Sunday, February 19, 2006

Entering the EMU - not such an easy task?


The recent article in Financial Times (17th of February, 2006) deals with the possible delay of Lithuania and Estonia to join the (European Monetary Union) EMU on the January 1st 2006. Lithuania is likely going to overshoot the Maastricht's inflation criterion of 2.8% in October's European Commision (EC) Convergence report - delayed from July. This is highly unfortunate for its fragile economy, which is finally growing fast, with the credit markets booming. Estonia, the other country besides Slovenia hoping for an entry in 2007, is experiencing high inflation rates and hopes that until the delay of EC's report inflation rates will fall below the Maastricht's margin.
The crux of the debate at the moment in these countries seems to be in what are the reasons for the high inflation rate and whether central banks are able to insult the inflation rates against them. The reasons are ranging form the booming credit market, to high oil prices and monetary policy strategy. Let us turn to each of these now.
The booming credit market is a phenomenon in Estonia and Lithuania most likely connected to the increased competition financial sector, and as a result the interest rates are at record low and credit growth is fast. Most of the tightening competition can be attributed to the EU accession in 2004 in the housing loan market sector while the price competition of consumer loans has not grown significantly in recent years. In fact, the annual increase of property loans was in the new UE states 43 percent between 2000 and 2004, versus eight percent in countries in the eurozone. The increase in lending volume is expected to continue, especially in the light of the low levels of indebtedness of households. This is shown clearly in Figure above. Higher disposable incomes in New Europe in recent years also help to fuel the credit boom.
The second reason for the growing inflation are the recent high energy prices observed. Particularly worrisome are the developments of oil prices. Since the oil prices have a greater weight in the national Index of Consumer Prices (CPI), since the national gasoline excise is lower and since the economy’s dependence on energy resources is heavier, the recent rise in oil prices has a significantly greater impact on Lithuanian and Estonian inflation than on th inflation of the euro area. In addition, the indirect effect of higher oil prices, which occur when producers feed through higher production costs into their final prices, could exert upward pressure on inflation in the months to come in these countries.
The last reason for high inflation is the monetary regime in these economies. They are both currently operating under the currency board regimes. This regime has its advantages over the alternatives in other EU countries, especially the inflation targeting (adopted by Hungary, Czech Republic, Slovakia and Poland) however it also has downsides. Among the advantages are that the central bankers' credibility is not an issue any more, as well as the inflation financing of high fiscal deficits channel is shut. At the same time the vices connected to the operational procedures of inflation targeting are avoided (Czech Rpublic and :oland had problems in the beginning of vershooting and undershooting the targets by wide margins at the onset of the regime). On the other hand, inflation targeting allows the central bank to insulate domestic shocks in addition to the foreign ones, which is particularly important in the current time of high credit growth, and allows the central bank to become accountable and transparent in puruing of its inflation goal. Not the last, inflation targeting would be more compatible to the strategy currently pursued by the European Central Bank.

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