Hungary's Eurozone Entry Date: What Do the Markets Think and What If They Change Their Minds?

Csajbok, Attila, Rezessy, Andras, Contemporary Economic Policy

I. INTRODUCTION

In the middle of 2004, 10 countries--most of them from the Central and East European region--joined the European Union. All of the new member states are required to adopt the euro in the future. Before introducing the euro, however, these countries must fulfill the so-called Maastricht convergence criteria, but there is no explicitly defined deadline for this. Financial markets form their own view about the future date of entry to the eurozone of these countries. If a change in the circumstances persuades markets that the convergence process will be delayed, the expected entry date may be shifted. Because of the forward-looking nature of financial markets, such a revision may affect current monetary conditions, that is, the spot exchange rate and long-term yields.

There is a large body of literature analyzing how financial markets assess the outlook of EU members of adopting the single currency in the future (see Bates 1999 for a review of this literature). This article adds an important insight to the existing work: It presents a simple framework that quantifies the potential size of the reaction of monetary conditions to a change in the expected entry date. In addition, the article provides important policy conclusions regarding the participation in the Exchange Rate Mechanism II (ERM II), a necessary precondition to entering the eurozone.

The article applies the method for the case of Hungary. From the 10 new EU members, Hungary presents an especially interesting and unique example because financial markets' expectations about the country's eurozone prospects have shown remarkable dynamics in recent years. Starting from rather optimistic expectations in 2001 and showing further improvement until mid-2002, the prospects deteriorated markedly by the end of 2004. Therefore the country presents an interesting example for studying the impact of this dynamics on monetary conditions.

The article is organized as follows. Section II provides an assessment of the markets' view on Hungary's eurozone entry date using information from forint and euro yield curves. Section III describes a simple method that quantifies the potential impact of an adverse shift in the expected entry date on the spot exchange rate and long-term interest rates. Section IV gives an illustration of the reactions of monetary conditions implied by the method and presents an ex post comparison of changes in the exchange rate and long-term yields with the changes predicted by the method presented in this article. Section V concludes with important policy implications for ERM II entry.

II. MARKET EXPECTATIONS ABOUT THE ENTRY DATE

Deriving Expected Entry Dates from Yield Curves and Surveys

Information on the markets' expectation about Hungary's eurozone entry date is available both directly and indirectly. Direct evidence is offered by regular polls of local financial market analysts conducted by Reuters. (1) However, because these surveys started in 2003, they provide a rather limited time span for analysis.

It is also possible to gauge entry date expectations indirectly, making use of information in the price of financial market instruments. According to Bates (1999), the basis of these analyses can be Arrow-Debreu type contracts, currency options, and yield curves. Arrow-Debreu contracts for the eurozone entry of Hungary are not available, and the time horizon of currency options for which there is enough data is not long enough for this purpose. Therefore the analysis is based on the information from the term structure of Hungarian yields.

The basis of the yield curve method is to compare implied forward interest rates derived from zero-coupon yield curves in Hungary and in the eurozone. This approach makes use of the fact that after adopting the euro, Hungarian nominal interest rates will differ from eurozone nominal rates by only a small default risk premium. Because implied forward rates are indicative of the markets' expectation of future short interest rates, the observed differential of one-year implied forward in, say, 2009, depends on the probability the market attaches to scenarios in which Hungary is already a full member of the eurozone by that year. The higher this probability, the lower is the implied forward differential for that particular year. Formally, F[S.sub.t,T], the observed one-year forward interest differential for year T, observed in t can be decomposed as the following:

(1) F[S.sub.t,T] = (1 - Prob[.sub.t](EM[U.sub.T]))*Spread[.sub.T.sup.Non-EMU] + Prob[.sub.t](EM[U.sub.T])*Spread[.sub.T.sup.EMU],

where Prob[.sub.t](EM[U.sub.T]) is the probability at time t that the market attaches to scenarios in which Hungary is a full member of eurozone by year T, Spread[.sub.T.sup.Non-EMU] is the expected interest rate differential if Hungary is not in the eurozone by year T, and Spread[.sub.T.sup.EMU] is the expected interest rate differential once Hungary is in the eurozone, that is, the expected default risk premium. Because of the currency risk, Spread[.sub.T.sup.Non-EMU] is obviously greater than Spread[.sub.T.sup.EMU].

From (1), the implied probability of Hungary being a eurozone member by year T:

(2) Prob[.sub.t](EM[U.sub.T]) = [Spread[.sub.T.sup.Non-EMU] - F[S.sub.t,T]]/[Spread[.sub.T.sup.Non-EMU] - Spread[.sub.T.sup.EMU]].

F[S.sub.t,T] can be calculated from forint and euro zero coupon curves. For the other two determinants of Prob[.sub.t](EM[U.sub.T]) one has to make assumptions. Euro-denominated Hungarian sovereign bonds currently trade around 20 basis points above euro swaps, that is, the default risk premium is already quite close to levels observable within the eurozone. Therefore the authors assume a 20 basis point value for Spread[.sub.T.sup.EMU].

More problematic is the choice of Spread[.sub.T.sup.Non-EMU], that is, the expected future interest rate differential if Hungary stayed out of the eurozone. Interest rate differentials are expected to decline from current levels for a number of reasons. First, with EU membership, Hungary will be better able to differentiate itself as a converging economy and may get more insulated from financial contagion coming from emerging markets. The result of this will be a decline in the currency risk premium and a shrinking of the interest rate differential. Second, the exchange rate stability required during the run-up to full eurozone membership can have a similar effect. Third, domestic interest rates may decrease as a result of progress in disinflation.

[FIGURE 1 OMITTED]

There are several approaches in the literature to approximate the value of Spread[.sub.T.sup.Non-EMU]. De Grauwe (1996) makes use of historical average of spreads, a J.P. Morgan study (1997) uses international measures of risk, Favero et al. (1997) estimate a central bank reaction function, and Lund (1998) builds a model for the term structure. For reasons of simplicity, this article uses historical averages of implied forward differentials.

These differentials can be useful in approximating Spread[.sub.T.sup.Non-EMU], but beyond a given horizon, the possibility of eurozone membership is discounted into them as shown in (1). Therefore, one should choose a future year in which Hungary is already an EU member but the probability of full eurozone membership is technically 0. For instance, the year 2005 satisfies these conditions. Between the middle of 2001 and the middle of 2004, the average of one-year implied forward …

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Publication information: Article title: Hungary's Eurozone Entry Date: What Do the Markets Think and What If They Change Their Minds?. Contributors: Csajbok, Attila - Author, Rezessy, Andras - Author. Journal title: Contemporary Economic Policy. Volume: 24. Issue: 4 Publication date: October 2006. Page number: 343+. © 2003 Western Economic Association International. COPYRIGHT 2006 Gale Group.

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