Emerging Europe’s Euro Trap: IMF Finds Monetary Policy Losing Power in Euroized States

When inflation surged in the wake of the pandemic, central banks across Europe scrambled to rein in prices. But in parts of emerging Europe, the fight proved far harder. A new IMF working paper shows that in countries where households and firms borrow and save heavily in euros rather than in their national currencies, the ability of monetary policy to steer inflation and growth is deeply weakened. This phenomenon, known as financial euroization, is widespread in the Balkans and parts of Eastern Europe, and it undercuts the effectiveness of domestic monetary tools just when they are needed most.

The study, covering nine European economies between 2007 and 2023, finds that monetary tightening is only half as effective in highly euroized economies as it is in countries with independent financial systems. While Norway and Sweden see a sharp contraction in growth and inflation after a policy rate hike, countries like Serbia and Romania experience only muted effects.

Why Euroization Undermines Monetary Control

The IMF researchers explain that euroization erodes monetary policy through two main channels. First, when a large share of loans and deposits is in euros, interest rates on those products track the European Central Bank (ECB) rather than the local central bank. This directly disrupts the credit and interest-rate channels. Second, euroization often prompts governments to stabilize their exchange rates against the euro, blunting another vital transmission channel.

The result is a policy dilemma: central banks are forced to juggle inflation and exchange-rate stability, often pulling in opposite directions. As one earlier study cited in the paper put it, these countries face the “impossible trinity” of wanting monetary autonomy, exchange rate stability, and free capital flows, an equation that rarely balances.

Evidence from Nine Nations

The paper’s dataset spans Albania, the Czech Republic, Hungary, North Macedonia, Poland, Romania, and Serbia, alongside Norway and Sweden as benchmarks. The contrasts are stark. Figures in the report show that credit-to-GDP ratios in euroized economies are often below 40 percent, while in Norway and Sweden they exceed 100 percent. Exchange rate volatility is also far lower in euroized states, reflecting managed regimes.

The analysis uses Bayesian Structural Vector Autoregressions (SVARs) to estimate the impact of a standardized 100-basis-point interest rate hike. Results are striking: in Norway and Sweden, GDP fell by around 7 percent in the first quarter and inflation by 2.5 percent. In Serbia and Romania, GDP drops only 3 percent and inflation by about 1.5 percent.

Two countries buck the trend. Albania and North Macedonia, despite high euroization, show surprisingly large contractions after hikes. The IMF team suggests this may be because Albanian policy rates closely tracked the ECB during the tightening cycle, creating the illusion of stronger transmission. North Macedonia’s unique institutional setup may also play a role, warranting further research.

The Transmission Channels: Weak Links in the Chain

The paper dissects how euroization hampers three main transmission channels.

Exchange rate channel: In non-euroized economies like Poland, monetary tightening leads to currency appreciation, reinforcing disinflation. In heavily euroized states, currencies barely move, as central banks intervene to stabilize them.

Credit channel: After the pandemic, many euroized countries began raising rates before the ECB. The result was a surge in demand for euro loans as firms sought cheaper credit. In Romania, this substitution was so strong that total corporate credit grew despite domestic tightening. Charts in the report vividly show foreign-currency loans climbing while local-currency lending shrank.

Interest-rate channel: For loans denominated in local currency, the pass-through from policy rates to lending rates works well across all countries. But for euro loans, domestic policy is irrelevant; rates follow Frankfurt, not the national capital. In some cases, like Albania, the domestic and ECB cycles were so closely aligned that the distinction blurred. Yet overall, this disconnect explains why national rate hikes fail to bite in euroized economies.

Lessons for Policymakers: De-Euroize or Drift

The IMF paper’s conclusion is unambiguous: the more euroized an economy, the weaker its monetary policy. To regain control, countries need to reduce euroization through credible macroeconomic frameworks, stronger institutions, and targeted regulation. That means discouraging foreign-currency lending, encouraging savings in local money, and, crucially, allowing more exchange rate flexibility.

The authors stress that successful de-euroization is not only about low inflation, though that is vital. It also requires breaking entrenched expectations that the euro is the only safe hedge against risk. Deposit euroization and loan euroization, they argue, may require different strategies: the former addressed through credibility, the latter through regulation and incentives.

The study also raises a cautionary note. Synchronization with the ECB may temporarily mask euroization’s costs, as in Albania, but it risks leaving domestic economies misaligned with their own needs. Future research, the paper suggests, should examine whether exchange-rate stabilization itself has produced suboptimal inflation outcomes in euroized economies.