and the CPI-based real effective exchange rates, 1991–2001
Source: NBH.
Nominal depreciation 40
30 20 10 0 –10 –20
Jan-91 Jul-91 Jan-92 Jul-92 Jan-93 Jul-93 Jan-94 Jul-94 Jan-95 Jul-95 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02
%
Real depreciation
36Although here the purpose of the exchange rate correction is also to improve competitiveness, it is important to distinguish between the situations when an unforeseen shock necessitates a correction and when devaluation to restore competitiveness is applied due to the economy’s lack of nominal discipline.
forint inevitable.36In the past, inflation was instrumental in formulating the general government position. This is because a portion of general government expenditures is not fully indexed. Hence, an unexpected rise in inflation following forint devaluation had the effect of improving the fiscal position, affecting as it did a much wider section of the receivables from the state. In the wake of the 1995 correction, the value of existing nominal wages and other expenditures plunged in real terms and the real burden of the fixed-interest domestic debt also eased. Devaluing a currency will reduce the purchasing power of a country’s income as well as the real value of national-currency-denominated liabilities. Thus, surprise inflation triggered by the devaluation proved to be an efficient instrument in rapidly lowering the current account deficit.
After the entry into the euro area, economic policy will no longer be able to take advantage of the income and wealth effects of the exchange rate. However, the likelihood will also decrease that the country faces a situation where devaluation is the most efficient solution. The strengthening of ownership controls has significantly reduced the danger that nominal wages will grow at a rate far removed from corporate income growth, and it is no longer typical that wage settlements determine wage increases for several years ahead. One of the requirements of joining the euro area is that the fiscal position is sustainable and can be financed over the long term.
This also implies that once the fiscal adjustment set as a necessary condition for monetary union membership is attained, the chances that the fiscal authorities have to resort to surprise inflation will fall substantially. Furthermore, the future lack of today’s permanent inflation gains will be offset by the prospect of robust growth and the fall in interest rates on the general government debt (see Chapter IV). Hungary’s participation in the euro area will cause a shift in the significance of the balance of payments. Of course, every country should seek to achieve a sustainable balance of payments position over the long term, but as a euro area participant Hungary will run a much smaller risk of losing investor confidence to an extent that would call for urgent and radical change in the external balance position.
Another further implication of the common currency is that Hungary will also adopt the common interest rate policy. Should monetary conditions for the euro area as a whole be inconsistent with domestic economic developments, the economy would
incur excess costs. The effectiveness of the common monetary policy in the domestic economy depends on several factors. The most crucial factor appears to be that we now have in place the institutional conditions facilitating the effective transmission of monetary impulses towards the real economy. Private sector indebtedness which is lower than the euro-area average and the low stock of lending makes the transmission mechanism less efficient in Hungary. Thus, one unit of change in central bank interest rates has a smaller impact on the interest spending of the corporate and household sectors, investment and consumption decisions and, ultimately, inflation. This impact dampening effect is partially offset by faster interest rate transmission in Hungary than in the European countries, and by a high proportion of short-term and floating rate loans.
The second condition for monetary policy efficiency is that the reviewed economies should be in cyclical harmony, as the ECB decisions take into consideration the average cyclical position of the euro area. As noted earlier, the Hungarian economy is characterised by a high degree of cyclical co-movement with the EU. Due to the similarity of production structures and the high weight of EU imports, there is also a high degree of synchrony in respect of the price shocks. Therefore, the Bank believes that the ECB’s interest rate policy would be consistent with the requirements of the Hungarian economy. Indeed, it can even be argued that should Hungary not enter the euro area, this would lower its ability to adopt an interest rate policy that is consistent with the economy’s cyclical position. The reason for this is that the countries outside the euro area fall into a different risk category, which makes them much more exposed to financial market contagion (see Chapter IV.3).
The impact of an imported monetary policy also depends on the equilibrium real appreciation concomitant with real economic convergence. Due to higher inflation, a single level of nominal interest rates leads to lower real interest rates than in the more advanced countries of the region. The fall in real interest rates will in turn set the economy on a new growth path, presumably characterised by more rapid growth financed by larger amounts of foreign funds. The short-term expectation, however, is that the drop in interest rates upon accession will trigger asymmetrical demand shocks, while supply will only be affected more slowly. The ensuing imbalances will have to be offset by fiscal policy, that is common monetary policy will impose increased burdens on fiscal policy in controlling aggregate demand.
III.1. Integration and structural similarity
The size of the costs entailed when a country gives up its own monetary policy depend on the extent to which the economic behaviour of the member countries (regions) participating in monetary union is in synchrony. A condition for similar behaviour is the similarity of economic structures, and at least as importantly, similar behaviour by economic agents. Similar structures enhance the probability that the individual shocks will affect the economies of the various countries to a similar extent. In turn, similar behaviour implies that economic agents’ responses to the shocks will be broadly consistent, and hence that the intertemporal behaviour of the economies will remain similar. The section below will use multiple indicators to explore the extent of this similarity between Hungary and the euro area member states. Based on the OCA literature the probability of the incidence of asymmetric shocks to an economy is affected by the following factors:
– structural similarities;
– degree of trade integration;
– synchrony of business cycles.
As economic theory fails to provide precise numerical measures for optimality, the degree of real convergence attained by the Hungarian economy can be assessed by a comparison with euro area countries that are closest toHungary in terms of the level of development and economic structure. This is based on the implicit assumption that participation is beneficial to the least developed euro area countries.
III.1.1. Similarity of economic structures
A comparison of the contribution of the main sectors to GDP reveals that the Hungarian data fall between euro area extreme values in respect of each sector (see Table III–1). As far as the sectoral breakdown of employment is concerned, the percentage of manufacturing employment shows some deviation from the maximum value for the euro area (see Table III). It is a fair assumption that as manufacturing productivity increases, the employment ratios will also converge towards the euro area average.