Real and nominal stochastic convergence: Are the new EU members ready to join the Euro zone?

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Abstract

A key requirement for the new members to join the European Economic and Monetary Union (EMU) is real and financial convergence to European Union (EU) levels. This paper expands the analysis in [Kočenda, E., Macroeconomic convergence in transition economies, Journal of Comparative Economics 29 (2001) 1–23] and [Kutan, A., Yigit, T., Nominal and real stochastic convergence of transition economies, Journal of Comparative Economics 32 (2004) 23–36] by investigating the convergence of the new EU members to these standards. Using panel unit root techniques, we find strong evidence of real stochastic convergence for all new members, which indicates that they adjust to Euro-area output shocks. However, the degree of nominal convergence is idiosyncratic. The Baltic states exhibit the strongest monetary policy and price-level convergence, suggesting that they are ready to adopt the Euro. However, Central and East European countries should address the reasons for their lack of convergence before adopting the Euro. Journal of Comparative Economics 33 (2) (2005) 387–400.

Introduction

A key goal of transition economies in Central and Eastern Europe (CEE) is to join the European Economic and Monetary Union (EMU) after their admission to the European Union (EU). To join the EMU and to adopt the Euro, the Maastricht criteria for full EMU membership must be met; these require convergence in inflation, interest rates, exchange rates, and government deficit and debt towards the EU averages. The next stage of monetary integration is to join the Exchange Rate Mechanism (ERM II) of the EMU. According to the European Central Bank, nominal and real convergence within the ERM II framework should be achieved before the adoption of the Euro (European Central Bank, 2002). In this paper, we test for such convergence in the ten recent members that joined the EU in May 2004. Of these ten countries, eight are transition economies, namely the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, the Slovak Republic, and Slovenia. We refer to these eight countries as the CEE8; to consider separately the performance of the Baltic states, i.e., Estonia, Latvia and Lithuania, we divide the CEE8 into two groups, namely the Baltic states and the remaining five countries, denoted the CEE5. Cyprus and Malta are the other two new members. Our findings have important implications for the choice of an exchange rate regime and the time of entry to the Euro zone by the new members before they consider a formal and permanent peg to the Euro.

Babetskii et al. (2004), Boone and Maurel, 1998, Boone and Maurel, 1999, Backè et al. (2003), Brada and Kutan (2001), Fidrmuc and Korhonen (2003), and Richards and Tersman (1996) investigate the convergence of the candidate countries to EU standards. Most of these papers do not provide comprehensive evidence in terms of country coverage and they rely on relatively small time-series data sets. Some studies focus on nominal convergence, while others examine only real convergence to EU standards. Babetskii et al. (2004) analyze both nominal and real convergence of the CEE8, in addition to the experiences of Ireland, Portugal, and Spain. Using the Kalman filter, these authors study the time-varying correlation of demand and supply shocks between these countries and the Euro area. They find significant convergence of demand shocks, but divergence of supply shocks. In a similar study, Fidrmuc and Korhonen (2003) find that the correlation of supply shocks of selected CEE countries with the Euro area is higher than those of demand shocks. Using different time-series methodologies, Boone and Maurel, 1998, Boone and Maurel, 1999 find that business cycles in CEE countries are similar to those in Germany and the Euro area, suggesting that full EMU membership for CEE countries would be fruitful. Overall, the evidence on convergence of the new members to the Euro-area standards is mixed.

In this paper, we examine both nominal and real economic convergence to EU standards for all ten recently admitted members. Kočenda (2001) and Kutan and Yigit (2004) analyze real and nominal convergence within transition economies, but not to EU standards. Employing panel unit root tests, these papers examine real convergence based on industrial output and monetary variables, such as the producer price index (PPI), the consumer price index (CPI), narrow money (M1), and both nominal and real interest spreads. Using monthly data from 1991 to 1998, Kočenda (2001) finds considerable real and monetary convergence. The first-round EU candidates, which are now new EU members, exhibit relatively high degrees of convergence. The Baltic states yield the highest degree of convergence, due partly to their common exchange rate regimes and their lack of independent monetary policy. Considering a more stable, post-1993 period and adopting a panel estimation approach, Kutan and Yigit (2004) show that convergence results are sensitive to the choice of econometric methodology and that nominal and real convergence is not as great as Kočenda's results indicate.

In this paper, we extend the earlier work in several directions. First, our sample period is longer, covering January 1993 through December 2003 period, so that our inferences on convergence are more reliable. Second, we use a set of confirmatory heterogeneous panel approaches that allow us not only to test for convergence more reliably than is possible with only time-series data, but also to maintain an assumption of cross-country differences. Third, we address the issue of convergence of the new member states with respect to both the founding and the newer members of the Euro zone. Germany and Greece are taken to represent a core member that is the most important trading partner in the region and a peripheral country, respectively. Finally, we investigate individual country performance by utilizing a series-specific panel technique. This panel approach allows country-specific inferences without sacrificing the increased power associated with the panel dimension.

Section snippets

Methodology

In the past decade, several empirical techniques to test for convergence have been developed based on the neoclassical growth model. One branch of the literature consists of studies using time series methodology to test the convergence hypothesis. Based mainly on unit root tests, these papers capture the persistence of shocks relative to per capita incomes. Barro and Sala-i-Martin (1992), Friedman (1992), and Quah (1993) concentrate on notions of β convergence for which poor countries grow

Data and results

We use data from the first month of 1993 to the last month of 2004 to test for the convergence in annual growth rates of monthly industrial production, prices measured both by the PPI and CPI, and nominal interest rate spreads for the ten recently admitted EU countries.5 Germany is taken as the benchmark to represent core EU standards, and Greece, a more recent member, is taken to check the robustness of our results applied

Conclusion

Using macroeconomic data from January 1993 to December 2003, we test for real and monetary stochastic convergence in the ten recently admitted EU economies. Our findings indicate that these new members have made significant progress in real convergence towards the EU, regardless of whether Germany or Greece is used as the benchmark. Regarding nominal convergence, the Baltic states that pursued hard pegged exchange rate regimes exhibit the strongest convergence. The CEE5 countries show weak

Acknowledgments

We thank two anonymous referees and Selin Sayek, for their useful comments. The usual disclaimer applies. We are grateful to John Bonin, the Editor, for his editorial comments and suggestions, and to Héléne Bonin, the Managing Editor, for her support and encouragement.

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