Exchange rate variability as an OCA criterion: are the candidates ripe for the euro?

Are candidate countries in Central and Eastern Europe (CEE) ready to join the eurozone? Answering this question requires determining what values and indicators suggested by theory are acceptable in determining whether candidate countries are ready to join the eurozone.

According to the authors of the paper, empirical research has provided very mixed results which are not easy to interpret. Therefore, the authors attempt to explore the variability in real exchange rates that the candidate countries are experiencing at present, as one measure of whether candidate countries in CEE should join the euro.

The paper provides:

• an overview of the Optimum Currency Area (OCA) theory and the most commonly used OCA indicators
• empirical evidence on the conventional OCA indicators for candidate countries
• description of the methodology and data used for computation of the exchange rate variability indicator
• empirical results on the remaining variability in real exchange rates in Central Europe and the implication of these results.

Major findings of the paper are:

• the real and nominal exchange rates of currencies in CEE countries behave in the same way as that of Club Med countries during the early 1990s (which were found ready to join the euro as part of the initial group)
• at present the candidate countries already have an even lower degree of exchange rate variability than the "Club Med"
• the remaining variability of real exchange rates in Central Europe might be mostly due to the fact that nominal exchange rates are still a source of economic shocks
• the traditional OCA criteria, e.g. trade structure, do not seem to be related to exchange rate variability.

Based on their findings, the authors conclude that there is little evidence that the candidate countries need to undergo a lengthy period of real convergence before they should join the euro. The reason is that despite the still ongoing structural changes, the variability of Central European countries’ real exchange rates has been surprisingly low.