Waiting for the Euro: What Companies Need to Think About Now

Adopting the euro: who, when, why and how?

On the first working day of EU membership, Vahur Kraft, Estonia’s central bank governor, announced he had paid in his share capital at the European Central Bank and was now ready for the next step-adopting the euro. “Only after completing this change can we be sure that our state is capable of fully utilising the possibilities that the merger with a powerful economic area offers,” he said. “Estonia hopes to be among the very first member states to do that.”

It will be. Estonia, Lithuania and Slovenia joined the Exchange Rate Mechanism, the obligatory two-year antechamber to the eurozone known by its acronym ERM2, at the end of June 2004. If the new ERM2 members meet the Maastricht criteria at the time of their assessment in 2006 (see box), their citizens will be jiggling newly designed and minted euro coins in their pockets on January 1, 2007.

Rapid euro entry is only a realistic option for a few tiny economies. Next to come on board will be equally small Cyprus, Latvia and Malta and possibly Slovakia, if it sticks to its current policies. These countries, which can join ERM2 whenever they are deemed ready without waiting for each other, are expected to move into the ERM2 between 2005 and 2006, adopting the euro in 2008 or 2009. The three largest new member states, Poland, the Czech Republic and Hungary, are unlikely to shift into ERM2 until 2008 and won’t have the euro until 2010.

Why the delay?

It’s a strange state of affairs. After all, the new member states are obliged to join the eurozone sometime-they have no opt-out clause like the UK and Denmark. What’s more, they would all really like to have the euro as soon as possible. EU membership extended the single market, but most Central Europeans believe the single currency will provide a stronger push for rapid integration, bringing Central Europe into the heart of European business. What’s more, once in the euro, the problem of volatile currencies is gone for ever.

The trouble is that joining the eurozone is not an option without joining ERM2 first (see box, previous page). For the front-runners, ERM2 is generally seen as an unpleasant and unnecessary waitingroom. The larger countries see it as two years in purgatory, if they are lucky. Not only will their currencies be perfect targets for attack by speculators, but failure to stay within the system’s fluctuation bands will keep them interned for a further two years.

Why is ERM2 more dangerous for some countries than others? There are two interconnected reasons: the flexibility of the current exchange rate regime and the strength of political will to enforce strict budget discipline (see table below). Countries like Estonia and Lithuania, which pegged their currencies firmly to the euro years ago, had nothing left to lose-they no longer had independent monetary policies to help them steer their economies. Both opted for rigid currency boards to bring stability in the early 1990s when their economies were spinning out of control. The tight discipline worked and was undoubtedly an excellent solution to a difficult problem. But it had downsides. Output declines were steep-Estonia only caught up with its 1989 GDP level last year; Lithuania is expected to cross that threshold next year. Both countries are among the poorest in the EU, with less than half of the EU-25’s GDP per capita even after taking purchasing power into account see table, page 15.

But their sacrifices are now paying off with an enviable combination of balanced budgets, low inflation and high growth. The EU recognised that it would be crazy to ask these countries to abandon their own successful fixed-rate regimes to spend two years in limbo, practising how to peg their currencies to the euro. So it gave them the option of keeping their currency boards for two more years and will probably agree to keep their current fixed exchange rates as the central parity. For Estonia and Lithuania, ERM2 membership merely enhances confidence and credibility until the countries adopt the euro.

At the other extreme, Poland, Hungary and the Czech Republic have all increased the flexibility of their exchange rate strategies over the past few years. One reason was that a combination of high foreign direct investment and large speculative inflows was pushing local currencies up. But another crucial reason for abandoning fixed pegs (particularly in the Czech Republic and Slovakia) was that macroeconomic imbalances had created currency crises. The fixed peg no longer had any credibility.

In many ways the flexible regimes have been positive, allowing solid growth along with macroeconomic stability. But they have also allowed a series of weak governments to relax on fiscal policy (impossible under a currency board and unsustainable under a fixed peg), with budget deficits rising substantially over the past four years. Except in Slovakia, which is now moving towards fiscal consolidation and will be able to join ERM2 in 2006-7, the introduction of more flexible exchange rate regimes has created serious tensions between discipline-loving central banks and governments, trying to buy their next term in office with public spending.

Poland, the Czech Republic and Hungary all have grand plans to bring their budget deficits down-and as member states have presented these formally to the European Commission as “convergence programmes”, getting a slap on the wrist for breaking the 3% limit defined in the Stability and Growth Pact. But even Hungary has accepted that there’s no point in moving into ERM2 until the plans start turning into reality. Without credibility and an understanding between central bank and government on the need for fiscal consolidation, ERM2 would be suicidal.

That Slovenia felt ready to join ERM2 is largely due to the exceptionally strong consensus and co-ordination between government and central bank. The Slovene central bank introduced a crawling peg system in 1992, which allowed the tolar to depreciate very

smoothly against the euro, while inflation remained relatively high. After many years of solid growth, along with disciplined fiscal policies, it believed the tolar had more or less reached equilibrium. Having finally pushed inflation down to around 3.5% this year, it was ready to take the leap.

Joining ERM2 is not without risk for Slovenia, which had to replace its controlled depreciation with fluctuation around a central parity rate and remove a web of controls to bring monetary policy into line with the ECB. “Being a small open economy with a fixed exchange rate almost by definition raises some warnings-especially if somebody knows that you are protecting your exchange rate,” said one board member of the Slovene central bank recently. “I just hope that this minimum two years will be the maximum two years.”

The dangers come from two sides. First, there is the fear of opening the gates to uncontrollable capital inflows due to higher interest rates, direct investment and increasing liquidity. These factors could push the exchange rate out of the 15% bands, leaving Slovenia with no credibility and pushing it back to the beginning of its compulsory two years of stability in ERM2. The second danger is that macroeconomic imbalances like inflation, a growing budget deficit or currentaccount balance could grow in a situation where monetary policy is no longer an active policy instrument.

But as currency trader George Soros, who infamously forced the pound to exit the first ERM in 1992 (see Chapter 2), recently pointed out, the key to getting the most out the euro process is disciplined policies. “If they join ERM2, they will become more stable,” he said, referring to the new member states, “except if policies are too out of line and there is a danger of trading out of the band.”

Hungary: once bitten…

It was precisely this scenario that tripped up the Hungarian central bank in 2003-ultimately causing them to abandon their goal of entering ERM2 as soon as possible after EU membership. Hungary is now likely to be in the last wave of entrants, adopting the euro at the end of the decade.

Hungary has shadowed ERM2 since 2001, with a 15% band around a central parity, and generally assumed that taking on the real thing would be quick and relatively painless. But recent wobbles have forced Hungary to listen to EU pleas and postpone the decision to join ERM2 until macroeconomic balances are clearly under control. (Cyprus, which also has a 15% band and planned to move straight into ERM2 this year, is also taking a closer look at the potential dangers due to a burgeoning budget deficit.)

Back in January 2003, the Hungarian economy was buzzing along, boosted by the big-spending generosity of both the incumbent government and then the new one. Short-term currency traders saw the forint gettingcloser to its upper 15% band and speculated heavily on appreciation, hoping to push the band upwards or force a change to a floating system. Some $500 billion was invested in just two days. But the central bank was nifty, buying euros to keep the forint down within its band and dropping interest rates. The Hungarians had won the battle.

The victory didn’t last long. In June, the government and central bank started talking the currency down a little, hoping to position the forint low for entering ERM2. The move backfired-investor confidence evaporated, the forint slumped far below the target level, and Hungary had to hike its interest rates to cover the increased risk premium. Another outflow took place in October and the authorities are still trying to rebuild credibility.

What are the lessons of this experience? The first is that targeting particular exchange rates is difficult, because it makes a currency vulnerable to flows of “hot” money, looking to push a currency up or down. Hungary lost control of the situation once it started targeting a specific exchange rate rather than keeping its eye on inflation targets as in the past. Juggling the two targets, as required in ERM2, is fine when the government and central bank have a credible policy of fiscal consolidation and low inflation. But Hungary’s announced plans to reduce the budget deficit had little relationship to policy reality. Speculators got cold feet, pulled out their money-and the forint nose-dived.

And that’s the second lesson: that ERM2 is really dangerous when there is no credible strategy for bringing down budget deficits and inflation. Although speculators make life difficult, they can only do so successfully where there is a discrepancy between the currency and economic fundamentals. In Hungary, the central bank’s credibility was dependent on a government policy that had been dragging the country away from the Maastricht criteria for several years. As much as Hungary’s central

bank governor Zsigmond Jarai believes that rapid adoption of the euro is the best course, he was forced to accept the inevitable. “The main issue is the credibility and transparency of medium-term policy, ” he said, analysing the situation. “You need to deliver on your promises.”

Why not just join the eurozone now?

The new member states are creating a new challenge for the eurozone officials. Over the past decade, they have faced either considerable scepticism about the whole single currency project (from the UK, Denmark and Sweden); grumbling about the specifics of the Stability and Growth Pact criteria (Germany, France and Italy) or gratitude and relief for the successful convergence brought about by ERM membership (Greece, Spain, Italy).

The Central Europeans have a different perspective. They are wholeheartedly in favour of adopting the euro, seeing a wide range of benefits that will foster long-term economic growth and accelerate the speed of catch-up (see box). Most analysts agree. A new IMF study reckons eurozone membership alone could increase GDP by up to 20% over 20 years through increased trade and investment.

But they are equally convinced that the long and winding road to the euro through ERM2 is not only dangerous but totally unnecessary. Even the Slovak central bank governor, Marian Jusko, who can rely on a supportive government, regards it as an unnecessary waiting-room.

So why does the EU insist on two years in ERM2? Wouldn’t it make more sense just to move straight into the eurozone once they meet the Maastricht criteria? A few economists agree. They believe transition countries need to opt for either a hard peg or a flexible exchange rate, steering clear of halfway houses like ERM2. And some even recommend unilateral adoption of the euro-something the ECB insists is out of the question for future eurozone members.

But the EU is adamant that ERM2 is a necessary training ground, where would-be eurozoners “gradually adjust to the requirements of a single monetary policy”, according to ECB governor JeanClaude Trichet. ERM2, the Bank likes to say, is a work-out room, not a waiting room.

Their argument runs like this. Joining the eurozone means abandoning an independent monetary policy and restricting fiscal policy. To do that without jeopardising long-term growth, countries in the currency must be broadly in sync with each other, have similar policies and be flexible enough to cope with the strains.

The ERM2 functions in two ways. First, it acts as a discipline, encouraging governments to take the difficult but necessary reforms that will ensure sustainable convergence. The whip is wielded not only by the EU, which will assess progress on the Maastricht criteria, but also by the market, which will lash out at any signs of wavering from the convergence course. Secondly, ERM2 is a testing phase, to ensure that the parity rate selected is really appropriate, and allowing it to shift before becoming irrevocably linked to the euro.

It’s a sound argument, if a little hypocritical given the eurozone’s problems disciplining its existing members. And it rightly focuses Central European attention on the dangers of joining the currency union prematurely (see box). But it doesn’t quite show the whole picture for transition countries, facing a series of major reforms in the public sector, while absorbing the effective costs of EU membership and facing billions of dollars of hot money ready to swoop in at any moment.

A new consensus

That’s why, behind the rhetoric on both sides, a new consensus is emerging. It stresses two conditions to make ERM2 work as a constructive training ground for monetary union. First, that euro candidates should get the main business of reform out of the way before joining ERM2, rather than using the mechanism to force the pace of change as in Spain and Portugal.

For some of the new member states, this means tackling inflation and squeezing out the remnants of price liberalisation. For most, it means radical reform of the budget. A deficit no higher than 3% of GDP is, of course, a criterion for joining the euro. Beyond that, fiscal consolidation and low public debt are the conditions for longer-term growth. But the real challenge of budget consolidation is to introduce into the public sector the kinds of reformts that have transformed the private sector. This would boost longterm growth, while freeing up money to improve public services, tackle the problems of ageing and meet the requirements and opportunities posed by EU membership. Only once this policy is well underway, the thinking now goes, does it make sense to step into the limelight of the ERM2.

The second aspect of the consensus, again going against the experience of the previous euro-joiners, is that countries should aim not to spend more than two years in ERM2. That is sufficient to test the viability of the exchange rate and the durability of nominal convergence. But the challenge of steering a straight course in the face of volatile flows of hot money is too exhausting to maintain for long. Local currencies are not just shock absorbers, they can also create instability that has a very real and destructive effect on exports, inflation and competitiveness. A recent paper put out by the Austrian National Bank expresses the paradox nicely: “The challenge of ERM2 is to allow the exchange rate to move in line with fundamentals, but also to stop it moving out of line with fundamentals.”

The business impact of joining the eurozone

Ask most managers in Central Europe how participation in the eurozone will affect their business, and they’ll say it’s probably a good thing-and then look a bit blank. One Hungarian executive sums up the general feeling: “I’ve never really understood why the switch to the euro caused such a fuss in the EU-it’s just another currency.”

In some ways, he is right. The fuss in the late 1990s was overdone, overlapping with the preparations for Y2K. When the euro was introduced on January 1, 2001, there were no dramatic corporate failures anywhere. Despite the official midnight deadline for companies to use euros, the transition was actually less abrupt. Companies, banks and tax authorities muddled through until even the worstprepared had changed to euros. “I’m not sure whether our drastic warnings worked or whether they weren’t really necessary,” admits Noel Hepworth, an accountant at the Institute of Public Finance in London and one of the architects of the European campaign to get companies ready.

The new member states will have it even easier now the euro is an established currency. First, the process will be much clearer: there will be no transition period between introducing the euro as a virtual currency and actually handling it. And secondly, the two most difficult and expensive elements of the process last time round-converting IT systems and cash-handling (see chart)-will be relatively simple for Central Europeans. Most decent IT systems are already euro-compliant and the cash is already in existence.

But our Hungarian executive is still wrong to see the euro as just another currency. The conversion itself might well be a lot easier this time round, but the impact on business-both in the run-up to the euro and once it exists-will be far more substantial.

Why? The whole point of introducing the single currency is to make the EU’s single market function effectively, boosting trade and investment by facilitating cross-border competition and improving price transparency. That was true last time round too, of course, but the differences between the markets entering the eurozone then were relatively small. Those countries that were significantly behind the others, like Greece and Portugal, were peripheral to mainstream European business and remained so.

That’s not the case for the new member states. Here the gap to the core of the eurozone is much greater across the board. And the commercial value of taking advantage of these gaps-either as an investment location or a market-is too great for European businesses to ignore:

• Average prices in the main Central European markets are only 45%-55% of eurozone levels.
• Labour costs are on average only 25% of EU-15 levels.
• Market size is tiny per capita compared to Western Europe and growth levels are correspondingly higher.
• The market is still fragmented among many players, with the battle for market share still open.

The introduction of the euro is only one aspect of the many changes brought about by EU enlargement. Companies can choose to ignore it and muddle through when it comes. Or they can start thinking now about what the expansion of the eurozone will mean for their business, and incorporate strategic and operational preparations into their wider strategy for making the most of the enlarged EU. As one finance director for a global consumer goods company expresses it: “We want to have a framework in place in the next 12 months so that all actions we take move towards the right goals.”

What does the eurozone mean for business dynamics?

EU enlargement marked a shift in the perception of Central Europe. Until this year, the new member states were a group of fast-growing but largely peripheral emerging markets. Now, they are becoming an unavoidable part of mainstream European business strategies. Any sizeable company doing business in Europe has to ask itself whether it should be doing business in Poland or Hungary, whether it should be relocating production to Slovakia or R&D and shared services to Prague. Those that already have operations are asking themselves whether they still make sense in a pan-European context.

The probability that the eurozone will stretch to the new member states by the end of this decade accelerates this process. For many global companies, the adoption of the euro will finally mark the end of special treatment for the Central Europe region. Pricing strategies and trade terms will be harmonised across Europe. Information systems will be standardised. Supply chains and distribution strategies will be pan-European. And the “CEE region” will become a footnote in European corporate history.

For local and international companies operating in the new member states, this changing perspective on Central Europe is already having an impact. Markets are becoming even more competitive and cut-throat, with large players pushing for market share and many smaller players backing out. Sectors that still have fragmented distribution will increasingly face consolidation, with large, specialised European distributors shifting their attention to Central Europe, following the same aggressive acquisition strategies that have transformed business in Western Europe.

Companies are also starting to feel the side effects of convergence towards the euro:

• Companies that rely heavily on government spending will face a serious growth squeeze as budget consolidation gets underway. Pharmaceutical companies in Central Europe, for example, are already starting to see declining sales in some areas as health ministers cap spending and focus resources on improving services. This process will intensify as governments progress towards the Maastricht criteria, eased only where EU funds supplement the public investment role (in road-building, environment and rural development, for example).
• The beginnings of a credit boom have already changed consumer preferences, diverting disposable income away from everyday consumer goods and durables as mortgage lending grows. As credit growth accelerates, lending to small and medium-sized businesses will increase dramatically, increasing their buying power, viability as suppliers and competitive position in the market.

How will the eurozone affect pricing?

Every company will be obliged to convert its prices into euros. For some, that will largely be a technical question of conversion and rounding. But for any companies close to end-users, pricing strategies will be a key part of their early preparation for the euro.

International consumer goods and retail companies are already starting to plan. One large own-brand retailer, for example, has adopted a long-term pricing strategy until the introduction of the eurozone. It is gradually squeezing price levels in Central Europe down, shifting them from slightly above average West European levels to slightly below them. In this way, it hopes to double sales over the next five years and increase market share. From next year, a euro project team will start to track price differentials with eurozone markets and gradually steer local prices towards convergence, bringing them to suitable levels for conversion to the euro.

During the first wave of euro conversion, companies soon realised it would be a mistake to use the initial price conversions to raise prices, since there was a great deal of scrutiny from media and consumer protection agencies. Most kept exact conversions, with dual prices, for a short transition period before gradually introducing more suitable price points.

That process is much easier if there has been convergence beforehand. One international food company, which has much lower prices in Central Europe, is currently developing its long-term euro strategy. Now it is focusing on harmonising prices across the new member states. But by mid-2005, it wants to create a plan for converging with the overall European pricing strategy. Once the euro is introduced, there’ll be a completely new set of trade terms in place, defining list prices and discounts as in Western Europe now. “Price convergence will be more a gradual process than a big bang,” says the regional finance director. “Look at the price on the shelf and there’s still a 30% price difference between Italy and Germany.”

Raising prices without losing business is the big problem for some international companies. For others, it’s price erosion. Many multinationals still charge more in Central Europe due to higher risk premia, smaller volumes, more complicated logistics and lower competition. Enlargement has already dented the arguments, not least by allowing retailers and wholesalers to buy product where it’s cheapest. The eurozone finishes off the rest by making price differentials transparent.

Finding ways to cope with pricing pressures will be a major part of many companies’ strategies as the eurozone approaches. The situation could be exacerbated by devaluation, if countries decide to devalue their currencies as they move into ERM2 (by setting substantially lower central parity rates than current market exchange rates, as in Greece). The three new ERM2 members did not follow the Greek example. Estonia and Lithuania kept their fixed rates. Slovenia considered using a mild version of Greece’s strategy, but ultimately opted for taking the market rate.

One pharmaceuticals company has taken a very proactive approach to the problem. It is limiting exchange rate risk now by negotiating euro prices for its products on government reimbursement lists. “We were willing to exchange more pricing transparency for less exchange rate risk,” says the regional chief financial officer. As with companies in other sectors, pharmaceutical companies will be looking to keep list prices high, while negotiating discounts to factor in affordability. “The euro makes it easier for us internally to make a business case for lower prices in Central Europe,” he says. “That gives us a chance to be more competitive on the market.”

Local Central European companies, without European pricing frameworks to adhere to, will be in a stronger position to compete both at home and in the rest of the EU as international competitors adjust to the euro. But it will be crucial to watch the tactics of the global players and find the right pricing niche to compete effectively.

The impact of the euro on IT systems

No wonder it was impossible to find IT technicians in the late 1990s. Companies were panicking simultaneously about e-commerce, Y2K and the euro, frantically making adjustments to a hotchpotch of IT programmes, built up and lovingly adapted over a quarter of a century.

Making changes for the introduction of the euro was complicated because it affected every part of the business, from payroll and suppliers to customers and the tax authorities-and that hasn’t changed. But it was incredibly time-consuming and expensive because there were so many different systems in place and virtually none of them were made to cope with the euro. Eurocompliancy was a very new concept.

The new member states will have it easier in two ways. First, most standard systems available are designed with the euro in mind. And secondly, most companies in Central Europe have not spent 20 years or more collecting bits and bobs of systems. “Central Europe has the advantage that it doesn’t have much of a legacy system,” says Brian Gregory, Senior Director of Applications Marketing at Oracle, and a veteran of the first round of euro changeover. “The problem is that it doesn’t have much in the way of business systems at all.”

Most large international companies are just starting to address that problem for their subsidiaries in Central Europe. One reason for doing that now is that business volumes are getting to a point where Excel sheets are no longer sufficient. The other reason- and the real driver of such projects-is that global companies have dumped legacy systems and are now busy standardising and simplifying software across the entire company.

Standardisation is not just a management fad-it’s the cold, hard lesson of the IT challenges of the 1990s. Complicated, bespoke systems, adapted to a company’s specific needs, may be wonderful at solving today’s problems, but they can’t c