Interest rate convergence in CEE countries towards EMU levels, bond market performance and the perspective of EMU membership

Transcription

1 Interest rate convergence in CEE countries towards EMU levels, bond market performance and the perspective of EMU membership Michael Holz Universität Trier * First draft: December 2004 This draft: January 2006 * Dr. Michael Holz, Universität Trier, Fachbereich IV Volkswirtschaftslehre, insbesondere Geld, Kredit, Währung, Universitätsring 15, D Trier, Telefon (+49) (0) 651 / , Telefax (+49) (0) 651 / , holzm@uni-trier.de

2 2 Interest rate convergence in CEE countries towards EMU levels, bond market performance and the perspective of EMU membership Abstract Government bond yields of several Central and Eastern European (CEE) countries had reached unprecedented low levels, just a year before they joined the EU on May 1, The story behind this rapid interest rate convergence, the abrupt rise of bond yields in Hungary and Poland starting just six month later, and determinants of the bond market spread vis-à-vis EMU are investigated. Total bond market returns are analysed from an investor s perspective and a forecast for the convergence path over the next few years is deducted. A list of possible interest rate criteria for accessing EMU as well as their degree of fulfilment is presented. Some main implications for monetary policy credibility, inflation targeting frameworks, differences in the transmission mechanism and stable macroeconomic policy mixes as well as adequate exchange rate regimes for different groups of EMU candidates result. Keywords: EMU enlargement, CEE countries, convergence of interest rates, monetary policy, exchange rate regimes JEL-Codes: E 43, F 33, F 36

3 3 1 Introduction On May 1, 2004 eight Central and Eastern European (CEE) countries have joined the European Union together with Cyprus and Malta. For the last few years, these countries have shown considerable effort and success on the bumpy road towards EU accession and by the end of the decade after fulfilling the Maastricht criteria they envisage the introduction of the Euro as legal tender. Since the end of the 1990s, in some of the CEE countries, namely the Czech Republic, Hungary, Slovenia and the Baltic states, there has been a remarkable interest rate (long-term bond yield) convergence from high double-digit levels close to those of EMU member countries. This process seemed to be fostered by considerable progress in the monetary, real, fiscal and institutional area. It was reinforced by a general trend of shrinking emerging market bond spreads (vis-à-vis the United States and EMU). This convergence play had come to a standstill in autumn Especially the Polish and Hungarian bond market spreads widened considerably, reaching 285 and 447 basis points by September At the same time, the Czech spread has shown only a moderate widening to 90 basis points. This article tries to explain the story behind this rapid convergence and the abrupt swing back in bond market yields of the biggest three CEE countries. Section 2 presents results of cointegration tests for short-term and long-term interest rates of the ten new EU member countries. Co-movements between these countries and the so far reached convergence of some CEE countries with EMU are identified. Section 3 asks which factors determine the bond market spreads against the lower EMU levels. Section 4 scrutinises on the high-yield convergence plays of international bond market investors. It asks whether risk premia have become too low, regarding that there are some years to go until EMU membership of the Czech Republic, Hungary and Poland (expected by 2009/10). A comparison with the convergence process of Italy and Spain in the years before the introduction of the Euro 1999 seems a promising approach. A long-lasting period of convergence has shown shorter episodes of considerable divergence (of spreads as well as fundamental economic factors). Section 5 presents a list of possible interest rate criteria for EMU enlargement countries, their degree of fulfilment in each of the new member countries and lessons which can be learned concerning monetary policy credibility, inflation targeting frameworks, differences in the transmission mechanism from money to bond markets and stable macroeconomic policy mixes as well as adequate exchange rate regimes for groups or blocks of potential EMU members struggling with different economic problems. Section 6 concludes. 2 Interest rate convergence in CEE countries towards EMU levels 2.1 Money market rates The ten EU newcomers are so-called member states with a derogation. In the near future, the first of them are expected to introduce the Euro as their legal tender. On June 28, 2004 Estonia, Lithuania and Slovenia joined the European exchange rate mechanism 2 (ERM II) as

4 4 a prerequisite for introducing the Euro after two years of ERM II membership without excessive fluctuations. Latvia, Malta and Cyprus followed in May 2005, Slovakia on November 28, Although the three biggest EU entrants, the Czech Republic, Hungary and Poland, are not expected to participate in the ERM II for the next one or two years, their monetary policies show by now more or less convergence with the euro area. Inflation targeting has become state of the art for the central banks of the big three, so it is expected to find a comovement of short-term interest rates in most of the EU accession countries with those of EMU, of course with a considerable spread for some countries struggling with relatively high inflation rates. For the ultimate goal of EMU membership these countries have to fulfil the Maastricht criteria. 1 In this section we are looking at interest rate convergence, as required for long-term interest rates on government bonds, but as a first step we investigate short-term interest rates, which mirror to a large extent the monetary policy of the central bank in each country. Because of the Maastricht inflation criterion, only a monetary policy which aims at preserving price stability is expected to lower interest rate risk premia far enough, so that the Maastricht interest rate criterion (not more than 150 basis points above the long-term interest rates of the three countries with the lowest inflation rates) will be met without problems. Interest rate criteria for CEE member countries of the EU will be discussed later on. By now, the so far reached different states of convergence deserve a closer look. Only a couple of years ago, money market rates in CEE countries reached double-digit levels because of high inflation rates, experiments with various monetary policy and exchange rate regimes in the global wake of the East Asian and Russian crises 1997/98, and to a lower extent after the Brazilian devaluation in Therefore it seems appropriate, to start our empirical analysis of short-term interest rate convergence with the year Calculating pairwise correlations of 3-month money market rates for EMU and the new EU member states in a sample starting January 2000 and ending September 2004 yields the following results: The Czech Republic, Estonia, Malta and Poland show correlation coefficients above 0,9, but even those of Latvia, Lithuania and Slovakia are well above 0,7. The only exception is Hungary with a coefficient of only 0,22. If we do not correlate the levels, but monthly changes of shortterm interest rates, the picture changes drastically. The highest correlation coefficients are registered for Estonia (0,73), Poland (0,44) and Cyprus (0,43), the Czech Republic only reaches 0,20, the coefficients of two of the Baltic States are even slightly negative. Therefore, the adequate statistical method for identifying long-term convergence processes seems to be the cointegration analysis of time series. 2 It allows us to model the long-term co- 1 See EU COMMISSION (2004), GERN ET AL. (2004), KURTZ ET AL. (2003). 2 See HOLTEMÖLLER (2003), HERRMANN and JOCHEM (2003).

5 5 movement of interest rates and the error correction process in the case of short-term divergence. The cointegration technique identifies stationary relationships between two or more non-stationary time series. The assumption of non-stationarity of money market rates in EU member countries as well as EMU is tested with the Phillips-Perron and the advanced Dickey- Fuller test. Interest rate data are taken from the ECB statistical database. Due to data availability some time series start as early as mid-1995 (e.g. Czech Republic, Hungary and Poland), the Slovenian series in According to the Phillips-Perron test all 11 time series show no unit root and therefore are non-stationary. The Dickey-Fuller test gives hints for a unit root in the Hungarian interest rate series, but this is of minor importance here, because we do not expect to find cointegration between Hungary and EMU according to the correlation results. This is supported by the cointegration test results. There seem to be two groups with similar money market developments in recent years. The 3-month money market rates of the Czech Republic, Slovakia and the three Baltic states are cointegrated with EMU. Further cointegration relationships are identified between the Czech Republic and Slovakia as well as Poland. The second block is a cointegration between Estonia and Lithuania, the two countries which have a currency board regime with the Euro. The left part of Table 1 shows in short the cointegration and error correction results. The cointegration coefficients range from ideal results near 1 to relative high values for the Czech- Polish cointegration of 3,9 (with a constant term of 5,4), showing that there are considerable differences in the interest rate levels. The error correction terms are significant, but relatively low, showing that episodes of divergent interest rate movements can last relatively long (e.g. a Czech error correction term of 0,06 vis-à-vis EMU, which means a divergence period of about 1 ½ years). The highest value is 0,36 for Lithuania, which means an error correction vis-à-vis EMU money market rates after three month. 2.2 Long-term bond yields A slightly different pattern shows up, when we switch our focus from money markets to bond markets. Despite the outstanding importance of long-term interest rate convergence as postulated by the Maastricht criteria, there is by now only scarce empirical evidence on cointegration of bond yields in EU accession countries. KOUKOURITAKIS and MICHELIS (2003) present results for and conclude that there is a considerable degree of co-movement of bond yields dominated by EMU yields. However, capital market trends have changed since then. Due to convergence plays on the CEE bond markets, in 2002 the fulfilment of the Maastricht interest rate criterion seemed a pure pro forma issue, since all new members had no problems meeting the benchmark. By mid-2004 this had changed substantially. Bond market spreads widened, so that with Poland and Hungary two of the big new EU members failed the convergence test.

6 6 Therefore renewed empirical testing allows investigating the up-to-date status of long-term interest rate convergence. The data basis has become by now much more reliable, because only data from the ECB database are taken. The time series start in January 2001 and only 10- year government bond yields of CEE countries are used. Earlier bond yield data are only available from the national central banks of some new EU members and there are wide differences in time to maturity (the definition of long-term varies from country to country). The bond markets of some smaller countries are not well developed, Slovenian data are only available for a too short time span and in Estonia there are no government bonds, so only the Czech Republic, Hungary, Poland, Slovakia and Latvia together with EMU are included in our tests. The results of the Dickey-Fuller and Phillips-Perron unit root tests for long-term interest rates are quiet similar. Only the time series of Lithuania shows a unit root, so the country was not included in the cointegration tests. Calculating the pairwise correlations for levels and first differences of long-term interest rates yields results which are similar to those for money market rates. The highest correlation coefficients show up for the bond yields of Slovakia (0,92), the Czech Republic and Poland (0,79), while Hungary stands apart (0,19). Inspecting the interest rate changes reveals a high correlation in the Czech Republic (0,68) and Poland (0,44). An overview of the cointegration tests demonstrates that for the time being, there is still a way to go for full convergence of bond yields in CEE countries with the lower EMU level. A cointegration relationship vis-à-vis EMU can only be identified for Slovakia, although the Czech bond yield shows considerable co-movement with EMU in recent years. (One explanation for the absence of statistical cointegration might be, that the time series crossed in During a period of mild deflation, for several months the Czech nominal bond yield was lower than EMU bond yields. This crossing seems to prohibit the finding of cointegration in relatively short time series.) The Slovakian cointegration coefficient vis-à-vis EMU is 2,71 (with a constant of 6,53), the error correction term 0,16 (see the last three columns of Table 1). Instead, the forming of a cointegration block between the three biggest CEE countries (namely the Czech Republic, Hungary and Poland) emerges. Bond yields of these countries co-move, although their connection with EMU bond market developments has loosened during 2003/04. The cointegration coefficients are 1,01 for Hungary and 2,07 for Poland vis-àvis the Czech Republic. Remarkably high are the error correction terms, which are both about 0,4, indicating a rapid correction of interest rate divergences between these three countries within less than three month. Summing up, during the last few years a considerable degree of interest rate convergence has emerged in CEE countries, which are now members of the EU. The convergence towards the

7 7 lower EMU interest rate levels will take some additional time on the way to EMU membership. The convergence process of money market rates has made greater progress than the convergence of government bond yields. Stable long-run relations (as measured by cointegration tests) between the interest rates of the big three CEE countries have developed faster, despite diverging real economic situations, than a reliable and uncontested state of lasting convergence with EMU. The coming years will see further progress, but inevitably also some further drawbacks until the introduction of the Euro in all of the new EU member states. 3 What determines bond market spreads of new EU member states vis-à-vis EMU? Having dealt so far with the process of interest rate convergence in EU accession countries towards EMU levels, we now turn to the question, what are the determinants of the bond market spreads of these countries, i.e. the differences between their 10-years nominal government bond yields and those of EMU. Of course, what first comes to mind are inflation differentials. But there are further potential explanatory variables to be tested. Following (uncovered) interest rate parity, exchange rate changes (i.e. devaluations) are expected to equate a higher bond yield in a CEE country over the holding period of the bond to maturity. When the convergence plays are purely market-driven, we may expect to see a significant influence of general emerging bond market trends. The years have witnessed a remarkable shrinking of risk premia for bond debtors with low ratings, be it corporations or national entities. A general tendency of low government bond yields in EMU and the United States stimulated the risk appetite of international investors seeking for higher rents. Additionally, we are testing whether the national monetary policies of CEE member countries are able to influence longterm bond yields via the transmission mechanism (interest rate channel). For the following regression analysis, we concentrate on the Czech Republic, Hungary and Poland, because these three countries account for 84 % of the ten EU accession countries GDP and they have the most developed bond markets of this country group. The mean bond market spread vis-à-vis EMU over the period 2001: :09 has been only 13 basis points (0,13 %) in the Czech Republic, although it widened to 91 basis points (bp) by end of September The mean (end of sample period) spread for Poland has been 224 (285) bp, the Hungarian spread 288 (447) bp (see Figure 1). The left part of Table 2 presents the regression estimation results. The inflation differences vis-à-vis EMU are statistically significant in each country (see Figure 2). For the Czech Republic with its relatively credible anti-inflation record, the coefficient is 0,09, for the formerly higher-inflation countries Poland and Hungary about 0,25. This is the only common feature in the three regressions, apart from the fact, that own lags of the bond market spread have explanatory power in each of the three countries. Exchange rate changes do not matter in the Czech Republic, because of a relatively stable exchange rate development. On the contrary, in Hungary and Poland a depreciation of the home currency vis-à-vis the Euro widens the spread.

8 8 The emerging market bond index spread isn t significant for the CEE countries. At least since the December 2002 announcement of the ten EU accession countries, they are no longer regarded as emerging markets from a global investor s point of view. So they are in a relatively comfortable position, that in the absence of financial crises, the national economic fundamentals - apart from EMU trends - have reached dominance. A transmission channel from short-term to long-term interest rates seems to exist only in the Czech Republic, where 3-month interest rate changes are a main determinant of the bond market spread. The regression coefficient of 0,64 has to be seen in combination with a coefficient of 0,12 for the influence of the money market spread between the Czech Republic and EMU. A restrictive monetary policy of the Czech central bank, mirrored in a rising money market rate (and ceteris paribus a lowering of the money market spread towards EMU), raises the Czech bond market spread. This is a first indicator that markets regard Czech monetary policy to be credible. In Hungary, this link is completely missing. In Poland, the money market spread vis-à-vis EMU is also significant (coefficient of 0,21), but this seems not to be home-driven, but influenced by the ECB s monetary policy, because the change of the Polish money market rate is not significant. There is another remarkable result for the Czech Republic, underlining the given interpretation. When we are trying to explain changes (first differences) of the Czech long-term bond yield (instead of the bond market spread vis-à-vis EMU), the following results show up: A remarkable part (adjusted R 2 of 0,65) can be explained with the help of only four variables (see the right part of Table 2). In addition to the own lags of Czech bond yield changes a period before, changes of the EMU bond yield as well as changes of money market rates in EMU as well as in the Czech Republic are significant. This means, that despite the failure of the cointegration test to indicate a long-run stable relationship between EMU and Czech bond yields, the interest rate ties between the two are very tight. So, of the three big CEE countries the Czech Republic seems to have advanced the furthest on the way towards EMU membership. 4 Convergence plays and bond market speculation Is there a fair balance between risk and return? 4.1 The historical perspective: Italy and Spain in the 1990s We now change the perspective of looking at bond markets of new EU member countries and take an investor s point of view, by asking if the risk premia embedded in long-term government bond yields of the CEE countries are adequate. Their returns over at least some of the past years seem to be extraordinarily high. To judge if this is really true calls for an adequate benchmark. There is an obviously natural benchmark for this, namely the experiences of Italy and Spain during the couple of years before the introduction of the Euro on January 1,

9 Interest rates and inflation rates in these two countries have been very high compared with core Euro countries (Germany, Austria, France and the Benelux). The exchange rates of the Italian Lira and Spanish Peseta vis-à-vis the German Mark were all but stable during the two ERM crises 1992/93, but also in the years thereafter. Nevertheless, a remarkable convergence rally took place starting in 1995/96. While nowadays the Czech Republic may be compared with France in 1995, Poland and Hungary are in a similar position like Spain and Italy a decade ago. Which lessons can be learned from a historical perspective? We will proceed in several steps, to see what speaks in favour and what speaks against a repetition of these successful convergence stories. Because bond markets in most CEE countries are far less developed than in industrial countries, we will concentrate again on the big three new EU members. Nevertheless, some summary statistics are presented for all new member countries with government bond markets. First of all, a bond market performance index needs to be calculated for each country, comparable to the German REX. Because of data restrictions we take the government bond yield series for each country and calculate a performance index for an idealised 10-year government bond with a fixed coupon, varying from 6 % to 8 % (depending on the initial interest rate level in 2001), to make the indices comparable. But for the ultimate performance, the chosen coupon doesn t really matter. Bond yield changes feed through into varying bond prices, while the time to maturity is always set at 10 years. In a second step, we calculate the total return of a Euroland investor buying CEE government bonds. This total return per annum is the sum of three components: the current bond yield, the capital gain of changes in the bond market index of the country under analysis, and finally the currency gain or loss resulting from exchange rate variations of the local currency in which the bond is denominated (vis-à-vis the Euro). Because bond yield time series from the ECB database are starting in January 2001, we are only able to calculate a bond market index starting in January Therefore the assumption of a fixed coupon for each country index isn t too restrictive. Finally, we will compare total bond market returns in different countries with the help of summary statistics for the time span 2002: :09. The mean and standard deviation are compared with EMU investments in Euro government bonds (without exchange rate risk). Then the co-variances between total returns in EU accession countries are regarded, and following the Capital Asset Pricing Model (CAPM) for shares, a beta factor for each country s government bonds is calculated. We start with the historical perspective of Spain and Italy. The calculation technique for total bond returns is the same as described above, apart from the fact that we calculate exchange rate changes of Peseta and Lira against the German Mark and not against the Euro. The con-

10 10 vergence rally in the forefield of Euro introduction started in This can be seen from the steep rise in the bond market indices of Italian and Spanish government bonds with 10 years to maturity. Starting from a low point in January 1995, both indices have risen parallel by 60 to 70 % in four years. This smooth time path of the bond market indices was accompanied by dramatic exchange rate fluctuations in the years 1995/96, more exaggerated in Italy than in Spain. During the four year convergence period, the maximum total return on an annual basis was 37 % for Spain and 43 % for Italy. In this light, the by times enormous returns with Polish or Hungarian bonds seem to be quiet normal developments against a background of rapid convergence of the economic fundamentals. Figure 3 shows the total returns for Italy and Spain over the period Large swings in total performance were far from being exceptions, they were the rule in these bond markets (at least from the point of view of a German investor). The first three columns of Table 3 presents a decomposition of the average total bond market returns in Spain and Italy over the period The mean return is far less dramatic than the extremes presented above. The total mean return for Spain is 16 % per annum, for Italy it s 15,5 %, but the Italian standard deviation is nearly 40 % higher than the Spanish. This is the result of a very high exchange rate volatility of the Lira vis-à-vis the Mark (nearly three times the volatility of the Peseta), even if the mean annual change of this exchange rate is very low (0,65 %). The total return in both countries is quiet even split between the current bond yield (nearly the same for both) and the sum of bond price and exchange rate changes. 4.2 Total bond market returns in new EU member countries We now turn to the main focus of our paper, the bond markets of the CEE countries, which have joined the EU together with Cyprus and Malta on May 1, As we have already seen, there were considerable differences in recent years concerning the development of longterm government bond yields. For getting a first impression, we do not want to regard the volatile time series of the 9 different yields (Estonia missing), but we construct a GDP weighted index called the CEE-9 bond yield index. 3 This index can be compared with the 10- year EMU government bond yield. By this, we get a first glance on the status quo of the overall interest rate convergence process. By mid-2003 the spread between our CEE-9 index and EMU reached its historical low. Since then, government bonds of EMU member states outperformed those of the CEE-9. The spread widened again, mainly driven by the bond yields in Poland and Hungary. But despite the different long-term interest rate trends in the Czech Republic (data available since 2001:01) on the one hand and those in Poland and Hungary on the other, our calculations of total bond market returns show a relatively parallel development (see Figure 4). 3 The underlying calculations are available from the author upon request.

11 11 This is also confirmed by inspecting pairwise correlations of the total bond market returns. With the exception of Slovakia (correlation coefficient 0,78), the total return correlation with that of EMU is relatively low (a coefficient of 0,30 for the CEE-9 index). For Latvia, Lithuania and Malta it is even negative. On the other hand, there is a strong correlation within the block of the big three CEE countries (CZE and POL 0,94, CZE and HUN 0,82; HUN and POL 0,89). But as was seen for Italy and Spain, it is quiet interesting to have a look at the decomposition of the total return into its three components and the risk-return trade-off (mean and standard deviation). The bigger right part of Table 3 shows that the mean total return (averaged for the CEE-9) is 9,5 % p.a. over the period 2002:1 2004:09, compared with 6,7 % for EMU. The standard deviation is 12,8 for the CEE-9 and only 4,0 for EMU. This is a first indicator for an overall quiet fair trade-off between higher risk and higher return in CEE countries. But the countryspecific statistics vary considerably. The highest return could be earned in Lithuania with a mean of 16,3 %, and this came at the lowest standard deviation of 8,4. In Latvia on the contrary, the mean return was just 6,2 % (0,5 % below EMU levels) at a standard deviation of 10,0. The other top performer (mean of 16,3 %) was Slovakia, the only country with a cointegrated bond yield vis-à-vis EMU. The returns of the Czech Republic, Hungary and Poland were lower, their standard deviations higher than those in Slovakia. The return decomposition presents EMU as a benchmark. Over this episode of low and falling interest rates, 2/3 of the total return came from the bond yield of 4,46 % on average, the remaining 1/3 resulted from rising bond prices. In the CEE-9, rising bond prices (on average 7,2 % p.a.) exceeded the current bond yield (6,2 %), but were partly compensated by an average exchange rate devaluation of 4,0 % against the Euro. A further hint for our question, which countries have made the biggest progress on their way to EMU membership over the last few years, is presented by the return components of individual countries. The Czech Republic, Slovakia and Lithuania show the common feature, that all three yield components are positive. On the other hand, the two countries with the now highest bond market spreads vis-à-vis EMU have one negative component each: For Hungary it s a slightly falling bond price, demonstrating that the real convergence of economic fundamentals has come to a standstill in the recent past. For Poland it s the problem of a freely floating exchange rate with a yearly average devaluation of 9 % against the Euro. The same can be said for Latvia (average devaluation of about 6 %), but not because of free floating, but as a consequence of a wrong currency board regime with the SDR (special drawing right) instead of the Euro, which was changed as late as January 1, 2005.

12 12 Our final calculation of beta factors is only indicative, because the data set is too narrow to present a full-fledged model of risk and return in CEE government bond markets. But a comparison with the stock market and therefore some CAPM calculations may seem useful. From the literature we are aware of the equity premium puzzle, that value stocks show higher returns with lower risk than growth stocks. Why not comparing e.g. government bonds of the Czech Republic with a value investment and those of Poland with a growth investment? According to asset pricing theory, not the total risk is compensated, but only the nondiversifiable risk in a portfolio. For individual assets, this is demonstrated by the beta factor, measuring the covariance risk of an individual asset in relation to the variance of the market portfolio. For simplicity we take the EMU Euro government bond market to be the market portfolio (in reality it s only about 95 % of EMU-12 plus CEE-9). 4 In line with CAPM theory, Slovakia shows the highest return and by far the highest beta of 1,86. But Lithuania shows exactly the same return and a negative beta of 0,59. On the other hand Latvia, the only country with a lower return than EMU, has nearly the same negative beta of 0,58 like Lithuania. So for Latvia as well as for Slovakia, the risk-return trade-off seems to go conform to theory. But for some other countries (e.g. Lithuania, but to a lesser extent as well the Czech Republic and Hungary) the bond market risk is not correctly priced by international investors. Explanations may be manifold, e.g. it s not only the Euroland investor we regard here who matters (because of a different value of the exchange rate component for e.g. US or Eastern European investors). But we sympathise with an alternative explanation: The convergence players may be right on average in what they expect to happen in the market place. But times and again they are totally wrong and drive bond prices of CEE countries too far away from fundamentally justified levels. This seems to happen, because in phases of high market volatility it is too complicated to forecast the future path of the three different return components. The interplay of monetary policy, bond yields, risk premia, bond price changes and exchange rate devaluations or revaluations is by now not fully understood, especially concerning relatively young government bond markets. The result resembles an overshooting, normally only seen in the foreign exchange markets, rarely in bond markets. What is the policy recommendation following from these reflections? The new member countries on their way towards EMU need a credible and steady monetary policy, a sustainable exchange rate regime with low volatility and good macroeconomic policies in the fiscal and wage policy field. Only a good fundamental foundation of bond markets yields will make it easier to reach interest rate convergence with EMU on a reliable and enduring basis. For this purpose, criteria are needed. 4 The underlying calculations are available from the author upon request.

13 13 5 Will the CEE countries be ready for EMU in the near future? 5.1 Interest rate criteria for potential EMU enlargement countries We have adopted a bond market view on the EMU convergence process of the ten new EU member states. So far, we have investigated co-movements of short-term and long-term interest rates between these countries and vis-à-vis EMU, searching for explanatory variables of bond market spreads and total bond market returns. Common trends and differences between groups of CEE countries have been traced out. The results were relative statements against a certain benchmark, be it a time trend, the level of EMU interest rates or the development in other countries of the same group. Now we are testing the fulfilment of absolute interest rate criteria as guidelines for the further convergence process. These criteria include bond yields as well as short-term interest rates and therefore aspects of adequate monetary policy. The criteria chosen are thought to be relatively uncontroversial, no matter if one takes a more Keynesian or a more neo-classical point of view. The following criteria are applied: Because of the nature of a convergence process, nominal bond yields of future EMU candidates cannot be lower than those in the Euro area. Exceptions are only possible for very short periods of time and with a real or monetary justification, e.g. a deep recession or a deflation. Long-term real interest rates should be positive even ex-post, and not only expectedly positive ex-ante. If convergence also means a catch-up process of income levels, a markedly higher GDP growth rate of accession countries as compared with the Euro area calls for a long-term real interest rate which is not lower than the real long-term interest rate in EMU. A higher return to real capital investment in accession countries may necessitate a higher real interest rate than that in EMU, if capital is not perfectly mobile, i.e. if there are capital controls, segmented capital markets or an imperfect substitutability between home and foreign investments. As seen in section 4.2, the total return of bond market investments in CEE countries (including exchange rate gains or losses) should exceed the total return on government bonds of EMU countries, as far as the risk is expected to be higher (existence of a risk premium). Higher bond yields are expected to compensate for potential devaluations. A credible conduct of monetary policy with the aims of disinflation (consumer price inflation in nearly all accession countries is by now higher than in EMU) and exchange rate stability requires money market rates, which are not lower than those of EMU. This implies that short-term real interest rates should be positive too. A last criterion looks at the term structure of interest rates. Economic theory tells us, that in normal times long-term interest rates will be higher than short-term interest rates. The explanations for this differ between schools of thought. In the case of CEE countries we

14 14 assume, that a steep interest rate structure (a positive spread between the 10-year bond yield and 3-month money market rate) signals a credible and time-consistent path of monetary policy. Whereas an inverse interest rate structure signals severe problems of monetary policy meeting the goals of disinflation and stabilisation of the exchange rate (according to the chosen national exchange rate regime). There might be further possible criteria, but we are searching for at least some criteria, which are easy to verify. Estimations of fundamentally justified or equilibrium interest rates vary considerably. A paper by LIPSCHITZ, LANE and MOURMOURAS (2004) presents two alternative concepts. On the one hand, uncovered interest parity requires arbitrage to move real long-term interest rates in CEE countries towards the real rate in EMU minus the expected real appreciation of their exchange rates against the Euro. Following this strand of argumentation, the CEE bond yields could be lower than those in EMU. On the other hand, regarding the limited amount of capital flows from EMU into CEE countries, an equilibrium real interest rate which equals the estimated marginal product of capital in accession countries would require far higher bond yields in those countries (probably double-digit ones). Defining equilibrium exchange rates for CEE countries isn t an easier task. 5 Table 4 shows results from testing of our battery of criteria for those 9 EU accession countries, in which national government bond markets exist (all with the exception of Estonia). In the second and third column the bond market spread of each country vis-à-vis EMU is shown as the mean value in the sample period (2002: :09), as well as the end-of-period spread. The last column reproduces the results from the total bond market return analysis in section 4.2. With the exception of the Czech Republic, all countries had higher long-term and short-term nominal interest rates than EMU. The real long-term bond yields have been positive ex post in most countries, with the exception of two smaller countries and Slovakia. The real money market rates are positive ex-post only in a minority of countries, namely those that have the highest bond market spreads, and in the Czech Republic with some exceptions. This is an interesting finding, if one takes the evidence in combination with the second indicator also mirroring the conduct of monetary policy: the term structure of interest rates. Hungary as well as Poland, and to a lesser extent Slovenia (in the first part of the sample), show an inverse term structure with the highest bond yields of the CEE countries and even higher money market rates. Evidence for the two real long-term interest rate criteria is mixed. There are only two CEE countries (in addition to Cyprus and Malta), where the real ex-post bond yields exceed that of EMU, and yields are higher than the national GDP growth rate. These two countries, the Czech Republic and Poland, are the diametrical cases concerning the degree of interest rate convergence with EMU. This indicates that bond yields are fairly ade- 5 See KIM and KORHONEN (2002), MAESO-FERNANDEZ et al. (2004).

15 15 quate for both countries, but that there are diverging fundamental factors, which determine the difference of their interest rate levels. Following the criteria in Table 4, the main difference between the Czech Republic and Poland is the degree of credibility of monetary policy (as seen by the term structure of interest rates). The result is a mean difference of more than 200 basis points in the bond market spread vis-à-vis EMU. An explanation calls for further aspects of the macroeconomic policy mix in these countries, especially an evaluation of exchange rate regimes Possible explanations for different degrees of interest rate convergence What are the driving forces behind interest rate convergence in CEE countries towards EMU levels, and why do we see a clear difference between the Czech Republic on the one hand, having achieved nearly full convergence, and Poland or Hungary on the other hand, still showing bond market spreads of 200 and 350 basis points at the end of 2005? These big three accession countries have different monetary policy regimes and different exchange rate arrangements. According to ORLOWSKI (2001, 2002), the Czech Republic follows a strict inflation targeting regime, as well as Poland, while Hungary operates a more flexible inflation targeting regime, which additionally aims at stabilising the Forint-Euro exchange rate. These monetary policies are combined with an implicit target zone (exchange rate band) of +/- 15 % (without ERM II membership) in Hungary, free floating of the Polish Zloty and a managed floating regime for the Czech Koruna. These are the official announcements, but how successful have they been regarding the objective of disinflation, exchange rate stabilisation and interest rate convergence towards EMU (three of the Maastricht criteria)? According to OR- LOWSKI (2002), monetary convergence can be split up into three parts: reduction of the inflation risk premium, the default risk premium and the exchange rate risk premium. All three risk premia are determinants of the bond yield. The Czech Republic is by far the top performer concerning interest rate convergence vis-à-vis EMU. It was the first of the big three introducing an inflation targeting framework in January 1998 (Poland January 1999, Hungary June 2001). The reward is a low bond market spread, that equals the inflation differential between the Czech Republic and EMU. Over the past few years there was a parallel development between the Czech spread and Koruna-Euro exchange rates (see Figure 5). Steady revaluations went hand in hand with a diminishing spread, from mid-2003 until mid-2004 we saw a moderate devaluation and a moderately widening spread. The negative spread (lower Czech bond yields than in EMU) during some month of 2002/03 was justified by a negative inflation differential of 2 percentage points because of a mild deflation in the Czech Republic. In 2004 inflation surpassed 2 % without a monetary tightening, so the bond market spread widened a bit. There is no hint for default or 6 See DE GRAUWE and SCHNABL (2004), SZAPARY (2001), HOCHREITER and WAGNER (2002).

16 16 exchange rate risk premia any more. Therefore, the future convergence path promises to be very smooth. The situation in Hungary is quiet different. The bond market spread reached 450 basis points in September But this development seems to be fully justified, because the transmission channels are nearly the same as in the Czech Republic. From mid-2002 until the end of 2004, the Hungarian spread nearly exactly coincided with the inflation differential towards EMU, so no additional risk premium could be identified. This has changed in 2005, with the reemergence of inflation risk premia. There is a parallel development of the bond market spread with the Forint-Euro exchange rate too. Of course, what we have seen was a devaluation of the Forint starting in the winter of 2002/03, with the consequence of a restrictive monetary policy. The devaluation together with accelerating inflation called for higher short-term interest rates. It seems as if this monetary policy reaction came too late, and then was very rigid with money market rates rising by nearly 8 percentage points. The consequence was an extremely inverse term structure of interest rates with up to 13 % at the short end and a rise from 6 % to 8 % at the long end. One point has to be noted in favour of the Hungarian policy reaction: the exchange rate volatility has been the lowest of the big three CEE countries. Looking at Poland, two points have to be made, showing that the situation is totally different from that in the two countries before. There are still considerable risk premia, i.e. the bond market spread is 200 to 300 basis points higher than the inflation differential vis-à-vis EMU and there has been a diverging trend between spread and exchange rate. From 2001 to 2003, the bond market spread was reduced from 650 to less than 150 basis points, while the Zloty devalued against the Euro (see Figure 6). There was a remarkable success of the disinflation program. As the devaluation continued until spring 2004 and consequently higher inflation picked up again, the expansive monetary policy of the Polish central bank had to be abandoned and higher short-term interest rates became necessary. This stopped devaluation, but by the same token let the bond market spread rise again. It is interesting to note, that beginning in mid-2003 Poland saw a normal term structure of interest rates, which had been inverse before for many years. By the end of 2005, monetary policy seems to have gained credibility and a successful disinflation has brought the bond market spread down again. This graphical interpretation of the interest rate convergence process since 2001 is backed by the results of Granger causality tests and regression analysis. The picture for Hungary and Poland looks similar. Table 5 shows that in both countries the bond yield and the bond market spread Granger cause changes of the national exchange rate against the Euro. On the other hand, there is no interrelation between the bond yield and the spread, because as we have already seen in section 3, the main determinant of their spreads are inflation differentials vis-àvis EMU. If one assumes that the spread is influenced by monetary policy decisions, there is

17 17 by and large no dominant influence of national short-term interest rate changes on the bond market spread. For the Czech Republic, Granger causality is just the other way round. The exchange rate Granger causes the Czech bond yield and the bond market spread against EMU. Additionally, the bond yield determines the bond market spread, so national Czech fundamentals are mirrored in this spread and not only EMU influences. Of course, these results are tentative, because Granger causality mustn t mean economic causality. The regression results in Table 6 give some hints, which factors influence the conduct of national monetary policies. In the Czech Republic these are mainly changes in inflation. A higher inflation rate (changes on a month-by-month basis) leads to higher short-term interest rates. For Poland, the monthly changes of short-term interest rates (on average falling, so there is a negative constant term) were mainly influenced by short-term interest rate changes in EMU. So the Polish central bank oriented its monetary policy towards the ECB model, although on a higher level. Devaluations of the Zloty caused higher short-term interest rates. For Hungary, the exchange rate also mattered, even stronger than in Poland (regression coefficient of -0,038 compared with -0,013 for Poland) because of the implicit exchange rate target in the flexible inflation targeting framework. In addition, it is not inflation that shows up as a second determinant of short-term interest rates in Hungary, but changes in the Hungarian bond yield. This indicates that monetary policy reactions to rising inflation came too late and that bond markets participants realised this danger and took action. By now, much has been said about monetary convergence, but a short somewhat broader look seems appropriate especially for Hungary, which has the highest bond market spread of all EU accession countries. The DEKABANK has constructed a useful indicator for measuring overall convergence of CEE countries towards EMU levels. 7 Their DCEI (DEKA Converging Europe Indicator) is a composite measure for monetary, fiscal, economic and institutional convergence of each individual country. There are clear trends of increasing convergence over the past few years, as well as shorter episodes of divergence in some of the countries. Figure 7 shows the Hungarian bond market spread vis-à-vis EMU ( ) and the DEKA Hungarian convergence indicator (which is defined in a range from 0 to 100, while 100 would mean full convergence with the EMU average). The overall convergence process in Hungary has come to a standstill since mid Being the most advanced CEE country some years ago, Hungary has been surpassed by the Czech Republic, Slovenia and Estonia. At the end of 2004, Slovenia was in lead as the first country that fulfils nearly all criteria of optimum currency area theory. 9 Even Poland and Slovakia reached higher scores in the summer of 2004, but have fallen again behind the Hungarian score thereafter. The considerable widen- 7 See HORNUNG (2004a,b,c). This indicator wasn t published any more in See CSAJBOK (2003). 9 See LAVRAC and ZUMER (2003).

18 18 ing of the Hungarian bond market spread from less than 200 to 450 basis points within 2 ½ years mirrored the fall of its convergence indicator from 79 to 70 points. So it is interesting to see, which single determinants of the overall DCEI for each individual country show weaknesses and how these pieces fit together as explanations for the reported bond market spreads. 5.3 Policy implications In the Czech Republic, there have been only minor weaknesses in the field of fiscal convergence. The government budget deficit surpasses the 3 % of GDP Maastricht criterion since 2001, with a record high of 12,5 %, coming down to levels slightly above 3 % in 2004/05. But this is the only drawback, which demonstrates that higher budget deficits are tolerable for at least a couple of years of convergence, if all the other indicators show a good performance. Poland s budget deficit also lies above the 3 % reference value, but the realised (forecasted) values about 3,5 to 4,5 % over the period are less problematic. Poland suffers from a double weakness. The monetary convergence is rather weak because of the devaluation of the Zloty in consideration of a freely floating exchange rate. But the most serious drawback is the economic performance. The GDP per capita is very low compared with most other CEE countries which have accessed the EU, and a constant unemployment rate of around 20 % hinders a further catching-up. The disinflation process initiated by the Polish central bank (with the help of strict inflation targeting initiated in 1999) brought inflation down to EMU levels of about 2 % during the year The complementary introduction of a managed exchange rate regime for stabilising the Zloty will eventually foster capital investment and GDP growth in Poland with the perspective of creating new jobs. The Hungarian list of weaknesses is again a different one. The overall economic performance (as measured by high GDP per capita, a low share of the agricultural sector, a low unemployment rate and a high trade share with the EU) is better than that of Poland or even the Czech Republic. Government budget deficits of 5-6 % of GDP show a fiscal problem, but as we have seen for the Czech Republic, this alone is no reason for a high bond market spread vis-àvis EMU. The main problem of Hungary, which shows up in bond yields, is the weak monetary convergence itself. Consumer price inflation in 2004 (2005) was about 7 % (3,5 %), whereas in the Czech Republic it was only 2,6 % (1,6 %). These facts demonstrate, that it is predominantly the monetary convergence that matters for the short-term overall assessment of the markets, if a country will be ready to join EMU in due time. From a longer-term perspective, it s of course the economic convergence as well; whereas fiscal and institutional factors show a wide tolerance band. In other words, it s the macroeconomic policy mix which has to be consistent and adequate for the situation the country is in.

19 19 For the Czech Republic, the combination of strict inflation targeting and a managed exchange rate is adequate. Inflation is quiet low and the Koruna exchange rate relatively stable. The only matter of concern was fiscal policy, but as soon as deficits fall steadily below 3 % of GDP, full convergence with EMU will be reached. For Poland the main problem is its weak economic performance. The convergence process towards the EMU average will take some years longer than in the Czech Republic. Exchange rate risk premia in bond yields seem still to be present. For a faster GDP growth, lower interest rates would be helpful. For this reason, Poland should move away from free floating to a managed floating or implicit target zone regime, now that inflation seems to be under control. 10 Finally for Hungary, the monetary convergence has to speed up again and reach levels (as measured by the DCEI) already seen in 2001/02. The monetary policy mix of flexible inflation targeting and managing the Forint exchange rate within an implicit target zone seems reasonable. What has been missing in the recent past, is an adequate conduct of monetary policy. Of course, monetary policy is at least as much an art as it is a science. There doesn t exist much experience to count on, when trying to find the optimal dosage and timing of monetary easing and restriction in transition countries. Furthermore, the inflation rate has to be brought down to levels reached in the Czech Republic and Poland. This necessitates a cooperative macroeconomic policy mix, which means more fiscal consolidation, and a moderate wage policy to break the wage-price nexus Conclusion The process of interest rate convergence in CEE countries towards EMU levels has shown big progress in recent years, but it has also seen a number of setbacks. The Czech Republic and some of the smaller countries are on the best way to an introduction of the Euro as soon as possible (maybe 2008), but Hungary and Poland are struggling with a variety of problems. These problems are mirrored in government bond yield spreads vis-à-vis EMU. At the gateway to EMU membership, there stand the Maastricht criteria. As it had been uncontroversial in 2002/03, that all CEE countries will meet the interest rate criterion, it seems by now out of reach at least for Hungary. The relevant long-term interest rate is a market-determined one. So it is of considerable importance, what do markets think and what happens if they change their mind. 12 All forecasting and foretelling has to be regarded with a bit of scepticism, because we are looking many years into the future (2010 or further). But maybe the historical episode of Italy, Spain (and France) in the 1990s tells us a good story how the convergence process of the CEE 10 See DE GRAUWE and SCHNABL (2003, 2004). 11 According to ECB statistics from the Monthly Bulletin (Table 9.1 in the Data Appendix), Hungarian unit labour costs grew by 8,9 % in 2002, 7,2 % in 2003, and 4,2 % in See CSAJBOK (2003), MÜLLER (2004).

20 20 countries will proceed. The Czech Republic seems to be unproblematic. From today s point of view, it has reached already the status of an informal member of the Eurozone, as far as the bond market is concerned. Until the introduction of the Euro, the Czech spread will possibly fluctuate in a narrow band of +100 to 50 basis points. This was the case for France during the period Our forecast for Hungary and Poland (dated from December 2004) is shown in Figure 8. For the sake of simplicity, we do not make any difference between the two, because the lessons from Italy and Spain have shown that despite all economic differences their bond market indices moved in parallel from 1992 to First take a look at the years from 2001 to The interim low of bond market spreads was seen at the end of 2002, when the EU commission announced the ten countries to join the EU by May 1, Thereafter, the monetary, economic and fiscal conditions in Hungary and Poland worsened in 2003/04. Because they undertook counteracting measures of monetary and exchange rate policy, the spread came down again in 2005 (as was expected). Over the period 2006/07 this convergence will possibly speed up. We expect the introduction of the Euro at the beginning of There has to be a time span of at least two years of membership in ERM II without devaluation. So, not later than January 2008 both countries have to change their exchange rate regimes towards a more proactive stabilisation of the Forint and Zloty vis-à-vis the Euro. Like during the run-up to EMU 1997/98, we expect only minor bond market spreads of a few basis points during 2008/09. So the bulk of convergence has to come in the two years 2006/07. If markets will expect an earlier EMU entry date, maybe January 2008 or 2009, this interest rate convergence process has to accelerate, but at the time this scenario looks overly optimistic. Altogether, it seems that EU accession marked only the beginning of a convergence process for the CEE countries, whose value-added is potentially present in Hungary and Poland, but still needs to undergo its baptism of fire. A monetary strategy of inflation targeting together with managed exchange rates, as well as reasonable fiscal and wage policies are central parts of a cooperative policy mix, which will bring them back on track and let them overtake the other accession countries that have progressed by now a step further.