1

Meeting Maastricht:
Nominal Convergence of the New Member States
Toward EMU


Pierre L. Siklos*
Department of Economics
Wilfrid Laurier University
Viessmann European Research Centre


[August 2009]
Please do not quote or cite without permission






* Part of the research for this paper was done while I was visited the European Commission under the
Directorate General Economic and Financial Affairs (DG-CFIN) Visiting Fellows program, January
2008 (contract No. 309/2097/S12.483468), and held the Bundesbank Foundation Chair at the Freie
Universitt, Berlin, from October 2008-March 2009. Comments from seminar participants at DG-ECFIN,
detailed and constructive comments from four anonymous referees, as well as helpful discussions with
Lars Jonung and Istvn Szkely, also improved the paper. Additional results not presented in the paper are
relegated to an Appendix available at http://www.wlu.ca/sbe/psiklos.





2



Abstract
This paper estimates whether the New Member States (NMS) that joined the EU in 2004
have achieved a form of inflation and long-term interest rate convergence. Using quarterly data
from the mid-1990s, convergence is evaluated through a series of unit root and cointegration
tests. Both univariate and panel tests are performed, including tests for a large number of
combinations of inflation and interest rates satisfying the Maastricht inflation and long-term
interest rate criteria. It is generally found that nominal convergence in inflation has been attained
among the NMS. There is, however, less evidence of convergence in long-term interest rates.
Possible exceptions include Estonia and the Czech Republic and, to a lesser extent, Slovakia
which has since joined the euro area. There is also a large degree of consistency between the
various unit root and cointegration tests in both the univariate and panel variations.


Keywords: convergence, unit root, cointegration, new Member States
JEL Codes: E31, E42, E58, C22, C23
Pierre Siklos, e-mail: psiklos@wlu.ca, Home Page: www.wlu.ca/sbe/psiklos


1
1. Introduction
The Maastricht Treaty, notably the inflation criterion
1
, has been viewed as critical to the
successful launch of the European Monetary Union (EMU), and the euro. A drop in inflation
worldwide, as well as the political will to carry out the project of monetary unification, also
tipped the balance in favour of success. As 2009 began, the euro area expanded to 16 countries,
with six of ten accession countries (new member states, or NMS) that joined in 2004 still in the
euro adoption planning stages, with many likely to remain in that state for some time.
2
Adoption
of the euro is mandated by the enlargement process.
3

Other than Cyprus, Malta, and Slovakia, which entered the euro area in 2008 and 2009,
intended EMU membership dates of almost all new EU members have proven to be overly
optimistic. von Hagen and Traistaru-Siedschlag (2006, Table 1) suggest euro adoption dates
ranging from 2008 to 2010 for all but one of the accession countries.
4
However, on both
economic and political grounds, euro adoption by the 7 remaining new EU members may be
delayed.
5


1
The macroeconomic, or convergence, criteria are specified in Article 109(j) of the Maastricht Treaty
(http://www.eurotreaties.com/maastrichtec.pdf). A brief background on the history of the Treaty can also be found
in Siklos (2008).
2
For convenience, this study refers to the EMU-13 as the euro area member countries as of December 31, 2007.
they are: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands,
Portugal, Slovenia, and Spain. Denmark and the U.K. have relied on an opt-out clause to remain outside the euro
area while Sweden has apparently exploited a loophole (De Grauwe 2007), as well as having politically rejected
the euro (Jonung 2004), to stay out of the euro area. The new EU members consist of : the Czech Republic, Estonia,
Cyprus, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia. Bulgaria and Romania, both joined the
EU in January 2007, are not considered in this study due to data limitations.
3
Once membership in the exchange rate mechanism (or ERM II, as it is called) has lasted for two years without a
devaluation. ERM II describes the exchange rate regime for EU members outside the euro area in preparation for the
adoption of the euro. The latest agreement, in 2006, can be found at
http://www.ecb.int/ecb/legal/pdf/c_07320060325en00210027.pdf.
4
Poland has no official intended date for adoption. Hungary and the Czech Republic have not officially joined ERM
II.
5
The decision by the European Central Bank (ECB) and the European Commission (EC), to deny entry into the euro
area to Lithuania, in part because of a failure to meet the inflation criterion by 0.1% may also have discouraged
entry into the euro area among the NMS. In reaching this decision the responsible bodies excluded episodes of
negative inflation thus artificially raising the countrys reference inflation rate.
2
There continues to be an outpouring of research on the general question of convergence.
The present study follows a purely statistical approach in order to focus attention on the process
of meeting two of the key convergence criteria named in the Treaty, namely the inflation and
interest rate thresholds. Ultimately, both the ECB and the EC will also focus on the question of
nominal convergence, for good or ill, as these are the only criteria that open the door to euro
adoption.
6
Using quarterly data from the mid-1990s, nominal convergence is assessed through a
series of unit root and cointegration tests. It is found that nominal convergence in inflation has
been achieved among the NMS. There is somewhat less evidence of convergence in long-term
interest rates. Although not, strictly speaking, comparable to the Convergence Report procedure
(see below), the time series approach does provide an indication of the likely success at meeting
the salient Maastricht criteria.
The rest of the paper is organised as follows. Section 2 provides some background about
the scope of the study and a brief review of the related literature. Section 3 describes the
methodology of the paper. The data and empirical results are discussed in Section 4. Section 5
includes a summary and concluding remarks.
2. Scope of the Study and Related Literature
This paper focuses exclusively on the following two Maastricht Treaty criteria applied to
the NMS:
Inflation rates must not exceed 1.5% of the average of the three best performing member
countries with respect to price stability;

6
Arguably, real economic convergence is of greater concern for purely economic reasons. Lein et.al. (2008)
consider the progress made in real convergence along one dimension, namely productivity growth. However, they
also point out that EU membership, combined with the prospect of entry into the EMU, produces offsetting
implications regarding price level convergence. Mixed evidence is generated regarding the current state of real
convergence for the NMS. Clearly, the decision to join the euro area indirectly involves real convergence. Formally,
however, only nominal convergence matters.
3
Long-term interest rates must not exceed 2% of the average of the three best performing
member countries with respect to price stability.
It has now become conventional wisdom to argue that a price stability objective is
synonymous with good monetary policy while the interest rate objective is supposed to signal the
durability of the existing inflation regime since changes in long rates reflect changes in
inflationary expectations.
Convergence is defined here by relying on the well-known and widely used concepts of unit
roots and cointegration. Hence, convergence amounts to asking whether there exists a single
stochastic trend shared by all series. For example, if all 10 of the most recently admitted
members into the EU share a common stochastic trend in inflation rates and interest rates, then a
finding of nine cointegrating vectors implies a single common trend. This means that the linear
combination of these series is mean zero stationary. A single stochastic trend is, therefore, one
possible interpretation consistent with the notion of convergence. However, as we shall see, care
must be taken in identifying unit root and cointegration behavior with the convergence property.
Moreover, it is not at all obvious that all the NMS should be treated as a single block.
Unit root tests are used to determine if the resulting time series are stationary, based on
the differential between each countrys inflation or interest rate and the reference value mandated
by the Maastricht Treaty that are pre-conditions for membership in the EMU.
7
More
importantly, some of the unit root tests reported below are based on the use of covariates
(Hansen 1995). Covariates are variables chosen according to economic theory, and presumably
correlated with the time series under investigation. After all, it comes as no surprise that success
at meeting the Maastricht Treaty criteria depends on the behaviour of a constellation of

7
The fact that the hypothesis is expressed in terms of inflation has implications for the time series properties of the
price level. We return to this issue below.
4
macroeconomic aggregates that influence inflation and interest rates.
8
For this reason, the search
for structural breaks is eschewed in the present study.
Unit root tests using covariates have been shown to possess more power, and may also be
more economically useful for the question whether certain aggregates can better explain the time
series properties of inflation or interest rates. To complement the univariate analysis, tests in a
panel setting are also considered. Clearly, there is a possibility that the currently excluded
members of the euro may join temporally closely to each other, perhaps by virtue of the fact that
they all lie to the east of the existing EMU-13. Also, many of the countries in question share
common borders not to mention a common entry date into the EU. While the span of the data set
is comparable published tests of this kind (e.g., see Lein et.al. 2008) panel tests also assist in
establishing the robustness of the results. Finally, we turn to cointegration testing. Siklos and
Wohar (1997) and, more rigorously, Pesaran (2007a), show that convergence requires that all
pairs of time series be cointegrated.
A variety of approaches have been adopted to study nominal convergence. Studies that
estimate the determinants of inflation, or inflation differentials, via cross-section or panel studies
come closest to the approach followed here. Another strategy is to examine either the persistence
properties of inflation (e.g., see Galati and Melick 2006, Franta, Saxa and mdkov 2007, and
references therein), or assess the cross-sectional determinants of inflation differentials as in, for
example, Hammermann and Flanagan (2007).
9


8
Needless to say, this approach is far from being the only one. For example, one could instead ask whether the time
series in question have a unit root, or are cointegrated, subject to some kind of structural break that upsets the
stationarity property. However, there is a continuing controversy over the ability of existing tests to precisely date
the location of the break, not mention the possibility that there may be multiple breaks (e.g., see Bai and Perron
2006). This aspect of the problem of testing for convergence is left for future research.
9
Related to this question is the extent to which domestic versus global factors drive inflation differentials. See, for
example, Mody and Ohnsorge (2007), and Borio and Filardo (2007).
5
Busetti et al (2007) consider inflation convergence among the first 12 countries to
introduce the euro in 1999. They split their sample into two groups: pre-1997 and post-1997,
which is the year that the Maastricht criteria had to be met to qualify for euro adoption. They
apply a variety of unit root tests to inflation differentials for each pair of countries to test for
absolute convergence (i.e. inflation differentials converging to zero) and find evidence of
converging inflation rates between 1980 and 1997. When performing the unit root tests, the
intercept term is omitted since this is believed to increase the power of the tests largely because
the test equation (see below) contains one less coefficient. As such, the test is for absolute
convergence so that the inflation differential would be zero (on average) under the convergence
hypothesis. The authors conclude that the countries in the sample can be sub-divided into
clusters of low, mid, and high inflation groups. Accordingly, there is not complete convergence,
especially after the exchange rate mechanism was changed.
Camarero et al (2002) analyse the convergence properties of interest rates using quarterly
data from 1980-1996 for the original countries that joined the EU, including the UK, Sweden and
Denmark, which did not to adopt the euro. They identify and test for two forms of convergence,
namely long-run convergence and catching-up. Long-run convergence means that the countries
have already converged, whereas catching-up refers to the narrowing of the interest rate
differentials, that is, countries are in the process of converging. The degree of convergence is
determined by testing for the presence of both a stochastic and a deterministic trend, using unit
root tests of interest rate differentials. Camarero et al (2002) define the inflation differential in
relation to the interest rate criterion set out in the Maastricht Treaty, as well as vis--vis
6
Germany.
10
They find that long-run convergence exists for five countries, while six countries are
in the process of catching-up, and three are not converging at all (Finland, Portugal, and Italy).
Siklos and Wohar (1997) also resort to the cointegration methodology to consider the
convergence property of the data. However, they clarify the link between cointegration and
convergence. Most notably, convergence is consistent with a particular cointegrating vector,
namely (1,-1) in the bivariate case. This is the statistical equivalent of stationarity in inflation
differentials.
11
Moreover, in a multivariate setting, convergence has a common trends
representation. That is, if convergence between n countries is investigated, convergence requires
n-1 cointegrating vectors or one common trend. Siklos and Wohar (1997) consider the
convergence of inflation rates and interest rates in seven EU countries (five of which are
currently EMU member countries) as well as Canada, the U.S. and Japan. With respect to
interest rate convergence, the cluster of countries that were among the first wave of EMU
members show evidence of one or two cointegrating vectors for the 1981-1995 sample. These
results are not indicative of convergence.
Relatively less empirical work has been done on the convergence properties of data from
the NMS. Data limitations pose a significant problem. Holz (2006) tests for interest rate
convergence in Central and Eastern European (CEE) countries using an error correction model.
The CEE countries include all the so-called accession countries that joined the EU, with the
exception of Malta and Cyprus. Estonia and Slovenia are also excluded since no long-term
interest rates data were available for Estonia, while data for Slovenia are only available
beginning in 2002. Slovakia is the only country to show evidence of cointegration with the

10
However, they do not specifically identify how the Maastricht long-term interest rate criterion is actually
calculated in their study.
11
Horvath and Watson (1995) demonstrate that tests for cointegration have relatively more power when the
cointegrating vector is specified a priori.
7
EMU. The validity of these tests is clearly in question, as cointegration tests require a long span
of data and only five years of data were employed. Other studies, such as Koenda (2001), Kutan
and Yigit (2004), Koenda, Kutan, and Yigit (2006), also examine the convergence properties of
macroeconomic data for a variety of NMS. No firm conclusions are reached. Again, the
benchmarks used are either Germany, or some combination of EU member states.
Weber and Beck (2005) test for convergence in inflation rates among six EMU countries.
Using data for the 1995-2004 period, they report that once a country has met the Maastricht
criteria, it will loosen the policies in place and converge at a slower rate.
3. Methodology
According to the Maastricht Treaty, EMU membership requires comparison with the
performance of the average of the three Member States with the best inflation record and long-
term interest rates.
12
For example, the May 2007 convergence report relies on the April 2006 to
March 2007 period to arrive at an inflation reference value of 3%, which is 1.5% above the
arithmetic average value of inflation in Finland, Poland, and Sweden, then the three countries
with the lowest inflation rates.
13
As such, when testing for convergence, it follows that each
country should be compared to the EMU criterion.
3.1 Unit Root and Panel Unit Testing
The existence of a unit root in the differential between the series indicates that there is no
convergence since the two variables do not then share a common trend. Therefore, the absence
of a unit root implies convergence in the sense just described.

12
There is no certainty as to the timing of convergence reports. The ECB is required to report to the Council of the
European Union at least once every two years, or at the request of a Member State. The European Commission (EC)
is given the same mandate, and two reports are submitted to the Council in parallel. Convergence reports have been
published since 1998, with the last three in May 2006, December 2006, and May 2007, and again in 2008 which saw
a convergence report that led to a recommendation that led to Slovakias entry into the euro area in 2009. See
www.ecb.int/pub/convergence/html/index.en.html.
13
When no long-term interest rate data are available, a broad analysis of financial markets is conducted.. (ECB
2007, p. 13).
8
The most frequently used unit root test is based on the Augmented Dickey Fuller (ADF)
specification. Nevertheless, a large variety of unit root tests exist, owing to the relatively low
power of the ADF test, among several statistical issues that have been raised in connection with
unit root testing (e.g., see Maddala and Kim 2003). In its most parsimonious form the ADF test
equation is written
1
1
o | c

=
A = + A +

p
t t i t i t
i
y y y (1)
where y
t
is the time series under investigation, defined as inflation in a country relative to the
Maastricht Treaty mandated reference value, A is the differencing operator (i.e.,
1 t t t
y y y

A = ),
and the distributed lag of the dependent variable captures remaining serial correlation in the time
series. Schwarzs Info Criterion (AIC) is one of several available criteria that may be used to
select the lag length in the augmented part of the test equation (see below) and is the preferred
choice under the circumstances, in large part to economize on degrees of freedom.
14
Equation
(1) has no constant or deterministic terms. The possibility of a trend contaminating the
convergence test is another complication (e.g., see Pesaran 2007a).
15
The role of the constant
can also be problematic. If the series in question is stationary, then o is statistically
insignificant, and there is convergence in the time series sense of the word. As previously noted,
a test of absolute convergence (e.g., as in Busetti et. al. 2007) would exclude an intercept.

14
In most instances, relying on the Akaike Information Criterion (AIC) produced the same lag lengths (results not
shown).
15
Elliott, Rothenberg and Stock (1996) propose the DF-GLS (and point optimal) test wherein the series are
detrended using GLS and the ADF test is applied to an auxiliary equation shown below.
1
1

o

=
A = + A +

k
t t i t i t
i
y y y u (2)
where
t
y

is the demeaned time series being investigated. More precisely,

2
1 2 1 1
, 1, ( )( ), (1, (1 ),..., (1 )) ', ( , ( ),...( )) ', 1 , 7,
t t t t t t t t T T
c
y y z z z zy z y y y y y y c T
T

| | o o o o o

= = = E E = = = + =


is the number of observations. Test results (not shown )based on this procedure did not qualitatively change the
conclusions in the overwhelming number of cases.
9
Clearly, however, there can be a form of convergence such that there is a constant differential
between the Maastricht criterion and a NMSs inflation rate. A negative shift, for example,
relative to the minimum acceptable inflation rate, would be consistent with the Treaty
convergence requirement.
16
The existence of this tolerance factor in the inflation criterion
suggests that absolute convergence, as defined above, is not the only condition that complies
with the Treaty requirements. A form of convergence, conditional on a constant differential, may
also be consistent with convergence.
Beyond the well-known limitations of the ADF test, perhaps the most striking is that only
the past history of the time series is used to make inferences about the unit root property of the
data. Hansen (1995) augments the ADF test with information from (stationary) covariates (also
see Elliott and Jansson (2003), and Caporale and Pittis 1999). The result is the so-called the
Covariate ADF or CADF test, which adds a correlated stationary variable to the test equation (1)
and this is shown by Hansen (1995), and Elliott and Jansson (2003), to considerably increase the
power of the ADF test. Hence, equation (1) becomes (again, omitting a constant, and
deterministic components)
1
1
p
t t t i t i t
i
y y x y o o | c

=
A = + A + A +

(4)
where (0)
t
x I A .
There is intuitive appeal to the CADF test since covariates should be economically
relevant variables that would be incorporated, for example, into a structural VAR type model. In

16
However, both the sign and the size of the constant may matter. Some of the tests considered do include an
intercept and it turns out that the role of the constant does not change any of the conclusions reported below. If, for
example, there is a permanent shift in the inflation rate this will bias the test towards the rejection of stationarity and
in favour of the unit root null hypothesis. Another possibility not considered below, is that there exists an asymmetry
around some equilibrium value. This extension requires testing in the univariate framework (e.g., see Enders and
Granger 1998, Enders and Siklos 2001). Extensions to the panel setting have not yet been developed. This extension
is also left for future research.
10
the context of a test for convergence in the spirit of the Maastricht framework, there are clearly a
number of excellent candidates that can serve as covariates. Romer (1993), and Gruben and
McLeod (2004), argue that openness is correlated with inflation, and is therefore an obvious
covariate candidate. The openness variable is usually defined as:
( ) Exports Imports
Open
GDP
+
= (5)
where Exports is the flow of the value of goods and services exported, Imports is the flow
of the value of goods and services imported, and GDP is nominal GDP. Other candidates as
covariates include of a measure of output growth (or the output gap), and a real exchange rate.
The latter is relevant in the present study owing to the impact of the Balassa-Samuelson effect in
the NMS (e.g., see gert et.al. (2006), Lein et.al. 2008). The CADF test, applied to the long-term
interest rate, would consider inflation or, rather, expected inflation, as a covariate. This is easily
motivated by the Fisher equation that captures the wedge between nominal and real interest rates.
Other covariates include the long-term interest rate in the euro area.
Panel unit root tests are considered next. Since all NMS joined in 2004, it is likely that
there will be some cross-sectional correlation in the behaviour of the time series under
investigation. Of course, the extent of the correlation may vary as there is potential variation in
the anticipated euro adoption dates. Pesaran (2004) proposes a simple test statistic to measure
cross-sectional dependence. In the present context, pair-wise correlations between the residuals
of individual ADF type specifications which omit a cross-sectional element can also be used to
derive the appropriate test statistic.
17
A version of a panel test performs an ADF test on each

17
Specifically, the following estimate of the average of the pair-wise correlations is obtained from
1
1 1
(2 / ( ( 1))

= = +
=

N n
jk
j k I
N N , where is the pair-wise correlation of the residuals across the countries (total =
11
country individually, and Im, Pesaran and Shin (2003; IPS) provide the critical values. The ADF
tests tend to have a downward bias, which is corrected for when a panel test is used. Generally,
if all independent parameter estimates are unbiased, then the mean of these estimates is also
unbiased (Enders 2004, p. 225). This version of the panel unit root test generates a test statistic
for each cross-section, as well as a country specific lag augmentation term. In contrast, if the
hypothesis that
'
o o =
j j
, where ' j j = , represent the unit root test statistic for two different
countries, and it cannot be rejected then an alternative formulation of the test specification (2),
where o (as well as | in equation (1)) are fixed across all countries results in the more
restrictive Levin, Lin, and Chu (2002; LLC) panel unto root test.
18

These tests are the standard ones used in the literature but they all have in common the
fact that the tests are designed for cross-sectionally independent panels. This could be a strong
assumption since all new EMU countries must meet the reference inflation rate prior to entry.
19

In the panel setting, there have similarly been several developments addressing the role of cross-
sectional dependence. Pesaran (2007) is a recent contribution that provides a brief overview of
the literature (also see reference therein). Assuming that there is a single common factor that can
be represented by the cross-section mean, he shows that the following specification tends to out-
perform other similar panel unit root tests in terms of power. The resulting test, called the cross-
sectional ADF test statistic (CS-ADF) is written as follows (omitting deterministic factors):
, 1 1
| o o q

A = + + + A +
jt j j j t j t t t
y y y y (6)

N) in the data set. The statistic for cross-sectional dependence (CD), is then evaluated as
1/ 2
( ( 1) / 2) TN N where
T is the total number of observations in the panel. The formula is slightly different if the panel is unbalanced.
18
LLC advocate removing the overall mean of the series (i.e., y ) prior to running the test. It is not immediately
obvious that this is necessary when the series under investigation is a differential between two existing series.
19
Since the timing of entry can be different this can have the effect of reducing cross-sectional dependence but may
not eliminate it entirely. Karlsson and Lthgren (2000) show that the power of the IPS and LLC tests is affected by
these considerations.
12
where the resemblance to the ADF specification should be clear except for the additional terms
that capture the cross-sectional mean and change in the mean, both lagged one period. We
continue to be interested in the ( , )
j
t N T on the parameter o
j
as an indication of whether there is
a unit root in the panel that consists of N cross-sections and T observations. Pesaran (2007a,
Table II) derives critical values and these are shown to depend on T/N. In the present application,
T/N ranges between 20 and 76.
3.2 Cointegration and Panel Cointegration Testing
The Johansen cointegration test is employed on each individual country and the EMU
variable, as well as in a panel, with all ten NMS pooled together. However, it is also sensible to
consider separate tests where Cyprus, Malta, Slovenia, and Slovakia, all recently admitted into
the EMU, are treated as belonging to one cluster (cluster #1) while the remaining NMS are
relegated to a second cluster of countries (cluster #2). The tests are run on the full sample
because the convergence process is assumed to have begun well before entry into the EU. As
with the unit root tests, the cointegration tests are run with an intercept only, and the Schwarz
criterion is used to select the lag lengths. The specification for the Johansen cointegration test is
written:
...
jt j 0 jECt 1 1 jt 1 p 1 jt p 1 jt
t o |t t t c
+
A = + + I A + + I A + (7)
where
jt
t is the inflation/interest rate of country j at time t,
jECt 1
t

is the error correction term, p is
the number of lags, Is are m x m matrices of unknown parameters and
jt
c is an error term. In
order for a country to be converging with the EMU benchmark, results must indicate evidence of
one cointegrating vector.
4. Data and Empirical Results
4.1 Data
13
The data, unless otherwise stated, are from Eurostat and are sampled or were converted
to the quarterly frequency. This includes data for the covariates (exports, imports, nominal GDP,
real exchange rates, debt to GDP ratio). All statistical tests cover the 1995.1-2007.4 period.
However, data limitations required generating some additional results for shorter samples (e.g.,
1996.1-2007.4). It is not straightforward to pinpoint an appropriate start date for unit root and
cointegration type tests. Ideally, cointegration testing requires a long span of data but this
ultimately depends on how quickly euro adoption is expected. When the 10 accession countries
considered in this study joined the EU in May 2004 the expectation was that euro adoption
would take place as soon as possible as this was viewed as arguably the most desirable element
of euro area entry. It is also known that negotiations for accession began soon after the candidate
countries began to liberalize their economies and modified legislation to conform to the EUs
acquis communautaire. Therefore, a mid-1990s start data appears reasonable as it excludes the
ERM crisis and avoids, though not entirely, the era of administered pricing. Inflation was
constructed from the raw Harmonized Index of Consumer Prices (HICP).
20
The annual inflation
rate is defined as:
12
100*(log log )
t t t
HICP HICP t

= (9)
As several of the covariates (e.g., Open, output gap) are only available at the quarterly
frequency, the monthly inflation figures were converted into quarterly data by arithmetic
averaging.
21
Since the Eurostat HICP data begin in 1996 data from the IMFs International
Financial Statistics (IFS) CD-ROM (December 2007 edition) for the calendar years 1994 and
1995 were used to supplement the price series. A check of the series (not shown) from the two

20
It is also worth pointing out that most time series studies of convergence rely on the IMFs CPI data, which is not
identical to the HICP that is used in the convergence reports.
21
Inflation estimates based on measurement at the quarterly frequency do not change the conclusions.
14
sources suggest few differences in the early part of the sample (e.g., 1996-1997).
22
Long-term
interest rate data, namely the yield on government bonds maturing in 10 years, were obtained
from the ECBs website because these are the rates used in evaluating whether member states
have achieved the relevant convergence criterion, as well as because one country, Estonia, does
not have comparable long-term interest rate data. Hence, the relevant proxy was constructed by
the ECB for this purpose (http://www.ecb.int/stats/money/long/html/index.en.html). These are
available since January 2001. Additional data from the IMFs IFS were spliced with the ECB
series to extend the sample back to 1997.
As the CADF test requires stationary covariates, either differencing or Hodrick-Prescott
(H-P) filtering was used.
23
Gaps were generated for the real exchange rate and real GDP using
the standard 1600 smoothing parameter. The real exchange rate variable is based on unit labor
costs as this was the definition available for the widest possible number of countries. There were
no comparable real exchange rate data for Slovenia. For the openness and debt to GDP ratio
covariate differencing was used to generate stationary series.
It was, of course, necessary to create a series that represents the inflation criterion in the
Maastricht Treaty. The following procedure was adopted. From the monthly HICP inflation
figures an annual inflation rate was created via simple arithmetic averaging. While convergence
reports can, in principle, occur at any time during a calendar year it is unlikely that more than
one will be published in one year. Next, the three lowest inflation rates in a given calendar year
were used to create the reference rate. To arrive at the reference values, negative inflation rates
were removed. In addition, only the EU-15 member countries inflation rates were used in the
period 1995-2003, inclusive. Thereafter, the sample of countries included in the calculation was

22
This appears less true in subsequent years though no formal statistical comparison was carried out.
23
The H-P filter has well-known deficiencies but is widely used. Alternative filters (e.g., band pass, Beveridge-
Nelson) have their own drawbacks.
15
expanded to the EU-25. If we take the ECBs reference inflation rate from the May 2007
convergence report, that is 3% (ECB 2007, p. 8), the procedure adopted here selects the same
countries (Finland, Poland, and Sweden) and produces a reference value of 2.85%. Other
reference values were also considered for the sake of comparison since there is inherent
uncertainty about which countries and what inflation rates will prevail in future. One obvious
alternative is the ECBs own inflation objective of below 2% in the rate of change of the HICP.
Alternatively, I took the three lowest values from the highest inflation rates on a monthly basis
recorded for each member state in a given calendar year to construct a maximum reference
value for inflation. I also constructed a minimum inflation reference value where the three
lowest monthly inflation rates within a calendar year for each country was the norm used against
which inflation rates across member states were compared. Finally, all of the above reference
values were also constructed using euro area wide data.
Figure 1 plots a variety of reference values together with the resulting convergence
criterion estimates for the long-term interest rate. By way of comparison, the shaded area
displays a range of 1-3% that is typical of inflation targets in many industrialized economies. The
ECBs 2% rule is meant to reflect the ceiling for its price stability objective. The Maastricht
criterion approaches but never quite reaches the ECBs objective. Only the minimum version of
the Maastricht definition reaches the ECBs goal but only on three occasions (1999, 2000, 2004).
Interestingly, 2004 marks the year when the NMS considered in this study joined the EU. All the
other alternatives produce substantially worse inflation outcomes. This is most clearly seen in the
third part of the Figure which shows that a euro area based calculation appears to result in a
permanently higher reference value relative to the ECBs own price stability objective.
16
Tests are based on the differential between the NMS inflation or interest rate outcome,
and the appropriate reference values, the series tested are defined as
=
M
jt jt t
d y y (10)
where
jt
d is the difference either between inflation ( ) t
jt
or the long-term interest rate ( )
jt
r in
country j, at time t, and the reference values denoted
M
t
y .
24
For the panel tests, the results
reported below are based on two clusters of countries. This is done mainly to differentiate
between countries that recently joined the euro area, namely Slovenia (2007), Cyprus and Malta
(2008), and Slovakia (2009). Figure 2 plots the inflation and interest rate differentials defined
above arranged according to the cluster definitions provided above. One sees the sharp
downward movement in the inflation differentials across all countries in the second half of the
1990s, although it is interesting to note that progress toward the Maastricht criterion appears
more pronounced among the second cluster of countries. At least half of the NMS in the first
cluster were achieving inflation records that were consistently around the reference value, an
indication perhaps of the sustainability requirement highlighted in the Maastricht Treaty
protocols. It is also the case that for the NMS in the second cluster of countries there is a
noticeable rise in annual inflation toward the end of the sample. This is also apparent, though to a
lesser extent, for the cluster 1 group of countries while, as Figure 1 reveals, average euro area
inflation is fairly stable after 2002. Turning to the interest rate differentials, we see that these are
almost all below the Treaty requirement.
25

4.2. Empirical Results

24
To economize on space only results pertaining to the Maastricht defined convergence rules are presented.
25
A particularly important problem with interest rate data is that while long-term rates are supposed to reflect
domestic inflationary expectations, in practice here are other factors that affect such rates including, of course,
liquidity and risk considerations but perhaps also the expectation that all the NMS are eventually required to join
EMU.
17
Table 1 provides test results concerning the univariate properties of the series of
differentials (i.e.,
it
d ). When openness is the covariate, 3 of the 4 member states inflation rate
differentials are found to contain a unit root.
26
In contrast, for only half of the second cluster of
countries (i.e., the last six countries listed in the Table; all are first Cluster countries) is there a
non-rejection of the unit root null, though it is worth pointing out that these non-rejections are
overturned when the DF-GLS version of the same test is applied (not shown). Since this test
applies a form of detrending which might be important under the circumstances (e.g., see Figure
2) it is still reasonable to conclude that while inflation differentials are I(0), reasonable doubts
can be raised for certain countries (e.g., Slovakia). Roughly, the same conclusion holds
approximately when the output gap is used as a covariate.
27
Similarly, other covariates, such as
the real exchange rate gap, produce some contradictory results relative to the standard, but
statistically less powerful, unit root tests (results not shown). It is likely that the stationarity
property is less a feature of the data for the Czech Republic, Estonia, Slovakia, and, possibly
Poland, than for the other NMS examined. Finally, it is instructive that when a shorter sample
that begins in 2000 is used, permitting the use of the debt to GDP ratio, the unit root hypothesis
cannot be rejected for six of the ten countries examined. The only rejections are to be found for
two of the four cluster 1 group of countries that have joined the euro area in 2008, namely
Cyprus and Malta. Since the debt to GDP ratio involves a shorter sample, the remaining tests
were also carried out again for the post 2000 period (not shown). The case against a unit root in
inflation is once again confirmed for all members of the first four countries listed in Table 1.

26
The case of Slovakia is overturned when the DF-GLS version of the unit root test is applied.
27
In principle it is possible to rely on more than one covariate at a time but owing to the span of the sample it is
likely statistically inadvisable to do so. Moreover, as these covariates are likely to be somewhat endogenous, it is
unclear that the simultaneous addition of several covariates will improve on the precision of the test.
18
Hence, it is possible that convergence is indeed a feature of the data for the countries that have
joined the euro area, and Slovakia, but this is not the case for the six remaining NMS countries.
Turning to the interest rate series, the results are overwhelmingly in favour of the finding
of a unit root in the interest rate differential. This implies lack of convergence. It should be
emphasized that this lack of convergence need not arise because
jt
d is too high in the NMS but,
as Figure 2 suggests, long-term rates may be too low relative to the Maastricht criterion.
28

Table 2 considers the test for cointegration based on pairs of series. In other words, the
test asks whether the linear combination of ( , )
M
jt t
y y is I(0) rather than directly testing the
stationarity property of the differential series. If cointegration is found, we can then test whether
the cointegrating vector has the (1,-1) property. If the cointegration tests are to be consistent with
the unit root tests then the pairs of series should be cointegrated in the case of inflation and not in
the case of the long-term interest rate. For countries in cluster #1, this conclusion holds up with
the exception of Cyprus inflation rate.
29
In cluster #2 cointegration is rejected for Lithuania,
Latvia and Poland. In a few instances the cointegration hypothesis was overturned when one of
the covariates in the unit root test was added as an exogenous variable in the cointegration test.
30

The convergence property of inflation is more apparent than in the long-term interest rate series.
Additional cointegration tests, also displayed in the Table, this time asking how many common
trends there are among the NMS clusters considered in this paper, suggest that the number of
common trends is sensitive to the inclusion of covariates. For example, there is evidence of

28
I also considered other covariates with no impact on the conclusions. I tried the long-term interest rate in the euro
area as well as well as a dummy set to zero prior to 2004Q2, and then set to 1 for the first year the NMS were
members of the EU, 2 for the second year, and so on. The conclusions reported in Table 2 are unchanged (results not
shown).
29
Before estimating each VAR, a test was conducted to determine the appropriate lag length. This was limited to, at
most, three lags due to data availability.
30
Once again, in order to economize on degrees of freedom, only one lag of the covariate in question was added to
the VAR.
19
convergence as defined in this paper, when the debt to GDP ratio is added. As noted previously,
this case applies to a shorter sample (i.e., post 2000). Otherwise, the results reveal relatively less
cointegration among the second cluster of countries which is a result compatible with the
previous cointegration and unit root test results. In contrast, there is a single cointegrating vector
among the first cluster of countries so that there is no interest rate convergence in this group.
However, the opposite conclusion is reached for the second cluster of NMS since five
cointegrating vectors are found, an indication that there is one common trend in long-term
interest rates among, the Czech R., Estonia, Hungary, Lithuania, Latvia, and Poland. When
cointegration is found, the estimates of cointegrating vectors return a (1, -1) verdict only for
Cyprus, Malta, Lithuania, and Poland.
31

Table 3 considers the above tests as before but in a panel setting.
32
The panel unit root
tests for inflation confirm the findings based on univariate tests, the panel tests. The CS-ADF
tests reveal a clear rejection of the unit root null indicating non-convergence for interest rates
while, interestingly, convergence is a feature only of the first cluster of countries. There is no
convergence for the second cluster of countries.
33
The panel cointegration tests also support the
earlier findings of inflation convergence. Similarly, the results of the panel cointegration tests
echo the univariate tests with three of the four cases considered consistent with non-convergence
in long-term interest rates.
7. Conclusions

31
Error correction terms suggest a fairly quick speed of adjustment for Cyprus and Malta (roughly 2 quarters), and
considerably longer adjustment (e.g., 8 to 13 quarters) for Lithuania and Poland (not shown).
32
A panel of all ten countries was also considered but the conclusions are not fundamentally changed, for reasons
that will soon become apparent.
33
The results tend to hold up even if the panel tests are run for a run or a sub-sample beginning in 2000 (results not
shown).
20
This study examines the time series properties of inflation rates and interest rates of the
New Member States that joined the European Union in 2004. Since the Maastricht Treaty has
set specific guidelines that countries must meet before entering the EMU, it is useful to
investigate whether these countries are in fact converging to the euro area member countries.
Moreover, since four of the ten NMS have recently joined the euro area the procedures used in
this paper can be judged against the much broader examination that all prospective EMU
members must go through before being admitted into the euro area. The approach taken in this
study asks whether each of the NMSs inflation and long-term interest rates has converged to the
reference value mandated by the Maastricht Treaty on the basis of a series of statistical tests. The
relevant tests are conducted in both the univariate and panel settings.
Overall, the results are suggestive of convergence in inflation but not of interest rates.
There is some question about whether inflation in the Czech R., Estonia, and possibly Poland,
violate the inflation convergence criterion. Nevertheless, what is clear is that the test for
stationarity is illuminated by including covariates, that is, economic variables that are
theoretically linked to the time series of interest. It is important to emphasize that the finding of
inflation convergence is a somewhat weaker requirement than the finding of convergence, or
non-divergence, in interest rates. Moreover, the non-convergence of long-term interest rates need
not imply that the NMS have not satisfied the requisite criterion as the evidence simply suggests
that long-term interest rates are, for the time being, permanently below the Maastricht Treaty
requirement. Whether this reflects what some believe to be the peculiar global behavior interest
rates in recent years is, of course, unclear. Nevertheless, and this is a salient conclusion of this
study, proper time series tests of convergence can serve as a useful short-hand expression of the
prospects of the remaining NMS joining the euro area.
21
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24
Table 1 Unit Root Tests
Country Inflation Long-term interest rate
Open ygap Debt REERgap Open ygap Debt REERgap
Cyprus -3.92* -4.13* -3.39* -4.35* -1.19 -1.17 -0.87 -1.08
Malta -1.14 -2.70* -2.74* -3.39* -0.61 -0.52 -0.38 -0.43
Slovenia -2.05 -1.65 -2.03* N/A -1.17 -1.09 -0.99 N/A
Slovakia -2.12 -2.09 -3.40* -1.98 -0.80 -0.77 -2.07 -0.29
Czech R -2.12 -1.99 -1.86 -1.66 0.13 -0.02 -0.29 0.06
Estonia -2.07 -1.79 -0.50 -2.33 -1.79 -2.12 -2.90* -2.38
Hungary -3.93* -3.53* -1.27 -3.80* -2.46 -2.20 -1.47 -2.27
Lithuania -4.94* -4.91* -0.56 -4.80* -0.80 -0.86 -0.72 -0.63
Latvia -5.05* -4.42* 1.05 -4.32* -0.87 -0.37 -0.70 -0.54
Poland -3.88* -4.04* -2.48 -3.47* -1.23 -1.19 -2.14 -1.96

Notes: The unit root null is tested, and * indicates rejection of the null. The test statistic for the CADF test with the addition of the
specific covariate shown. They are: the openness of the economy (OPEN), the output gap (ygap), the debt to GDP ratio (Debt), and the
real exchange rate gap (REERgap). The critical value is from Hansen (1995, Table 1) and is -2.57 at the 1% level based on correlation
that expresses the relative contribution of each one of the covariates to the ADF type test equation. The correlation coefficients are not
provided but they are available on request and range from a low of 0.88 to a high of .999. Series definitions and sources are provided
in the main body of the paper. The inflation and long-term interest rate series are expressed as differentials from the Maastricht
reference value whose calculation is described in the text.
25
Table 2 Cointegation Tests
A. Pairwise Tests
Country Inflation With Covariate Long-term
Interest Rate
With Covariate
Cyprus 17.76 (.01)* 3.00 (.85)
Malta 7.28 (.30) 16.12 (.01; ygap)*
14.65 (.02; Debt)*
4.42 (.65)
Slovenia 3.76 (.74) 24.66 (.00)*
Slovakia 7.78 (.25) 12.15 (.05; Debt)* 4.86 (.59)
Czech R. 4.32 (.66) 10.93 (.08) 14.92 (.02; Debt)*
Estonia 11.27 (.07) 12.62 (.04; Open)* 6.95 (.33)
Hungary 9.21 (.16) 18.10 (.01)* 8.42 (.21; Debt)
Lithuania 15.70 (.01)* 19.51 (.003)*
Latvia 12.32 (.03)* 9.04 (.17)
Poland 13.84 (.03)* 3.26 (.81)
Notes: Cluster # 1 consists of: Cyprus, Malta, Slovenia, Slovakia; Cluster # 2: Czech R., Estonia, Hungary,
Lithuania, Latvia, Poland. The number of cointegrating vectors in parenthesis are shown for cases where the
addition of an exogenous variables changes the number of vectors found above. The test statistic is for the null of
zero cointegrating vectors between pairs of series consisting of either inflation or the long-term interest rate and the
Maastricht reference value. Tests rely on the Johansen VAR methodology, as shown in the main body of the paper.
Except when the test statistic is in italics, in which case a VAR(1) is estimated, all other test statistics are based on
VAR(2), based on a variety of lag length selection criteria (e.g., AIC, SIC). The column headed by With
covariates provides the test statistic when a single lagged value of the covariate shown is added to the estimated
VAR. The critical values used are not, strictly speaking, appropriate under the circumstances, however. * indicates
rejection of the null that r=0 with p-values in parenthesis.

B. Multivariate Cointegration Tests
Group of Countries Inflation Long-term Interest Rate
Cluster # 1 (n=4) r=0, 37.69(.09)
r1, 12.44 (.67)
r2, 6.41 (.65)
r3, 0.13 (.77)
(r=1; Debt)
(r=2; ygap)
r=0, 57. 55(.0004)
r1, 22.63 (.08)
r2, 12.32 (0.70)
r3, 4.13 (.72)
Cluster # 2 (n=6) r=0, 196.97 (.0004)
r1, 97.15 (.000)
r2, 56.51 (.001)
r3, 22.30 (.09)
r4, 7.55 (.27)
r5, 0.20 (.71)
(r=4; Open)
(r=4; ygap)
(r=3; Debt)
r=0, 301.01 (.000)
r1, 138.98 (.000)
r2, 74.88 (.000)
r3, 40.32 (.0002)
r4, 17.10 (.01)
r5, 1.03 (.36)

Notes: see notes to Table 2A. r refers to the number of cointegrating vectors found (the number of common trends is
then n-r). For inflation and the long-term interest rate, the cointegration test is based on
it
d defined in the text, that
is, the inflation and interest rate differentials vis--vis the Maastricht reference value. Bold indicates the number of
cointegrating vectors, p-values in parenthesis.

26
Table 3 Panel Unit Root and Cointegration Tests
A. Panel Unit Root

Group of Countries Inflation Long-term interest rate
Cluster # 1 LLC (DF-GLS): -8.87 (.00)
IPS (DF-GLS): -10.67 (.00)
LLC (DF-GLS): -2.02 (.02)
IPS (DF-GLS):-4.36 (.00)
Cluster #2 LLC (DF-GLS): -8.50 (.00)
IPS (DF-GLS): -8.29 (.00)
LLC (DF-GLS): -3.45 (.00)
IPS (DF-GLS): -6.14 (.00)
Cluster # 1
CS-ADF
CY: -3.43*
MT: -4.91*
SI : -3.88*
SK: -4.98*
-4.93* CY: -1.93
MT: -1.96*
SI: -4.38*
SK: -3.85*
-4.94*
Cluster # 2 CZ: -2.07
EE: -3.38*
HU: -3.74*
LT: -6.64*
LV: -6.39*
PL: -3.61*
-6.82* CZ: -1.62
EE: -3.63*
HU: 0.35
LT: -1.75
LV: -1.88
PL: -2.10
-3.18*
Notes: LLC is the Levin-Lin-Chu test, IPS is the Im-Pesaran-Shin test. CS-ADF is the cross-
sectionally augmented DF test due to Pesaran (2007a; critical values in Table II), while
versions of the LLC and IPS tests based on the GLS detrending of Elliot, Rothenberg, and
Stock are the remaining tests given. P-values are given in parenthesis for the null of a unit
root in the panel. The text provides an explanation of the differences in the test
specifications.


B. Panel Cointegration Tests

Inflation Long-term interest rate
Cluster #1: 1.07 (.39)/2.00(.05)
Cluster #2: 9.43 (.00)/12.21 (.00)
Cluster # 1: 1.19 (.20)/2.38 (.02)
Cluster #2: 0.20 (.40)/1.80 (.08)
Notes: The test statistic is an Engle-Granger type test in a panel setting. The first set of tests
imposes a common autoregressive parameter while the second set of test statistics assumes
that individual AR parameters are estimated for each cross-section in the panel. See Table 1
for the definitions of the Clusters

27
Figure 1 The Maastricht Inflation and Long-Term Interest Rate Criteria
0
1
2
3
4
5
1996 1998 2000 2002 2004 2006
Ma a st r i c h t a r t i c l e Eu r o a r e a a v e r a ge
Eur o ar e:best of hi ghest Eur o ar ea:best of l owest
Maast r i cht ar t i cl e:best of hi ghest Maastr i cht ar t i cl e:best of l owest
ECB ' t a r ge t '
P
e
r
c
e
n
t
Var i et i es of Infl at i on Cr i er ia:Annual Basi s
0
1
2
3
4
5
6
7
8
9
1998 2000 2002 2004 2006
Maast r icht ar ticle Best of hi ghest Best of l owest
Var i et i es of Long-t er m i nt er est r at e cr i t er i a:Annual Basi s
P
e
r
c
e
n
t
0
1
2
3
4
5
1998 2000 2002 2004 2006
Eur o ar ea aver age
Eur o ar ea Maxi mum
Eur o ar ea Mi ni mum
P
e
r
c
e
n
t

Note: For a description of the sources of data and the detailed calculations, see the text.

28
Figure 2 Inflation and Interest Rate Differentials Vis--vis Maastricht Reference Value
-5.0
-2.5
0 .0
2.5
5.0
7 .5
10 .0
12.5
15.0
1994 1996 1998 20 0 0 20 0 2 20 0 4 20 0 6
Cy p r u s Mal t a
Sl ov en i a Sl ov ak i a
I
n
f
l
a
t
i
o
n

D
i
f
f
e
r
e
n
t
i
a
l
:

P
e
r
c
e
n
t
-10
0
10
20
30
40
50
1994 1996 1998 20 0 0 20 0 2 20 0 4 20 0 6
Czech R. Est on i a Hu n ga r y
Li t h u an i a Lat v i a Pol an d
I
n
f
l
a
t
i
o
n

D
i
f
f
e
r
e
n
t
i
a
l
:

P
e
r
c
e
n
t
-3
-2
-1
0
1
2
3
1998 20 0 0 20 0 2 20 0 4 20 0 6
Cy p r u s Mal t a
Sl ov en i a Sl ov ak i a
I
n
t
e
r
e
s
t

r
a
t
e

d
i
f
f
e
r
e
n
t
i
a
l
:

P
e
r
c
e
n
t
-3
-2
-1
0
1
2
3
4
5
6
20 0 0 20 0 2 20 0 4 20 0 6
Czech R. Est on i a Hu n ga r y
Li t h u an i a Lat v i a Pol an d
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Note: Sources and calculations are described in the text. The vertical bar in the top two figures
indicates the quarter in which the NMS became EU members.