The Euro's Impact on the Developing and Transition Economies
by Charles Wyplosz
With all the hype in Europe and on financial markets worldwide, what does the birth of the euro mean for the developing and transition countries? Good news? Bad news? Or no news at all? This article summarises some of the results emerging from a recently completed WIDER project on the European Monetary Union (EMU) and its impact on Europe and the rest of the world.
Three Effects on Developing Countries
There are many ways in which the single currency could affect the developing countries. First comes trade. If the euro indeed reshapes specialization and trade patterns, this could change market shares for every one of its trade partners. For example, if the euro encourages further trade integration within Europe, the result will be some degree of trade diversion, most likely at the expense of developing countries. If, on the other side, the euro re-dynamizes Europe, this could mean a growing market. Second, what about a possible reshaping of the international monetary system as we see a recent trend towards polar exchange rate regimes—floating rates and currency boards or dollarization? Third, is the possible replacement of the dollar as a currency of invoicing and of setting commodity prices, an important development for countries whose exports are little diversified?
We find that the trade links of developing countries with Europe are too weak to have much of an effect, positive or negative. Possible exceptions are a few countries, mostly around the Mediterranean basin and in Africa’s CFA zones. Financial linkages are potentially more substantial. Flows of private savings from developing countries are likely to be diversified away from the dollar and into the euro, including in offshore markets. European savings, so far diversified across many European currencies, could look for new support currencies, opening up a niche that some developing countries could be able to exploit. This would increase the already existing trend towards emerging markets in Asia and Latin America, but the size of the effect is unlikely to be earth-shaking. At the official level, diversification of foreign exchange reserves is found to be slow and small. More substantial, maybe, is the possibility that a deep and efficient bond market in euro will allow some developing countries to match the currency denomination of their indebtedness with their trade flows.
New Currency Areas May Emerge
The interplay of politics and economics when it comes to the choice of an exchange rate regime cannot be ignored. There is a looming rivalry between the US and Europe to offer their currencies as the reference for a peg, and possibly for outright adoption, with the yen as a third contender. The argument here concerns not only the economics of an exchange rate regime and the anchor currency, but the political aspects too. Politicians are sensitive to influence, protection and prestige. Developing countries might exploit this rivalry in a number of ways. One possibility is to keep equal distance between the euro and the dollar by adopting basket pegs. Another is the emergence of two or three very large currency blocks, Latin America becoming dollarized, part of Africa and of the Mediterranean basin being euroized, and Asia being on the yen or even the Chinese renminbi. Yet another possibility includes currency areas among developing countries.
One such currency area has been in existence for decades. The CFA zones, which regroup most of the francophone part of the African continent, have operated as currency areas tied to the French franc, and they are now de facto tied to the euro. Our study asks how this choice could be affected by the creation of EMU. African countries have very little trade with each other, so the intra-regional appeal of a currency union is very modest. Most of sub-Saharan Africa’s trade links are with Europe. Thus, for those countries which wish to adopt a fixed exchange rate regime, the euro is the obvious choice. This choice would be reinforced were the United Kingdom to join EMU. It could bring the francophone and anglophone countries under the same roof. Such a move could well succeed in triggering economic cooperation throughout much of the continent, a feature that has been conspicuously lacking so far. EMU might have a demonstration effect, promoting currency boards or even full euroization. However, our study casts doubt on this effect.
Impact on Primary Commodity Prices
What of the impact of the euro on primary commodity prices, a vitally important question for many developing countries? Europe is an important player in commodity markets, on both the demand and supply sides. Commodity prices are highly volatile, as volatile as exchange rates, and WIDER’s project has analyzed the sources of volatility. The study finds that, in the past, major changes in exchange rate regimes (during the post-World War II era) have significantly affected the behaviour of commodity prices—the effect varies from commodity to commodity—and this is an important starting point. It is also the case that commodity prices are sensitive to changes in the volatility of the main currencies. As a major, historical, step in monetary arrangements, the euro is therefore likely to have an impact on commodity prices, but which one? One possibility is that the advent of euro could foster more overall exchange rate stability. This would certainly be good news for the developing countries if it led to reduced export income volatility.
Impact on the Transition Economies
The transition countries are particularly interested in the adoption of a single currency. Europe is their main trading partner, by a large margin. Many transition countries are already in the process of accession to the European Union; they will have to determine their position vis-à-vis the euro, which they will eventually adopt as their own. What is the proper exchange rate regime for the transition economies on their way to full EMU membership? This is a topic whose importance is likely to grow in practical importance and is much in need of research.
The place to start is to ask what is special about the transition countries and, in particular, how different are they from countries which were previously in accession to the European Union. Several considerations arise. Having initially suffered from high inflation, most transition economies have had to restore their credibility. Some have adopted tight currency pegs, in some cases even currency boards, others have pursued independent stability-oriented macroeconomic policies. They have tightened their monetary policies, of course, but many also managed to close down often huge budget deficits. At the same time, the transition countries have had to undertake the massive structural changes required to establish a market mechanism and to change their industries and trade patterns. While a few have a gone a long way down that road, they are not home yet, and several others are still in the early stages.
Three of the most important challenges faced by transition economies are: building up central bank credibility, disciplining fiscal policy, and structural reforms. These three tasks are inter-related. Low inflation implies little seigniorage, hence the need to resort more heavily to distortionary taxation. Poor, unreformed, economic structures imply high tax distortions. In such a situation, research shows that many standard results are challenged. It is no longer clear that a conservative central banker is desirable: the best degree of conservatism is not set forever, it rises as reform progresses. Nor is an independent central banker optimal; the optimal central bank recognizes that inflation affects tax distortions. Monetary and fiscal policies can be too tight in the sense that a shock may prompt the government to renege on its commitment to reform.
On the way to EMU, these results matter a great deal for the relationship between the transition countries and the European Union. The conventional wisdom is that the accessing countries must converge in the sense of Maastricht: low inflation, low budget deficits and ERM membership, including full central bank independence as defined in the treaty. Our research shows that these constraints work as a commitment device and, as such, may be useful where governments cannot restrict themselves to a set of consistent policies. But these constraints leave out the reform process, quite possibly the transition countries’ critical policy objective. As reform progresses, overlooking the need to pursue an active reform process becomes of second order of importance, but it is not so as long as serious distortions survive. The best trajectory might be one where the accession conditions put heavy emphasis on structural reforms and much less on traditional Maastricht-type criteria. In particular, straight-jacketing monetary policy within the ERM may have counterproductive effects on fiscal discipline, or lead to highly distortionary taxes, and could possibly slow down the reform effort.
In summary, EMU has significant implications for the developing and transition economies. Some of these can be predicted now, but others will take many years to emerge.
Professor Charles Wyplosz is with the Department of Economics at the Graduate Institute of International Studies, Geneva. He was the project director for the WIDER study on EMU, and is the editor of The Impact of EMU on Europe and the Developing Countries, Oxford University Press for UNU/WIDER.