New EU member states and the Euro: economic readiness, benefits and costs

Abstract

All of the new EU member states (NMSs) have made a commitment to adopt the Euro. This essay considers the countries’ economic readiness to adopt the Euro as well as the economic benefits and costs of adoption. Paper applies a method suggested by Bayoumi and Eichengreen (1997) and finds that the changes of real effective exchange rates between the Euro area and the new EU member states follow the pattern predicted by the optimum currency area theory. This finding allows the construction of the readiness for adoption index for every NMS. The tangible benefits (for NMSs) of adoption are also examined in this essay. Analyses suggest that the costs of currency exchange and hedging against the uncertainty in foreign exchange markets account for about 0.08–0.012% of the countries’ GDP. In addition, countries that adopt the Euro might expect lower inflation and interest rates. This essay also examines the possible costs of adoption. These are in the forms of the lost ability to use monetary policy tools and set the level of seigniorage. Analysis suggests that many countries had given up their independence over monetary policy even before the accession to the EU. In addition, bigger NMSs have not used seigniorage as the source of fiscal income. However, they used exchange rate flexibility to depreciate their currencies during the recent crisis.

Appendices

Appendix

Table 7 Estimation results of an alternative specification of Eq. 2: a dependent variable is log(e _ijt )

Technical notes on the calculation of the counterfactual (alternative) interest rates for the NMSs

The method employed here is simple. I analyse long term (10 year government bonds) interest rates in the Euro area countries (12 countries) in 1999–2007.¹⁶ Long-term interest rates for a given year and a given country are taken as a dependent variable. They are regressed (using Pooled OLS as in Sect. 2 we found this estimation method to be appropriate) on a country’s rate of inflation, the size of its government debt and the ECB main policy rates for the same year.¹⁷ The coefficients of independent variables are estimated. They are then used in combination with the data for the new EU countries to estimate the alternative long-term interest rates in those countries (Table 7).

The idea is to find how inflation, government debt and ECB main interest rates influenced long-term interest rates in the old Euro area members. Then I take the coefficients and use them for every new EU member state. I multiply actual rates of inflation and government debt (and ECB interest rates) in every new EU country by the coefficients found for the Euro area. Thus, the new EU countries would have had the same economic parameters. However, the way they affect the long-term interest rates would have been different (would have resembled the way they affect interest rates in the Euro area).

The initial estimating equation is:

$$ {\text{BOND}}_{jt} = \alpha + \beta_{1} {\text{INFLATION}}_{jt} + \beta_{2} {\text{DEBT}}_{jt} + \beta_{3} {\text{ECB}}_{t} $$

(1A)

BOND _jt is the long-term interest rates on country’s 10-year government bonds in a year t. INFLATION _jt is an inflation rate in a country j. DEBT _jt is the government’s debt as a percentage of country’s GDP. ECB _t is the main policy rate set by the European Central Bank (ECB). Initial estimations report a positive autocorrelation in the model. Further analyses suggest that the model suffers from the second order autocorrelation. I introduce an AR(2) type error in the model. The readjusted model does not suffer from autocorrelation at the 5% confidence interval. The estimation for 12 Euro area countries in 1999–2007 yields the following results (with standard errors in parenthesis):

$$ {\text{BOND}}_{jt} = \mathop {2.8535}\limits_{(0.3357)} + \mathop {0.0131}\limits_{(0.0636)} \;{\text{INFLATION}}_{jt} + \mathop {0.0074}\limits_{(0.0029)} \;{\text{DEBT}}_{jt} + \mathop {0.2668}\limits_{(0.0572)} {\text{ECB}}_{t} $$

(2A)

$$ n = 106\quad R_{2} = 0.60\quad S.E. = 0.4372 $$

In the adjusted model all the independent variables except for inflation are significant at the 5% significance level. The model has quite a good fit (R ₂  = 0.60). As explained above, coefficients of significant variables are used to calculate alternative long-term interest rates for the new EU countries.