NÁRODNÁ BANKA SLOVENSKA

7 October 2008

Riga1

Slovak Road to the Euro Slovak Road to the Euro AreaArea

Ivan ŠramkoGovernor

22

Presentation OutlinePresentation Outline

Necessary policy adjustments and reforms

Road to the fulfillment of Maastrichtcriteria

Challenges to benefit from €

3

Beginning was not EasyBeginning was not EasyLow level of real and nominal convergence Result of unstable development before 1998 and subsequent implementation of necessary stabilizing measures

In 2002 Slovakia did not meet Maastricht criteriaPositive trend was partially visible. The SKK exchange rate has stabilized, inflation and average interest rate declined. Public finance consolidation has started, but general government deficit was still very high

Economic performance and relative price level were below 50% of EU averageHowever, even in that time EU represented the most important trade partner (60% of export) and economic growth differential with EU was increasing

44

Consistent Strategy and PlansConsistent Strategy and PlansEuro adoption strategy in 2003 – set target for euro area entry in 2008 or 2009Specification of euro adoption strategy in 2004 – €target set in 2009National euro changeover plan approved in 2005New government in 2006 confirmed plans to adopt euro in 2009Updated Changeover plan in 2007

Euro adoption had broad political support in Slovakia

55

Monetary Policy AdjustmentsMonetary Policy Adjustments2004 decision: from implicit towards explicit inflation targeting

Inflation targeting within ERM IIWhat were/are the puzzles?

Assessment of exchange rate development with respect to Maastricht criteria fulfilment: close to parity – what does it exactly mean?How to cope with appreciation trend, when to intervene, how to communicate exchange rate developments (in fact when to maintain silence) if it is necessary to consider exchange rate while deciding about interest rates?

66

Public Finance ReformPublic Finance ReformIntroduction of programme budgeting (3 years ahead)Creation of State Treasury and Agency for Debt and Liquidity ManagementFiscal decentralization – delegation ofresponsibilities and their financing to local government

93.5% of PIT revenues addressed to local governmentsdisadvantage: extra PIT revenues cannot be used for additional fiscal consolidation

77

Tax system reform– flat tax, very simple systemPension reform – 2nd and 3rd capital pillarsPrice deregulations – major adjustment of relative prices Social, healthcare and education system adjustments

Main Structural ReformsMain Structural Reforms

88

Other Structural ReformsOther Structural ReformsRestructuring and privatization of banking sector (no bad loans now)Privatization of some state-owned enterprises (wages not higher than productivity)

Abolishment of cross subsidies (pressure on inflation until 2005, now all regulated prices are at cost recovery levels, and energy prices are at or above EU average)

Labour market reforms (towards its greater flexibility, reforms are oriented to activelabour market policy)

99

Road to the Road to the FFulfillmentulfillment

1) Previous year figure known at the time of assessmentCR – Convergence reports of ECB and EC

Source: NBS, EC, ECB

EU entry CR CR CRMay 2004 Oct 2004 Dec 2005 Dec 2006 Dec 2007 May 2008

3.5 3.7 3.3 3.1 3.7 2.242.8 42.6 43.6 34.5 30.4 29.4NO NO NO NO NO YES8.9 8.4 2.9 4.3 2 2.2

state: NO NO NO NO YES YES5.1 5.1 3.6 4.3 4.5 4.5

state: YES YES YES YES YES YES

out of ERM IIout of

ERM IImember

of ERM IImember

of ERM IImember

of ERM IImember

of ERM IIstate: NO NO NO NO YES YES

Inflation criterion (HICP, %)

Interest rate criterion (% )

Exchange rate stability

Fiscal criterion1)

(% GDP)

public deficitpublic debtstate of fulfillment:

1010

„The European Union's finance ministers adopted the legal acts necessary for Slovakia to adopt the euro on 1 January 2009. Based on a Commission proposal, they also decided that the Slovak koruna will be replaced by the euro at the rate of 30.1260 SKK to the euro.“

Slovakia Slovakia –– 16th Country of the Euro Area16th Country of the Euro Area„(8 July 2008) Economic and Financial Affairs Council(ECOFIN) adopted final and formal decision allowing Slovakia to adopt the euro as from 1 January 2009.“

(Source: press releases of EC and NBS, 8 July 2008)

1€ = 30.1260 Sk

1111

CriterionMarch 2008

Reference value

State of Fulfillment

Inflation (average, %) 2.2 3.2Interest rates (%) 4.5 6.5Public debt (% GDP) 29.4* 60.0Public deficit (% GDP) 2.2* 3.0ER stability ERM II since Nov. 2005

* Year 2007

Maastricht Criteria were Met with Maastricht Criteria were Met with a Sufficient Margina Sufficient Margin

Source: Eurostat, European Commission, MF SR, NBS

1212

What are the Main Challenges Here?What are the Main Challenges Here?Impossible Trinity„Shooting Moving Target“Tailored for EU-15Balassa-Samuelson EffectExchange Rate Pass-ThroughEU-12 itself fails to meet the criteria in longer-run

1313

Impossible TrinityImpossible Trinity

Our solution: „Inflation targeting in the conditions of the ERM II“

Priority 1: InflationPriority 2: Exchange rate stability

Country with open capital account cannot control both exchange rate and inflation. => As short as possible participation in ERM II

1414

Shooting Moving TargetShooting Moving Target

BE

CZ

DK

DKFIN

FIN FIN

FR

FRNL

NL

LT

LX

MT

DEPL

AT

AT

ATSE

SE

SE

UK

UK

0

0.5

1

1.5

2

2.5

3

3.5

XII

.99

VII

.00

II.0

1

IX.0

1

IV.0

2

XI.0

2

VI.0

3

I.04

VII

I.04

III.0

5

X.0

5

V.0

6

XII

.06

VII

.07

II.0

8

%

Source: Eurostat

Reference value

Reference valueSlovak EU entry

Lithuania – country with the lowest inflation

Inflation criterion is not known in advance. It often depends on development in countries out of euro area.

1515

The Criteria were The Criteria were DDefined for EUefined for EU--1515Criteria were tailored for developed and relatively homogenous EU 15 countries. Convergence process makes them harder for the New Member States(NMS).

GDP per capita in PPS (EU-27=100)

Real GDP growth (y-o-y)

HICP inflation (y-o-y)

EU-15 (2007) 125.7% 3.1% 2.2%NMS-12 (2007) 66.3% 6.5% 4.8%

Source: Eurostat

* Simple averages

1616

BalassaBalassa--Samuelson EffectSamuelson Effect⇒ Higher price increases in the non-tradable sector lead

to higher headline inflationEstimates differ significantly. Different authors –different methods – different resultsWe expect only 0.7 p.p. contribution to headline inflation in medium term, due to several mitigating factors:

Wage increase in the tradable sector is lower that labour productivity growthWage increase in the non-tradable sector lags behind wage increase in the tradable sectorWe have observed slight productivity increase in the non-tradable sector based on foreign direct investment inflow

1717

Exchange Exchange RRate versus ate versus IInflationnflationExchange Rate has only limited impact

Source: NBS, ŠÚ SR

-13.0-11.0

-9.0-7.0-5.0-3.0-1.01.03.05.0

III.0

2

VII

.02

XI.0

2

III.0

3

VII

.03

XI.0

3

III.0

4

VII

.04

XI.0

4

III.0

5

VII

.05

XI.0

5

III.0

6

VII

.06

XI.0

6

III.0

7

VII

.07

XI.0

7

III.0

8

%

YoY (SKK/EUR) YoY industrial goods excl energy YoY tradable goods excl fuel

1818

Sustainability of Inflation CriterionSustainability of Inflation CriterionEuro area countries fail to meet price stability criterion in long-run. Only Austria and Germany retained inflation below reference value after euro changeover.

Source: Eurostat

2

2.5

3

3.5

4

4.5

5

5.5

XII.99 XII.00 XII.01 XII.02 XII.03 XII.04 XII.05 XII.06 XII.07

%

Ref. value

ATBE

FIFR

DEEL

IEIT

LUNL

PTSI

ES

1919

Sustainability of Fiscal CriterionSustainability of Fiscal CriterionEuro area countries fail to meet also fiscal criterion in long-run. Only Finland, Ireland and Luxemburg retained both deficit and debt below reference value after euro changeover.

Source: Eurostat

-8

-6

-4

-2

0

2

4

6

8

AT BE FI FR DE EL IE IT LU NL PT ES

% G

DP

1999

2000

2001

2002

2003

2004

2005

2006

2007

Ref. value

General Government Budget Balance

2020

0

20

40

60

80

100

120

AT BE FI FR DE EL IE IT LU NL PT ES

% G

DP

1999

2001

2003

2005

2007

Referencevalue

Sustainability of Fiscal CriterionSustainability of Fiscal CriterionEuro area countries are in average more indebted than NMS. Majority of them recorded debt higher than 60% of GDP.

Source: Eurostat

General Government Debt

2121

Challenges to Benefit from Challenges to Benefit from €€

2222

Impact of Changeover on Inflation Impact of Changeover on Inflation in Slovakiain Slovakia

In our predictions we expect an impact of 0.3 p.p., the outcome may be different, if these risks materialise:

Increase of certain price before euro changeover Misuse of external cost effects (food and energy price increases) for higher than justified price increaseLow inflation expectations and consumer protection system may reduce the overall impact

2323

Will Euro Increase InflationWill Euro Increase Inflation??

Probably yesSlovakia catches up with the EU also in terms of price levels, after euro adoption inflation will constitute the only channel. The catching up process will be gradual.

Nevertheless, income will increase faster than prices.

Inflation in eurozone

0%

1%

2%

3%

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

before euro introductionduring transition periodwith euro

Source: Eurostat

2424

Estimated Convergence PathEstimated Convergence Path

40

50

60

70

80

90

100

40 50 60 70 80 90 100

Comparative price level

GD

P p

er c

apita

in P

PS

Basic scenario(AWG)

Pesimisticscenario

Optimisticscenario

Actualdevelopment in SR

(EU-27=100)

(EU

-27=

100)

There is still space to converge (GDP per capita at 70% EU)Output convergence and price convergence are interrelated

» 18 years to converge (AWG growth assumptions)» 23 years to converge (10 year average growth)

» 6 years to converge (growth recorded in 2007)

Based on ECM : Δ(Pt) = 0.04 + 0.50Δ(Yt) – 0.12(Pt-1 – 39.65 – 0.49Yt-1) + εtSource: NBS

2525

Due to continuing process of convergence inflation rate in Slovakia is expected to be higher than in Euro area

How much higher?

Based on our baseline scenario the average annual inflation differential with EU is expected to be

1.2 p.p. 1

(This does not necessarily mean that the reference value for inflation will be exceeded)

Estimated Inflation DevelopmentEstimated Inflation Development

1 20 year average, annual inflation equals annual growth of relative price level

2626

• In the euro area the changeover effect was approximately 0.3%, but people felt that prices increased much moreFighting against price jumps:

competition in retailmandatory dual pricingrounding rulesvoluntary commitments of retailers and public pressure

communication will be essential

Perceived inflation in eurozone

-100

102030405060

I.98 I.99 I.00 I.01 I.02 I.03 I.04 I.050%

1%

2%

3%

4%

Perceived inflationHICP (right axis)

Source: Eurostat

ConsumerConsumer’’s Inflation Perceptions Inflation PerceptionSurge in perceived inflation - all Euro area countries phenomenon

2727

To preserve wage development based on productivityAvoid growth of Balassa-Samuelson EffectFaster movement towards balanced general government budget and use of automatic fiscal stabilisers Efficient use of increased capital inflowManage credit growth

Further ChallengesFurther Challenges

2828

Long-run goal: increase flexibility of the economyStructural policies, especially labour market flexibility

real (and nominal) wage flexibilitygeographical, sectoral and occupational mobility of labour sourcesflexible labour relations

Movement towards knowledge economyHigher support of human capital (education)Investments in research and development

Economic Policies to Support Economic Policies to Support Euro AdoptionEuro Adoption

Euro adoption benefits are not automatic, will be realized only if euro is supported by appropriate policies

2929

No One Strategy Fits AllNo One Strategy Fits AllBut we have learned:

Experience of NMS is more valid (convergence, big-bang approach, etc.)It is worth to listen (EU, IMF recommendations)Finish major structural reforms (Maastricht criteria sustainability)Sustained exchange rate appreciation is in line with exchange rate sustainability (if based on fundamentals)As short as possible ERM II membership (additional pressure)

3030

Thank Thank yyouou for for yyour our aattentionttention

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