Fitch comments on Eastern European euro adoption

On 21 March, the ECOFIN Council of the European Union announced some amendments to the Stability and Growth Pact. In particular, it has decided to allow the net cost of the reform of pension systems - from a publicly managed pay-as-you-go to a mandatory private sector fully funded system - to be taken into account in all budgetary assessments in the framework of its "excessive deficit procedures" (EDP). The costs will be taken into account according to the following formula: for the initial five years after a member state has introduced pension reforms, or five years from 2004 for member states that have already introduced reforms, with 100% allowance of the cost in the first year, 80% in the second, then 60%, 40%, 20% and 0%.

The allowance of pension costs as a relevant factor for the EDP has implications for the assessment of the Maastricht criteria, Fitch believes. Although the Maastricht budget deficit criterion is often understood to be 3% of GDP or below, this is actually the reference value under the EDP. The criterion itself is whether the EU Council deems that an excessive deficit exists. Fitch understands that a country could, therefore, meet the Maastricht budget deficit criterion even if it had a deficit above the 3% of GDP reference value. However, the Council would need to judge that any excessive deficit has been corrected, and as the pension cost allowance is temporary, Fitch understands that the Council would need to be convinced that the deficit - including pension costs - is on a clear downward path to 3%, and be "close to the reference value".

Poland is the greatest potential beneficiary as it has the largest pension costs (estimated at around 1.9% of GDP). For example, for 2007 (the year when Poland would need to meet the public finance Maastricht criteria in order to meet its current timetable of adopting the euro in 2009) it would need to reach a deficit (including pension costs) of only 3.8% of GDP rather than 3% previously. Fitch's forecast for the deficit (including pension costs) in 2005 is 5.8%, so in that case, Poland would need to reduce the deficit by a total of a further 2% of GDP in 2006-07 (rather than 2.8% previously), with a credible plan for a further 0.8% over the next two years. Therefore, its target date of 2009 now looks more attainable than previously. Nevertheless, it would still be extremely challenging and depend on the political will, composition and coherence of the government after this year's election. Fitch still views 2010 adoption as a more central expectation. The risk of a material delay beyond 2010 has, however, diminished.

For Hungary, pension transition costs are estimated at around 1% of GDP, so the pension cost allowance in 2008 (relevant to the government's 2010 adoption target) would be only 0.2% of GDP. Hungary's 2004 budget deficit was 5.4% of GDP, including pension costs, so it would need to cut the deficit by 2.2% of GDP (2.4% previously) over 2005-08 (as well as meet the other Maastricht criteria). However, Fitch expects little progress in fiscal consolidation until after the election in 2006, so its 2010 euro target remains challenging. A fiscal adjustment would be needed both for Fitch to revise the Negative Outlook on Hungary's LTFC rating of 'A-' (A minus) and for Hungary to meet its euro adoption timetable.

The change could bring forward Slovakia's euro adoption date to 2008 from 2009. Fitch had expected it to be able to meet its current target date of 2009 even without any changes to the EDP. The authorities have stated that a change in the target to 2008 was possible in the event of a favourable ruling on pensions. Pension reform costs are expected to be around 1% of GDP in 2006. With an 80% allowance, it would then only need to cut the deficit to 3.8% of GDP, which should be relatively straightforward. An advance in its prospective euro adoption timetable would likely have positive rating implications. Slovakia's LTFC rating is currently 'A-' (A minus) with a Stable Outlook.

There is no immediate impact on the Czech Republic as it has not yet started pension reforms. If it were to start reforms, however, then they would be less likely than before to delay the euro adoption timetable, other things being equal. Fitch expects the Czech Republic to adopt the euro in 2010 at the earliest.

Source: Reuters