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ECB RESTATES INFLATION RISKS

Euro-enthusiasm sweeps markets

THE EUROPEAN Commission's approval of the country's euro-membership has left financial markets enthusiastic and predicting no serious complications in the months before Slovaks actually start using the single European currency.

THE EUROPEAN Commission's approval of the country's euro-membership has left financial markets enthusiastic and predicting no serious complications in the months before Slovaks actually start using the single European currency.

After the European Commission (EC) released its regular Convergence Report on Euro Readiness, the Slovak currency climbed to new heights, breaking the Sk32.00 barrier on the way to hitting a record level of Sk31.98 to one euro.

The European Central Bank (ECB) also published its own 2008 Convergence Report on Slovakia, restating its concerns about the risks of inflation in the country. State officials remain confident that Slovakia will be able to sustain its inflation below the required level.

Market watchers praised the benefits of the euro and attributed the EC's approval to the strong performance of the country's economy.

"The report is a culmination of the economic and, in fact, also the political efforts of Slovakia to adopt the euro," chief analyst with UniCredit Bank, Viliam Pätoprstý, told The Slovak Spectator. "We will now have to focus on the technical side of the transition."

The adoption of the euro should stimulate the country's economy and boost trade and investment, said Pätoprstý, adding that this is already happening to some extent since investors had already anticipated adoption of the single currency.

Mária Valachyová, a senior analyst with Slovenská Sporiteľňa bank, said that the EC's positive stance on Slovakia's entry to the eurozone had in fact been expected, since Slovakia has been meeting all the nominal Maastricht criteria.

"Only the sustainability of the criteria, mainly inflation, was disputed," Valachyová told The Slovak Spectator. "However, the EC assumes that up to the end of 2009 we should meet the inflation criterion. This was the relevant period for European institutions."

As for the benefits, Valachyová said that the euro will make Slovakia an even more attractive country for investors. The higher influx of investments should lead to technological progress and job creation, she added.

"Slovakia is an open economy and a large part of its foreign trade is with countries within the eurozone," Valachyová said. "By introducing the single currency, exchange rate risks will fall, along with the expense of managing them."

According to Juraj Valachy of Tatra Banka, the EC's report means that Slovakia will certainly switch to the euro as of January 1, 2009.

"The report itself says that there are risks that inflation will be higher than the inflation criterion, but it probably does not consider those serious enough to disqualify Slovakia from the race to join the euro," Valachy said. "At the same time, the European Central Bank has released its report, which does not have a clear conclusion and only warns about the risks of higher inflation and the need for greater consolidation of public finances."

According to the ECB, Slovakia's average harmonised inflation rate over the reference period, from April 2007 to March 2008, stood at 2.2 percent - well below the reference value of 3.2 percent. However, the bank notes that annual inflation has been rising in recent months, reaching 3.6 percent in March 2008.

"There are upside risks to inflation in Slovakia," the ECB said in its Convergence Report. "These relate first to the fact that the dampening effects on inflation of the trend nominal appreciation of the Slovak crown against the euro would fade away in an environment where the exchange rate would be fixed against the euro."

Tight labour market conditions and emerging bottlenecks in specific regions and labour segments pose a risk of accelerating wage growth, the ECB said. Energy prices are also potential risks to inflation, as the recent increase in global energy prices has not yet been fully reflected in consumer prices, the bank added.

"In sum, there are considerable concerns regarding the sustainability of inflation convergence in Slovakia," the ECB said in an official release.

Valachy said that for Slovakia the most problematic part was meeting the inflation criteria in a sustainable manner. However, an exact definition of sustainability was lacking.
However, Valachy notes, the European Commission's spring economic forecast for 2008 and 2009, released on April 28, has given a clear answer, since the EC says that inflation should remain under the Maastricht criterion for 2008 and 2009.

Now only the conversion exchange rate remains to be decided, Valachy said.

Fico targets strong conversion rate

The conversion rate which will be used to exchange Slovak crowns for euros should be the most advantageous possible for the people, Fico told the press adding that a strong conversion rate is a priority of his government.

While the governor of the National Bank of Slovakia (NBS), Ivan Šramko, refused to comment on the conversion rate he did confirm that Slovakia has been in a "very good dialogue" over the rate, which he said should be at a level causing no substantial problems for the economy.

"Our estimate is 32.3 [crowns to one euro], but different reports, mainly from political circles, favour the alternative of fixing the crown at the level just before the decision by the EU council," Pätoprstý told The Slovak Spectator.

According to Pätoprstý, this increases the probability that the conversion rate could reach a level stronger than 31.5, where he thinks the rate will then be.

Slovenská Sporiteľňa's Valachyová said she expects the conversion rate to be 32.0-32.5 crowns to the euro; while Tatra Banka's Valachy is also predicting a rate of Sk32.50 to one euro.

According to Valachyová, a weaker exchange rate could cause a temporary increase in the price of imported goods when converted to crowns, which would lead to higher inflation.

"This would later get reflected in higher wage demands, which would return the population's purchasing power to its original level," Valachyová said. "Temporarily we would have higher inflation and higher wage growth than with the optimal exchange rate."

Valachyová added that a weaker crown might also support the competitiveness of Slovak exports.
"This would however be only a temporary effect and after a certain time exporters would face higher wage demands from their employees, thus being forced seek ways to achieve higher productivity as they would in the case of stronger crown," she said.

Slovakia has the lowest GDP per capita of any country which has ever officially joined the euro.
Entry to the eurozone, and using all the benefits of entry, should in fact make convergence with more developed countries faster, said Valachyová.

"The only risk is that with higher growth we will have higher inflation than the old EU countries," she said. "From our point of view it does not really matter since even now Slovakia has been catching up with the price level of these countries, partly through the exchange rate and partly through inflation."

Since Slovakia's share of total European inflation is minimal, because Slovakia's economy is so small, our higher inflation will not cause any problems in the eurozone, Valachyová said.
The situation would be different if Poland were to enter the eurozone, since its greater size might mean higher inflation there could require adjustments in European monetary policy, Valachyová concluded.

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