What a difference a year makes. At the end of 2002, convergence seemed a one-way bet. Ireland had given the green light to the enlargement of the European Union (EU) by giving a thumbs-up to the Nice treaty in a knife-edge referendum; Moody’s eagerly upgraded the foreign-currency debt of the eight Central and East European accession candidates on the grounds that the process of integration with the EU was “virtually irreversible”; and foreign investors were piling into central Europe’s debt markets in the expectation that government-bond prices would rise as the applicants made a seamless transition from EU membership in May 2004 to entering the eurozone in 2006 or 2007. Yet 14 months on, it is a different story. Poland, much to the dismay of its euro-enthusiastic central bank governor, Leszek Balcerowicz, has eschewed an early adoption of the single currency as its social democrat government struggles to enact a much-needed public finance reform plan ahead of parliamentary elections in 2005. Hungary is likely to follow suit after the dismissal in early January of its finance minister, Csaba Laszlo, whose failure to curb public spending was the root cause of a series of speculative attacks against the forint last year that severely tarnished Hungary’s reputation for financial stability. As Morgan Stanley put it in a recent note on EU enlargement and the euro: “The prospects for the eurozone being significantly enlarged over the next three to four years have clearly receded.”
Most analysts saw the writing on the wall. “The euphoria [in the wake of the Irish referendum] never reflected underlying fundamentals. There have been cumulative policy failures in Poland and Hungary. Toward the middle of last year it dawned on the markets that these problems were not going away. The fiscal performance has been very disappointing,” says Zsolt Papp, head of EEMEA economics, strategy and research at ABN AMRO in London. “They [Poland and Hungary] were already in a challenging fiscal situation at the end of 2002, and since then things failed to improve. Indeed, in Poland they got significantly worse,” adds Martin Blum, head of emerging European markets research and strategy at Bank Austria Creditanstalt in Vienna.
Convergence traders have been most disheartened by Hungary’s financial woes. Once the most revered Central European economy, Budapest’s star has waned as foreign portfolio investors—which still hold over one-third of forint-denominated government bonds—lost confidence in the country’s macroeconomic policies. The National Bank of Hungary (MNB), which targets an inflation rate and seeks to stabilize the forint in a 15% band either side of a central parity against the euro, has been hauled over the coals for poorly communicating its dual (and often contradictory) objectives and agreeing to a botched devaluation of the forint last June. A nasty combination of a bulging current-account deficit financed largely by fickle short-term capital inflows and recklessly loose fiscal and incomes policies prompted a series of speculative attacks against the forint, forcing the MNB in December to jettison its narrow exchange-rate target and focus on meeting its inflation goal of 4% by the end of 2005.
Yet even with brutally high interest rates of 12.5% (the highest in the region), the forint is still vulnerable to market sentiment on the twin deficits. While the current account gap this year should begin to narrow as domestic demand is curbed, the outlook for the budget deficit, which reached a higher-than-expected 5.6% of GDP last year, is grim. Although Hungary’s new finance minister, Tibor Draskovics, unveiled a package of spending cuts worth 120 billion forints ($572 million) on top of previously announced cuts in mortgage subsidies to help trim the deficit to 4.6% of GDP this year, analysts believe the savings are too tame. “The package will not involve any cuts in the politically sensitive and very expensive subsidies which are part of the government’s cherished welfare program,” says a recent note from Goldman Sachs. Erik Neilsen, head of new European markets economic research at Goldman Sachs in London, goes even further: “It’s nigh impossible to have a credible exchange rate target with loose fiscal policy,” he says.
Even if Draskovics pledges to cut the fiscal deficit further, he has promised to undertake a review of Hungary’s commitment last July to join the EU’s revamped exchange rate mechanism (ERM2) this year with a view to adopting the euro in 2008. Most analysts believe this will inevitably result in a delayed entry to euroland given the reluctance of the governing socialists (MSzP) to rein in the deficit. “The fundamental problem is that the government does not have the political support to push through the needed [fiscal] tightening. Without the fiscal credibility, it’s nigh impossible for the central bank to keep its side of the bargain,” says Blum. Papp adds: “There’s a huge credibility gap. Nobody fully believes in the government’s [fiscal] numbers. This has been the underlying problem. It’s sad because Hungary was the darling of the markets for many years.”
Poland’s Fiscal Follies
Unlike Hungary’s government, Poland’s cabinet never explicitly committed itself to a date to join the euro. While a working group from the National Bank of Poland (NBP) and the finance ministry agreed on an outline plan in October 2002 to adopt the euro in 2006, it acknowledged that a number of factors could delay membership. On the domestic front, the biggest obstacle is a bloated budget deficit that is bringing Poland’s public-debt-to-GDP ratio perilously close to the 60% ceiling that is both fixed by the country’s constitution and laid down as one of the Maastricht criteria for qualifying for the euro. The sharp rise in indebtedness has belatedly spurred the government into action. Jerzy Hausner, Poland’s Keynesian-minded labor and economics minister, has prepared a four-year plan to streamline public expenditures and head off a fiscal crisis. A well-intentioned program that seeks to curb chronically high and oft-abused social entitlements while slimming a notoriously bloated public administration, the “Hausner plan” has won plaudits from financial institutions and is strongly backed by Poland’s prime minister, Leszek Miller, who has even threatened to resign if parliament rejects the plan. Yet the program has already been watered down to placate combative labor unions and staunch defenders of the welfare state inside the governing social democrats. “It’s one of the most detailed public finance reform plans, but it’s being chipped away at on an almost daily basis,” says Blum. Hausner has already been forced to postpone or scrap crucial social security legislation, weakening the zloty and sparking fears among investors that the final version of the program will be too timid.
Neilsen is skeptical about the plan’s potential for real success: “The whole plan is a big ‘if,’” he comments.
All eyes are on Poland’s reformist opposition party, Civic Platform, which has offered to support Hausner’s plan in parliament in exchange for a flat-tax of 15% and more aggressive and front-loaded cuts in the public administration. Negotiations between the ruling social democrats and Civic Platform are under way, and a deal could be struck by early March. If the bulk of the legislation is enacted this year or in early 2005, then Poland could be in a position to cut its budget deficit (currently more than 6% of GDP) to below 3% by 2007 or 2008, allowing it to join the euro in 2009 or 2010. “If Poland doesn’t carry out the types of reforms Hausner is talking about, then we’re looking at a substantially later date,” says Papp. Blum believes Civic Platform holds the key to genuine public finance reforms: “Everything is contingent on having a more reformist government in place. A lot hinges on Civic Platform’s ability to form a majority government with popular support.”
Neilsen: “It’s nigh impossible to have a credible exchange rate target with loose fiscal policy.”
Blum: “[Hungary’s] government does not have the political support to push through the needed [fiscal] tightening.”
Papp: “There have been cumulative policy failures in Poland and Hungary.”
It is not only burgeoning budget deficits that stand in the way of a swift adoption of the euro. The European Commission and the European Central Bank (ECB) have repeatedly urged the accession candidates not to rush into the single currency. They fear that the stern Maastricht criteria for adopting the euro—budget deficit under 3% of GDP, government debt below 60% of GDP, low inflation and long-term interest rates and a two-year stint in ERM2 prior to joining the eurozone—could squash growth in emerging economies. Numerous EU officials have suggested that some of the candidates might initially benefit from monetary flexibility to cope with the pressures of the single market. “The commission clearly favors a go-slow approach,” says Papp. At a recent conference in Prague of the Central European accession candidates’ central bankers, the IMF, EU and the ECB once again urged the candidates not to hurry into the euro. Neilsen adds: “It was clear from the conference that there is no appetite [on the part of the EU and ECB] to bring the candidates into euroland for at least several years.”
The risk of a currency crisis in the run-up to adopting the euro is also prompting some of the candidates to revise their timetables. The ERM2 requirement, which will probably involve a much narrower band than previously envisaged, is strongly criticized by those applicants, like Poland, that float their currencies and fear Hungarian-style speculative attacks. Moreover, the financial benefits that would accrue from joining the eurozone are not as significant as they were for some of the previous applicants. “The debt levels [of Hungary and Poland] are not as high as those of Italy and Greece at a similar time before entering euroland. This means that the financial costs of slippage are more limited given lower corporate and government leverage [as a percentage of GDP],” notes Blum.
Analysts expect more volatility in Poland and Hungary in the coming months as the prospects for convergence become ever more bleak. Only swift progress on the fiscal front, they say, will improve market sentiment. Yet with spendthrift governments, record-high unemployment in Poland and a slowing economy in Hungary, the scope for fiscal tightening is limited. “EMU [European Monetary Union] is just not a big enough vote-winner. It’s as simple as that,” says Blum.