Assessment of the Fulfilment of the Maastricht Convergence Criteria and the Degree of Economic Alignment of the Czech Republic with the Euro Area - 2023
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 14 February 2024.
The Czech Republic undertook to adopt the euro by signing the Act concerning the conditions of accession of the Czech Republic to the European Union. One of the conditions that must be fulfilled by each Member State in the process of joining the euro area is the achievement of a high degree of sustainable convergence, which is assessed according to compliance with the Maastricht convergence criteria. This document assesses the Czech Republic's compliance with these criteria.
Setting a specific date for joining the euro area is fully within the competence of each Member State, but it should ideally depend on its degree of 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 exchange rate of the koruna as stabilising macroeconomic instruments. The preparedness of the economy to join the euro area must therefore be assessed from the perspective of its economic alignment and structural similarity with the monetary union, and also from the point of view of its ability to absorb asymmetric shocks using other mechanisms, in particular via fiscal policy, the labour market and the banking sector, after the loss of independent monetary policy.
This year marks the 20th anniversary of the signing of the Accession Treaty. Since then, the euro area and the European Union as a whole have experienced the economic recession of 2008 and 2009, followed by the euro area debt crisis in some euro area countries. In 2020 and 2021, the world was paralysed by the Covid-19 pandemic, and last year the energy crisis and Russia’s aggression in Ukraine accelerated growth in the price level. These and other events affect other processes of European integration aimed at strengthening economic and fiscal coordination and completing the banking union and the capital markets union. The new institutions and rules are thus changing the shape of the euro area and the content of the obligation to adopt the euro. These facts also need to be properly assessed and considered in decisions about the timing of monetary union entry.
In addition to assessing legal compatibility, the assessment of a country’s preparedness for euro adoption and the related rights, obligations, privileges and commitments includes an assessment of compliance with the convergence criteria: the achievement of a high degree of price stability, the sustainability of the government financial position, the observance of the normal fluctuation margins of the exchange rate, and the durability of convergence being reflected in the long-term interest-rate levels.
The analysis contained in this document reveals that the Czech Republic did not fulfil the criterion on price stability in 2023. The Czech economy – despite a significant slowdown in price growth – is still among the EU countries with the highest inflation, which has, until recently, been intensified by strong supply and demand pressures, and increased inflation expectations. The criterion on the convergence of interest rates is likely to be fulfilled both this year and the next due to the decreasing difference in the monetary policy stance of the Czech National Bank and the European Central Bank. Public finance consolidation has been slowed by measures aimed at reducing the impact of the energy crisis on households and businesses. Therefore, the Czech Republic does not fulfil the reference value for the general government deficit. However, given the persisting uncertainty about macroeconomic developments, the European Commission did not propose the opening of an excessive deficit procedure during the activation of the general escape clause, which is part of the European Union’s common fiscal rules. The Czech Republic is thus still formally compliant with the criterion on the government financial position.
In 2024, the Czech Republic will probably fulfil the reference values for the criterion on the government financial position, the convergence of interest rates and price stability. Inflation should fluctuate close to the upper boundary of the tolerance band around the CNB’s inflation target next year due to the fading of adverse supply-side factors and the effects of the previous monetary policy tightening. A recovery package and the expected economic recovery will foster a drop in the general government deficit. The Czech Republic is formally non-compliant with the exchange rate fluctuation criterion, as it does not participate in the relevant exchange rate mechanism.
As regards the Czech economy’s alignment with the euro area and its ability to adjust to possible asymmetric shocks without its own monetary and exchange rate policy, the characteristics of the Czech economy can be divided into three groups.
The first group consists of economic indicators suggesting a relatively low level of risk associated with potential euro adoption in the area analysed. This group has long included the Czech economy’s close trade and ownership links with the euro area. These factors represent preconditions for the realisation of the benefits of euro adoption and also foster alignment between the Czech and euro area business cycles. The latter is currently very high. However, it is not clear to what extent its increase is only a temporary consequence of the similar impacts of strong global economic shocks. The close trade links are also reflected in an increasing share of euro-denominated financing of Czech corporations. This was fostered last year by a high interest rate differential between koruna and euro interest rates as well. The koruna remains aligned with the euro vis-à-vis the dollar and is thus not a barrier to joining the euro area either. As regards the adjustment mechanisms of the Czech economy, the low long-term unemployment rate, which is still among the lowest in Europe, can be positively assessed. The development of the domestic banking sector is also favourable. The sector is characterised by a robust capital and liquidity position, high profitability and a low ratio of non-performing loans. Its resilience to potential negative shocks thus remains high.
The category of indicators with a neutral message primarily includes the similarity of monetary policy transmission in the Czech Republic and the euro area. Although the Czech Republic differs from the monetary union average in some financial indicators such as the structure of households’ financial assets and the structure of loans for house purchase by fixation period, this cannot be considered a fundamental barrier to euro adoption. The depth of financial intermediation and the level of private sector debt in the Czech Republic are relatively low and thus do not represent a potential source of systemic risk. The alignment of the Czech and euro area financial cycles, which was little changed last year, and, in the longer run, the convergence of interest rates are also assessed as neutral. The latter has increased again since the second half of 2022 amid flat domestic interest rates and a tightening of ECB monetary policy. The volatility of the koruna exchange rate, which fell back to pre-crisis level as the energy crisis subsided and uncertainty on financial markets calmed, does not pose a risk either. The alignment of the Czech and euro area financial markets is also returning to the levels of the previous decade. Most labour market indicators are also neutral. The geographical mobility of the labour force is rising further due to an increase in the share of foreigners in the population, while labour efficiency indicators are little changed. The participation rate of early-middle aged women in the labour market also remains low, which is linked with long parental leave and the low share of part-time jobs. As regards the risks associated with potential euro adoption, the assessment of general government debt is also neutral. However, the debt increased again last year.
The third group consists of indicators suggesting economic risks associated with euro adoption in the area analysed. These indicators include the unfinished process of economic convergence of the Czech Republic towards the euro area, especially as regards the convergence of the price and wage levels. Their lag behind the euro area average remains significant despite faster convergence last year, most notably in the case of wages and prices of some services. The relatively low structural similarity of the Czech economy with the euro area consisting in an above-average share of industry in domestic GDP would also be a risk in the event of euro adoption. The persisting structural imbalance of Czech public finances is a problem as regards the adjustment mechanisms of the Czech economy. Several measures have been taken in recent years which have had a negative impact on public finance long-term sustainability. At present, however, the government is seeking to improve fiscal indicators, either as a result of public finance consolidation via a recovery package or changes to the pension system. Czech legislation expects a gradual return to the medium-term objective, which corresponds to a structural deficit of 0.75% of GDP (in this context, a structural deficit of no more than 0.5% of GDP usually applies to euro area countries).
The design and functioning of the economic and monetary union are evolving over time, so these processes continue to require monitoring and assessment. Apart from the benefits, the adoption of the single currency also entails institutional and financial 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 change. 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 will not meet two of the Maastricht convergence criteria in 2023. Specifically, it will not fulfil the price criterion and the exchange rate fluctuation criterion. No substantial progress has been made as regards the Czech Republic’s economic preparedness for euro adoption. The economic level has even diverged slightly from the euro area average over the last two years, while there was only partial convergence in the price level and especially the wage level. There are still large differences in the structure of economies. The issue of Czech public finance long-term sustainability is also yet to be resolved. The impacts of the energy crisis further highlighted the euro area’s economic heterogeneity. The fiscal positions of most euro area Member States also remain unfavourable.
In view of all the above facts, the Ministry of Finance and the Czech National Bank 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 either.