Eurozone membership for Central and Eastern Europe an application of the optimum currency area theory

Abstract

The accession of the former socialist countries of Central and Eastern Europe to the European Union has placed a legal obligation on them to relinquish their national currencies and adopt the euro. This dissertation applies the theory of optimum currency areas to evaluate the economic rationale of EMU membership for nine CEECs. OCA properties are embedded in a cost-benefit analytical framework and applied to the CEECs in order to comprehensively analyse the economic case for EMU membership. Due to evidence of the limited capacity for alternative adjustment channels to absorb the impact of asymmetric shocks, the cost side of the analysis focuses on the degree of business cycle correlation between the CEECs and the euro area. Applying the Hodrick-Prescott filter to quarterly real GDP data between 1995 and 2010, the tests find that despite considerable progress in convergence, the degree of correlation between the CEECs and the aggregate euro area business cycle is below what is observed among the existing EMU members. This indicates a substantial risk still exists that the ECB‟s monetary policy may be ill-configured to economic conditions in some CEECs. The benefit side of the analysis focuses on the degree of trade integration with the euro area. Hungary and the Czech Republic were found to be best-positioned of the CEECs to benefit from the elimination of transaction costs. The overall findings of the analysis suggest that EMU membership represents no additional cost to Estonia, Latvia, Lithuania and Bulgaria, and that they should experience a net benefit from participation in the eurozone. By fixing their exchange rates to the euro, these countries have already relinquished monetary policy autonomy as indicated by the Impossible Trinity principle. Croatia, Czech Republic, Hungary, Poland and Romania would be well-advised to wait until business cycles achieve closer correlation with the euro area core before proceeding with EMU accession. Three key policy recommendations are made to help minimise the costs of EMU participation. Structural reforms increasing the flexibility of labour markets are necessary to ensure unemployment does not bear the brunt of economic disturbances. Prudent fiscal policy is advised to ensure the sustainability of the public finances and to counteract the risk of economic overheating. Finally, tight financial sector supervision is encouraged to mitigate the risk that an anticipated fall in interest rates leads to asset price bubbles which could threaten the stability of the financial sector and the wider economy.