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. …