Buba - Best if euro hopefuls delay joining ERM-2

Frankfurt, July 21 (Reuters) - The Bundesbank said on Monday countries joining the EU next year should join the exchange rate mechanism ERM-2 -- a preparatory phase for the euro -- "later", putting off full membership of the single currency.

Ten countries mainly from eastern Europe are due to join the European Union next May and the euro a few years after that but the Bundesbank said in its July monthly report it would be "economically sensible" to keep exchange rates flexible by delaying membership in ERM-2, which bars currency swings.

"Most accession countries have already declared that they want to join the exchange rate mechanism as soon as possible after joining the EU. However, from the economic point of view, a question arises about the optimal timing of this step," the Bundesbank wrote.

Its report carried the sub-headline "Later membership of ERM-2 sensible given circumstances".

The 10 euro hopefuls must adapt their economies for the competitive onslaught membership in the single currency bloc will bring. This transformation process would be easier with a higher degree of exchange rate flexibility, the Bundesbank said.
"This is especially true for countries that only recently have liberalised their exchange rate regimes to obtain greater leeway for economic policy. Therefore the timing of ERM-2 membership should be carefully considered," it added.

EU rules say countries wishing to join the euro must demonstrate trouble-free membership of the exchange rate mechanism for at least two years before adopting the single currency, keeping their exchange rate stable within a +/- 15 percent band against a set euro parity rate.

The Bundesbank's recommendation contrasts with the official policy of countries like Hungary, which last week said it planned to join ERM-2 next May, when it enters the EU. Hungary wants to join the euro on January 1, 2008.

On the other hand, the Czech central bank last week said that country should stay out of ERM-2 for some time, targeting euro zone membership in 2009-2010.

Maintaining a stable exchange rate against the euro is just one of the criteria for entry into the euro zone. Candidates must also pass convergence tests for low inflation and long-term interest rates, deficit and debt limits and central bank independence.

Meeting all these requirements at the same time is difficult given the rapidly changing economies in many candidate countries and pressures from both investment and speculative foreign exchange flows.

Some accession country central bankers argue that it would be easier for their economies to adjust after joining the euro.

RULES ARE RULES

The Bundesbank also urged that accession countries should stick to European Union rules for fiscal policy and they must not be allowed to use more budget leeway than existing members to boost much-needed infrastructrure investment.

Critics of the EU's Stability and Growth Pact under which countries have to close their budget gaps over time have said accession countries should be given more fiscal policy room as they generally have low debt levels compared to the EU average.

"Exceptions to the way the Stability and Growth Pact is being applied would hurt the credibility of the rules and should be avoided," the Bundesbank said in the monthly report.

The 10 accession countries have to obey EU budget rules even though they have not yet adopted the euro, but unlike euro zone members cannot be fined when trespassing.

Bundesbank figures showed that budget deficits in most accession countries were well above the EU limit of three percent of Gross Domestic Product, although Slovenia and the three Baltic states, Latvia, Lithuania and Estonia, were already below the cap.
But debt-to-GDP ratios were already below the required 60 percent now -- a test many current EU members find hard to meet -- with the exception of the tiny island state Malta.

The ten mainly ex-communist countries planning to join the now 15-member strong EU are the Czech Republic, Cyprus, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia.

By Jonathan Gould and Douwe Miedema