Academic journal article The European Journal of Comparative Economics

Real Convergence in the New Member States of the European Union (Shorter and Longer Term Prospects)

Academic journal article The European Journal of Comparative Economics

Real Convergence in the New Member States of the European Union (Shorter and Longer Term Prospects)

Article excerpt

1. Real and nominal convergence

1.1. New challenges of convergence during the crisis

The potential advantages of adopting the euro are of great importance for new Member States (NMSs). Euro adoption can contribute positively to long term growth and stability. It has an impact on economic performance through several macro- and microeconomic channels: the stability-oriented macroeconomic framework, access to liquid markets, more trade and foreign direct investment, lower transaction costs and increased competition.

Indeed, Eurozone membership has to be assessed in a broader context when considering it from the point of view of economic policy. The static view on the state of nominal convergence is not enough (Angeloni, Flad and Mongelli (2007)). In order to take full advantage of the single currency--taking into consideration the restrictions of the common monetary policy and irrevocably fixed exchange rate--the economic policy needs to ensure the proper functioning of the internal adjustment mechanism safeguarding stability. Adequate labour- and product market flexibility, as well as sufficient fiscal buffers were identified as the preconditions of successful euro adoption (Rybinski (2007), Darvas and Szapary (2008)). Closer economic integration with the Eurozone might contribute to mitigating vulnerability against asymmetric shocks.

Considering the special conditions of the NMSs, special attention needs to be paid to the risks related to convergence. Countries accumulating huge internal and external deficit are very vulnerable under the conditions of the present crisis. At the same time there has been a progressive price level convergence and real equilibrium appreciation as part of the process. On the other hand the catching up process of the NMSs is effected by globalization and financial integration. The NMSs are highly sensitive against shock impacts due to their relatively small size, high level of openness and greater need for external financing. These risks have become apparent during the current crisis. The retreat from risk and the search for liquidity by investors might contribute to heavy pressures on the financial markets of the NMSs.

1.2. Price level and real convergence

The majority of the NMSs achieved remarkable convergence (taking into account the advancement of macroeconomic stability and the supply side reforms related to EU-accession). Nevertheless, a broad difference among certain member states remained. The new MSs have to face a shortfall caused by the crisis and sharp decline in growth (often accompanied by a decrease in GDP). Certain countries, which had a significant catch-up growth during the past years (e.g. the Baltic States) entered into a recession. Growth in the region has slowed down permanently. Therefore real convergence--within and outside the Eurozone--remains a determinant factor shaping the economic policy strategy for most NMSs in the medium term.

The equilibrium real exchange rate appreciation (price level convergence) is considered a natural consequence of the economic catch-up (De Grauwe and Schnabl (2005)). Real exchange rate appreciation--depending on the monetary policy and exchange rate levels--might occur following two paths (or through the combination of the two): by nominal exchange rate appreciation and/or a higher internal (domestic) inflation. The pace and the channels of the equilibrium real appreciation are of great importance as regards the trajectory of nominal convergence. The fixed exchange rate system (which was introduced by the Baltic States) excludes the nominal exchange rate channel of the real appreciation. Therefore, higher trend inflation is evolving for converging economies than for the anchor area.

Beyond the Balassa-Samuelson effect further factors effect significantly the dynamism of real appreciation. The pace of the income convergence, the domestic demand growth exceeding GDP growth and the exchange rate regime are significant determinants of the price level convergence dynamics. …

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