104 b/1 of the Maastricht Treaty: The Community shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.



Hungary and the Economic and Monetary Union

In the second chapter of the thesis I assessed the costs and benefits of joining an

optimal currency area. Whether we consider the EMU an OCA or not, the costs and possible benefits of the accession will be similar to those of an optimum currency area, only
their extent will be different. Since the adoption of the euro will be compulsory for Hungary after it fulfils the Maastricht convergence criteria, it is good to know what we can expect from giving up our national currency, the forint and plan with economic policy accordingly. Alternatively, if policy makers conclude that it is best to keep our own currency it is still possible deliberately not to fulfil the criteria as Sweden does. It also has to be noted, that in itself the fact that the EMU does not fulfil all requirements of optimum currency areas does not mean that Hungary cannot benefit from joining the euro zone. If the similarities and the degree of integration reach a certain level it is beneficial for us to adopt the euro. However it has to be added, that not only the nominal extent of gains and losses count. The extremes of business cycles are also important; it is better and safer to have a slower but sustainable economic growth, then having rapid expansion with overheated economy and dramatic collapse. The level of integration and the applicability of the common monetary policy are crucial in this respect. In 2002, a study conducted by the Hungarian National Bank concluded that the monetary policy of the Economic and Monetary Union is applicable to the Hungarian economy at least as much as it is for the less developed members of the euro zone. As we see, today the less developed countries, especially Greece faces huge crisis, which shows that their euro accession was too early, and the strong common currency ruined their competitiveness within only a few years, or led to unsustainable growth, which than made the economy collapse. This can be warning sign for Hungary, showing the importance of level of integration at the point of accession and the timing of the euro adoption. The same study has also shown quantified data to interpret the aggregate effect of Hungarys euro accession. The studys English title is Adopting the euro in Hungary: expected costs, benefits and timing, and was edited by Attila Csajbk and gnes Csermely. This study serves as the basis for the next paragraphs of my thesis.



The Benefits of joining the EMU

When we assess the benefits and costs of membership in the monetary union, first it

needs to be clarified what is the alternative to the accession, what do economic prospects look like in case of keeping the own currency. In the above mentioned study the editors related the costs and benefits to an alternative path of joining the European Union at a relatively early stage (this was fulfilled in 2004), but keeping the own currency, monetary and exchange rate policy. The study also assumed that despite the country refrained from the accession to the monetary union, the continued convergence of inflation rate and incomes towards the euro area. The benefits of joining the EMU can be classified into three main categories, which I have already indicated in the second part. These are the following:

reduction of transaction costs expansion of external trade reduction of real interest rates

The use of the national currency can be considered as an administrative burden, which ties up part of the physical and human resources. These losses appear at a household and firm level as well, since the cost of conversion of forint to euro (and vice versa) takes form in commissions, bank fees and bid-ask spreads. According to estimates based on the volume of trade of the forint on the foreign exchange market and the corresponding fees, the reduction of transaction costs means a single (one time) 0.18-0.3 percentage point increase in the level Hungarys gross domestic product. Maintaining the national currency can have a negative effect on the volume of external trade as well. The common currency makes prices more transparent and comparable. Also, the risk of exchange rate fluctuation disappears. This motivates trade, which in turn leads to further exchange of technology and know-how. Based on this argument the adoption of the euro will lead to a 0.55-0.76 percentage point increase in the rate of GDP growth in the long run.

The risk of exchange rate fluctuation is also included in the risk premium of Hungarian securities (bonds for example). This extra interest compensates external invertors for uncertainties regarding future exchange rates. The common currency will remove this extra interest from nominal rates, which in turn causes real interest rates to be lower. This not only makes financing cheaper, but the threat of devaluation caused by the current account deficit will also be ceased for euro zone investors. This removes a major restraint on investment growth, and accelerates the convergence of incomes to EU levels. Analysts suggest that this change will raise the rate of GDP growth by 0.08-0.13 percentage point. According to the study the euro will have a positive effect on the financial integration as well. As the exchange risk ceases domestic households will have the possibility to broaden their investment portfolios with foreign assets from the euro zone. The better diversification can reduce risks and the exposure to asymmetric shocks, leading to more efficient portfolios. This can also increase the GDP growth rate on the long run by an estimated 0.6-0.9 percentage point. A further benefit of giving up the own currency is that by using the euro a small and open economy, which is classified in the emerging market investment category can reduce the likelihood of financial infections and speculative attacks against its currency. The use of the own currency would lead to a greater fluctuation of capital flows, which can be harmful for the business cycle as well.


The costs of joining the EMU

The quantifiable cost of giving up the own currency is the loss of income from

issuing the money. Of course Hungary will also receive a share of the seigniorage income of the euro zone, but due to the rules of distribution of this income, the money received will be less than the seigniorage earned if Hungary kept the forint. The share of the seigniorage income is base on the countrys contribution to the capital of the European Central Bank. The money that a country has to pay into the capital base of the ECB is calculated using a key which reflects the respective countrys share in the total population and gross domestic


product of the EU. The lower seigniorage income causes a 0.17-0.23 percentage point loss to the annual GDP level. Another type of cost will stem from abandoning the monetary autonomy, this cost, however, is not really quantifiable and will be determined by the fluctuation of economic cycles after the accession to the euro zone. The fluctuations will be determined by the extent of asymmetric shocks to which Hungary will be exposed. These shocks are rapid changes in the economic environment that have a different affect on Hungary and the euro zone. There are two ways of adjustment to these changes, namely the operation of automatic stabilizers and active fiscal measures. In Hungary the role of automatic stabilisers is minor, which is not exceptional within the less developed member states of the euro zone. It should be noted that the EU prefers aggregate demand adjustment via automatic stabilizers in contrast to fiscal measures. Since it cannot be measured or quantified there is a big uncertainty behind the cost of stability loss, which needs to be reckoned with.

Table 2 Effect of the short-term factors on the level of GDP as percentage point of GDP Reduction in transaction costs Change in seigniorage revenue Net effect
Source: Csajbk - Csermely (2002)

0.18 0.30 (-0.17) (-0.23) 0.01 0.07


Table 3 Effect of long-term factors on GDP growth as percentage points Reduction in real interest rates Expansion of external trade Net effect
Source: Csajbk - Csermely (2002)

0.08 0.13 0.55 0.76 0.63 0.89

The cost-benefit comparison of joining the EMU can be summarized in the following way. Although in the short run quantifiably benefits and costs cancel each other out, on the longer term benefits arising are can significantly exceed the costs entailed. With the common monetary policy the country loses a major device for keeping asymmetric shocks at bay, but at the same time a potential source of asymmetric shocks disappears by giving up the national currency (e.g.: financial infection and speculative attacks). (Csajbk Csermely, 2002)


The timing of the accession

As the cost benefit analysis showed that benefits will significantly exceed costs

when Hungary joins the euro zone, the answer for the timing of the accession seems to be obvious: the sooner the better. However it is not that simple. The too rapid fulfilment of the nominal convergence criteria can lead to losses in the real economy. The most problematic factors in this sense are the inflation and the budget deficit. A too fast disinflationary and fiscal convergence can sacrifice too much of the real growth of the economy. However it also has to be noted, that in the period between the EU accession and the adoption of the euro a country can face a speculative inflow of capital, if investors are on the opinion of an early euro accession. If investor confidence falls for some reason, the speculative capital can be withdrawn from the country, causing a

rapid devaluation of the currency. The fluctuation of capital flows can cause extreme volatility in the valuation of a nations currency. Since Hungarys is in this stage of the integration, this also has to be taken into account in the convergence programme. A credible programme can reduce fluctuations and stabilize the exchange rates, as international experiences show that exchange rates tend to converge to the expected rate of conversion as the date of entry approaches. (Csajbk Csermely, 2002) As it can be seen on Figure 2 there were quite lot fluctuations in the EUR/HUF exchange rate in the past years. Extremes of the volatility were reached during years of the financial crisis in 2008 and 2009. In this period, due to the instability of the markets the exchange rate shoot up from the all-time low (strong forint) 230 to the all time high (weak forint) 310. This is a 35% change in only a few months. If we do not consider this period, some volatility still remains, however it can be noted, that the exchange rate fluctuated around 270 (+- 10%). Figure 2 The EUR/HUF exchange rate between 2004 and 2011



The governments commitment to an early accession to the euro zone is one of the most important factors that make a disinflationary programme credible. The more inflationary expectations start to sink after the announcement of the disinflationary path, the easier it becomes to reduce inflation to the required level. Also it will take less time, which means that the economy needs to suffer much lower losses. Hungary submitted its first convergence programme in the spring of 2004, and since 2007 submits an updated programme, which includes aims and completed measures. As some experts say, Hungarys development level is too far below the average of the euro zone countries to join the EMU in the near future. According to Pter Rna the Hungarian real economy is at about a level of 60% compared to the monetary union, while the accession to the euro zone would be a mistake under 85-90%. According these estimates and the current economic situation an accession before 2020 seems to be unrealistic, if Hungarian governments are willing to wait until the economies development reaches a certain level. (Frjes Judit, 2010) And it is worth waiting to an adequate level of integration, because as we see in the previous chapter the net effect of the accession will depend mainly on the long-term benefits and costs. As long-term costs/stability losses are hardly quantifiable Hungary needs to make sure in advance, that its economy is ready for the adoption of the euro by good policy making and by preventing a too early accession. In the recent financial crisis many experts and analysts said that Hungary needs to join the euro zone, because the introduction of the euro can solve the problems, but the words of Jrgen Stark should always ring in our minds, when hearing about the straight away accession to the monetary union: In short, unilateral euroisation is not a panacea. Its
benefits are uncertain, whereas the costs are real, and the risks serious. In particular, it should be stressed that euroisation is not a quick-fix for structural problems or external pressures. Admittedly, euroisation would provide some shelter against adverse winds coming from the outside. (Jrgen Stark, 13 February 2008, Reykjavik)



Hungarys EMU maturity

In 2002, the Hungarian National Banks comprehensive analysis (Csajbk

Csermely, 2002) concluded that Hungarys accession to the Economic and Monetary Union has significant net benefits, which implies it is worth to join the monetary union as soon as possible. After Hungarys 2004 accession to the European Union, the government proposed more possible dates for the introduction of the euro, which all turned out to be infeasible. In the last few years, Hungarys euro accession seemed to be drifting away. Also, since 2006 the Hungarian National Banks Analysis of the Convergence Process has more and more emphasis on the necessary conditions for the successful adoption of the euro. One of the most important factors is fiscal consolidation; Hungary not only has to fulfil the formal requirements for inflation and debt level of the Maastricht criteria, but also needs to create a reasonable room for fiscal manoeuvring before the euro accession. (Hungarian National Bank, 2010) When assessing Hungarys maturity preparedness for joining the euro zone it seems to be logical to start with comparing Hungarys performance to the Maastricht criteria. Since the reference levels of the inflation and long-term interest rate are changing from year to year it is necessary to highlight that the prevailing economic situation of the EU, especially its members with the lowest inflation rates are determinant when assessing how well Hungary is approaching the criteria. In the recent years of economic slowdown for example the three members of the euro zone with the lowest inflation experienced reduction in prices (negative inflation or deflation), which according to most of the economists is far more dangerous than a moderate level inflation, because it can slow the economy down even further. Also, at this point another weakness of the Maastricht criteria can be discovered, namely that when it considers inflation as the measure of price stability, it does not take into account that inflation can be negative as well, or turning this around considers negative inflation more desirable then zero inflation (perfect price stability). The reference values for the Maastricht criteria are published by the European Central Bank every two years. The last report was published in May, 2010. According this convergence report the three countries are Portugal (-0.8%), Estonia (-0.7%) and Belgium

(-0.1%). The average inflation of these three is -0.5%, which means that the reference level for inflation since May, 2010 is 1.0% (-0.5% + 1.5%). The reference value for long-term interest rates (after similar calculation) is 6.0%. (European Central Bank, 2010) Table 4 The Maastricht criteria and Hungary Criteria Inflation rate Long-term interest rate Budget deficit to GDP Debt level to GDP Exchange rate stability Reference Level (2010) 1.0% 6.0% 3.0% 60.0% ERM II Hungary 3.6% * 7.6% * 3.2% ** 76.1%* No

source: European Central Bank, Hungarian National Bank, Ministry of National Economy * - September, 2011 ** - 2010

As it can be seen in Table 4 today Hungary fails to match any of the Maastricht convergence criteria. Although Hungary is not a member of the ERM II (which will be compulsory sooner or later), until February, 2008 the Hungarian National Bank let the forint to fluctuate against the euro only within a certain fluctuation band. This was a unilateral shadowing of ERM II (Allam, 2009). The centre of this band was at 282.36, with the lower extreme of 240.01 and a higher extreme of 324.71. The EUR/HUF exchange rate has stayed mostly within these rates even after February 26, 2008, when the Hungarian National Bank revoked the fluctuation band. As I have mentioned earlier the economic slowdown in some of the member states, which resulted in deflation has effected that the reference value for inflation is 1.0%. As the Hungarian National Bank states on its website (, that the medium term inflation rate in Hungary is 3.0%, it can be concluded, that is not the goal of policy makers to chase the Maastricht criteria at any cost. Additionally it is more likely that as the economies recover prices will increase in those countries, which experienced deflation in the recent years. This means that the reference value will increase to a more healthy value


as well. The average inflation target of the European Central Bank is below but close to 2%. (Jrgen Stark, 13 February 2008, Reykjavik) The criteria for long-term interest rates, budget deficit to GDP and debt to GDP have a common point. Strict fiscal policy can make these figures improve. Lower government spending directly improves the budget deficit and debt level. Although on the other hand it needs to be done properly. Suddenly cut government spending can have negative effect on the GDP. If GDP fall, these figures get worse, even if the nominal amount of deficit or debt does not change. While fiscal policy indirectly, monetary policy directly has effect on long-term interest rates. To improve this figure, Hungary needs to gain credibility in investors eyes, so that they are more willing to finance the country even at lower interest levels. By joining to the euro zone and giving up monetary autonomy Hungarys economic structure will be more or less fixed. The threat of asymmetric shocks is caused by the different sensitivity of countries to changes in the economic environment in different industries. This different sensitivity stems from the structural differences among countries. Since after the accession the only tool in individual economic policy making will be fiscal measurements, Hungary should get to a high level of real convergence before the introduction of the euro. In the narrow sense this means that wages catch up to EU levels and the economic structure becomes similar to the EU. In the latter case it can be said, that convergence is appropriate (although the level of development is low), but the adjustment of wages is expected to be a very slow process. The optimal operation of the EMU needs perfectly flexible markets, which can stabilize changes in the economic environment. On the goods market this means priceflexibility, while on the labour market a supply of labour force that adjusts to the production conditions. The barriers to a flexible labour market are the high rate of longterm unemployment, the inelastic education and low mobility. In the new member countries, like Hungary, the mobility of labour is significantly lower than in the developed countries. Until differences among regional unemployment rates dont reduce (indicating low labour mobility within the same country), it is unrealistic to expect reduction between different member states.


The experience of some other EMU members

In the previous parts of the thesis I assessed the possible consequences of Hungarys

euro zone accession from mainly a theoretical point of view. However before deciding about, whether it is beneficial for us to join the EMU, it is good to take a look at the experiences of some member states, which introduced to euro at an economic development and integration level that is similar to Hungarys current situation. Perhaps, the most obvious choice for this would be Slovakia, but they only joined the EMU a few years ago, right before the financial crisis. The short timeframe and the exceptional world economic situation could have a biasing effect on the conclusion about Slovakias euro experience. However there are still some other states from South-Europe that can be used for this kind of analysis. According to Horvth and Szalai (2001) the way of integration of Greece, Ireland or Spain can be a good starting point for Hungary, but they also highlighted that Hungary has a different economic structure and environment than the previously mentioned countries. The reason for still using their example is that the development level of these countries was similar to Hungarys current situation. The authors concluded, that for the earliest possible accession to the EMU the joining countrys government and national bank has to co-operate advisedly, since both fiscal and monetary policy making is the most effective in this way. In Greece, Spain, Portugal and Ireland this seemed to be working, as all countries could reduce their inflation from high levels to acceptable values. In case of Greece this meant to a reduction of price increase from almost 20% in 1991 by around 3% in 1999. After the accession the EMU inflation rates were rising in these countries as a result of the common monetary policy. This is the result of the previous wrong approach to decrease inflation within a relatively short time. This wrong approach could be that instead of strengthening confidence of investors and companies, they implemented restrictions through contractionary fiscal policy, which led to a decrease in inflation through the decrease in demand. After the introduction of the euro, the higher level inflation returned to these countries.


While inflation and budget deficit can be reduced by one time measurements and restrictions on spending, the progress of integration and the way towards the implementation of the euro needs to be sustainable. Long-term interest rates indicate how confident investors are, that the fiscal and monetary policies of a country lead to a sustainable development path. The level of public debt is another key factor which determines investor opinion and thus the interest rate. A high debt level increases the risk of non-payment, which risk will appear in interest rates. In the beginning of the integration process the risk premium of Spanish and Portuguese bonds was much higher than the similar maturity date German bonds. After the 1995 ERM crisis this difference rapidly decreased as the schedule for the creation of the Economic and Monetary Union was finalized, and the fulfilment of the Maastricht criteria became the priority of Southern countries as well. (Horvth Szalai, 2001). Regarding budget deficit and debt level, the example of these countries show, monetary discipline and strict fiscal policy making made it relatively easy to meet target levels, or at least show a trend of approaching target at a high pace. After the EMU accession, however it turned out that the Greek and Portuguese approach was somewhat wrong. In these two countries budget deficit was decreased to a large extent by increasing state incomes, while Spain implemented cut backs on the expenditures side. The latter turned out to be the sustainable solution. (Horvth Szalai, 2001) One of the major questions regarding the accession to the monetary union is the exchange rate at which the countries original currency will be converted to the euro. In this respect, the goal of previously joined countries was to prevent their currency to be overvalued compared to the euro. This is a reasonable idea, because the overvalued currency would worsen the countries competitiveness, lead to unemployment and recession. Also it would set back integration to the western countries. As a preventive measure Greece devaluated the drachmas by 10% before the accession. The exchange rates of both the Portuguese escudos and the Spanish pesetas were nominally at around the final conversion rate for 4-5 years before the accession and the volatility of fluctuations has decreased continuously. (Horvth Szalai, 2001) For the future my only advice for Hungary regarding exchange rate policy is to prevent joining with and overvalued currency,

as it would easily ruin the countrys competitiveness in the euro zone. (For individual conversion rates of countries see Appendix 1.)


Should Hungary join or not?

As it could be seen in this chapter the gains of joining a properly functioning euro

zone would exceed costs on the long term. However, this picture of the ideal world is not reality. Reality is, that the neither the European Union nor the Economic and Monetary Union can be considered as optimum currency areas in their current form, which implies that member countries risk the possibility of emerging asymmetric shocks that cannot be handled easily. From this point of view, in my opinion it is best to stay out of the monetary zone, and observe its development, even if it takes some tricks as for example in the case of Sweden, which country stays out by deliberately not fulfilling the Maastricht criteria. However Hungary is not yet at a point of development to ask itself the question whether it should join the monetary union or not. The fact is that today Hungary is far from being able to join the euro zone and the government and policy makers should concentrate on developing a plan not to fulfil the nominal criteria of accession, but to get the real economy behind the numbers start to converge to those of the more developed countries of Europe. Even if it takes time, this is the sustainable way of improvement, and at the end, the sustainable way is the only way to go. Furthermore this is not only the condition of joining the Economic and Monetary Union but the own interest of the country for the future. To answer the question given in the title of the thesis I have to say, that in my opinion Hungary should NOT join the Economic and Monetary Union even if it was (nominally) ready for the accession. The reason behind my argument as it turned out from the previous pages, is that both sides, the EMU and Hungary fail to meet the necessary requirements for a flourishing future with a common currency; the EMU does not have the properties an optimum currency area needs to have, thus cannot operate optimally, while Hungary not only fails to meet the convergence criteria, but also lacks the necessary real economic development level, which could serve as a good ground for using the common currency.


At the end of my thesis work I shall assess and conclude the findings of the

previous pages. The main aim of the thesis was to assess the costs and benefits of Hungarys accession to the Economic and Monetary union and to conclude whether Hungary should join the euro zone or not in a form which is easily understandable for the reader. In the first part of the thesis I introduced the main theories about optimum currency areas and assessed the possible benefits and certain costs of joining a monetary union. Then, after taking a view on its history, I examined the Economic and Monetary Union and reached the conclusion, that it cannot be considered as an optimum currency area for different reasons. The main reason that I highlighted was that the necessary homogeneity of member countries is missing, furthermore some of the mechanisms that can prevent the economy from the consequences from asymmetric shocks does not work properly as well (e.g.: labour mobility). However I also admitted that some competitive core countries of the EMU can be considered as countries forming an optimum currency area, but this is not enough to say that the monetary union as a whole was a good decision to be made. In the second half of the thesis I compared Hungary to the Economic and Monetary Union, examined whether the country fulfils the Maastricht criteria and gave some information about what kind of experiences similar countries had before and after joining the monetary union in the past. I also assessed the numerical costs and benefits of joining the EMU. As a conclusion to these I admitted that an adequately timed accessions benefits can exceed its costs. However, based on theoretical material and the experiences of Greece, Portugal and Spain I suggested that Hungary should wait with the adoption of the euro until it gets closer to the economic development level of the core countries, to minimize risks of the accession. Since currently Hungary does not fulfil the Maastricht criteria, and Europes economy faces hard times the possible time for Hungarys accession to the monetary union seems to be in the distant future. Even optimistic estimates say that the chances are minimal for an accession before 2020, but as the euro itself is not a cure for diseases the timing of the accession does not need to be compelling.



Appendix 1 Fixed euro conversion rates

Country and Currency Belgium, Belgian francs (BEF) Germany, Deutsche mark (DEM) Estonia, Estonian kroon (EEK) Ireland, Irish pound (IEP) Greece, Greek drachmas (GRD) Spain, Spanish pesetas (ESP) Cyprus, Cyprus pound (CYP) France, French francs (FRF) Italy, Italian lire (ITL) Luxembourg, Luxembourg francs (LUF) Malta, Maltese lira (MTL) Netherlands, Dutch guilders (NLG) Austria, Austrian schilling (ATS) Portugal, Portuguese escudos (PTE) Slovenia, Slovenian tolars (SIT) Slovakia, Slovak koruna (SKK) Finland, Finnish markkas (FIM)
source: European Central Bank

Conversion Rate 40.3399 1.95583 15.6466 0.787564 340.750 166.386 0.585274 6.55957 1936.27 40.3399 0.4293 2.20371 13.7603 200.482 239.640 30.1260 5.94573


Appendix 2 Euro banknotes


source: European Central Bank



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