EU Enlargement: Implications For The Euro

In a previous article focusing on European Union enlargement issues we looked at some of the factors that were expected to shape the macroeconomic environment for the accession countries, with particular reference to the policy implications of projected high growth rates, capital inflows, and continued relative price adjustments[1]. We continue our series on EU enlargement issues by looking at the likely effects of enlargement on the euro and whether, as the EU-15 turns into the EU-25 as early as 2004 the euro, other things being equal, might come under downward pressure.

A number of factors are likely to have a bearing on whether enlargement per se will have implications for the euro exchange rate. One such factor stems from the impact on average per capita GDP associated with the coming together of two sets of countries with very different levels of income and at different stages of development. PPP exchange rates show that GDP per capita among candidate countries are somewhere in the range of 30-70% of the EU average. While there is a process of convergence underway and the adoption of the euro by the new members is still some way off, nevertheless, enlargement will inevitably lead to a lowering of per capita income in the EU-25. Since none of the countries joining have an opt-out from EMU, they will all adopt the euro in due course, well before the process of convergence has run its course. Some have even put forward the argument that the weakness of the euro since its inception may, to some extent, reflect the expectation that enlargement will go forward and that the euro's value will then be partly determined by new countries' levels of productivity, their less stable macroeconomic environments, and other institutional weaknesses.

Furthermore, candidate countries are likely to face a number of policy challenges. Their relatively good growth performance and low labour costs should continue to boost FDI and other capital inflows and put currencies under appreciating pressure. This could keep these countries' current account deficits at the relatively high levels seen in recent years. Continued relative price adjustments should, likewise, keep rates of inflation above the EU-15 average. Fiscal consolidation may also take longer than anticipated, as new members have to boost public investment and carry out accession-specific expenditures, such as environmental cleanup. With budgets already under pressure in some of the key accession countries (eg, Poland, the Czech Republic), the overall macroeconomic environment in the EU-25 area may look a bit weaker, leading to pressures on the euro.

While the above concerns are real enough, they should not be overdone. First, the combined GDP of the 10 countries due to join in the next round of enlargement accounts for some 5-6% of the euro area GDP. Second, as noted above, EMU membership is not imminent and may well be some 4-6 years off - indeed, under present Maastricht rules, new members have to participate for two years in an ERM-like mechanism after accession. It is also not clear that the rule whereby each central bank governor has one vote in the governing council of the European Central Bank (which could lead to coalitions of small states pushing, say, for a more "active" monetary policy) should be a source of undue concern as the Nice Treaty of 2000 allows for a change in the "decision-making rules of the ECB," if need be. Furthermore, enlargement could bring other benefits as well (eg, further economies of scale), which could boost growth in the EU area and contribute to appreciation of the euro.

[1] See "EU Enlargement: Managing The Transition", GWEM, 15 March 2002