SLOVAKIA TIES ITS CURRENCY TO EURO

UNCLAS BRATISLAVA 000952

SIPDIS


DEPT PASS TO USTR FOR RDRISCOLL
TREASURY FOR AALIKONIS
USDOC FOR MROGERS AND STIMMINS

E.O. 12958: N/A
TAGS: ECON EFIN LO
SUBJECT: SLOVAKIA TIES ITS CURRENCY TO EURO


1. SUMMARY. On November 26, Slovakia entered the European
Exchange Rate Mechanism II (ERM-2),a minimum 2-year
probation period before joining the Euro, at a central rate
of 38.4550 SKK/EUR. The entry, which came several months
ahead of schedule, would make it possible for the country to
adopt the Euro by 2007-end, but Slovak authorities
reiterated their previous commitment to introduce the Euro
from January 1, 2009. Slovakia is the first of the four
largest new EU members to join the ERM-2. END SUMMARY.

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SURPRISING, BUT POSITIVE STEP
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2. In an unexpected move, Finance Minister Ivan Miklos
announced that Slovakia had as of November 26 joined the two-
year waiting room for the Euro adoption. The GOS had
initially planned to enter the ERM-2 in June 2006. According
to Miklos, "the earlier-than-planned entry should provide
the country with more time to prepare for introduction of
the single European currency". Slovakia is the seventh and
so far the largest EU newcomer to join the ERM-2 after
Lithuania, Latvia, Estonia, Slovenia, Malta and Cyprus.
Slovakia's regional peers, the Czech Republic and Hungary,
have put back the euro adoption deadline to 2010, while
Poland has yet to set a target date.


3. Miklos hoped that Slovakia's participation in ERM-2
would "keep its currency unit more stable, boost its
economic performance and, last but not least, send a good
signal to foreign investors". According to economists, the
earlier entry would limit the koruna's volatility before
2006 parliamentary elections. Importantly, it should also
isolate the unit from other central European currencies and
thus make it less vulnerable to economic and political
turmoils on neighboring markets. (NOTE: In the past, the
koruna has very often suffered from the turbulences in the
region, such as recently the recent political uncertainty in
Poland and continued fiscal worries in Hungary.)

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PARITY WEAKER THAN EXPECTED
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4. Under ERM-2, the Slovak koruna will be allowed to
fluctuate in a band of plus or minus 15 percent on either
side of the central exchange rate, which was pegged at
38.4550 SKK/EUR. This means that the crown shall trade
within a range of 32.6868 to 44.2233 against the euro before
the European central bank and the National Bank of Slovakia
must intervene to stabilize the unit. In spite of the fact
that Slovakia did not negotiate any unilateral exemptions,
experts expect that the Slovak authorities will seek to keep
the koruna within an effective asymmetric band of 2.25
percent on the weak side and 15 percent on the strong side.


5. The central parity was set in line with the current
exchange rate and many observers believe that as a result of
the earlier entry it is somewhat weaker than had been
expected. However, the ERM-2 mechanism allows for
revaluation of the central parity if needed, while
devaluation in the regime is not permitted. Furthermore,
the final conversion rate must not equal the chosen parity.
Economists expect the Slovak crown to gain between 5 to 10
percent over the next two years of convergence, which would
indicate the final conversion rate at around 36.00 SKK/EUR.

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MARKETS REACT POSITIVELY
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6. The entry into ERM-2 came as a positive surprise for the
foreign exchange markets. The Slovak crown strengthened to
a more than 8-month high against the Euro on Monday (37.812
SKK/Euro),enjoying its largest single daily gain since
September 2002. Currency traders explained that the
Slovakian membership in the ERM-2 was just another piece of
good news, which underlines country's overall economic
health. Importantly, the market saw the move as further GOS
commitment to continue its implementation of structural
reforms.

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PROGRESS ON MAASTRICT CRITERIA
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7. The main role of the ERM-2 mechanism is to test the
currency stability before the Euro adoption. During the
probation period of two years at minimum, Slovakia still has
to fulfill four other, so-called "Maastricht", criteria. As

outlined below, Slovakia is already meeting the requirements
on public debt and long-term interest rates, an should met
the fiscal deficit ceiling and inflation criterion by 2007.

-- BUDGET DEFICIT below 3 percent of GDP: Slovakia's public
sector deficit accounted for 3.3 percent of GDP in 2004 and
is projected to reach 3.25 percent of GDO in 2005, 2.9
percent in 2006, 3 percent in 2007 and 2.7 percent in 2008.
(Note: new EU entrants exclude pension-related spending from
their fiscal accounts until March 2007.)

-- PUBLIC DEBT of less than 60 percent of GDP: Slovakia is
well below the criterion with public debt of 43.8 percent of
GDP in 2004, and a projected public debt of 37.72 percent of
GDP in 2007.

-- INFLATION RATE within 1.5 percent of the three EU
countries with the lowest rate (0.9 percent as of October
2005): The average HIPC (harmonized index of consumer
prices) inflation rate in Slovakia as of October 2005 was
3.2 percent. The average CPI inflation is forecasted at 2.8
percent in 2005, 2.5 percent in 2006, and 2.0 percent in

2007.

-- LONG-TERM INTEREST RATES within 2 percent of the three
lowest interest rates in the EU (3.21 percent as of October
2005): The average long-term interest rate in Slovakia in
October 2005 was 3.25 percent, well within the convergence
criteria.

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2009 TARGET STILL IN PLACE
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8. Slovak authorities reiterated that the earlier entry
into ERM-2 has no impact on the target day for joining the
Euro itself. According to the National Strategy on Euro
Adoption from the July 2005 Euro roadmap, Slovakia should
officially introduce the single European currency unit on
January 1, 2009. The plan stipulates that following a 16-day
"dual regime" period the Euro will become the only accepted
currency in Slovakia as of January 17, 2009.


9. COMMENT. The Slovak currency is expected to stay within
the set boundaries given the strong trajectory of the
economy. Fulfillment of all other criteria to qualify for
the Euro will require Slovak authorities to pursue prudent
fiscal policy with high a degree of budgetary discipline and
continue the timely implementation of further structural
reforms. A great deal of responsibility for Slovakia's
final convergence result will thus be in hands of the future
government, which comes to office after the September 2006
elections. SUMMARY END.

VALLEE


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