By Gunter Deuber, RBI, Zrinka Zivkovic Matijevic, Raiffeisenbank Croatia and Emil Kalchev, Raiffeisenbank Bulgaria
Finally, the accession of Bulgaria and Croatia to ERM II and ECB-led Banking Union was completed last week. The local community is happy to finally belong more to the core Europe. At the EU level politics are also happy to have sent out a nice diplomatic signal – especially before the important EU summit this weekend. On the one hand, two countries are now being admitted to the euro waiting room, which at the same time receive substantial support under the new EU Multiannual Financial Framework (MFF) and the Next Generation EU (NGEU) instrument. In relative terms Bulgaria and Croatia are among the largest recipients inside the EU. Moreover, the Bulgarian and Croatian ERM II entry is a much-needed signal into the CEE region that the euro is a key tool to grow closer together in Europe over time.
However, the final euro area entry decision will be most likely based on a thorough analysis of the sustainability of convergence. Not to forget that from now on it will be even more closely monitored by the ECB and European Commission whether the reform drive will increase or slow down – the latter being a key concern of ECB. Here the dimensions of boosting competitiveness, resilience and institutional quality are key, while it remains to be seen whether public debt-to-GDP ratios can be easily put on a firm downward trend in 2021. In case of Croatia’s ambitious reforms to “reduce the administrative and financial burden for the economy through further simplification of administrative procedures and reduction of parafiscal and non-tax charges” will also be key. This task also includes a further restructuring of state-owned enterprises and all this has to be achieved in a challenging environment of COVID-19 related economic damages.
There are also some additional risk factors on the inflation and financial markets front. First, it is not given that the inflation criterion will be so easy to meet. It is precisely the small and open convergence economies of Croatia and Bulgaria that receive a lot of frontloaded EU money from the MMF and NGEU in the next few years to come. This could lead to considerable inflationary pressure here. This is especially true in case of Bulgaria with its completely fixed exchange rate and keeping in mind that this was possibly the trickiest Maastricht-criterion in the Baltic exchange-rate fixers. Secondly, Bulgaria and Croatia have made considerable political and reform commitments (so-called “post entry commitments”), which must be honoured in challenging macro-financial and socioeconomic times. And third, they are now members of ERM II at a stage where the ECB’s ultra-expansive monetary policy can induce substantial capital flows and capital outflow risks – in the case of unsound policies – on the ground. This is particularly important in the case of Croatia with its relatively high public debt ratio and its relatively liquid public debt market (compared to some other previous ERM II members).
All in all, there is a high chance that Bulgaria and Croatia can enter the euro area in the next five years ahead, while a fast-track entry in two and a half years is not a given thing. For such a scenario to play out many economic and political factors would have to interact in the best possible way. Moreover, on the side of the EU Commission and above all at the ECB, the length of stay in ERM II shall be possibly based less on the minimum duration of two years and more on the benefits for the reform and convergence process. After all, Bulgaria and Croatia have already spent quite some time to join ERM II after joining the EU in order to deliver on the reforming front and this does not necessarily suggest that a fast-track entry is now the most likely scenario. Moreover, the fact that they joined at the same time does not suggest that their final entry into the euro area will take place at the same time. But now let’s turn to the situation on the ground.
Croatia: High ambitions, mixed track-record and political tailwind
Croatia’s entry into ERM II and finally the euro area has become a strategic priority for (economic) policy makers. A firm commitment to achieving this goal resulted in entering the euro area lobby within just one year. However, finally adopting the euro will be challenging, and it would probably take more than some two years. Such a more sceptical view is based on several points of concern, including a less successful fiscal consolidation than one might superficially think as well as institutional concerns. Both aspects will be key in accessing the “sustainability” of “real convergence”. Every honest analysis shows: Croatia has made a little progress in improving the business environment and institutional quality in general, while fiscal consolidation has been achieved primarily on the revenue side. Keeping expenditures frozen might be judged as a success but this is not enough. Moreover, it could create an illusion of success as keeping fiscal consolidation with the same structure of expenditures, together with the poor rule of law, high bureaucracy and inefficient public administration, is a fragile and risky constellation in the long run. Therefore, it is crucial to ask several questions: what will be the future attitude of economic policy makers? Will the government have the strength to resist the pressures from competing claims on the strained budget? And finally, how long will Croatia be able to maintain an investment grade rating on the wings of joining the ERM II?
Doubts with regards to Croatia’s euro entry perspectives are also nourished by the modest projected recovery and the imbalanced growth model. The growth model has remained the same over time and will remain largely unchanged. The last crisis (6 years of recession/2009-2014) did not bring any significant reallocation of resources, the dependency on tourism has increased in the meantime. We do not see that this crisis will bring a reallocation of resources. So, once when Croatia starts to grow, it will grow again on tourism and possibly EU investments. We don’t see a very fast and strong growth, and as for tourism, we can expect only a very gradual recovery. Therefore, with moderate growth rates in 2021-2022 it is unlikely that public finances will once again be on a strong path of consolidation. Eventually, new tax reliefs have been announced and will require further reform moves in order to keep public finances under control and make the economy more resilient. Otherwise there remains always the risk that the budget criterion can be missed by a small margin depending on cyclical fluctuations.
On a positive note the results of the last parliamentary elections enable the ruling HDZ to have a stable majority in Parliament. Prime minister Plenkovic has already announced that the number of ministries shall be significantly reduced at the beginning of the new mandate and this might be a signal that some administrative reforms might finally take place. Moreover, one should bear in mind that the PM and the ruling HDZ are pro-European and will do everything to (at least) define the date of euro adoption before the next parliamentary elections (2024). For now, it seems there is strong support at the EU level – whereby the special and possibly only temporary conditions of the current political situation at the EU level mentioned at the beginning must be considered here as well.
Bulgaria: Demonstrators, EU authorities and ECB pull together
Bulgaria’s entry into the Banking Union and ERM II was expected and, from a local perspective, well deserved. However, it came at a very inopportune political moment, with widespread street protests against the government, the chief prosecutor and the political status quo. In fact, this strategically important decision sank into the noise of discontent in the streets. In the light of the necessary reforms after ERM II entry, this can even be considered a positive fact. Otherwise, in a situation of competing populism, the country’s path and the necessary efforts to introduce the euro could be possibly easily stigmatized with arguments and emotions such as: the future of the euro area is highly uncertain in any case because of the high level of debt of some of its members, membership would mean the loss of yet another part of the oh-so-important national sovereignty, prices would explode when the euro is converted, etc. Whereby rationally and market-oriented thinking Bulgarians and companies see the euro accession process also as a key anchor plus a framework that provides sensible checks and balances, i.e. obligatory control of the banking sector together with the ECB and in memory of the bankrupt fourth-largest lender (KTB), an irreversible civilizing orientation towards the EU, the elimination of the specific tail-risk on the currency side (i.e. the tail-risk of peg break in a severe crisis), logical end of the currency board (in force since 1997), use of foreign exchange reserves for necessary structural reforms (EUR 28 billion), access to cheaper financing, possibilities to support the banking system and the economy in case of financial difficulties, etc.
Of course, joining the euro area will require further targeted efforts by national authorities to implement agreed policies, including “major reforms in the judiciary and the fight against corruption and organized crime”, which is clearly in line with the demands of the demonstrators. There is no doubt that Bulgaria is indeed on its way into the euro area … but the road to reform could take much longer than 2.5 years. For the demonstrators and probably also the EU institutions, the reform perspective is more important than the minimum period of stay in ERM II. Usually there is a demonstration in front of the ECB and/or EU headquarters, in case of Bulgaria it seems that demonstrators and ECB will pull together in the same direction.
Gunter Deuber is Head of Economics, Fixed Income and FX Research at Raiffeisen Bank International in Vienna and designated Head of Raiffeisen Research.
Zrinka Zivkovic-Matijevic is Head of Economic and Financial Research at Raiffeisenbank Croatia.
Emil Kalchev is Head of Research at Raiffeisenbank Bulgaria.