COMMENT: After ERM2 entry is before the very fiddly euro entry path

COMMENT: After ERM2 entry is before the very fiddly euro entry path
By Gunter Deuber of Raiffeisen Research in Vienna July 16, 2020

Finally, the long-awaited accession of Bulgaria and Croatia to the euro area lobby (ERM2) and European Central Bank (ECB)-led Banking Union was completed last week. The euphoria is currently very high on every level. The local community is apparently happy to finally belong more to the core Europe.  

In addition, especially in the current crisis, Croatia and Bulgaria have seen once again that euro membership offers a great deal of protection in difficult times. It’s the ECB PEEP that allows a smooth financing of public deficits of 9% of GDP or higher inside the euro area. At the EU level politicians are also happy to have sent out a nice diplomatic signal — especially before the important EU summit this weekend. On the one hand, two countries are now being admitted to the euro waiting room, while at the same time they receive substantial support under the new EU Multiannual Financial Framework (MFF) and the Next Generation EU (NGEU) instrument. In relative terms Bulgaria and Croatia are among the largest recipients here inside the EU. Croatia and Bulgaria may receive 15-16% of their annual 2021 GDP (spread over a few years) in grants and guarantees within the NGEU instrument. Moreover, the Bulgarian and Croatian ERM2 entry is a much-needed signal to the CEE region that the euro is a key tool to grow closer together in Europe over time. Possibly the Croatian and Bulgarian ERM2 entry may also help EU authorities breathe new life into the euro debate in countries like Poland or Hungary. In the Balkans, the Bulgarian and Croatian ERM II entry may also breathe some life into the faltering process of EU integration, because almost every EU candidate in the Balkans wants to enter the eurozone, even in view of the high level of de facto euroisation there.

At present, the melange of euphoria and political motives outlined above is clearly a win-win constellation. But the concrete euro area entry outlook is definitely less rosy. Therefore, it is not so clear that the currently discussed accession date of 2023 — provided that all convergence criteria and dimensions are met — can be easily kept. On a political level, it cannot be taken for granted that the European tailwind for Croatia and Bulgaria will remain as strong as it is at present, i.e. that key EU countries can maintain their current “willing to integrate further” stance that is dominating at present. 

Moreover, the final euro area entry decision will be most likely based on a very thorough analysis of the sustainability of convergence. Not to forget that from now on the two countries will be even more closely monitored by the ECB and European Commission to see whether the local reform drive will increase or slow down — the latter being a key concern of the ECB. In this respect, the following applies here: after the reforms necessary for joining ERM2 and the banking union is before the reforms necessary for finally joining the euro. Here the dimensions of competitiveness and resilience are key, while it remains to be seen whether public debt-to-GDP ratios can be easily put on a firm downward trend in 2021. In case of Croatia and according to official agreements with ECB and the European Commission, ambitious reforms to “reduce the administrative and financial burden for the economy through further simplification of administrative procedures and reduction of parafiscal and non-tax charges” have to be delivered. Those tasks also include a further restructuring of state-owned enterprises and all this has to be achieved in a challenging environment of coronavirus (COVID-19)-related economic damages.

There are also some additional risk factors on the inflation and financial markets front. First, it is not said that the inflation criterion will be so easy to meet. It is precisely the small and open convergence economies of Croatia and Bulgaria that will receive a lot of frontloaded EU money from the MMF and NGEU in the next few years. This could lead to considerable inflationary pressure. This is especially true in the case of Bulgaria with its completely fixed exchange rate and keeping in mind that this was possibly the trickiest Maastricht criterion for the Baltic exchange-rate fixers that previously joined the eurozone. Secondly, Bulgaria and Croatia have made considerable political and reform commitments (so-called “post entry commitments”), which must be honoured in challenging macro-financial and socioeconomic times. And third, they are now members of ERM2 at a stage where the ECB's ultra-expansive monetary policy can induce substantial capital flows and capital outflow risks — in the case of unsound policies — on the ground. This is particularly important in the case of Croatia with its relatively high public debt ratio and its relatively liquid public debt market (compared to some other previous ERM2 members). In this respect, the envisaged euro area membership in 2023 will certainly not be a foregone conclusion and in the case of Croatia, financial market investors can now actively speculate on the prospect of accession on foreign exchange and/or fixed income markets.

All in all, there is a high chance that Bulgaria and Croatia can enter the euro area in the next five years, while a fast-track entry in two and a half years is not a given. For such a scenario to play out many economic and political factors would have to interact in the best possible way. Moreover, from the viewpoint of the European Commission and above all at the ECB, the length of stay in ERM2 shall be possibly based less on the minimum duration of two years and more on the benefits for the reform and convergence process. After all, Bulgaria and Croatia have already spent quite some time getting ready to join ERM2 after joining the EU in order to deliver on the reforming front, and this does not necessarily suggest that finally a fast-track euro area entry is now the most likely scenario. Moreover, the fact that they joined at the same time does not suggest that the final entry into the euro area will take place at the same time.