LONDON – Last week, central bankers from around the world assembled in Frankfurt to bask in the glory of the euro’s first ten years. But for those coming from euro candidate countries, the event was a cold shower. Just as the global financial crisis has made euro membership seem more urgent and necessary than ever, euro incumbents have started floating proposals that would raise the bar for entry.

Under the proposal that was openly discussed in Frankfurt, in addition to the macroeconomic Maastricht criteria that have been in place since the euro’s launch, the quality of a country’s banking system would be used as an additional criterion for euro entry. Leaving aside the hypocrisy of Western governments pontificating on this topic while they are bailing out banks after massive regulatory failures, the proposal is seriously flawed.

To fully appreciate the proposal’s absurdity, consider the extraordinarily successful East European growth model of the past two decades. The model advocated by Western Europe and embraced by Eastern Europe has been based on the idea that capital should flow from capital-rich to capital-poor countries. Economists have to go back to the nineteenth-century United States to find a similar textbook example of successful growth, with large current-account deficits financed mainly through foreign direct investment. Financial flows have been accompanied by unprecedented financial integration, with most East European banks now controlled by Western parents.

This model has worked remarkably well not just in generating growth, but also, as documented in the European Bank for Reconstruction and Development’s 2008 Transition Report , in improving the institutions that support markets and democracy in Eastern Europe. But it has also left these countries vulnerable to the twists and turns of global financial markets. Over the last year and a half, they withstood these pressures remarkably well; but, as the global crisis hits them with full force, they are now seeking help from the International Monetary Fund.

The main vulnerability in the current crisis has been massive exposure to foreign exchange movements. Actors in all parts of the economy, households and companies alike, have bet that their local currencies would continue to appreciate. Mortgages in Swiss francs and car loans in Japanese yen have been common throughout the region. But it was probably in Hungary, the first country to seek an IMF package, that these practices were most widespread.

Yet this vulnerability was largely created, or at least accommodated, by Western banks. The funding from the parent banks that in the earlier phase of the crisis helped provide liquidity to the East European banking systems now appears more as a liability and possible source of contagion. It was also the West European financial regulators and supervisors who, under “home rule,” were supposed to discourage these excesses. The penetration of foreign banks has also effectively deprived countries in Central and Eastern Europe of monetary policy tools, leaving them with little control over extremely rapid credit growth.

Add to this the impact of the current West European bank rescue packages on the banking systems of Eastern Europe. On one hand, these programs help promote stability by supporting the parent banks active in the region. On the other hand, the interventions have also undermined the East European financial systems. 

Governments in Eastern Europe cannot credibly match the broad deposit guarantees issued by their Western neighbors, and the generous recapitalizations have brought down Western banks’ relative funding costs, further weakening local institutions’ competitiveness. Finally, many governments explicitly or implicitly restrict parent banks’ ability to use government funds to back up their East European subsidiaries, many of them critical to the stability of the local financial systems.

To make the quality of the banking system a new criterion for euro membership is not only hypocritical; it is also counterproductive. Relatively high levels of inflation have been the main reason why euro membership was perceived as increasingly remote in most countries, and why the prospect of euro entry has had a diminishing impact on domestic reform efforts. A small consolation in the current crisis is that inflation rates are now coming down. More importantly, the crisis has demonstrated the value for these small economies of being part of a larger currency area.

Instead of exploiting the current opportunity of unprecedented leverage over euro candidates to push them to meet the Maastricht criteria, euro incumbents are contemplating a new and exceedingly vague criterion based on the quality of banking systems. And whose banks are these? Who are we kidding?