The NBP's Conference in Falenty on 22-23 October 2001
(Technical Report)

Poland belongs to a group of states having a golden opportunity to accede the European Union as early as 2004. Historically, the country has a unique chance of sustainably joining the West European economic structures and making a big leap forward. This move will entail our country's commitment to adopting the euro and joining the area of common monetary policy. In fact, Poland will become EMU1 member (albeit with a derogation) already upon gaining EU membership. This means that upon the satisfaction of the Maastricht criteria only the timing of euro adoption will be for our authorities to decide (but not whether to adopt or not). This opens up a discussion on the costs and benefits in connection with the process and its optimum routing and pace. The purpose of the conference organised by the NBP in 2001 was to present the relevant scholarship and bring closer positions on the overarching issue of Poland's road to the euro.

The conference was opened by Leszek Balcerowicz, President of the National Bank of Poland. His address highlighted three basic problem areas critical to the Conference.

The first area focuses around the choice of the optimum exchange rate strategy in the run-up to joining the eurozone. These issues are gaining special prominence of the light of candidate states' diverse experience in terms to their respective exchange rate regimes: from the currency board to the floating regime. The experience leads to formulating certain conclusions relating to the choice of the exchange rate policy in the run-up to ERMII. What is central to this problem area is first of all the establishment of an appropriate central rate (parity) as well as choice of the optimum date for exchange rate fixing.

Poland's fiscal and structural policy constitutes another problem area, extremely relevant to the health of the economy both before and after euro adoption. Monetary policy, including interest rate policy, can be no substitute for structural reforms, which determine long-term growth fundamentals.

The third area critical to joining the eurozone covers the issues connected with the Balassa-Samuelson effect. Its impact on the ability to meet the Maastricht inflation criterion (MIC) and its implications for joining the eurozone, call for empirical studies.

President Balcerowicz stressed that the purpose of the Conference should be to speed up the solving of the above-mentioned problems and to formulate practical recommendations relating both to the way and speed of Poland's joining the eurozone.

The participants of the Conference agreed that Poland as a future member of the European Union should ultimately adopt its common currency. This is justified by the economic and political benefits which can be derived by Poland from the adoption of the euro. It also follows from new members' obligatory EMU membership (initially with a derogation). Although the conference title might suggest a one-sided (accession country's) view of this issue, much room was left to arguments put forward by the Union side. It was emphasised that enlargement was a historical challenge for EU countries too. That's why EU opinions were particularly carefully listened to.

The subject-matter of the conference was thus the choice of the optimum pathway and timing of reaching the objective. As stressed by President Balcerowicz in his opening address, floating rate countries like Poland, Hungary and the Czech Republic (unlike currency board countries) have full discretion in their choice of the exchange rate in the run-up to ERMII. The choice should be informed by an analysis of alternative proposals in terms of their benefits and costs, as well as threats. The benefits and costs depend on the status of Poland's convergence with EU economies.

The spectrum of possible solutions in terms of exchange rate policy is quite broad: from the floating rate, through managed float, fixed exchange rate, currency board to unilateral euroisation. After joining the EU the choice will cover the timing of ERMII accession and the form of participation in it.

Conference participants differed in their opinions as to the choice of the optimum exchange rate regime in the run-up to the euro. Some of the participants favoured unilateral euroisation.

The idea of unilaterally adopting one of the principal world currencies as domestic currency had already been proposed for some countries and presented as a more sustainable solution than the standard hard peg or even currency board. A. S. Bratkowski and J. Rostowski modified this idea for Poland on the assumption that unilateral euroisation was to constitute merely a temporary phase, to be followed by full-fledged EU membership. In presenting the paper J. Rostowski pointed to a number of advantages of unilateral euroisation, including increased access to foreign savings and possibility of lower interest rates.

Poland's fastest lane to the eurozone consisting in unilateral euroisation sparked lively debate.

During the discussion S. Gomułka stated that unilateral euroisation would allow Poland to use its strong foreign position - with most corporate debt accounted for by branches of foreign companies, low level of short-term debt and ample scope for increasing external debt. For a few years after unilateral euroisation Poland could contract debt in relative safety using external savings to fund its development.

But it was also argued that among others due to the operation of the Balassa-Samuelson effect inflation could stay in excess of EU levels for a long time. It was also pointed out that short-term interest rate convergence need not mean analogous trends in long-term interest rates. Other arguments spoke of the danger of engineering a consumer and investment boom, caused by an inflow of capital in the period of preparations for unilateral euroisation (which would take 1 - 2 years according to the proponents of the concept) and after the adoption of the euro - until the country's debt and credit risk have significantly mounted. It was argued that lack of instruments of influencing the exchange rate and the level of short-term interest rates would considerably push up macroeconomic risk to an unforeseeable level. One risk would be that the monetary authorities of a unilaterally euroised state would no longer be able play the role of a lender of last resort, i.e. they would not be able to extend refinancing credit to banks, if they did not have a central bank' foreign reserve coverage.

The discussion benefited from presentations by representatives of the European Commission and eurozone central banks. They focused not only euroisation-related economic, but also institutional-legal and political issues. It was stressed that ultimately all EU countries would become full-fledged EMU members, except the UK and Denmark (countries with an opt-out). After EU accession Union institutions would be able to work for Poland's development with no requirement of unilaterally introducing the euro. In responding to the concerns formulated during the discussion J. Rostowski focused on a few basic issues. He noted that the apparent incompatibility of euroisation with the Treaty of Maastricht, as pointed to by discussion participants, followed from an incorrect interpretation of the Treaty and was no longer sustained by the Union side. He also noted that Poland was more economically integrated with EMU than half of its members (including the four biggest ones). The problem of having no lender of last resort should not be relevant to domestic banks, because most banks had foreign strategic investors who would provide the refinancing. In fact, the central bank itself could be the lender - a credit line could be negotiated and a liquidity fund ought to be created based on the reserves remaining after the purchasing of money values, so banking system risk should not go up either. He noted that the concerns, as raised, could not undermine the expected bonus from unilateral euroisation coming in the shape of lower inflation or interest rates.

It was emphasised that the introduction of a currency board or unilateral euroisation was not merely a "contingency plan" to be used in a situation of overcoming an economic disequilibrium. Two opposing viewpoints emerged from the discussion on Poland's unilateral euroisation. However, both sides were of the opinion that only full-fledged EMU participation could be recognised as a completely stable hard peg.

The arguments put forward in the discussion on the need of exchange regime evolution and, in some cases, extended to the circumstances of joining ERMII can be broken down into several groups.

The first group of arguments focused around the concept of an optimum currency area (OCA), nature of asymmetric shocks and convergence. The second group of issues, directly connected with the first one, focused around the assessment of the relevance of autonomous monetary policy to shock absorption and its credibility in various exchange rate regimes. The third group covered the issues of interest rate levels and their impact on growth. To a certain extent the issues led to the fourth group of arguments which spoke of the risk of capital inflow stops and financial crash. In what follows let us present, one by one, the most important arguments which belong to the groups just enumerated.

With respect to the first issue, i.e. assessment of the extent to which Poland constitutes an OCA, opinions should be noted which point to a rather high business cycle correlation between Poland (and more broadly Central European countries) and the European Union. J. Borowski noted a growing strength of intra-industry linkages between the economies of Poland and the EU, which reflected considerable progress in integration, constituted an important factor in the convergence of cycles and made Poland's economy more immune to asymmetric external shocks.

A relatively high correlation of the business cycle and advanced growth of intraindustry trade imply a relatively small risk of major external asymmetric shocks or cycle divergences whose consequences would have to be absorbed by exchange rate volatility. It thus seems that Poland to a high degree meets the criteria of an OCA with EMU. After all, as stressed by F. Corricelli, there are also major differences (asymmetries) between EU regions.

What is also very important in assessing the impact of asymmetric shocks on a currency area is the extent of mobility of production factors (including labour) and labour market flexibility. Many conference participants stressed at this juncture the relevance of the necessary labour market liberalisation in Poland (increasing labour mobility and wage flexibility) to the prospects of adopting a fast lane approach to the euro (limiting its potential downside). The issue of labour movement liberalisation between Poland and the Union was not discussed.

H. F. Jensen discussed the experience of Denmark's participation in ERMII, to which the Danish krone is pegged. According to him such arrangement was only possible in circumstances in which monetary policy (subordinated to the exchange rate) had a negligible impact on the shape of the Danish financial system. H. F. Jensen pointed out that Denmark's economic shocks came from internal economic policy (were "home-made"). The fixed rate constituted a major factor in ordering the economic policy and elimination of policy-induced shocks, while the main anticyclical responsibilities were shouldered by fiscal policy. It was argued that the fixed rate was no substitute for structural reforms. The subsequent discussion threw up the issue of the importance and sources of shocks in the Polish economy.

The question was also raised if the differences between monetary transmission mechanisms in particular countries did not possibly constitute a source of asymmetric shocks in EMU. It was found that despite considerable differences in transmission mechanisms between particular countries, the effects of such divergences were difficult to assess. The opinion was also voiced that ERMII and EMU accession might constitute a factor conducive to the approximation of transmission mechanisms.

Talking of Maastricht criteria convergence D. Gros pointed to the possibility of Poland's euro adoption in a few years' horizon. Much attention was paid to real convergence, uneven growth rates and the Balassa-Samuelson effect. These issues provided a starting point for the discussion on the possibility of sustainable convergence of the inflation rates under a fixed exchange rate and the need to modify the Maastricht criteria.

The usefulness of a float (second group of arguments) as a shock absorber was subject to diverse or even totally opposing views of conference participants. An anticyclical monetary policy in a floating regime is usually anything but credible and ultimately leads to rising inflation A few papers expressed the view that monetary policy in a floating system was often pro-cyclical, which meant that countries which declared a floating rate showed "a fear of floating". However, monetary policy in a floating regime was usually assigned a direct inflation target rather than the objective of smoothing down the real cycle or mitigating real external shocks. Certain comments should also be noted on potential, export-adverse consequences of business cycle stabilization policies (and, correspondingly, price stabilization policies) under a transmission mechanism using primarily the exchange rate channel. The effect intended to be achieved through higher interest rates is then produced mainly through appreciation and leads to undermining the competitiveness of the export sector. This issue was raised by H.F.Jensen, who made it into a case for maintaining a fixed exchange rate in Denmark.

The choice of the exchange rate regime optimal for Poland should take into account the probable nature of potential shocks (internal or external), extent to which Poland and the EU constitute an optimum currency area and the strength of the interest rate channel in the transmission mechanism. A choice of the exchange rate regime is also a choice between the categories which can become a monetary policy target; real product changes, exchange rate or inflation rate.

Conference participants did not always share the view that the choice between the fixed rate and the direct inflation targeting (DIT) accompanied by a floating rate always had to be a purely either/or choice. K. Lutkowski's paper called for complementing the DIT strategy with a policy whose purpose would be to retain the economy's competitiveness by maintaining some exchange rate controls (by way of establishing a "soft" fluctuation band). At the same time K.Lutkowski expressed the view that in the long-run the objectives would not be inconsistent, although he also took note of potential conflicts between the inflation-bashing monetary policy and the exchange rate policy.

The requirement of taking into account the impact of monetary and exchange rate policy on real economy through interest rates was taken up by the third above-mentioned group of issues and arguments. F. Coricelli found, based on Poland's example, that the floating exchange rate went hand in hand with high interest rates which encumbered the economy. However, there were voices in the discussion that high interest rates did not result from a floating exchange rate but rather from a monetary policy geared toward quick disinflation. To corroborate this proposition the much lower interest rates in the Czech Republic and Hungary were adduced (although until recently the exchange rate in Hungary was closely controlled by the central bank, while in the Czech Republic has a floating rate). This brings to the fore the question if the magnitude of destabilisation risk in various exchange rate regimes is comparable. We are thus turning to the fourth of the above-mentioned groups of issues.

R. Hausmann noted the importance of a certain feature of an economy which consisted in the inability to borrow long-term in one's own currency ("original sin"). This feature had the consequence that domestic entities borrowed either in foreign currency, which resulted in currency mismatches between their liabilities and receivables, or in domestic currency, which precluded long-term borrowing and resulted in mismatches of debt and investment returns. The mismatches led to a risk of, respectively, currency or financial crises which could come as self-fulfilling prophecies. R. Hausmann stated that the unhedged FX liabilities resulted from hard pegs, but also admitted that there were many countries with a floating regime borrowing unhedged funds from abroad.

Hausmann also demonstrated that irrespective of the mismatched structure of liabilities and receivables a sudden capital inflow stop might occur under any exchange rate regime, which could lead to a financial crisis, rising interest rates, budget deficits, inflation and depreciation. Apparently, a self-fulfilling prophecy mechanism would operate in this case. But it was tentatively suggested in discussion that perhaps a floating regime might be precisely the mechanism which could allow to avoid sudden capital stops. However, many papers and interventions shared the underlying assumption that a floating rate might be highly volatile and considerably diverge from long-term equilibrium. The view constituted a strong case for the already mentioned opinions on the desirability of exchange rate controls. Also, concerns were formulated about the sheer practicality of an effective market rate adjustment policy conducted by the central bank through reducing exchange rate misalignment with the hypothetical equilibrium level. Fears were also voiced that this could lead to continued but ultimately misguided interventions. Such concerns were even more pronounced with respect to the fixing of the point of equilibrium by the central bank.

One particular aspect of this discussion was also the issue of the potentially stabilising effect of ERMII participation. While some conference participants showed their faith in such stabilising impact, others demonstrated that sudden capital inflow stops and resulting turmoil were a possibility also under ERMII, as exemplified by D. Gros with the case of Spain. It was repeatedly pointed out that EMU accession prospects might trigger appreciation pressures leading to an overvalued currency and the necessity of its subsequent devaluation already under ERMII. This underscores the central importance of the manner in which the zloty's central parity vis a vis the euro will be established under ERMII, including the timing of its announcement and the role which can be assigned in this context to freely operating market forces.

The issue of potential zloty exchange rate destabilisation under ERMII is connected with the issue of choosing the optimum date for joining ERMII. Late ERMII accession was favoured only by E. Pietrzak in his paper. The issue of assessing the risks associated with particular exchange rate regimes brings to mind the issue of economy overheating (which could accompany the adoption of any form of hard peg) and subsequent recession (boom-bust). A speculative bubble in the asset market can be considered a special case of this phenomenon. However, it was not ruled out that a floating regime could exhibit similar problems too. It was noted that critical to avoiding serious financial market turmoil was the maintaining of the internal discipline of the domestic financial sector and the degree of its integration with the world market.

It follows from declarations that new Union members will try to adopt the single currency as soon as possible. This made the issue of meeting the Maastricht criteria by candidate countries a crucial one. The meeting of the criteria by new member countries is a guarantee of the euro remaining a strong currency and the eurozone a stable and competitive currency area. In discussing whether the Maastricht criteria were appropriate for candidate countries the participants focused on two basic issues: inflation and exchange rate.

The conference has provided a forum for the discussion of the basic factors which will hinder a relatively quick satisfaction of the Maastricht criteria. Its participants pointed to the possible operation of the so-called boxer's diet effect (before a fight). It would be possible to quickly repress the inflation ratio to the required level. But if this did not follow from real adjustment, then upon the country's eurozone accession the artificially suppressed inflation would rebound.

The main problem in connection with the satisfaction of the inflation criterion of EMU membership is the occurrence of the so-called Balassa-Samuelson effect, which captures price formation phenomena in fast growing economies. In such countries international competition necessitates and their relative technical backwardness or economic reforms enable a growth of labour productivity in the tradables sector. This phenomenon results in wage growth pressures which are also transferred to the non-tradables sector, not subject to fast productivity growth. This regularity results in inflation rising in the non-tradables sectors of such countries, which (with the same inflation in their tradables sector as in highly developed economies) breeds higher average inflation than in the countries with slower economic growth.

In his presentation W. Orłowski stated that accession countries faced the necessary process of closing the income gap with respect to EU countries. Consequently, accession states would generate a faster GDP growth rate in order to exceed the Union average. So the Balassa-Samuelson effect should be assumed to be at work. In the short run a difficult choice had to be made. If we wanted to repress inflation quickly, we would have to abandon accelerated GDP growth. This sparked a discussion on the possibilities of overcoming this difficult situation.

One of the options under discussion was the relaxation of the criteria for candidate countries in view of the impact of the Balassa-Samuelson effect on the evolution of price formation in those countries. But this was immediately followed by the comment that the scale of this phenomenon was difficult to isolate and estimate. G. Fagan pointed out in his paper that even at that stage the inflation level in EMU differed from country to country. This was caused by factors which could be divided into two basic groups: idiosyncratic factors (e.g. resulting from differences in indirect taxes, uneven susceptibility of a country to external shocks) and fundamental factors (resulting from the Balassa-Samuelson effect, rising market integration and business cycle fluctuations in the economy.) Moreover, it would be difficult to uniquely divide goods into tradables and non-tradables, as in each tradable a non-tradable component could be detected.

The discussion led to the conclusion that the importance of the Balassa-Samuelson effect must not be overestimated, let alone make one revise Treaty provisions. On the adequacy of the convergence criteria it was said that the renegotiation of the Treaty of Maastricht would be politically impossible.

R. Koenig emphasised in his paper that the Maastricht criteria should be treated as a macroeconomic policy anchor and a kind of code of good practices.

In view of the above the basic challenge faced by candidate states is to answer the question: How to meet the criteria (especially the inflation criterion) without compromising economic growth acceleration? The conference papers and discussion suggested two basic recipes for achieving such purpose: labour market reform and further privatisation and demonopolising of the economy.

Labour market reform carries many (not merely social) benefits in the form of a falling unemployment rate. M. Góra in his presentation stressed that growth in labour market flexibility might bring concrete positive effects for the whole economy. Payroll taxes, resulting in rising labour costs to the employer and the rigidities of the minimum wage preclude the hiring of new, mainly young employees and less qualified people. This pushes up actual unemployment to levels higher than it would otherwise climb to if such barriers were scrapped. Higher unemployment is not merely a social cost. It also inflates budget deficits through increased spending on benefits and social assistance. On the other hand, unemployment results in potential opportunity losses to the Treasury resulting from the fact that the unemployed do not pay taxes and constitute an unrealised economic potential.

Labour market deregulation, including the limitation of the role of the minimum wage and reducing wage surcharges, will reduce wage growth pressures. Thus, labour market deregulation contributes to the softening the Balassa-Samuelson effect in the economy.

A further privatisation and demonopolising of major economy sectors, e.g. energy and telecom lead to growth in the productivity of such sectors and reduce inflation pressures. Similar effects come from privatisation.

The implementation of the structural reform recipe may largely contribute to lowering the cost of disinflation consisting in a slower growth rate.

* * *

CONCLUSIONS

1. The conference confirmed Poland's commitment to adopting the euro.
2. The standard strategy of adopting the euro by meeting the Maastricht criteria, and thus also ERMII participation, gained strong support. At the same time most conference participants agreed that the adoption of the euro as soon as possible (and according to some participants, by way of unilateral euroisation) and Poland's inclusion in the single European financial market would bring major benefits to the economy and accelerate economic growth.
3. Irrespective of the choice of the exchange rate regime, structural reforms constitute important part of the country's macroeconomic policy. They are indispensable in supporting monetary and fiscal policy on the road to meeting the convergence criteria.
4. The Maastricht criteria and ERMII principles provide sufficient elbow room for candidate states to meet their conditions.
5. Poland and EMU countries constitute an optimum currency area (OCA) to a high degree. In the light of the views formulated during the conference the floating exchange rate seems to have limited application as an absorber of both external asymmetric shocks and effects of business cycle divergences.
6. The floating exchange rate allows to mitigate the currency crisis risk and allows to neutralise the Balassa-Samuelson effect through nominal appreciation of domestic currency.
7. A precondition of avoiding exchange rate turmoil after joining ERMII is a correct analysis of strategies in the run-up to joining ERM2.