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CRISIL Young Thought Leader 2011

SHOULD POLAND ADOPT THE EURO ?

Ramasubramanian SV
First Year, IFMR, Chennai

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Executive Summary The European Union is the union of the most important European Countries and in 2004, Poland which is one of the largest European countries joined European Union ( EU) and agreed for the Euro adoption by 2011. The EU accession helped Poland to show a significant development in diversified economic sectors. With the EU funding, Poland strengthened its economy base through its efficient policy mix and successfully became the only country to avoid recession during 2008 crisis. Poland with its rapid economic development is all set for its Euro adoption which can boost its economy. But, the recent debt problems prevailing in major EU nations like Greece, Italy and Portugal are dragging down the rest of the Europe, and the political will in northern Europe to continue to bail out these debt-ridden countries is rapidly failing. Moreover, Major EU members are now in the verge of quitting EU zone and going back to its old currency. These issues raised Poland a question on Euro adoption and Polands way to the Euro Zone entry now looks like a snail race on a formula one circuit. This paper addresses whether Poland should really enter the Euro zone at this point of time. First, the paper throws light on the current Polish economy. Second, it touches upon various costs and benefits that the Euro adoption can provide to the Polish economy. Third, a macroeconomic model is developed which uses the optimum currency area theory, to decide whether Poland should adopt Euro or not. Finally, the paper comes out with some real time scenarios and suggests that even though Euro Zone entry is good for Poland from the long term perspective, it will be better off for the Poland to wait for about couple of years for European Economy to stabilize before going for the Euro Adoption. 1. Polish Economy Current Scenario The Polish Economy is a well developed and a stable Economy with good contribution from service and production sector along with foreign trade. Extra ordinary transformation has taken place in Poland in recent days. During the last two decades, Polish exports have increased by twenty folds. Currently Poland has a modern economy competing with world markets by manufacturing innovative products. Poland is rich in natural resources like coal and fossil fuels which enabled it to reach new heights in energy sector. During the Economic crisis, Polish economy was the only one EU country that did not fall into recession showing 1.5% GDP growth. Poland offers farm investors attractive investment opportunities. Fourteen special economic zones are created to serve this purpose. These developments made Poland the best place for any Foreign Investors. 80% of direct foreign investment has been made by EU and US. 60% of investment covers services, production, banking, research and developments and IT. Poland uses its own currency Zloty with free capital mobility and exchange of Zloty to any other foreign currencies following independent monetary policy with inflation targeting. According to World Bank, Poland is a relatively large and closed economy with low ratio of export/import

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activities to its GDP. Poland has the Smallest Ratio of Foreign trade to GDP as in figure 2 and hence limited impact of exchange rate pass through. This limited reliance on foreign trade helped Poland to cushion the destabilization during economic crisis. By 2013, Poland would have received 130 billion US Dollars. Unlike the majority of central and eastern European countries, Poland sustains a stable balance of payment and banks have low foreign financial obligation.

Source: Eurostat

Source: The World Bank

2. Poland Joining Euro Zone - Requirements: The Euro Zone is an Economic and Monetary Union of seventeen European Union member states (Euro zone/EU17) that have adopted the Euro () as their common currency. In order to join EU zone, Poland must satisfy two main conditions Masstricht Treaty Criteria and Exchange Rate Mechanism II participation which was set up to ensure that exchange rate fluctuations between Euro and other EU currencies do not affect the economic stability within the single market.

3. Zloty To Euro Pros and Cons

Figure 3: Maastricht Treaty Criteria

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3.1 Pros Elimination of Transaction Cost: Transaction cost is any cost associated with exchanging currencies. Common currency like Euro eliminates this cost during trade of goods across countries. This will in turn improve the trade activities between Poland and other EU countries. Greater Price Transparency: One common currency creates a simple platform for price comparison making price differences more noticeable. So, if any product in Poland is found to be cheaper in terms of Euro, there will be more demand for that product resulting in trade increase. Elimination of Exchange Rate Risks: The Euro completely eliminates exchange rate risk between the EU members. Eliminating exchange rates between European countries eliminates the risks of unforeseen exchange rate revaluations or devaluation Decrease in Import Cost: Weaker the Zloty, more money should be paid by the poles for any imports and other foreign transactions. So bringing in Euro will decrease this import Cost as Euro is relatively stronger than Zloty. 3.2 Cons Monetary Policy Conundrum: Poland would have to transfer its monetary policy, which is being controlled by Nation Bank of Poland, to European Central Bank. This might lead to many complications in case of Asymmetric Economic Shocks wherein, countries with high unemployment rate would be better off with loose monetary policy (low interest rates) whereas countries like Poland which are still expected to see more growth in near future are better off with tighter monetary policy (high interest rates) to maintain lower level of inflation. Increase in Price: Weakness of Zloty, when compared to Euro, makes polish goods cheaper from the perspective of a foreign buyer and for other Euro countries which now uses Euro as its currency resulting in increased foreign investment in Poland. So, Poland taking up Euro will drive up these prices and reduce the developing opportunities. Unemployment: In a single market, competition increases and consequentially, business in Poland will come down owing to higher quality of business elsewhere in the EU. This will make many people lose their business. Another issue is the agricultural restructuring necessary for Poland to become compatible with the EUs Common Agricultural Policy. As, Agriculture Sector represents 26.9% of total employment in Poland, many people have to be addressed for this restructuring. Bank Regulations: Poland will be losing its good banking regulations which now prevent foreign banks taking capital from Polish subsidiaries in order to cover their losses somewhere else. So while other countries struggle with a lack of credit, Poland still has money to lend for homes and businesses. When Poland adopts Euro, it will be forced to follow the regulations laid

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by European Central Bank which is not that stringent with respect to foreign subsidiaries and credit transfer. 4. EURO or zloty: 4.1 GP-LP Model: Here, we will be evaluating the Potential Costs and Benefits through a two sector macroeconomic model called Gains to Poland (GP)-Loss to Poland (LP) Model. According to the theory of Optimal Currency Areas [1], fixed exchange rates are most appropriate for areas closely integrated through international trade and factor movements. We will refer all the above addressed benefits and costs with two aggregate variables viz. Monetary Efficiency Gain (MEG) and Economic Stability Loss (ESL) respectively. Monetary Efficiency Gain is directly proportional to the magnitude of Economic integration between Poland and EU17. And, more freely the factor movement between Poland and EU17, more will be the MEG. So, we can say that MEG will increase as the Economic integration between Poland and EU17 increases. Similarly, we can come up with a relationship between Polands Economic Stability Loss due to Euro Adoption and its Economic Integration with EU17. More the economic integration between Poland and EU17, the less will be its ESL. Because, when they are closely integrated, there will be more factor (Labor and Capital) movement which in turn offsets the loss created by Euro adoption.

Figure 4: GP-LP line) and Figure 4 shows Polands gains (GP Model losses (LP line) due to Euro Zone accession as a function of Polands Economic Integration with EU17. A linear approximation is applied to the above functions.

Poland should go for Euro adoption, if the degree of economic integration between Polish markets and those of the Euro zone is at least , the optimum level of economic integration. According to Figure 4, for the levels of economic integration below , the GP line is below the LP line which implies the loss that Poland would suffer from economic instability after joining

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exceeds the monetary efficiency gain, and the country would be better off without joining the Euro zone. When the degree of integration is higher than , the monetary efficiency gain measured by GP line is greater than the stability loss measured by LP line, and we can say fixed exchange rate of Zloty against the Euro result in a net gain for Poland. Thus, the intersection of GP and LP line determines the minimum integration level (here ) at which Poland will desire to peg its currency to the Euro. So, measuring this economic integration between Poland and EU17 can help us to say whether Poland should go for Euro or not. 4.1.1 Measuring Economic Integration: Economic Integration of Poland is measured by considering four major economic indicators viz. Trade integration, Labor Mobility, Financial Integration and Price of goods. We will compare these four indicators of Poland with the sample of four Economies Germany, Italy, France, and Spain. Our Sample selection is based on high GDP contribution to EU zone and their proximity to Poland. Trade Integration: Intra-EU Trade as a percentage of Total External Trade is plotted and the country with highest value has high trade integration. From chart 1, we can say that Poland has very high Trade integration when compared to other four countries.

Chart 1: Intra-EU Trade of Poland and our sample economies Source: Eurostat

Financial Integration: Here, the correlation between the interest rates of appropriate National bank and European Central Bank for the past 12 months is compared. The countries with the highest positive correlation with ECB as shown in chart 3 are graded from the top.

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Chart 2: ECBs and Other Countries Interest Rates Source: Eurostat

Chart 3: Countries Interest Rates Correlation with ECB Source: Eurostat

Price Differentials: Comparative price levels are expressed in the form of price level indices (PLIs). PLIs provide a comparison of countries price levels with respect to the European Union average price (100). The Country which has Lowest Price differential is given the highest grade. Chart 4 shows Poland is having the highest price differential.

Chart 4: Eurostat Source: Price Level Indices Chart 5: Other EU member state citizens as % of total population Source: Eurostat

Labor Mobility: The central elements of Economic Indicators of cross border Migration are cost of migration viz. Transport cost, income loss during migration, wages and individuals age. Chart 5 which compare other EU member state population as a percentage of total Population for all the five countries shows that the Poland has the least other EU members population.

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Figure 5: Recently Euro Adopted Countries with their joining Year and Scores. Source: Eurostat

In order to achieve the optimum level of integration, Polands Grade in each of the integration factor should be at least the optimum grade of that respective factor. The last three countries that joined EU zone and that showed a positive economic growth till now is taken. And, these countries are compared with the same four sample economies (Germany, Italy, Spain, France) and the average of grades scored by these countries in each of these factors as shown in figure 5 is considered as optimum grade of that particular indicator. If Polands Grade is at least the optimum Grade in each of the integration factors, Polands degree of economic integration is optimal and it can go for Euro adoption. Else, Poland should not.

Figure 6: Poland Grade Plot and Optimum Grade Plot in four Integration

From figure 6, we observe that in terms of price, labor and financial integration, Poland scores only one and two respectively as compared to the optimum of three. However, Poland is highly integrated in terms of trade as indicated by its score in trade integration as five. Since we are taking four indicators and Poland is fairing abysmally poor in three of this four indicators, we can say that Poland is not presently ready for a Euro Adoption. 5. Conclusion: We have seen the Polands stand on Euro Adoption from the perspective of its Economic integrity with EU17 using a macroeconomic model. Now, from an intuitive perspective, one can

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say that the PIGS and Sovereign Debt Crisis had deteriorated the overall economic integration within the EU zone. Industrial orders in the Euro zone fell by 6.4% in September, the steepest decline since the 2008 crisis. As many major players of the EU zone are in debt and are facing a tough situation in improving their own Economy and the European Central Bank is reducing its rates day by day, it wont be a realistic approach to impose severe restrictions on the Polish economy amidst this crisis. Hence, the next one or two year period (2011-2013) may not be the best time for the Euro adoption. Only a monetary policy run by Polish national authorities can effectively maintain Polands prevailing economic improvement. By European standards, Poland is a big country with a strong demand for domestic goods which keeps the economy humming. Besides when domestic demand has faltered, exports to the rest of Europe which accounts for 40% of their economy will help to pick up the slack. Recently many new private sectors have been developed in Poland because of its low cost of labor and production. So, From Polands GDP figure and its recent economic opportunities, it can be said that Poland is expected to see some growth in near future which can make its economic integration even better than the present thereby increasing the Polands gains from Euro Adoption. Moreover, waiting for couple of years will also help in making the EU stabilize thereby reducing the Polands losses from Euro Adoption. So, based on the theoretical analysis and the current economic scenario in Europe, it can be said that although being a Euro Zone member provides stability to a country in long term, Poland must wait for the economy to recover before adopting Euro. 6. Bibliography: 1. Roman Horvth and Lubo Komrek*, (2009), Optimum Currency Area Theory: A Framework for Discussion about Monetary Integration 2. Yin-Wong Cheung, Matthew S Yiu and Kenneth K Chow, (2007), Measuring economic integration: the case of Asian economies 3. Elias Dinopoulos and Iordanis Petsas, (2000), Greece and the Euro, Paper by University of Florida CIBER for Economic and Financial Developments in the Era of the Euro