ON MIDNIGHT November 25, Slovakia tied the crown to the euro and consequently entered the Exchange Rate Mechanism II (ERM II). The surprise move, taking place seven months earlier than originally planned, brought Slovakia another step closer to euro adoption.
The move is expected to boost Slovakia's economic credibility, lift the value of its financial assets, and disentangle the crown from the fluctuations of currencies belonging to the three other members of the Visegrad Four.
The crown was pegged at the prevailing market exchange rate of SKK38.4550 to one euro. According to Slovak Finance Minister Ivan Mikloš, the Slovak crown will be allowed to fluctuate in a band of plus or minus 15 percent.
"Unlike countries that joined the ERM II in 2004 or at the beginning of 2005, Slovakia has not taken any one-sided obligations limiting the flexibility of the exchange rate beyond the standard fluctuation band," Mikloš said at a press conference.
Slovakia entered the ERM II after reaching an agreement with countries within the euro zone, the European Central Bank, and the seven other members of the ERM II that are currently outside the euro zone.
"The success of our reforms and our ability to consistently meet the goals of our convergence programme made it possible for Slovakia to enter the ERM II so early," said Slovakia's finance minister.
Slovak officials believe that Slovakia's earlier-than-expected entry will give the country more time to prepare for euro adoption, which is officially scheduled for 2009.
The governor of the National Bank of Slovakia, Ivan Šramko, considers Slovakia's early acceptance into the ERM II to be a confirmation of Slovakia's hard work.
"I think this will sustain Slovakia's positive image abroad [as a fiscally responsible country], and certainly encourage investors," Šramko said.
According to the governor, entry into the ERM II is normally fraught with complications and delays. Šramko said the smooth negotiations that accompanied Slovakia's entry proves just how positive the macroeconomic developments in Slovakia are.
Slovakia received wholesale support from the countries that are gatekeepers of the ERM II.
"All the countries promptly agreed that Slovakia is meeting the criteria [to enter the ERM II] and that it is a real candidate for installing the euro in line with the national programme, which is January 1, 2009," Šramko said.
Slovakia is now in the so-called euro adoption waiting room, where, according to Maastricht rules, it must remain for at least two years.
Analysts say the surprise timing of ERM II entry is ideal. Officials have been able to avoid speculative pressure on the crown, for example.
"The earlier-than-planned entry also bodes well for the value of Slovak assets since it firms Slovakia's nominal convergence path. Near term it postpones increases in official interest rates," said VÚB bank's chief analyst, Zdenko Štefanides.
"Back in February and March, when the crown was under significant appreciation pressure, the markets were building up rumours that Slovakia would enter the ERM II in 2005. Meanwhile, the increased global risk aversion subsided and the crown resumed strengthening, risking that the parity would be set at levels that would be too high," Štefanides told The Slovak Spectator.
Igor Barát from Slovakia's central bank told The Slovak Spectator that fixing the crown to current market rates "reduces the risks of immediate losses or profits to investors, depositors, importers and exporters".
He continued: "In the case of other than a fixed market rate, some of the entities active on the market would suffer losses. Slovakia did not want to cause a shock to the foreign exchange market."
According to Štefanides, Slovakia will attempt to stay in the ERM II as short a time as possible - a minimum of two years.
"To us this makes sense. Why bear all the costs (of ERM II) without enjoying the benefits (of the euro itself)? If technically feasible, euro adoption in July 2008 would seem plausible to us," Štefanides said.
As for the risks of entering ERM II, analysts say Slovakia faces a great challenge as the first serious euro candidate from the new EU member countries.
"Slovakia's predecessors to the ERM II include countries with currency boards (the Baltics) or countries that are isolated from global financial markets (e.g. Slovenia)," Štefanides notes.
He added that although the initial market reaction has been positive, the accelerated financial convergence might backfire if it gets misaligned with real economic developments.
According to Štefanides, it is possible, given excessive currency pressure, that the authorities may resort to interventions on the foreign exchange and repo markets and suspend access to the NBS repo facility or even cut interest rates.
Standard & Poor's Ratings Services said that Slovakia's entry to the ERM II supported further improvements in sovereign ratings on Slovakia.
"On December 13, 2004, Standard & Poor's changed the outlook on the Slovak Republic local currency ratings to positive from stable, and maintained the positive outlook on the foreign currency ratings (both A-/Positive/A-2), based on the assumption of timely accession to the European Monetary Union (EMU)," the rating agency wrote.
Apart from Slovakia, ERM II members so far include: Estonia, Latvia, Lithuania, Slovenia, Cyprus, Malta and Denmark.
Prime Minister Mikuláš Dzurinda was happy to see the crown in ERM II territory ahead of its Visegrad Four partners.
"We came through thanks to the vigorous reforms we have implemented," Dzurinda told the news wire SITA.
"The sooner the European single currency is in Slovakia the sooner further economic growth and an increase in living standards will appear," he said.
The country's economic performance in 2005 has shown Slovakia in a favourable light within the EU. The country is well on its way towards euro adoption, lining up favourably with Estonia, Lithuania and Slovenia.
Economists agree that if Slovakia keeps up its current pace, it might become the first new member of the European Union to adopt the new currency. The greatest challenge that Slovakia faces is meeting the Maastricht criteria, which pertains to inflation, interest rates, public finance position, and exchange rate stability.
Slovakia will have to keep inflation under 1.5 percentage points above the average for the three best EMU countries (read countries with lowest inflation rates) while the long-term interest rates should be no more than 2 percentage points above the average for the three inflation-best EMU countries. The overall fiscal deficit should be no more than 3 percent of the GDP and the public debt no more than 60 percent of the GDP. The country also has to maintain the exchange rate within the ERM II for at least two years.
Slovakia currently fulfils two of the above conditions, those on interest rates and the public debt.
