It is going to take at least a decade before the reformed eurozone regains credibility and it will take at least as long for the Czech political system to develop the capacity to implement structural reforms that are necessary for successful functioning in a monetary union.
Czechs are legally obliged to adopt euro, because—unlike Brits or Danes—they did not negotiate an opt-out from this Treaty requirement when joining the EU in 2004. However, the government retains full control over timing. It needs to fulfill all Maastricht criteria, including two years of participation in the EU’s exchange rate mechanism ERM II. In December 2011, the government decided not to set a date for euro adoption and not to apply for the ERM in 2012. This makes it certain that Czechs would not join in before 2015. However, there is nothing in current EU treaties that could prevent indefinite postponing, which is a strategy also applied by Sweden.
A flexible exchange rate regime proved a blessing before the financial crisis. Ongoing appreciation of the Czech koruna between 2002 and 2008, contributed to low inflation and low interest rates, which—together with a trustworthy banking system—prevented a build up of macroeconomic vulnerabilities such as massive lending in foreign currencies or dependency on foreign capital inflows that deepened crisis impact in neighboring countries such as Hungary or Poland. The role of the Czech National Bank as a potential lender of last resort and limited exposure to troubled European countries then shielded the economy from the eurozone turmoil. Given the circumstances, the economy finds itself in relatively comfortable state and it is capable of meeting the Maastricht criteria over the next few years. Nonetheless, even the traditional advocates of single currency among Czech exporters are taking a pause in advocating euro, until it is clear in what shape eurozone remerges from crisis.
The crisis did not change the basic arguments for adoption of the single currency. It is still true that single currency makes single market more transparent, efficient and competitive, which increases overall welfare. Removing exchange rate uncertainty reduces transaction costs of trade and frees up managerial capacities spent on currency hedging or speculation, for more important tasks such as innovation and productivity improvements. Large currency block is still more capable to prevent speculative attacks of financial markets than small national currencies and it still curbs vicious cycles of competitive devaluations. Although these benefits may add only a tenth of a percentage point to the GDP growth, they are still among the more effective pro-growth policies for countries like Czech Republic, if they can contain risks of joining in.
Operating a common currency creates risks for participating economies, as they cannot adapt to asymmetric shocks through flexible changes of exchange and interest rates. Instead, they need to devout much more effort to prevention of destabilizing imbalances and create robust institutions for resolving crises, in case that prevention proves insufficient. The eurozone rules proved too weak in the former and entirely insufficient in the latter, but this is changing fast. The eurozone the Czechs would be joining, will be much more robust than that joined by their Slovak neighbors in 2009.
A tsunami of policy initiatives such as EU 2020 strategy, European semester, Euro Pact Plus, fiscal compact and six-pack of directives, cumulatively strengthen the macroeconomic governance and thus prevent unexpected surprises such as revelations of much higher past deficits and debts after changes of governments in Greece or Hungary. Even more important are the reforms of financial market regulation, such as the creation of the European System of Financial Supervisors and European Systemic Risk Board charged with preventing excesses such as massive real estate bubbles, AAA rating of toxic securities or mispricing of risks that caused over-lending to Greece at German-like rates. These preventive measures are also being complemented by new crisis resolution tools such as European Stability Mechanism (ESM), novel uses of European Central Bank’s (ECB) powers and, most recently, proposals for the banking union.
Although, these reforms push eurozone towards long-term viability, they also push Czech politics further away from adoption. Prime minister Petr Nečas refused to sign fiscal compact, despite commitment of his government to fiscal austerity—a move largely motivated by appeasement of president Václav Klaus and his supporters within the senior coalition party. Moreover, eurozone reforms, combined with ESM participation that might create potential liabilities up to 9 percent of current GDP, provided Czech eurosceptics with pretext to call for referendum on euro adoption, despite the existing legal commitment. They argue that the new framework is not what the country accepted in 2004. Meanwhile, the Czech economy gets ever more integrated with eurozone economies.
Ever-closer Economic Integration
The risks of monetary union are substantially reduced by macroeconomic convergence and cyclical alignment of participating economies. Increasing similarities get them sufficiently close to the optimal currency area, which no longer requires dramatically dissimilar monetary policy. In this respect, the crisis brought the Czech economy closer to the eurozone.
Two-thirds of Czech exports go to the euro countries and enterprises producing at least one-third of GDP are owned by investors from eurozone, who control key industries such as car manufacturing and banking. This ties economic developments in the Czech Republic closely with the eurozone—a fact easily observable from strong correlations between numerous macroeconomic indicators. Recent reports of the Czech and European central banks note that the long-term convergence of inflation rate, nominal interest rates, as well as cyclical alignment of GDP growth, increased during the crisis. Such alignment reduces macro-financial risks associated with euro, while deepening integration magnifies potential microeconomic benefits of common currency.
On the other hand, the crisis also burdened public finance and temporarily disrupted the trend towards low and stable inflation. The public deficit deteriorated to 5.8 percent of GDP as a result of the economic slump and the anti-crisis fiscal measures, but returned to 3.1 percent in 2011, with debt levels increasing from 34 to 41 percent of GDP. Similarly, inflation jumped unexpectedly in 2008, but returned to 1 to 3 percent range targeted by the central bank. These numbers do not stand out from eurozone trends and confirm that Maastricht criteria remain within reach.
Neither the state nor the banking sector pose an obstacle. Banks are stable, well capitalized and meet all new regulatory requirements imposed in response to crisis. They are currently healthier than their eurozone parents, which may lead to a paradoxical situation, when Czech banks are fully integrated into eurozone, long before the country joins in.
Under the current banking union proposals, the European Central Bank (ECB) is to become home supervisor to all Czech banks that are owned by eurozone banks. The single market rules even allow bank owners to convert their Czech subsidiaries to branches, which would completely sideline the Czech National Bank (CNB) as a supervisor. Most of the financial sector would thus be overseen exclusively from the supranational level, without direct involvement of national authorities.
Parent banks are interested to pool resources from their Czech subsidiaries on transnational level. The CNB currently prevents the pooling of capital and liquidity by strict rules on the exposure to related parties, which, however, motivates foreign owners to shift away from national regulation by transforming subsidiaries to branches. Moreover, such a change would provide the Czech banks with access to the planned eurowide deposit insurance scheme, which may be more attractive for banks as well as depositors than the Czech-only deposit insurance.
Only considerable costs of reorganization prevent banks from conversion to branches. Apart from moral suasion, the CNB has no mechanism to prevent the change, although it also exposes the Czech banking sector to contagion from other countries. If foreign owners move ahead with reorganization, then the CNB becomes irrelevant as supervisor for over 80 percent of the Czech banking.
Institutionally, Czech banks may become part of the eurozone, even if the country stays out and their balance sheets are still denominated in koruna. Even if, the Czech Republic decides to opt-in and joins the banking union, it will not have full voice in the ECB until it adopts euro. Hence, banking is just the most recent example of the fact that in order to regain sovereignty over the ever more integrated economy, the Czech Republic will eventually need to accept common currency and assume full role in ECB decision-making.
Dangerously Incompetent Politics
While the financial crisis reduced some macroeconomic misalignments, it also stalled economic convergence. Nominal wages remain at mere 36 percent of eurozone average, which illustrates well the size of the gap yet to be closed. Moreover, the convergence process is fraught with risks that the Czech politics is as ill prepared to handle as was Greece, Portugal or Ireland.
Following the euro adoption, these economies experienced massive inflows of capital at very low interest. This fueled booms in nontradable sectors such as construction and led to wage increases that outstripped productivity improvements in all sectors, including those that produce tradable goods and compete on international markets. Hence, these economies lost their competitiveness vis-à-vis the core countries, which is undeniably one of the sources of their current predicament.
With the benefit of hindsight, the risks to competitiveness are all too well understood. Central banks’ reports now follow changes in unit labor costs closely and argue for ever more flexible labor markets, which would make possible drastic reductions of wages during crises. However, flexibility alone cannot prevent upward swings of wages during bubble-driven booms. Moreover, flexibility as such is not the policy successful core EMU countries rely on.
Economies such as Austria or Netherlands that are closely integrated with German economy, rely on various forms of economic coordination to prevent loss of competitiveness. The political institutions underlying this coordination typically bring together labor unions, producers and the government, who can together keep the economy closer to sustainable path. Although, these arrangements are under pressure from globalization, they are still capable of preventing excessive changes in relative competitiveness that may trigger dangerous imbalances within the monetary union.
Moreover, coordination mechanisms also infuse longer-term horizons into daily politics, thus facilitating bargaining about structural reforms that are necessary for successful participation in a monetary union. Examples of such reforms include the Hartz IV reform in Germany or Dutch labor market reforms that enabled widespread use of part-time employment. These were heavily contested, triggered large social protests, but in the end social partners were able to formulate acceptable compromises that were implemented and maintained even by subsequent governments.
This contrasts with attempts at structural reforms in the Czech Republic. Rather than viable compromises, they tend to be ad hoc coalition bargains that are watered down to near irrelevance at the slightest sign of social protests, before being finally abandoned by the next government. This was the case of past tax reforms and the ongoing pension reform is set onto the same path. The Czech political system lacks structures supporting participatory reform process, which represents a grave risk for functioning of the Czech economy within single currency. The monetary union abandons nominal adaptation through exchange and interest rates, and build up of dangerous imbalances can be prevented only by sensible, consensual policies.
As long as the country lacks the necessary policy-making capacity, the independent currency can serve as a safety mechanism for reducing potential impacts of inapt policymaking within fixed exchange rate regime of the eurozone. However, as the economic integration with core eurozone countries deepens, the CNB is forced to follow more and more closely the monetary stance of ECB. At some point in near future, it will become just like having the rates set by the ECB, except for foregoing the benefits of the single currency shared with the most important partners, while also bearing the risks of operating small and potentially volatile currency. In short, keeping koruna as mere insurance mechanism for crises is likely to become expensive luxury, especially if the reformed eurozone develops viable crisis management mechanisms.
Upgrading the Czech political system so that it becomes capable of controlling corruption, keeping wage setting reasonable, and implementing structural reforms of taxation, education and pensions, is important per se. However, it will be even more important when all the economic reasons line up overwhelmingly in favor of euro membership sometime in the next decade or so.
Economy Pulls Politics in
The Czech Republic will not be able to stay out of euro permanently. Eventually, the pull of ever more integrated economy would overcome the political resistance to single currency. Massive trade and ownership linkages to eurozone as well as increasing macroeconomic alignment indicate scope for benefits of euro adoption, while also limiting its risks. However, it is likely to take at least a decade, before reformed eurozone proves its credentials and before Czech politics becomes capable of delivering structural reforms, which are both prerequisites for joining in.
Political heavyweights as well as the public opinion are currently clearly against euro adoption. During the crisis, the number of people against joining the eurozone essentially doubled from 43 percent in 2007 to 81 five year later. Not only does this reflect the sobering experience of euro crisis, but also the influence of eurosceptic president Klaus. Not only did he appoint the central bank board full of ritual eurosceptics, but displayed capacity to sway government positions against the EU and euro at numerous occasions as well. On the other hand, entire half of survey respondents shifted from mild support of euro adoption to mild opposition, hence, stabilization of eurozone and the end of Klaus presidential term in 2013, may help to rebalance the Czech public opinion.
In any case, the Czech Republic is close to the point when eurozone membership provides greater degree of control over its economic policies than staying outside. This is to be the case in banking regulation, but it applies to monetary and fiscal policies as well. The monetary autonomy of the Czech National Bank is considerably constrained by ECB decisions and the need to preserve relative competitiveness of Czech export industries. Similarly, even if the country avoids fiscal pact, the market expectations will force de facto compliance with its provisions. Under such circumstances, there will be less and less to gain by staying out.
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