Assessment of the Fulfilment of the Maastricht Convergence Criteria and the Degree of Economic Alignment of the Czech Republic with the Euro Area - 2020
A joint document of the Ministry of Finance of the Czech Republic and the Czech National Bank.
Approved by the Government of the Czech Republic on 7 December 2020.
Besides being required to harmonise their legislation with Articles 130 and 131 of the Treaty on the Functioning of the European Union (the Treaty) and the Statute of the European System of Central Banks and the European Central Bank, EU Member States are required to achieve a high degree of sustainable convergence in order to join the euro area. The degree of sustainable convergence is assessed according to the Maastricht convergence criteria, which are set out in Article 140 of the Treaty and detailed in Protocol No. 13 annexed to the Treaty on the European Union and the Treaty on the Functioning of the European Union. These comprise a criterion on price stability, a criterion on the government financial position, a criterion on the convergence of interest rates and a criterion on participation in the exchange rate mechanism. The Czech Republic undertook to take steps to be prepared to join the euro area as soon as possible by signing the Act concerning the conditions of accession of the Czech Republic to the European Union.
Setting the date for joining the euro area is within the competence of the Member State concerned and depends on its preparedness. Besides undoubted benefits, such as a reduction in transaction costs and the elimination of exchange rate risk, adopting the euro entails giving up independent monetary policy and the flexible exchange rate of the koruna as effective stabilising macroeconomic instruments. The preparedness of the economy to join the euro area must therefore be assessed not only from the perspective of its economic alignment and structural similarity with the monetary union, but also from the point of view of its ability to absorb asymmetric shocks using other mechanisms and adjust appropriately to them, in particular via fiscal policy and the labour market, after the loss of independent monetary policy.
Negotiations are also continuing on deepening economic integration. The negotiations are focused on strengthening economic and fiscal coordination and completing the banking union and the capital markets union. Despite the adoption of some minor proposals, little progress has been made in the last two years. A whole range of elements of the economic and monetary union therefore remained unfinished. New institutions and regulations have fundamentally changed the form of the euro area and hence also the content of the euro adoption obligation assumed by the Czech Republic on acceding to the EU. Their functioning, as well as the new institutional and financial obligations arising for countries adopting the single currency from measures taken in the context of deepening euro area integration, must therefore be properly assessed and considered in future decisions about the timing of monetary union entry.
The Czech Republic will not be compliant with the criterion on price stability in 2020, due to persisting domestic inflation pressures. The Czech Republic ranks among the EU Member States with the highest inflation in 2020. This mainly reflects the fading of the very tight labour market situation before the outbreak of the coronavirus pandemic and related rapid growth in wages and aggregate demand. According to the inflation forecast, it should be compliant with this criterion in 2021.
The Czech Republic was compliant with the criterion on the government financial position in both the budget balance and debt components until 2019. The deep decline in economic activity in this year due to the COVID 19 pandemic and fiscal support measures led to a sharp deterioration in the general government balance, which in all probability will record a deficit of more than 6% of GDP. This was reflected in a marked increase in general government debt. However, the debt level should remain well below the reference value. Compliance with the criterion on the government financial position in the years ahead will depend on the pace and strength of the recovery of the Czech economy and on appropriately calibrated consolidation strategy.
The Czech Republic has long been compliant with the criterion on convergence of interest rates. Owing to the unavailability of interest rate projections for the reference countries, the expected value of the criterion cannot be accurately determined for this year and the next. However, based on the current trends and available figures, it is reasonable to assume that the Czech Republic will also be compliant with this criterion in 2020.
The Czech Republic is formally non-compliant with the criterion on participation in the exchange rate mechanism, as it has not joined the mechanism.
When deciding on euro area entry, account must also be taken of the Czech economy’s alignment with the euro area and its ability to adjust to possible asymmetric shocks without its own monetary policy. The characteristics of the Czech economy as regards its economic preparedness to adopt the euro can be divided into three groups.
The first group consists of economic indicators that speak in favour of adopting the euro. These have long included the high degree of openness of the Czech economy and its close trade and ownership links with the euro area. These factors provide for the existence of benefits of euro adoption, such as a reduction in transaction costs and the elimination of exchange rate risk. The strong trade integration also fosters a high degree of alignment between the Czech and euro area business cycles, although that has decreased somewhat in the past few years. Although the use of the euro in the Czech economy is increasing further, it is concentrated almost exclusively in the trade relations of the Czech business sector. The Czech and euro area economies have converged further in the case of interest rates due to the macroeconomic impacts of the coronavirus pandemic. The Czech koruna remains aligned with the euro with respect to the US dollar, and inflation inertia is not a barrier to joining the euro area either. Several indicators are also suggesting preparedness for adopting the euro as regards the adjustment mechanisms of the Czech economy. A high and in recent years rising rate of economic activity and a low structural, or long-term, unemployment rate signal increasing labour market flexibility. In recent years, these variables were favourably affected by the economic boom. The stable domestic banking sector, which entered the recessionary phase of the financial cycle caused by the outbreak of the coronavirus pandemic in good shape with a robust capital and liquidity position, can also be assessed as positive.
The second group consists of indicators with a neutral message, which primarily include overall similarity of monetary policy transmission. The Czech Republic differs from the monetary union average in some financial indicators (depth of financial intermediation, private sector debt and the financial assets and liabilities structure of non-financial corporations and households), but this cannot be considered a disadvantage or a fundamental barrier to euro adoption. The indicator of the alignment of the Czech and euro financial cycles is also neutral. As stated above, labour market flexibility is improving in some respects. However, the configuration of the tax and benefit system may reduce the incentive for low-income groups in particular to actively seek employment. The Czech Republic’s competitiveness score is also neutral, for example.
The third group consists of indicators suggesting economic risks associated with potential euro adoption. They primarily include a still unfinished process of real economic convergence of the Czech Republic towards the euro area and persisting lower structural similarity. The often procyclical nature of fiscal policy is a problem as regards the adjustment mechanisms of the Czech economy. The need to stabilise the pandemic-hit economy using fiscal policy tools has been reflected in a significant deterioration in the structural deficit this year. Czech public finance sustainability also remains an issue due to population ageing.
In addition to benefits, the adoption of the single currency also entails obligations, which must be taken into account when deciding on the timing of euro area entry. The total financial costs that will be associated with euro adoption in the future may evolve. The currently estimated financial obligations for the Czech economy, which were not known when the Czech Republic joined the European Union, mainly include a subscription of capital of the European Stability Mechanism and a transfer of contributions from banks registered in the Czech Republic to the Single Resolution Fund.
To sum up, the Czech Republic is only compliant with the criterion on the convergence of interest rates in 2020. In the context of the ongoing pandemic and the related global economic downturn, it is difficult to assess whether the Czech Republic’s economic preparedness to adopt the euro has improved or deteriorated. The deep decline in GDP in the euro area corresponds to the synchronised contraction of the global economy, the scale of which is unprecedented in the post-World War II era. Moreover, unresolved debt and structural issues persist in a number of euro area countries.
In view of the above facts, the Ministry of Finance and the Czech National Bank, in line with the Czech Republic’s Updated Euro-area Accession Strategy, recommend that the Czech government should not set a target date for euro area entry for the time being. This recommendation implies that the government should not aim for the Czech Republic to join the exchange rate mechanism for now.