SLOVAKIA TO ADOPT EURO IN 2009

UNCLAS SECTION 01 OF 02 BRATISLAVA 000216 SENSITIVE SIPDIS USDOC for 4232/ITA/MAC/EUR/MROGERS E.O. 12958: N/A TAGS: ECON EFIN EINV ETRD LO SUBJECT: SLOVAKIA TO ADOPT EURO IN 2009 ¶1. (SBU) SUMMARY: The European Commission's Convergence Report, released on May 7, recommended Slovakia for entry into the Euro zone as of January 1, 2009. The report noted that Slovakia's fulfillment of the Maastricht economic criteria (price stability, sound public finances, exchange rate stability and convergence in interest rates) is sustainable, confirmed that Slovak legislation is compatible with Economic and Monetary Union rules and stressed only "concerns regarding the sustainability of inflation convergence" as a future potential risk. PM Fico used the occasion to announce several new government measures to reduce the risk of speculative price increases that have been associated with other countries when adopting the Euro. The Convergence Report will next be discussed by EU finance ministers on June 2-3, and then by EU Heads of State at their Summit on June 19-20. The European Parliament will also provide an opinion in June. The formal decision will be taken by EU finance ministers on July 8, at which time the new Slovak Koruna / Euro conversion rate will be set. Slovak officials do not expect any difficulties with the remaining steps given the strong recommendation by the EC. The positive report boosted the Slovak crown, which broke through SKK 32 per Euro for the first time. End Summary CONVERGENCE REPORTS: MIXED MESSAGES, BUT NO DOUBT ABOUT RESULT -------------- -------------- ¶2. (U) In its May 7 Convergence Report, the European Commission (EC) said that Slovakia has met all necessary conditions for adoption of the Euro in 2009. The positive assessment was broadly expected, as Slovakia has easily met all the nominal Maastricht economic criteria. The European Central Bank (ECB) issued its own Convergence Report on May 7, which takes a more critical stance, noting that "there are considerable concerns regarding the sustainability of inflation convergence." However, the large buffer with which Slovakia met the inflation limit (12 month inflation in March was 2.2 percent, well below the reference limit of 3.2 percent) persuaded the EC that Slovakia's low inflation was based on sound fundamentals, and was not just accidental. Indeed, the EC forecasts (also released last week) showed that the Commission expects inflation to stay below the Maastricht limit in the forecasted horizon (till the end of 2009). Now it should take only formal procedure to get final approval by the European authorities. EU finance ministers are scheduled to take the final decision and set the conversion rate on July 8, 2008. EURO CRITERIA HAVE BEEN GOOD FOR POLICY -------------- ¶3. (U) The long-awaited green light was not seen as guaranteed even a couple of weeks before the official announcement. European institutions were more cautious during the assessment of Slovakia's Euro request for two reasons. The first is the lesson learnt from Slovenia, the first new EU member state, which experienced high inflation after entry into the Euro zone. The second reason was that Slovakia will serve as a benchmark for the assessment of other CEE candidates with flexible exchange rate regimes and relatively low price levels. Slovakia is one of the most open economies in the EU-27 in terms of the share foreign trade in GDP, almost half of which is done with Euro zone countries. The economic benefits have been strongly communicated, mainly by the National Bank. Also, the Ministry of Finance has been actively pushing the process forward, as a fixed timeframe was supportive in its consolidation effort. The argument "we want to adopt the Euro in 2009" has effectively reigned in government spending, which has surprised Smer's critics, who had assumed that Fico's social-welfare policies would lead to ballooning deficits. Without having an explicit goal to adopt the Euro in 2009, it is unlikely that this or any other government would have delivered such strong fiscal consolidation. DEBATE SHIFTS TO THE CONVERSION RATE AND POLITICS -------------- -------------- ¶3. (U) PM Fico used the EC's positive recommendation to begin his campaign for a strong conversion rate, noting that it "should be as advantageous as possible for the people." This is the prevailing view of the ruling coalition, which stressed that a strong Koruna/Euro rate "will be manageable by the business environment without any difficulties". The opposition SDKU, which initiated Slovakia's entry into ERM II in November, 2005, also supports a strong conversion rate, arguing that it will help to restrain price growth in the next couple of years. Outside of the business community, few are arguing for a weak convergence rate. The consensus view of major Slovak banks on the EUR/SKK final conversion rate for Euro entry on January 1, 2009, has moved to 31-32 EUR/SKK recently, with some analysts considering 30.3 EUR/SKK to be an equilibrium exchange rate. The official parity rate, which was revalued in March, 2007, is 35.44 SKK/EUR. ¶4. (SBU) PM Fico has been a strong supporter of Euro adoption since his post-election conversion in July, 2006, but he is now shifting his focus to minimizing any potential political fallout. In response to the DCM's May 8 congratulatory remarks that the EC's BRATISLAVA 00000216 002 OF 002 decision was good news, PM Fico, perhaps anticipating a negative reaction among his political supporters, responded with a shrug and a slight grimace, saying only: "We'll see." He made similar comments in a recent meeting with a large U.S. investor in Slovakia, noting that he "does not want the Euro to be (his) political suicide." ¶5. (U) A recent public opinion poll showed that almost three quarters of Slovaks fear the Euro will be bad for them due to associated price increases. Amid such concerns, Slovak politicians of all stripes will have to consider the potential inflationary effect in advance of the 2010 general parliamentary elections. On the same day as the EC and ECB reports were released, the cabinet announced additional measures to track pricing as well as to produce a monthly report on public opinion related to the Euro. PM Fico considers Euro adoption to be a "serious historic decision", but at the same recalls "respect for 'impacts'". His recent stump speeches include statements about "punishing those raising prices without valid reasons" and "classifying ungrounded price increases as criminal acts." REGIONAL VIEWS -------------- ¶6. (U) Fico also used the EC announcement to criticize the process for entering the Euro zone, arguing that the Maastricht criteria are unfair to new EU member states. The current definition of inflation criterion, calculated from the pool of all EU countries instead of just Euro zone members, is also criticized by economists. For comparison, the average reference limit since 1998 would have been 0.3 percentage points higher if it was based on EMU-12 and not on the EU-27. The stronger emphasis on sustainability is not clearly defined and therefore represents another challenge. Slovakia will enter the Euro zone as the member with the lowest price level, implying further price convergence as a side effect of income growth. The EC explicitly mentions in the report that Slovakia "has a potential for further price level convergence in the long-term, as income levels rise towards the EU average". The Koruna appreciation played a significant role in the process. Once the exchange rate is fixed, the only way to narrow existing price differences is through higher price growth at home than abroad. As a consequence, inflation in Slovakia is expected to be higher compared to Euro zone over the next 10-20 years. ¶7. (U) The positive assessment of Slovakia by the European Commission is viewed in the region as increasing the hope that the Euro zone project will not be stopped. However, analysts expect a long pause (at least three years) until the next CEE country qualifies for the Euro zone. A recent poll by Reuters shows market expectations about possible Euro adoption first in Lithuania and Estonia in 2012, than in Poland, Latvia and Czech Republic in 2013, Hungary and Bulgaria in 2014 and Romania in 2015. The assessment of Slovakia confirmed that nominal appreciation is tolerated within the ERM II and disinflation achieved partially thanks to currency appreciation can be acceptable. New member states share features that make them prone to above-average inflation, and meeting the price criterion when needed will remain a challenge. Specifically, their price levels have still not caught up to the Euro zone level, while their economic growth exceeds that of old Europe. COMMENT -------------- ¶8. (SBU) There is widespread relief throughout the government - and especially at the Finance Ministry and the National Bank - that Slovakia was able to overcome concerns about the sustainability of inflation and receive a strong recommendation from the EC. The Prime Minister, however, recognizes that he will have to share the upside of adopting the Euro with the opposition, who set the process in motion through economic reforms and early entry into ERM II, while Fico's Smer party is more likely to be viewed as responsible for the downside risk of inflation. Fico has made keeping food and energy prices down a center of his rhetoric for the past year, and is likely to continue his vigorous campaign for the foreseeable future. End Comment. OBSITNIK