EURO ADOPTION,
OPPORTUNITY AND CHALLENGE FOR ROMANIA
Silviu Cerna
The adoption of the euro is simultaneously a chance and a challenge for Romania, as it equates to the definitive return of this country to Western civilization, from which the communist regime kept it isolated for half a century. The official decision to replace the national currency (the leu) with a single European currency has already been taken through the “EU Accession Treaty”, but Romania can collaborate with the European institutions in establishing the right moment for entering the Economic and Monetary Union (EMU). The latter decision depends on achieving the balance between the positive effects (long and short term) and the costs (risks) related to the adoption of the euro.
Romania’s entry into the eurozone is conditioned by the fulfilment of the monetary and fiscal convergence criteria provided by the “Maastricht Treaty”. These criteria reflect the features of a healthy economy, where the inflation rate is low, public finances are balanced, and the exchange rate is stable. If these criteria are met, it can be concluded that the country in question is in a position to adopt the euro, as its economy will remain competitive beyond this point and will not be a burden on the other member states.
The analysis of meeting the convergence criteria shows that Romania does not satisfy any of them, for now. Moreover, the only two criteria met at a given time (the budget deficit and the public debt) have ceased to be so, due to the populist fiscal policy pursued by the Romanian governments lately. The authorities already announced through the “Convergence Programme” of 2007 that the date of entry into the EMU would be 2011. Later, however, they repeatedly postponed this term: 2014, 2015, 2019, 2024–2026, and now, it seems, sine die. This permanent hesitation shows that the adoption of the euro was never taken seriously by the Romanian authorities.
However, in December 2018, the Romanian government published a “National Plan for the Adoption of the Euro”. For its part, the government commission created for this purpose developed a “Report on the substantiation of the National Plan for the Adoption of the Euro”, in which it presents various aspects of this process. However, these official documents do not provide concretely the economic policy measures that will be taken for this purpose, nor the calendar of these policies nor a precise date, but they contain general analyses of various aspects of Romania’s economy and possible scenarios of its future evolution in the European context.
The positive effects of adopting the euro are both direct and indirect. The first ones come from the irreversible and historically unprecedented change in the monetary conditions of economic activity in Romania and will begin to manifest immediately. A direct effect of joining the EMU is the elimination of the leu/euro exchange rate, which will lead to the disappearance of both transaction costs and currency risk, both inherent in current economic relations with eurozone countries. The elimination of currency risk and the related risk premium, in turn, causes the interest rate to fall, stimulating investment – foreign and domestic – and, therefore, boosting economic growth.
The indirect effects of entering the eurozone are the radical and irreversible improvement of the general conditions of economic activity, the increase of foreign trade and investments, greater macroeconomic stability, the development of the financial market, and the increase of competition in the market of goods and services. All these processes will contribute to the acceleration of economic growth in the long term.
Nevertheless, giving up the national currency also involves certain costs. They stem primarily from the loss of monetary policy autonomy, which allows the relatively efficient use of the interest rate and the exchange rate as instruments of national economic policy. Since the economic cycles of the EMU member countries are not completely synchronized, the interest rates set by the European Central Bank (ECB) at the level of the eurozone may prove to be inadequate in light of the existing economic conditions in Romania. Also, joining the euro area implies the loss of the stabilizing function of the relatively flexible exchange rate.
Replacing the leu with the euro is indeed equivalent to abandoning the use of the interest rate to achieve some economic policy objectives (price levels, GDP size, employment rate, etc.), as well as the disappearance of the stabilizing function of the flexible exchange rate. But in an open economy, the central bank faces even before the adoption of the euro the problem of the “triangle of incompatibilities”: fixed exchange rates, free movement of capital, and autonomous monetary policy cannot exist at the same time.
The exchange rate regime currently existing in Romania (controlled floating, managed floating) gives the central bank considerable freedom in setting interest rates. This fact allows it to take into account, to a certain extent, the domestic economic conditions in the design and application of monetary policy. On the assumption that there are no major threats to price stability – the main objective of monetary policy -, the central bank can also concern itself with mitigating the fluctuations of the economic cycle (GDP size and the degree of employment). In addition, a floating exchange rate regime facilitates smoothing out fluctuations in output and employment, oscillations driven by external demand shocks, and/or exchange rate shocks.
However, the effectiveness of the regulatory role of the exchange rate depends on the factors that cause it to change. The stabilizing function of the exchange rate is exercised primarily through the mechanism of adjusting the equilibrium level of the exchange rate to changes in economic “fundamentals” (money supply, global income, price level, balance of current payments, etc.). Despite that, the exchange rate is also influenced by several factors that do not belong to the real sector of the economy (anticipations regarding the change in the future orientation of monetary policy, anticipated changes in the risk premium, the “contagion effect”, the depth of the financial market, etc.). Under these conditions, giving up the national currency by joining the EMU involves a lower cost than the one predicted by the traditional theory of the stabilizing function of the exchange rate. This statement, confirmed by recent empirical research, is explained by the fact that a floating exchange rate can itself generate shocks exerted on the real sector of the economy. Moreover, in some works dedicated to the development of the theory of optimal monetary zones, it is argued that the exchange rate adjustment mechanism does not have the role attributed to it in neutralizing asymmetric shocks. This does not, however, change the fact that entering a monetary union, equivalent to the complete abandonment of the exchange rate regulatory mechanism, necessitates the existence of other adjustment mechanisms. These alternative regulatory processes offset the negative effects of asymmetric shocks, and their presence or absence affects the overall balance between the benefits and costs of monetary integration.
One such alternative mechanism is a flexible labour market. After joining the euro area, the adjustment of real wages and the free movement of labour will constitute, in addition to fiscal policy, the only remaining economic mechanisms for mitigating the negative effects of asymmetric shocks. If an asymmetric demand shock occurs in a monetary union, the region where the demand decline occurs may suffer a reduction in output and employment. If the factors of production (capital and labour) are sufficiently mobile, their movement from a country affected by a negative shock on the side of aggregate demand to a country where there is no such shock allows restoring the macroeconomic balance and stopping the growth of unemployment in both countries.
The analysis of the labour market in Romania shows that this market does not constitute a feasible mechanism for mitigating the negative effects of asymmetric shocks. The main problem is the relatively high rigidity of real wages. Consequently, the abandonment of autonomous monetary policy creates the risk that, after joining the euro area, asymmetric shocks will amplify fluctuations in labour force employment and population incomes. In order to reduce this risk, an extensive reform of the labour market is necessary, by which to make the process of salary formation more flexible and to improve the other characteristics of this market.
Another possible means of mitigating fluctuations in output and employment caused by asymmetric shocks is fiscal policy. By abandoning autonomous monetary policy, fiscal policy becomes, in fact, the main instrument for stabilizing the economy.
The analysis of the fiscal policy carried out by the Romanian governments in the last period shows that, after joining the eurozone, a major obstacle to the effective use of this instrument will be the excessive structural deficit. Even if the deficit level is reduced to the 3% of GDP reference value, which seems unlikely even in the medium term, the automatic stabilizers of fiscal policy will not function normally. As a result, it can be assumed that fiscal policy will not be able to stabilize cyclical fluctuations. Therefore, a comprehensive reform of public finances is necessary in advance to restore the stabilizing function of fiscal policy and, therefore, reduce the cost of participation in the euro area. And there are several reasons why such a reform must focus on the spending side of the state budget. The public sector in Romania constitutes an enormous fiscal burden for the economy and the population, and there is a large volume of populist social spending, which is often bypassed by the pseudo-reforms expected by the authorities. Taxation of labour income is high and social security contributions are substantial, which constitute serious obstacles to the employment of new workers in the private sector.
The cost of reverting to autonomous monetary policy depends greatly on the country’s vulnerability to asymmetric shocks. The measurement of this vulnerability is usually based on quantifying the degree of synchronization of the economic cycle of the respective country with the cycle of the other countries in the monetary union. If these national business cycles are synchronous, asymmetric shocks are less frequent. As a result, there is less need for a floating exchange rate to smooth out asymmetric external demand shocks. Furthermore, there is no need for an autonomous monetary policy either, since fluctuations in consumption and investment follow similar patterns in the countries of the monetary union, making the ECB’s monetary policy sufficient to stabilize economic fluctuations throughout the euro area.
The cyclical convergence of the Romanian economy with the eurozone economy is very difficult to assess unambiguously. The “Convergence Reports” and “Country Reports” developed by the European Commission show, however, that Romania’s economy is relatively well integrated in the euro area both through foreign trade – including participation in global supply chains – and through foreign direct investment. These official documents confirm the existence of important macroeconomic imbalances in Romania, which are not found in other eurozone countries. This is mainly about the large fiscal deficit, the external account deficit, and the problems of competitiveness and potential economic growth, which have resurfaced recently.
Also, the analysis carried out in the “Report on the substantiation of the National Plan for the Adoption of the Euro” indicates a relatively high degree of asymmetry of the shocks in Romania and the euro area, especially because the degree of correlation of the shocks on the supply side is relatively low and there is no obvious tendency to increase this parameter. Thus, it can be seen that there are still important structural differences between the Romanian economy and the eurozone economy.
The adoption of the euro therefore requires solving the problem of the convergence of Romania’s economic cycle with the economic cycle of the other EMU member countries. It is important to know to what extent the degree of cyclical synchronization between the Romanian economy and the eurozone economy is sustainable.
In the literature, it is shown that monetary unification accelerates the development of economic ties between the respective countries, which causes greater synchronization of economic cycles, increasing the efficiency of the adjustment mechanism through labour markets and reducing the cost of abandoning autonomous monetary policies. This phenomenon is called in the literature “endogenization of the criteria of the optimal monetary area”. It is expected that it will also manifest itself in the case of Romania. The accession to the monetary union will lead to a greater synchronization of the economic cycle of Romania and the countries of the eurozone, as well as to an increase in the effectiveness of alternative adjustment mechanisms to the exchange rate mechanism. Consequently, the cost of giving up the national currency will be further reduced.
Meeting the inflation criterion, however, comes at a short-term cost, namely the temporary slowdown in GDP growth due to the deflationary process. The estimation of this temporary effect can be done with the help of various forecast models of economic growth, or the Phillips curve. Regardless of the results of these forecasts, it can be said that the possible slowdown of economic growth because of the reduction of the inflation rate towards the level defined by the related convergence criterion will be a short-term one.
An important issue is the elaboration of the economic policy to prepare Romania’s entry into the eurozone. This policy must fulfil a double requirement: on the one hand, to ensure the fulfilment of the convergence criteria, and on the other hand, to respond to the challenges created by participation in the Exchange Rate Mechanism (ERM II). Adherence to the latter implies giving up the adjustable nominal exchange rate (controlled floating) and implicitly limiting the autonomy of monetary policy. In this way, the appropriate coordination of monetary policy and fiscal policy and the strengthening of the latter become prerequisites for ensuring economic stability and joining the euro area.
The analysis of the issues of the economic policy, advisable to be applied on the way to the euro, leads to the following conclusions:
1) In the period before the adoption of the euro, the appropriate combination of economic policies is a disciplined fiscal policy combined with a moderately restrictive monetary policy. Joining the EMU requires a significant and sustainable strengthening of fiscal policy.
2) Safe passage of the ERM II phase is possible, provided that the terms of participation in this arrangement are adequately defined. This operation primarily involves establishing a central exchange rate close to the long-term equilibrium exchange rate and possibly a relatively larger fluctuation band than the current one, if it is to be changed.
3) Considering the risks characteristic of quasi-fixed exchange rate regimes (controlled floating), the period of Romania’s participation in ERM II should be as short as possible. The analysis of the issue of meeting the exchange rate criterion foresees the need to accept a greater tolerance for the appreciation of the leu in relation to the central rate than for its depreciation. This presupposes that, in the event of postponing eurozone membership, the current monetary policy (inflation targeting) and the adjustable nominal exchange rate regime (controlled float) are to be continued.
The balance of the positive economic effects and the costs and risks involved in the adoption of the euro by Romania is positive. This suggests that postponing the decision to adopt the European currency is, in fact, equivalent to renouncing the possibility of accelerating economic growth through convergence towards the developed economies of Western Europe. Therefore, entering the EMU as quickly as possible is primarily in Romania’s interest, and the economic policy must be oriented towards creating the conditions to achieve this objective. That policy must allow both compliance with the convergence criteria and the minimization of inherent costs and risks.
In its modern history, Romania found itself several times in dramatic situations, which endangered its existence as a state. However, these catastrophes have been overcome, the solution being, each time, the resumption and intensification of efforts to implement the defining elements of Western civilization: the rule of law, democracy, the economy based on private property, individual freedoms, critical rationality, and science. Three and a half decades after the collapse of the communist regime, which kept it isolated from the outside world between 1947 and 1989, Romania’s return to Western civilization requires the continuation of structural reforms likely to lead to the completion of the transition to the market economy and the adoption of the European single currency.
