Eurozone Watch ? Slovenia and EMU: Lucky 13?

リンク: Eurozone Watch ? Slovenia and EMU: Lucky 13?.

by Sebastian Dullien

When champagne bottles are opened to welcome the new year next Sunday night, the euro area will welcome member number 13: Slovenia. Unnoticed by most citizens of the currency area, the small country in southeast Europe has spent the past months for the currency changeover and is now ready to forego its national currency, the tolar.

While the discussion about the euro introduction in Lithuania, Estonia and Latvia has been rather noisy (the Lithuanians did not want to take the EU commission’s ‘No’ for a ‘No’, sending shock waves into the old member states), there was very little reporting about the actual steps taken in Slovenia to prepare for the euro introduction.

This is no mere coincidence, nor is it solely a result of Slovenia’s small size (its population is only 2 million, 0.6 percent of the euro area). In fact, Slovenia seems to be well prepared to become member of the currency union - probably better than any of the other former communist economies in central and eastern Europe.

Slovenia fulfills all of the traditional OCA criteria: Factors between Slovenia and the rest of EMU can move almost unhindered. Capital can already move freely. Slovenia’s geographical proximity to Italy and Austria and its small size make migration easy. Slovenia’s workers will soon be allowed to work everywhere in the EU, with the existing restrictions being slowly faced out in some EMU countries and set to disappear completely at the end of the decade. Moreover, Slovenia is by now closely integrated into the rest of EMU with a high share of exports and imports in GDP: A country-specific shock is not more likely than - just to pick two examples - for Belgium or Luxembourg.

Needless to say that Slovenia does not have any trouble meeting the Maastricht convergence criteria: Government debt is below 30 percent of GDP, the budget deficit at roughly 1.5 percent and inflation slightly above 2 percent.

However, it is not quite clear whether the traditional OCA criteria or the Maastricht criteria are really enough in order to judge whether joining EMU is sensible or not. When Eastern Germany introduced the Deutsche Mark in 1990 and later joined the Federal Republic of Germany, one could have argued that the simple OCA criteria where also met: Labour mobility between the East and the West was high, the on-paper-difference between the East and the West in the share of manufacturing or agriculture was rather small. Moreover, there was an inter-regional transfer system with provides poor German states with money from the rest of the country which in principle should make adjustment to asymmetric shocks more easy. Still, today, the introduction of the German Mark can hardly be seen as a success: Manufacturing industry in the East is still very weak, unemployment rates reach 30 percent in some regions and income convergence has stopped or even reversed - an outcome that some economists see as a result of a strong regional over-valuation after reunification.

Before joining a currency union, a country should therefore ask itself a set of questions in addition to looking at the Maastricht and the traditional OCA criteria. From the experience from Portugal as well as East Germany, I would propose to take the following three tests (you might want to call them the Eurozone Watch criteria):

1. Is there good reason to assume that the exchange rate for entering EMU is close to a real exchange rate with which the economy can be expected to be able to live in the future?
2. Are wage and productivity trends compatible with sustaining grosso modo the current real exchange rate position?
3. Are labour market institutions set to react quickly and appropriately to a future misalignment in the real exchange rate?

Eastern Germany missed the first two of the tests: The exchange rate with which the German Mark was introduced was probably too high. Moreover, first wage agreements tried to increase wages much stronger than productivity, pushing the region into a position of overvaluation. Even though de facto wages did correct afterwards, by the time the process was over, manufacturing industries had closed down and structural damage had been done.

When entering EMU, Portugal failed all of the tests above. The current account deficit in 1998 was already sizable, the relative unit labour cost position well above historical values. Finally, as we have seen in the past years, labour market institutions do not seem to react quickly to an over-valuation of the real exchange rate and a strong increase to unemployment.

Turning to Slovenia, the small country seems to fulfill all of the criteria. First, despite the strong economic growth (the EU commission estimates 2006 GDP growth at roughly 5 percent), the current account deficit is rather small (below 2 percent of GDP) and exports are growing much faster than imports. Thus, there is no reason to assume a significant misalignment of the real exchange rate.

Second, wage and productivity trends do not put this real exchange rate position into jeopardy: The June 2006 pay agreement stipulates nominal wages for the private sector to rise only by 2 percent. While this is only the floor, sectoral wage agreements may top up this figures and economy-wide pay-increases per worker might reach 5.4 percent (EU Commission November estimate), this value does not pose any major problems. With labour productivity growing at a rate of 4 percent, nominal unit labour costs have only risen by 1.4 percent, much less than in Italy (2.6 percent), Spain (2.5 percent) Portugal (2.3 percent) or even France (1.9 percent). Moreover, the boom in investment in equipment and software (plus 10 percent year-on-year in 2006) poses well for a continued strong increase of productivity, thus keeping unit labour cost increases low.

Third, the wage bargaining system in Slovenia seems to be well prepared to react to a possible future over-valuation: With central wage agreements being topped up with productivity-related sectoral contracts, the economy seems to be well prepared to react to shifts in the productivity trends, preventing the small country to become the next Portugal.

So, 13 might well turn out to be a lucky number this time. Welcome to the eurozone, Slovenia!