Panel IV :

Relations and
into the
World Economy

Integrating Central and East European Countries into the European Monetary Union: The Macroeconomic Aspects

Zdenek Drábek

The Association Agreements that most of the East European countries have signed with the European Union have created a formal level of regular institutional contact and preferential trade conditions for the Eastern partners. While a basic level of reform is required for Associate EU membership, the hard part is yet to come, says Zdenek Drábek. This is the preparation for Monetary Union. In the East, part of the problem could be a lack of consensus as to what form monetary and financial requirements should take. The other side of this coin is the absence of clear requirements from the European Union, on how it sees true monetary union.

Dr. Drábek is Senior Advisor, World Trade Organisation, Geneva.


It is well recognised in Central and Eastern Europe that national economies can no longer be closed and protected as in the past. The protection, which typically bordered on autarky, was extremely costly, and the countries in the region now better appreciate the merits of being "open economies". The countries are too small to be closed and too far behind the developed market economies to benefit from the exclusive reliance on the domestic market. It was undoubtedly the understanding of these simple ideas that led them to become associated members of the European Union (EU). It is also without any doubt that these considerations are instrumental in driving these countries to become full members of the EU.

What is far less evident, however, is the understanding in the region of the extent and the nature of the commitments that these countries will have to take on in order to fully integrate themselves into the EU. A part of the problem is the uncertainty about the specific requirements for the establishment of the monetary union in the European Union itself.

Another constraint could be the lack of understanding or, maybe, even of a consensus in the region on the type of integration that will be sought by these countries as the next stage after the Association Agreements. The third type of constraints is likely to be the full appreciation of the macroeconomic implications of integration into the EU.

The purpose of this article is to identify the major macroeconomic constraints in the region on the integration of these countries into the EU. We shall seek answers to the following questions: What have been the main perceptions in the region of the integration process into the EU? Is there already a consensus on "full membership in the EU"? Could the political process become one of the constraints? Considering the economic conditions of the region, are the economic "fundamentals" such that they would allow a smooth integration into the EU? If not, what are the main constraints? What policies or institutional changes would need to be adopted to alleviate these constraints?

The scope of this paper covers, in the Central and Eastern European region, six countries - the four Visegrad countries - the Czech Republic, Hungary, Poland and Slovakia and two Balkan countries - Bulgaria and Romania. The focus will be entirely on the relationship of that region with the European Union. Excluded will be a discussion of aspects of integration into world trading or monetary systems. We shall, therefore, not consider such important questions as the role of these countries in the context of the WTO, EFTA, international agreements on the protection of intellectual properties, shipping, air or other transport agreements, agreements on environment, etc.

By addressing the questions of macroeconomic constraints we shall focus on the internal constraints to the integration process. Discussion of external factors will be excluded but these factors must naturally be considered in future assessments. In general, the constraints on integration could be either internal or external. I do not deny that external factors have played and will play in the future an important role in shaping the integration process. For example, trade protection of EU or its agricultural policies have already determined the content and the shape of the Association Agreements. However, the analysis of the external factors would be beyond the scope of this paper.

Three Fundamental Impediments to Successful Monetary Integration

The full monetary integration - the Monetary Union - implies the integration of all markets for goods, services and the factors of production (capital, labour and land). In addition, monetary integration can take the form of a market with multiple currencies tied to each other through the system of fixed exchange rates or a market with a single currency. The trend is clearly in the EU to set up a single currency market - European Monetary Union (EMU) - and we shall assume that the Central and East European countries will strive towards the EMU as the ultimate aim.

I shall also assume that monetary integration will take place only if three fundamental conditions are satisfied. They include (1) the absence of a fundamental disequilibrium in the countries wishing to join the monetary union, (2) the economies are not too dissimilar and (3) the governments of these countries pursue policies that can be sustained over a long period of time. In theory, nothing prevents countries from establishing a monetary union even if any one of the above conditions or all of these conditions are not satisfied. However, the costs of such a union would be excessive and the union is unlikely to survive under such circumstances, as we shall briefly demonstrate in the remaining part of this section.

Condition 1 : Political Will to Establish a Monetary Union.

The first condition states that there must be a political will both in the applicant and in the existing member countries to create a Monetary Union. It is not entirely obvious that the EMU will be created even though the general expectations and widespread belief, of course, are that this will be the case. The objections to the creation of EMU are well known and they range from the dislike by the Germans of the fact that they should abandon their Deutsche Mark as the single currency to more general distrusts of the political implications.

But the problems are also more substantive. The establishment of the EMU will also require an agreement about the political resolution of conflicts that may arise once the EMU is established. This will be possible only if there is a political will to address and settle such important issues as cost-sharing arrangements that may be necessary to sustain the EMU whenever a bail-out of a member country is necessary due to its poor policies. This is a highly controversial assumption to make as anybody following the debate within the British Conservative Party would testify.

The other important issue is the question of the political process in the Central and East European countries and its relationship to the requirements for macroeconomic and structural adjustment. I am concerned about the former, that is whether these countries will accept politically the macroeconomic discipline that is required to control inflation. The difficult problem in controlling inflation will be the ability to control fiscal balances and, in this respect, the containment of social expenditures, especially on health, education and other types of social spending such as support to families with children, maternity leave, or other child benefits.

Even though some countries in the region may have substantially reduced in recent years various types of subsidies (such as food subsidies), others have had a considerably more difficult time to do so. For example, various types of household subsidies were reduced in Poland from 16 percent of GDP in 1988 to 2 percent in 1993. In contrast, the corresponding subsidies in Romania increased from 1 percent of GDP to 13 percent in 1992 and they were cut back in 1993 to 6 percent.

In addition, all countries in the region have increased various cash benefits to pensioners and unemployed as a part of their new "safety nets" for those who fall out of the process of transition. Thus, cash outlays on pensions increased from 7 to 15 percent of GDP in Poland and from 5 to 8 percent in Romania. Similarly, unemployment benefits increased in Poland from 0 to 2 percent between 1990 and 1993 and from 0 to 1 percent of GDP in Romania during the same period. (1)

Several observers have also expressed their concerns about these countries' political will to go through the required structural reforms. They point out structural changes in these countries will take many years, and this will also determine the time pattern of costs and, mainly, benefits. However, as these observers also point out, the political cycle in these countries is "only" four years, which is the standard period between two parliamentary elections. It is clear that politicians will seek to obtain some tangible benefits within the term of their tenure and that, as I have noted, tends to be much shorter than the period that is required for structural changes. (2)

Condition 2 : The Absence of Fundamental Economic Disequilibrium.

It is well-nigh inconceivable that the admission of Central and Eastern Europe into the EMU will take place at the time that these countries experience a "fundamental economic disequilibrium". The meaning of "fundamental disequilibrium" is not straightforward but the following can be suggested. It is possible to distinguish between internal and external disequilibrium. The former is usually defined as inflation and unemployment, the latter may be represented by the level of indebtedness. (3)

Disequilibrium is costly, especially if it is large. The disequilibrium can be either eliminated through domestic policy measures and this will call for domestic macroeconomic adjustment or it must be externally financed. The difference is, of course, that domestic adjustment costs are borne by domestic residents while external financing would have to come from abroad, mostly from the European Union. In the latter case, therefore, the higher the disequilibrium, the more costly will this be for the European Union. The crucial elements of the disequilibrium are, in my view, the rate of inflation, the level of unemployment and incomes and debt - both domestic and external. In sum, the fundamental state of the economy will be crucial for the negotiations on the entry into the EMU.

  • Inflation must be low and roughly comparable to other member countries at the time of accession into the EMU. The current situation is not very favourable. As we shall see further below, the country with the lowest inflation is the Czech Republic where the inflation rate reached about 10 percent in 1994, or about 3-4 times higher than the EU average. Moreover, the inflation rates have been "stuck" in most countries for some time, which indicates that further reduction of inflation will be difficult.

    The inflation rate could be, of course, brought down by the monetary discipline imposed by the Union. However, the risks of failure are high. There are three kinds of risk. First, the adjustment could result in a political backlash in the high-inflation country. The anti-inflationary policy may be deflationary, and this could provoke dangerous political reactions as the costs of adjustment could be "blamed" on the "foreigners". Second, the excessive costs imposed on the applicant country could be mitigated by financial transfers of the existing member countries. However, this, too, will likely lead to strong political reactions from some member countries. Third, the postponement of the adjustment until the accession would most likely increase the costs of adjustment.

  • Unemployment in the applicant country must be also on a level that does not pose a threat to the other countries. High unemployment encourages the unemployed to migrate, and the possibilities to do so will be considerably increased by the elimination of restrictions on the movement of labour. The incentives for outward migration will be greatly increased in the presence of large differences in real wages and in the level of consumption.

    In a certain sense, the income differences probably pose a greater threat to the stability of labour markets in the EMU than the presence of unemployment, particularly if countries with unemployment have an effective unemployment insurance policy. Low wages will also attract foreign investment and this, too, may lead to industrial relocation from high-wage to low-wage member countries. These concerns are particularly relevant for Central and Eastern Europe where wages including various social benefits are estimated to be currently more than ten times lower than in Germany.

    Thus, it is primarily the income differences that could be a major constraint on the integration of Central and Eastern Europe into the EMU. The larger the differences in the level of consumption, unemployment and wages the stronger the pressures for higher wages and for outward migration from low-wage countries to high-wage ones. In such a case, high unemployment could lead to exports of unemployment to other countries (regions) through labour exports or capital imports.

    The higher the level of unemployment and the larger the wage differences among countries, the more likely there will be "disruptive" movements of labour and capital. The integration of product, service and factor markets could, therefore, become extremely disruptive in the presence of large differences. In addition, the integration would become too costly for existing member countries, as we have seen above.

  • Debt Management is the third possible element of domestic disequilibrium. The settlement of debt liabilities of the applicant country raises the same problem as the need to reduce inflation or unemployment, that is the question of debt financing, how much this will come from domestic adjustment and how much this will have to be shared in the EMU by other countries. Clearly, the higher the debt liabilities of the applicant countries the greater domestic adjustment or the greater outside financing will be called for. As in the case of inflation and unemployment, the Central and East European countries can expect that the level of their indebtedness - internal and external - will not be too high to be considered threatening for the stability of the Union. The situation is not so clear-cut in view of large external debt in Bulgaria, Hungary and Poland.

Condition 3 : Credible Policies are in place.

The economy may not be in a state of a "fundamental disequilibrium" now but it may get into one with bad policies. There will be plenty of room for "bad" policies to intervene once the countries join the EMU. They can range from fiscal mismanagement or poor management of public enterprises to bankrupt health or pension systems. Moreover, the policies must be also credible at the time when the countries begin to negotiate because their effectiveness will determine the success of the domestic adjustment process. To ascertain what are "bad" policies and distinguish them from "good" ones is not always an easy task. Nevertheless, a few further examples that are actually based on the current situation in the region can be suggested to make the point but these examples are by no means exhaustive.

Introduction of full convertibility may be premature. In other words, the elimination of all foreign exchange restrictions may have taken place too fast. For example, it may have preceded the liberalisation of labour markets or it may have been introduced in the presence of high inflation.

The exchange rate regime can also become a major constraint on growth. A fixed exchange rate regime may not be sustainable if the domestic inflation rate is higher than abroad. On the other hand, an instability of exchange rate will be detrimental to investments. It is clear, for example, that the appreciation of the real effective exchange rate (REER) in the Czech Republic by 40-44 percent between 1992 and 1994 has dramatically increased the costs of labour and will undoubtedly adversely impact investment planning policies of foreign and domestic firms.

Market access, too, may be liberalised too fast if the domestic firms' adjustment to new market conditions is impeded by monopolistic practices in the market or other forms of imperfect competition, undeveloped financial sector, weak infrastructure etc.

Clarifying the Government Objectives

It would be unfair to expect at the present time a clear statement of objectives on the part of the governments in Central and East European countries with regard to the European Union. It may be too soon after the signing of the Association Agreements. After all, it is only at about this time that the countries are getting out of a deep recession. Moreover, the countries are only now introducing domestic mechanisms to study and ascertain the implications of their membership in the Union.

Nevertheless, a clear statement of objectives towards the European integration would be highly useful and the statement should go well beyond stating the obvious aspiration "to become a full member of the European Union". By July 1995, all of the Associated Countries have expressed their interest to become full members, and some of them have already formally submitted their applications, the last one being Romania, which did so in June of 1995.

The crucial issue at stake is a clear understanding of full membership, the goals of the integration, the commitments the countries would have to take upon themselves and the realism of the expectations. The discussion of government objectives can be conducted along the following three issues.

Issue 1: Unclear Goals and Expectations: Types of Integration.

It is well known that integration between the Central and Eastern Europe and the EU can in theory take different forms. The most elementary is (a) free trade area, next come (b) customs union and (c) economic union, and finally we can speak of (d) monetary union. Free trade area is characterised by the absence of internal tariff but also by the absence of a common external tariff. Factor markets are not fully integrated. Customs union has also no internal tariff but it has an external tariff that is common to all member countries. Economic union includes a customs union and an integration of factor markets leading to a free movement of capital and labour plus other forms of economic cooperation.

Finally, monetary union includes all features of the economic union and a fixed exchange rate mechanism (such as the EMS) in a multi-currency area that allows one's own currency and fiscal and monetary policies to (multi-currency area). Alternatively and more precisely, the monetary union stricto sensu is characterised by one single currency for the whole union which implies one single monetary authority.

In practice, however, the free trade area and customs union are probably irrelevant for the Central and East European countries. Their current contacts go well beyond customs union and, at the very minimum, they will seek full membership of the European Monetary Union (EMU). The status of a full member of the Economic Union is, after all, fully guaranteed by the successful conclusion of the transition period as Associated Members of the EU. The question stands, therefore, whether the countries wish to become full members of the EMU and if so when. But it is precisely this question that remains unclear.

First, the messages coming from the countries themselves are often contradictory. In the Czech Republic, for example, the general enthusiasm for the European Union is sometimes confused by the proclamations of Prime Minister Klaus who has often doubted in public the value of closer integration ties. Moreover, the Czech "success" is typically presented by the Czech government as one that does not recognise the need for "structural policy" as if future membership in the European Union required no adjustment on the part of the Czech Republic. It goes without saying that some adjustments will be necessary even in the Czech Republic.

Second, it is at best unclear whether all the implications of full membership are fully understood in the region. What is needed in particular is a sound understanding of the existing "economic fundamentals" and the extent to which they will call for an adjustment that can only be carried out through changes of domestic policy. Such an understanding is virtually impossible at present in view of the unstable nature of the recent and current developments.

Third, some Central and East Europeans contend that they cannot even begin to plan the next legislative, institutional and economic adjustments until they receive a firm timetable for accession. This is a very serious issue, one that is strongly pushed by the Polish government, and the issue will indeed need special attention in the EU. (4) Assuming, for example, that the Central and East Europeans are willing and able to take the necessary steps to adjust effectively, the EU must be ready in time to accept them. It is not possible to take measures that are politically and economically costly without some sort of arrangement between both parties. However, this card cannot be overplayed. The West Europeans themselves must understand what kind of adjustment they themselves will have to undertake in order to offer a firm calendar fro negotiations.

Issue 2: The Realism and Understanding of Commitments : Unilateral Trade Liberalisation As The First Big Test.

Many countries have liberalised their trade regimes very fast and not necessarily in an economically rational manner. (5) Poland, Hungary, the Czech Republic and Slovakia have offered and been bound to fairly significant concessions in the Uruguay Round since they were already existing members of GATT. However, some of these concessions have been short-lived as all of them, with the exception of the Czech Republic, have been forced very soon to adopt additional protective measures to help their industries and balance of payments. Poland, Hungary and Slovakia have introduced additional import surcharges which have led to requests for waivers from their international commitments in the newly established World Trade Organization. (6)

A similar example is provided by the history of the customs union between the Czech Republic and Slovakia. The customs union was established following the separation of the two republics and the establishment of two independent states. The union also provided for a special payments arrangement based on a clearing mechanism but both the trade and the payments arrangements ran into severe difficulties in the course of 1994 when Slovakia's balance of trade with the Czech Republic began to deteriorate. This was followed by a devaluation of the Slovak koruna and by the introduction of an import surcharge and several non-tariff barriers.

These measures have been highly effective, and the trade deficit turned into large surpluses with its partner. Given the presence of surcharges and of the highly distortionary payments mechanism, the Czechs proposed the elimination of the payments system to which the Slovaks responded by threats of abolishing the customs union. All these examples naturally raise the question whether the pace of trade liberalisation in most of these countries has not been too fast.

The unstable nature of trade relations of the region is also evident from the agreement with the EU about the so-called "sensitive products" in industry (mainly steel, textiles and coal). The Association Agreement provides for a gradual elimination of trade restrictions against exports of these products from the region but the need for adjustment in the region is unlikely to end with the liberalisation of this trade.

Further competitive pressures are likely to come from new associated members from other parts of Eastern Europe, from improved access of the CIS countries into the market of the EU and also from other low-cost countries in the developing world. Deep adjustments will be also needed in the agricultural and the financial services sectors of the region even though profound changes will be also necessary in the EU.

The other real test of the ability of Central and Eastern European countries to live up to their commitments will be their attitude towards the loss of independence in the conduct of monetary policy. The loss must be politically acceptable in these countries with full implications. This must mean, for example, that virtually any unemployment must be socially acceptable by the country concerned if it believes that nothing can be gained from having independent monetary and fiscal policies but that more will be gained from a single currency market.

As is well known, it is precisely the independence of monetary and fiscal policies that separates the "Euro-optimists" from "Euro-sceptics" in the present controversies in the United Kingdom and some other countries. It remains to be seen how the discussions evolve in the region once the governments in these countries are no longer in position to "monetize" excessive growth of wages, large fiscal deficits or high levels of unemployment.

Issue 3: The Mentality of "Entitlement".

Unfortunately, many Central and East European countries have taken the attitude that "the West owes them a full integration into the major international economic, political and military institutions". This syndrome has been experienced also in the case of their aspirations towards the European Union. I do not wish to comment in this paper about these countries' membership in NATO, which is primarily a military association rather than one that is based on economic considerations that we are discussing here.

This mentality of "entitlements" is very dangerous. The problem is that it can lead to the adoption of policy measures that the countries may not be able to sustain and to the problem of realistic trade commitments as noted above. The example could be an excessively fast trade liberalisation such as the one noted above. As a result, non-sustainable policies of a member country could become a destabilising force for the other member countries and the very integration grouping which these countries have joined.

To put it differently, the adoption of "wrong" policies may eventually lead to what economists call "policy backsliding", that is a reversal of those domestic policies that have become the basis for accession into a given integration grouping, and this will lead to a loss of credibility of these governments policies.


The views expressed in this paper are personal and should not necessarily be attributed to the World Trade Organisation.

  1. All these figures come from IMF (1995).

  2. This point was forcefully made, for example, by Dr. Andras Innotai at the Meeting of Senior Economic Advisers of the Economic Commission for Europe, 19 June 1995.

  3. It is possible, of course, to suggest other criteria of economic disequilibrium, such as debt servicing capacity or the current account imbalances that are difficult to finance through external loans, foreign investments and other forms of foreign capital. They are not considered here. One important reason is that external financing cannot be a constraint on macroeconomic policy in EMU.

  4. See "Poles await the starting gun to begin race for EU entry"; Financial Times, 10 July 1995,p.3.

  5. The extent of the liberalisation can be found in the study of Drabek and Smith (1995).

  6. The official justification for the new protective measures was balance of payments difficulties. However, several observers have suggested that these measures also had a protective character.


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