How synchronized are Central and East European economies with the Euro Area? : evidence from a structural factor model

Abstract

A high degree of cyclical synchronization between central and east European countries (CEECs) and the euro area is generally seen as a pre-requisite for successful EMU enlargement. This paper investigates comovements between CEECs and the euro area. We first establish stylized facts on economic linkages using dynamic correlation and cohesion measures. By means of a large-scale dynamic factor model, we then identify the main structural common euro-area shocks and investigate their transmission to the CEECs in comparison to the current EMU members. We finally carry out a counterfactual experiment which allows us to assess costs and benefits of an accession to EMU for individual CEECs in terms of economic volatilities and implications of an enlargement for synchronization. Overall, our results are mixed. Dynamic business cycle and inflation correlations between CEECs and the euro area are lower on average than between individual EMU members and the euro area, but they are higher than for some small peripheral EMU countries. This is confirmed by our other measure, variance shares of output and inflation explained by common euro-area factors. The proliferation of euro-area shocks to the CEECs does not differ significantly from the propagation to EMU countries in most cases. Based on our counterfactual experiment, we do not find significant stabilizing or destabilizing effects through a common monetary policy and fixed exchange rates. We also find that business cycle synchronization between CEECs and between most CEECs and the euro area will increase. There seems to be considerable heterogeneity across CEECs implying that for some countries, accession to EMU would be more costly than for others. According to our analysis and based on our measures, Poland, Slovenia, Hungary and Estonia are more suitable EMU candidates than other countries.