Foto: Adam Baker

 It especially holds true for the Czech Republic, which in each of the last four years preceding the collapse of Lehman Brothers fulfilled four out of five monetary and fiscal criteria set out in the Maastricht Treaty.

The reluctance towards the eurozone seems awkward considering that all the other seven countries that joined the EU in May 2004 have set out on the official road to the new currency. Some of them, like Slovenia, Slovakia, Malta and Cyprus, have actually already adopted the euro. The three Baltic states—Lithuania, Estonia and Latvia—had their currencies join the ERM II system, the mechanism which enforces a stability of exchange rates against the euro—Lithuania and Estonia already in 2004 and for the Latvian lat in 2005.

From EU entry in 2004 to the 2008 eruption of the deepest crisis since the Great Depression, the Czech Republic and Poland in particular enjoyed very healthy macro fundamentals. In 2006 for example, the 10-year interest rates on government bonds on the secondary market in the Czech Republic stood at 3.8 percent, far below the maximum reference value of 6.2 percent. Public debt and budget deficit in the country were 29.4 percent of GDP and 2.6 percent of GDP respectively against the required maximum of 60 percent and 3 percent figures. Inflation stayed virtually in check, 2.1 percent, below the maximum value of 2.8 percent.

Poland managed to fulfill all the Maastricht criteria in 2007, with bonds yielding only 5.5 percent, a budget deficit below 2 percent of GDP, inflation around 2.5 percent despite 7 percent GDP growth. The fulfillment of currency stability criteria for both countries would have depended on the assumed reference values. However, the difference between the highest and lowest rates in any consecutive two years in the period from 2004 till December 2009 did not exceed 30 percent, double the one sided divergence of 15 percent.

Hungary scored the weakest of the group, having failed to achieve any requirements since 2004, when the value of public sector debt exceeded 60 percent of GDP. Since then, Hungary has experienced GDP contraction and spiraling debt, causing the ratio to probably exceed 75 percent in 2009.

With a little bit more effort on the part of the Czech and Polish governments, quicker euro adoption could have been possible. However, there was not enough political will in either country, which preferred to stand on the sidelines and wait for a better moment. Especially in the Czech Republic politicians were focusing on the costs of disposing of the floating exchange rate. The more euro-enthusiastic Polish government, led by Prime Minister Donald Tusk, began serious preparations for euro adoption only when it was already too late. Back in autumn 2008, when the złoty started its free fall, Tusk set a non-binding target for Poland to enter the eurozone in 2012. The Polish currency was about to be fixed to the euro in the ERM II tunnel already in 2009. This declaration, however, in the opinion of market observers, was more aimed at soothing international investors abruptly retreating from the Polish market than any serious plan. In the aftermath of a swelling budget deficit and the Polish currency losing 34 percent of its value against the euro in the six months preceding Feb. 17, 2009, euro entry in 2012 turned out to be far too optimistic and was finally abandoned. Now the government is not setting a deadline but stresses favorable macro environment as a prerequisite of eventual euro adoption.

The previous Czech government, in turn, was never been a big fan of the euro. It wanted the economy to enjoy the advantages of a floating currency and flexible monetary policy as long as possible. That is why it never set any official deadlines on when the Czech Republic might enter the eurozone. Back in early 2008, when approached by CBW, Czech analysts were cautiously mentioning 2013, or even 2014, as the earliest possible entry date. They justified the delay by the government’s plans to first reform public finance, including carrying out systemic reforms of pension and health care systems. Still, these expectations were voiced before the financial crisis reached its peak.

Taming the CEE public debt avalanche

The economic downturn has hurt public finances and shaken macro stability in CEE countries so much that the monetary convergence with the eurozone has been shifted into the undefined distant future. “I am afraid that almost no country in the European Union will be able to manage its budget deficit below 3 percent of GDP in the coming 2–3 years. Further, the average indebtedness in the EU is set increase up to 90 percent of GDP within three years, according to EC forecasts. Therefore the enlargement of the eurozone, under the current five Maastricht criteria, would be impossible in the coming four to five years. The Czech Republic will not be able to meet them either,” said Petr Sklenař, chief economist at Prague-based brokerage Atlantik finanční trhy.

Now, experts consider Poland, Hungary and the Czech Republic to be in a similar position in respect to adopting the common currency. “Each country has different problems, but also specific advantages. Poland benefits from strong momentum in economic growth, and the Czech Republic, unlike Hungary, has low public debt and a strong currency. The advantage of Hungary is the relatively lower budget deficit in relation to GDP, thanks to recently carried out reforms. All the countries share the same challenge—to balance the budget, while Polish and Hungarian currencies tend to be overly vulnerable too,” said Remigiusz Górski, marketing and PR representative of the Prague subsidiary of Poland-based X-Trade Brokers Dom Maklerski.

Reducing the budget deficit, which in Poland could reach as much as 8 percent of GDP this year, remains the most challenging task of all. “In my view, to reduce the deficit will be most difficult for the Czech Republic and Poland. Both countries have postponed public finance reforms. Hungary, due to the IMF [International Monetary Fund] bailout, has made a significant improvements to the stability of public finance,” Sklenař said.

After 2004 Hungarian GDP growth was significantly lagging behind the regional average as the country was suffering under high budget deficits from financing welfare services, extensive foreign exchange indebtedness and high interest rates. When the global crisis added insult to domestic injury the Parliament, dominated by the ruling Hungarian Socialist Party (MSzP), decided to finally install a technocratic government and commissioned new Prime Minister Gordon Bajnai with reforming pubic finances. These reforms were also forced by the IMF, which opened generous credit lines to Hungary preventing evaporation of currency reserves in the aftermath of investors’ retreat from emerging markets in the beginning of 2009. So far the plan seems to be working, with the forecasted budget deficit in Hungary in 2009 at 3.8 percent, an impressive figure compared to the achievements of its neighbors.

For Poland, the Czech Republic and Slovakia the deficits should amount to 8 percent, 6.5 percent and 6 percent of GDP respectively. The budget instability in the Czech Republic and Poland could hurt their future growth. “The big deficit can become an obstacle for economic recovery. In the worst case scenario, if economic growth falters in 2010, the governments will be forced to suddenly cut spending, including investments, and at the same time to significantly raise taxes in order to stabilize their budgets. These steps could consecutively suffocate the fragile recovery of economy,” Sklenař said.

Hungary has already reached that point and is currently undergoing a painful shock therapy of reduced welfare benefits. “The effects of the crisis in fact enforced necessary changes to the Hungarian state budget structure and as a result Hungary is expected to have the lowest budget deficit among the rest of Central European countries. It is helping Hungary recover and opens the path to economic growth,” said Jiří Tyleček, analyst with X-Trade Brokers Dom Maklerski.

Czech public debt: more than meets the eye

At first sight the fiscal situation in the Czech Republic does not raise serious concerns. “The advantage of the Czech economy compared to other European countries today is the low level of public debt to GDP at as low as 37 percent. Still, the total budget deficit projected for 2010 should be above 5 percent of GDP, which is a Czech record high. However, Poland and Slovakia will also have a deficit above 5 percent,” Tyleček said. The problems are lingering beneath the headline figures. “The main problem is the pace of the deficit growth,” Tyleček added. Moreover, the official low level of state indebtedness can be misleading too, since the future pension liabilities are not included. “Lack of any pension system reform in the Czech Republic could lead to huge budget problems in the near future,” he said.

Therefore, serious savings need to be introduced soon in order to avoid a collapse of public finances. “The basic advice is to cut budget expenses, which is a bit of problem on the Czech [political] scene. Social security is the area where the biggest savings could potentially be found,” Tyleček concluded.

In fact the Czech Republic, similarly to Hungary, also has a government led by an independent expert—Prime Minister Jan Fischer—which should facilitate the restructuring of the public budget. However analysts are skeptical that Fischer can be as successful as Bajnai.

“Cutting spending or raising taxes is the simplest way to reduce budget shortfall. However, both steps are very unpopular, thus politicians have tried to avoid them, especially before elections to be held in May or June 2010,” Sklenař said. Roman Prorok, spokesman of the Czech government, is also very cautious. “The government is continuously acting to prevent excessive deficits by implementing specific measures. Nevertheless, the eventual structural reforms are a question of consensus across the political spectrum and the agenda of the government which emerges from the spring elections,” Prorok told CBW.

Unfortunately, even in the case of political willingness the scope for maneuver is very limited.  “The structure of the state budget is disadvantageous because of 80 percent of mandatory expenses. It is possible to save just in the last 20 percent without any legislative acts. It is almost impossible to change the budget structure markedly before the elections planned for June 2010,” Tyleček said.

So far, therefore, the government is trying mostly to block any legislative moves that would cause further deterioration of public finances. “In fact some deficit reduction measurements have already been undertaken. Firstly, most proposals that would cause an increase in spending were not accepted lately. Secondly, there has been a silence about cancellation of health care payments on the Czech political scene lately, too. Moreover, the car scrapping program and special grants to the public sector were cancelled because of a money shortage in the budget proposal,” Tyleček said.

Wishful thinking and creative accounting

The Polish government seems to be doing even less to tame the deficit than Czechs. The reason for this seems to be complacency stemming from the surprising resilience of the economy this year, which is expected to grow 1.3 percent according to the consensus of macro analysts in November. “The example of Poland shows that recessions actually can have a positive impact on economies, as they create the basis for structural reforms. That is happening in Hungary and to a smaller degree in the Czech Republic. The Polish government, on the other hand, is very reluctant towards any reductions in welfare, hoping the economy will outperform its peers in the coming years too,” Górski said. Given next year’s expected sluggish growth of around 2 percent, the government could face the threat of exceeding the constitutional limit of public debt to GDP of 60 percent. Macroeconomic research consultancy Capital Economics expects the figure to reach 53 already by the end of this year.

As the pace of Polish government receipts is already trailing the plan, the government is trying to resort to emergency measures to avoid the risk of a sudden forced reduction in the face of regulatory barriers. The most controversial ideas involve taking dividends from central bank profits and reducing payments to the compulsory pension funds, both of which are worth millions of euros per year in terms of budget deficit reduction. Both ideas face stiff opposition from financial market participants and their eventual enforcement is not certain yet. “The pension funds are very vulnerable these days, as they delivered very meager returns in the last decade due to their substantial exposure to equities. At the same time the companies managing the funds earned a lot of money, therefore the public mood towards them is evidently negative. The government is trying to capitalize on this sentiment. This decision is definitely negative from the point of view of the long-term interest of Polish citizens, as it is in fact a sort of ‘creative accounting’ that the pension reform was supposed to limit. The trick is based on the fact that the ensuing growth of future pension liabilities is not counted as public debt,” Górski said.



Slovak euro experience

The adoption of the euro caused a decline of economic activity in Slovakia this year. The high exchange rate against neighboring countries reduced the competitiveness of the country’s already struggling export market. “Also consumers traveled en masse to Poland and Hungary to shop, which hit domestic retail sales,” Górski said. “The painful adjustments needed for fulfilling the eurozone requirements should, however, contribute to long-term prosperity of Slovakia. The structural reforms of public finances and social benefits enforced there in the last few years will bear fruits of their own,” Górski said.

In 2009 Slovak GDP will contract by 5 percent and the budget imbalance should reach high levels, too. The government of Slovakia, although under less pressure to reduce the deficit than the eurozone candidates, is undertaking measures to fix state accounts.

“One of the most important measures to be taken is cutting public expenditures, mainly within capital and current expenditures along with saving in public procurement. Another important step is putting emphasis on drawing EU funds and so stimulating economic growth, entrepreneurial activity and, subsequently, tax revenues. The European Commission recommended the pace of consolidation of public finances for the Slovak Republic until 2013. However, the pace of consolidation of public finances proposed by the Ministry of Finance of the Slovak Republic is even more ambitious. Its aim is to reach a budget deficit below 3 percent of GDP in 2012. This ambitious plan is supported by considerable savings in public finances, especially in government consumption that is planned for 2010, 2011 and 2012,” Branislav Ondruš, head of the press and information department of the Government Office of the Slovak Republic told CBW.