UPDATE 1-Euro pegs pose challenges for new EU states-ECB

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New European Union members with currencies pegged to the euro may face a trickier path to adopting the euro compared to countries with more flexible exchange rates, top European Central Bank policymakers said.

Addressing an ECB seminar for central bank officials from new EU states late on Monday, Executive Board member Juergen Stark said countries with currency pegs had faster growth and inflation and this left question marks about whether their performance was sustainable.

Colleague Lorenzo Bini Smaghi said countries also sacrificed policy flexibility by tying their currencies to the euro and faced a particularly acute challenge in keeping the process of stable convergence on track.

"The key question for these countries is: how is it possible to keep inflation under control by pegging the exchange rate, which means adopting de facto the monetary policy of the euro area, especially since the euro area economy is growing at a rate that is less than a third of what a catching-up economy should aim to achieve? " he told the conference, according to a text published on the ECB's Web site on Tuesday.

Of the eastern and central European states which have joined the EU in the last four years, Bulgaria, Latvia, Lithuania and Estonia use a currency board system linked to the euro.

Stark said it was interesting to note that over the last two years growth in these countries had been almost twice as fast as the other new EU members and inflation 1-1/2 times as fast, despite economic theory suggesting the opposite.

Labour shortages were driving up wages, credit growth was rapid, house prices were booming and high private consumption boosted current account deficits.

"In principle, (this) could be seen as an indication that, for some of these countries, the current situation might not be sustainable," Stark said in his speech.

"This makes it all the more necessary to look more deeply at the macroeconomic developments and challenges ahead."

The 10 countries that joined the EU in 2004 and Romania and Bulgaria which joined this year are obliged to work toward joining the euro.

NO ESCAPE FROM REFORMS

The ECB has regularly warned that countries must bring their economies up to scratch not just at the time of euro entry assessment, but in a sustainable way.

So far only three -- Slovenia, Malta and Cyprus -- have passed the euro entry benchmarks on stable inflation, sound public finances, currency stability and market interest rates.

Lithuania narrowly missed qualifying for the euro in 2006 and aims to try again in 2010. Latvia does not expect euro entry until 2012-13, while Estonia and Bulgaria aim for 2011-2012.

Slovakia, which has a more flexible currency regime along with the Czech Republic, Hungary, Poland and Romania, hopes to be next to qualify to use the common currency starting from 2009.

Stark said the question of which exchange rate regime was the best suited for a stable convergence process had to be answered on a country-by-country basis but the answer did not absolve countries of the need for budget and structural reforms.

Countries with flexible exchange rates tended to have excessively high budget deficits and faced the risk of accelerating inflation as the catching-up process gained pace.

For these countries, Stark said, central banks had to be ready to raise interest rates to keep prices stable and fiscal consolidation was vital.

* To read the speeches, go to the ECB's Web site

http://www.ecb.int/home/html/index.en.html

* For a factbox on currency boards, please double-click on [ID:nL18869473]

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[FRANKFURT/Reuters/Finance.cz]