US embassy cable - 05BRATISLAVA952

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. 
 
----------------------------- 
SURPRISING, BUT POSITIVE STEP 
----------------------------- 
 
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.) 
 
--------------------------- 
PARITY WEAKER THAN EXPECTED 
--------------------------- 
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. 
 
------------------------ 
MARKETS REACT POSITIVELY 
------------------------ 
 
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. 
 
------------------------------ 
PROGRESS ON MAASTRICT CRITERIA 
------------------------------ 
 
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. 
 
-------------------------- 
2009 TARGET STILL IN PLACE 
-------------------------- 
 
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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